The concept of safety stock comes into the picture when businesses face the concern of running out of stock to sell to customers, as it not only leads to revenue loss but also loss of customers and impacts the efficiency of the supply chain. However, managing safety stock has its own set of challenges.
In this blog we will learn about how to effectively calculate safety stock, the challenges and risks to be kept in mind, and most importantly, how to create a streamlined safety stock system for your business.
What Is Safety Stock?
Safety stock, also called buffer stock is the extra amount of inventory that is stored in a warehouse to prevent an out-of-stock situation in case of unforeseen events. These events could include scenarios like when forecasts are not in line with demands, longer supply times, or failure to place timely orders. This stock is maintained in addition to the typical cycle stock.
There are essentially two uncertainties that safety stock accounts for, including demand uncertainty and lead time uncertainty. There are various methods to calculate the required safety stock, which we will get into in the later part of this blog. First, let's see why maintaining a buffer stock is important for businesses.
The Importance of Safety Stock
Stockouts are a major issue when it comes to inventory management. When there are stockouts, the business often loses sales as well as customers who find the items elsewhere and do not reconsider their choice.
Here's an example, suppose a customer places an order with your company but due to the stock out, the delivery time is extended which leads customer canceling the order. However, by this time you have already placed the order with the supplier. This will not only lead to the loss of customers but also the revenue and affect your relations with your suppliers.
Additionally, having a well-managed safety stock system will also help you to manage your inventory well and reduce your overall business costs. Stockouts tend to reduce the effectiveness of the supply network as a whole.
Keep in mind that it is not possible to always predict how much stock to hang onto. Several variables, including lead time variability, forecast accuracy, and service quality, influence it.
When the actual lead time is more than the forecasted one, there is a chance that the stocks set aside for consumption during the lead time will not be enough, leading to stock outs. Therefore, reasonable safety stock estimates should take the possibility into account, that the lead time will be longer than expected. However, during the stock calculation, more stress is typically placed on the demand variability, wherein the actual demand may be higher than the forecasted one. This is because forecasts are not always 100% accurate.
The disruption brought on by an out-of-stock scenario is reduced with the aid of safety stock. If there is enough safety stock, a company won't have to turn away customers or depend on suppliers to deliver quickly because its inventory levels are running low. Having understood the importance of safety stock, let's look at the benefits of keeping safety stock.
Benefits of Safety Stock Inventory
Additional benefits of maintaining a safety stock include:
Limit Rushed Shipping
Although a lack of inventory can lead to lost sales, that isn't the only expense companies face. Additional payroll expenses for administration and the warehouse are also probable, as is the chance that vendors will charge more for expedited delivery.
If the stockout is caused by higher demand that is anticipated to persist, these expenses might not be a significant issue. However, the expense might not be recovered at all for stockouts brought on by disruptions or other problems.
Ensure Customer Satisfaction
One of the best methods to maintain customer satisfaction and loyalty is through safety stock. Customers who know that a business will always have what they need in the store are more likely to return and spread positive word of mouth about the business. Long-term, that pays off greatly and supports the expansion of your company.
Increases Efficiency
Operations can be more productive even when there are supply delays thanks to safety stock. Deliveries are made on time, warehouse staff isn't overworked, suppliers aren't rushed, and there are reliable, consistent inventory amounts for reporting and forecasting needs.
Maintain Market Share
Losing customers, market share, and being unable to satisfy demand are frequently related. Maintaining customer happiness and lowering the chance of losing out to rivals both depend heavily on mitigating the risk of stockouts. One of the key benefits of keeping safety stock is that it helps businesses to avoid this risk of stockouts.
How to Calculate Safety Stock?
We have established that having a safety stock is essential for a business to prevent stockout situations. The next question is, how one should calculate the safety stock levels?
There are various methods you can use to calculate your safety stock. Before we move into these methods, there are a few terms you should know.
- Lead Time: The time it takes for the order to reach the warehouse after the order has been placed.
- Daily usage: Amount of products sold per day.
- Demand: How many products do you sell in a certain period?
- Service Level: Probability of avoiding stock out as a percentage.
- Average: How your products sell or how often you receive shipments.
- Standard Deviation: Variance of the lead time.
Average Max Safety Stock Formula
This is the simplest formula and is best for short lead times. This formula calculates the average maximum number of units that are needed.
Safety Stock = (Maximum daily usage x Maximum lead time) - ( Average daily usage x Average lead time)
For example, your company sells an average of 20 products per day and the average lead time is 10 day days. During peak periods, you can sell up to 30 products and due to delays in shipment, the lead time can be 15 days.
In this case, the safety stock will be (30 x 15) - ( 20 x 10)= 250.
This means that you should keep 250 extra products in storage to account for delays in shipment or high-demand periods.
The King Formula
This formula is best suited when the lead time is variable and demand is stable. This method gives a more accurate representation of your safety stock but is more complex to implement.
