Calculating Safety Stock
Safety stock is still a big part of our lives, despite the push to embrace just-in-time with goods arriving direct to the line the moment they are needed. Fantastic in theory, but with no room for error, and no buffer stock, just-in-time can be problematic, as Toyota found. Toyota famously only carried four hours of stock, but when a key supplier suffered a fire, car production stopped.
So, for most of us, safety stock is a modern-day reality. But how much to carry? Too much and we have money tied up, too little and delivery, service, revenue, and profit can be compromised.
Calculating safety stock is essential for determining the optimum amount of additional stock to have on hand for shortage prevention in the event current market demand changes. Although maintaining any amount of extra stock could theoretically protect a business from running out, there are many pitfalls to carrying too much stock, as well.
Striking the right balance is the key to limiting the amount of money tied up in inventory while preventing loss of customers, market share, and income due to underestimating need.
To safeguard against the hazards at either end of the spectrum, manufacturers apply a formula to calculate the correct levels of inventory to keep on their shelves.
On the one hand, not having enough materials to feed manufacturing can bring production to a halt when demand exceeds expectations. This could occur for many reasons: weather, logistics, or supply chain issues. It could be delivery issues of materials or ingredients, or it could be unforeseen sales demand. Either way it is a big problem that many of us wrestle with daily.
Having too much inventory not only ties up money, it consumes space that your warehouse may not be equipped to accommodate. If the materials or ingredients are perishable, then another world of problems starts to arise managing shelf life and potential waste.
There are several different ways to calculate safety stock levels for your products.
Finding the safety stock calculation involves determining the deviation from the average levels. If every factor were predictable, this wouldn’t be necessary, but lead times from supplier do vary. If reorder frequency doesn’t take the maximum amount of lead time into consideration, there are bound to be shortages. Lead time begins at the time of the creation of the purchase order and extends through to the time product lands on warehouse shelves. Normal leads times assume the supplier delivers in a set time frame. This is not always the case, hence the need for calculating the deviation from average delivery times.
We begin by summing up the varying times from normal lead times. For instance, if the lead time should be 5 days, and the product takes 6 days to arrive, the variance is 1.
Over a chosen time frame, the delivery could fluctuate over or under that number. If we monitor supplier performance and record the total the number of days late as positive numbers and days early as negative numbers, we come up with a difference of total number of days for actual delivery (as opposed to what we anticipated).
If we divide that number by the number of deliveries – we will calculate the average deviation. If we add that average deviation to the expected number of days to deliver, we now have a lead time that should be more realistic.
We then need to factor-in our desired service level to calculate safety stock.
Safety Stock Formula
Safety Stock = Desired service level x adjusted lead time x demand average (for time period calculated)
Desired service level is expressed as a percentage that represents the probability of filling an order on-time
The adjusted lead time is the lead time that accounts for late and early deliveries.
The demand average is average demand for the product
Next Step in the Equation: Demand
First decide on the time frame you want to work with. Many manufacturers use the time frame between orders to base their calculations. If you place orders once a month, then you will calculate the amount you normally order for that one-month period.
Add the sales volume for the entire one-month period. Divide that total by 30 and you will come up with an average daily sales volume.
The desired service level will fluctuate from business to business. Service level is expressed as a percentage that represents the probability of filling an order on-time. In the formula for safety stock, a corresponding service factor is applied in its place.
Retailers tend to aim for a 95% service level, a level that carries many risks, but is necessary in this sector. Each business must weigh the risks of stockouts versus the risk of having more funds tied up in inventory. The higher the value of the sale, the higher the priority to have it in stock, but the more money it ties up.
Once you have calculated your safety stock for a designated period, you can calculate the reorder point below which your systems should trigger a reorder.
Many factors affect demand, seasonality, holiday sales, weather, economics, and political climates can all play a role, so this is not an exact science.
Safety Stock Calculations Methods
- Our formula above represents the basic method preferred when product has been used for several years. It does not take other factors into consideration.
- Average/Max – Multiply the maximum sale times the maximum lead time. From that figure, subtract the average sale times the average lead time. This method includes the rise in demand which could occur over a period of time.
- Normal Distribution – this method is preferred for high sales volumes and factors in the probability of selling the same amount in the future as in the past.
SOS Inventory allows businesses to set reorder levels for all raw materials and supplies to prevent shortages. Once you have determined the safety stock level for an inventory item, SOS can automate purchase orders to prevent future stockouts.