Safety Stock = Z x σLT x D avg
'Z' is the target service level. A 95% performance level indicates that 5% of the time there might be a stockout. High service levels are more expensive for the company, but many still do it to prevent stockouts.
'σLT' is the standard deviation of lead time, and 'D avg' is the average demand for the products.
Safety Stock in Case of Unstable Demand
This method of calculating safety stock is recommended if the Lead Time is quite stable and variations are negligible compared to demand uncertainty. This method can also be used when there is almost no insight into the lead time data from the past.
Safety Stock = Z x σD x √LT
Here 'Z' is the desired service factor, 'σD' is the standard variation of the demand, and 'LT' is the lead time.
Safety Stock in Case of Unstable Demand and Unstable Lead Time
If the nature of your business is such that the demand for your products and your Lead Time both are unstable then you should use this method of calculation.
Here are two cases.
If your Demand and Lead time are independent of each other then,
Safety Stock = Z x √( LT x σD^2 + D-avg x σLT ^2 )
If the Demand and Lead time are dependent on each other then,
Safety Stock = Z x σD x √LT + Z x D-avg x σLT
EOQ Formula
EOQ stands for Economic Order Quantity and this is the ideal amount of stock a company should procure to minimize inventory costs.
EOQ = √DS/H
'D' refers to the demand for stock items in a given period, whereas 'S' refers to the cost of the orders, and H refers to the Holding Cost per item.
The total cost is calculated as follows: S= P + O + H, where P stands for purchase cost, O for ordering cost, and H for holding cost.
Heizer Render's Formula
Heizer Render's formula is used when there are quite significant variations in the supply on your vendor's side. It uses the lead time distribution's standard deviation to give you a more accurate image of your lead time and the frequency of very late shipments. However, it doesn't account for variations in demand.
Safety Stock = Z x σLT
'σLT' measures the difference between the average lead time and actual lead time and 'Z' is the desired service level.
Now that you are familiar with different methods of calculation of safety stock, which one of these should you use?
This depends on factors like:
- Size of your business
- The quality of your data and the forecasts
- Your inventory mix
- The actual and forecasted demand for your products
- Supplier's lead time
The average max safety stock formula gives you a ballpark number and a good starting point for determining your safety stock. The rest of the methods can help you pinpoint the exact levels of safety stock if you have a better idea of the above-mentioned variables.
If safety stock in inventory management is calculated and maintained properly, it can help businesses to improve inventory management. Let us see how.
How Can Safety Stock Improve Inventory Management?
When it comes to inventory management, safety stock is essential because even the most experienced professionals can't accurately predict actual customer demands and unexpected events in the supply chain. In such cases, safety stock gives you an emergency stock repository to fall on.
For a business that sells physical goods, it can take years to optimize the inventory and supply chain. Safety stock helps you to keep things running smoothly. Maintaining safety stock also helps to reduce costs by avoiding fast and unneeded stock reordering.
Why Should Businesses Keep Safety Stock?
Running out of stock to sell can be very expensive for businesses. There are various reasons businesses should monitor reorder points and keep safety stock.
Minimize the Effect of Supply Fluctuations
Unexpected supplier-side disruptions like a shortage of raw materials, manufacturing problems, political or legislative actions, or business closures can have a significant effect on your inventory levels.
These delays affect the supply chain significantly, affecting things like client delivery schedules, retail disruptions, and the completion of other product components. Up until the disruption passes or the business has located a new supplier, safety stock helps to reduce the effects of supplier interruptions and lead time uncertainty and keeps the supply chain moving.
Offset Demand Uncertainties
Demand fluctuations are one of the major reasons for keeping a safety stock. Seasonal impacts, abrupt changes in consumer preferences, panic buying, or the exit of a rival business are just a few of the many variables that can affect demand spikes. Companies have enough breathing space with safe stock to restock while still meeting the increased demand.
Reduce Administrative Hours
Safety stock reduces the amount of time needed for paperwork, and warehouse tasks in addition to ensuring the smooth operation of every stage of the supply chain. With a sufficient buffer in place, supply chain managers won't frequently need to scramble to locate and reorder additional stock, avoiding all of the calls, emails, rush requests, and invoice processing that comes with it.
Compensate for Forecasts Inaccuracies
Maintaining safety stock ensures consistency and decision-makers can create more precise forecasts across the company by maintaining an adequate safety stock. Demand forecasts are typically correct, but unexpected changes can cause them to be wrong. Stock disruptions have a compounding impact on other forecasts, like the staffing of the supply chain. These problems are particularly concerning when stock disruptions result in a loss of income or clients because sales and other financial projections are rendered useless.
Improve Supplier and Retailer Relationships
When there is a stockout, urgent reorders are frequently necessary, but most suppliers dislike being rushed because it can disrupt their business and consumers. Having safety stock on board eliminates the need for last-minute orders and ensures suppliers have a consistent workload. Similar to how businesses can retain positive working relationships with retailers by keeping their products in stock.
Protection Against Price Fluctuations
Unexpected market changes could cause a sudden increase in the cost of products, which would lower a company's profit margins. When faced with such unforeseeable circumstances, having enough safety stock could help a company avoid paying more for a stock without losing its sales.
Avoid Losing Existing Customers
In case of stockouts, if the business has kept a buffer supply, it will be able to hold off disappointing its customers for a day or two until its warehouse is restocked.
Safety Stock Challenges and Risks
Managing safety stock is an important tool that helps you to cover potential stockouts. However, safety stock comes with various challenges as well.
Zero Safety Stock
Managers often try to cut down on inventory costs by avoiding the maintenance of safety stocks or setting them at near-zero or negligible levels. This is a dangerous situation to be in especially if there is a sudden inflow of customer orders and if suppliers are unable to deliver on time. This can lead to increased costs for the business.
Static Safety Stock
At times the safety stock levels managed by the business remain static while the business grows. So even as the demand for products grows as the business scales, the safety stock levels don't accommodate it. So, production planners must keep reviewing the safety stock, adjust for bottlenecks and review regularly.
High Safety Stock Levels
Creating high levels of safety stocks blocks a large chunk of the capital of the firm. This means less room for new products. High levels of safety stock increase business expenses due to the efforts needed to manage it.
Additionally, there are a few cases where creating a safety stock is not the best investment.
- For startups and businesses that are in the early stages, there is not enough data to accurately calculate demand and supply. Inccoreclty estimating your demand and supply could put a dent in your finances.
- For businesses that are struggling to sell their existing inventory, creating a safety stock can lead to waste. Instead, this money should be put to use to revive your business wherever needed.
- Businesses that deal with perishable goods should be cautious with their inventory.
SMEs should work on creating a safety stock if they notice potential issues of stockout.
Safety Stock Examples
Let's see a few examples which emphasize the importance of maintaining safety stock.
For example, there is a company that sells umbrellas, and it identifies that it sells 2000 units per month. So as a precaution, they decide to keep 200 units of umbrellas as safety stock because the demand for umbrellas is not constant throughout the year. So now they can increase the quantity of safety stock during peak periods and reduce when the demand goes down.
Also when the company sells similar types of products like umbrellas and raincoats, it can keep reduced amounts of safety stock for one item as compared to other. If the customer wants to buy an umbrella but it is out of stock then the business can sell raincoats.
Steps to Create a Safety Stock System
A safety stock system is a critical component of supply chain management. By ensuring that a certain level of inventory is always set aside businesses can meet user demand, even in the event of unexpected changes in demand or supply chain disruptions. Here are some steps to create a safety stock system: To create your safety stock system, you need to follow these steps:
- Collect data about your demand and lead time. This can be done by gathering historical demand data for the product or products concerned. This will help you understand how demand fluctuates over time and identify any trends or seasonality.
- Based on this data create forecasts for your future demand and analyze the lead time.
- Then choose the safety stock calculation method best suited for your business based on various factors that have been listed above.
- Keep updating your data and track the performance of your inventory based on the current demand and lead times.
- Optimize your inventory to keep it up to date. A safety stock system needs to be regularly reviewed and adjusted as demand patterns change. Review your inventory levels and reorder points regularly to ensure they still hold true and adjust them as necessary.
- Use inventory management software to keep track of your inventory and automate the process.
Optimize Safety Stock Levels With Inventory Management Software
One thing that you should remember is that no safety stock formula can match up with a real-world scenario. But an automated safety stock management system can help you get close to it and assist you by making gradual adjustments supported with accurate inventory insights.
An inventory management software like TranZact helps you to monitor stock movements and reordering points in real time. This helps you to provide the best experience to your customers with timely delivery of goods while keeping your supply chain seamless!
FAQs on Safety Stock
1. What is the good safety stock level?
A good safety stock level depends on various factors which include inventory velocity, current and forecasted demand, lead time, and sales volume. The average max safety stock formula gives you the closest estimate to determine your safety stock, but this may vary from business to business.
2. What is the difference between safety stock and buffer stock?
While both terms are used interchangeably, there can be a slight difference between safety stock and buffer stock. Safety stock refers to the amount of inventory that a company keeps on hand to protect against unexpected changes in demand or supply. Buffer stock, on the other hand, is referred to when excess inventory is maintained to combat any unexpected uncertainty or risk.
3. How to calculate safety stock?
There are various methods to calculate safety stock. These formulas account for different situations that a business encounters. The basic formula to calculate safety stock is [maximum daily use x maximum lead time] - [average daily use x average lead time].
4. How often should I change my inventory stock level?
The level of safety stock should change based on the change in demand and lead time. Additionally, if you are scaling up your business then also you need to calculate your ideal safety stock requirements to suit your business needs.
