What is safety stock?
Safety stock is an extra quantity of a product which is stored in the warehouse to prevent an out-of-stock situation. It serves as insurance against fluctuations in demand.
Importance of safety stock
Safety stock helps eliminate the hassle of running out of stock. If you hold sufficient safety stock, you needn’t rely on your suppliers to deliver quickly or turn away customers because of depleted inventory levels. Safety stock covers you until your next batch of ordered stock arrives. Let’s see how safety stock is important for your business:
Protection against demand spikes
Safety stock protects you against the sudden demand surges and inaccurate market forecasts that can happen during a busy or festive season. It serves as a cushion when the products you’ve ordered take longer to reach your warehouse than you expected. It ensures that your company doesn’t run out of popular items and helps you keep fulfilling orders consistently.
Buffer stock for longer lead times
Even if your supplier has been consistent with delivering products on time and you’ve never faced a supply lag yet, this might not always be the case. Unexpected delays in production or transportation, such as a bottleneck at your supplier’s end or a weather-related shipping delay, can cause your products to reach you later than expected. During these situations, safety stock acts as your defense against a possible stockout scenario and helps you fulfill your orders until your ordered stock is delivered to you.
Prevention against price fluctuations
Unpredicted market fluctuations can cause the cost of your goods to increase suddenly. This can be due to a sudden scarcity of raw materials, an increase in price of raw materials, unexpected demand surges in the market, new competitors, or new government policies. If you’ve got enough safety stock during these unpredictable situations, it can help you avoid the costs of buying stock at higher prices without sacrificing sales.
How to calculate safety stock
To get the benefits of keeping safety stock, you need to know how much safety stock to keep. This is because too much safety stock can lead to higher holding costs, and too little safety stock results in loss of sales. Using a formula will help you calculate the optimal amount of safety stock for your business.
Each method of calculating safety stock uses slightly different details, but they all require you to know your lead time, which is the time between the initiation of an order and the completion of the delivery process.
There are several different methods to calculate safety stock:
- Fixed safety stock
- Time-based calculation
- The general formula
- Heizer Render’s formula
- Greasley’s method
Fixed safety stock
Fixed safety stock is a method used by production planners. They determine the amount of safety stock to keep from the maximum daily usage for over a period of time, but without using a particular formula. The value for fixed safety stock generally remains unchanged unless the production planner decides to change it. Fixed safety stock levels can even be set to zero for items that you want to phase out. However, if there is a sudden demand surge for an item with very little safety stock, you might not be able to fulfill the orders.
In this method, safety stock levels are calculated over a particular time period, based on the future forecast for the product. This method includes a combination of actual demand from sales orders, and forecasted demand based on statistical methods. This method cannot predict business uncertainties, so using it involves a risk that you might end up carrying too much unwanted stock if your products are moving slower than forecasted.
The general formula
This is the most simple and commonly used method to calculate safety stock. It calculates the average safety stock the company needs to hold during a stockout scenario, but it doesn’t consider the seasonal fluctuations of demand.
Safety stock is calculated by multiplying maximum daily usage (which is the maximum number of units sold in a single day) with the maximum lead time (which is the longest time it has taken the vendor to deliver the stock), then subtracting the product of average daily usage (which is the average number of units sold in a day) and average lead time (which is the average time taken by the vendor to deliver the stock).
Heizer & Render’s formula
Heizer & Render’s formula is ideal when there are significant variations in supply on your vendor’s end. It uses the standard deviation of the lead time distribution, giving you a more accurate picture of your lead time and how frequently you deal with very late shipments. However, it doesn’t take demand changes into account.
Safety stock is calculated by multiplying your desired service factor (Z score) by the standard deviation in lead time (𝜎𝑑𝐿𝑇), which is the degree and frequency by which the average lead time differs from the actual lead time.
The Z score, also called the desired service factor, is a way to decide how confident you want to be about having enough stock. It is a value that you select so that you don’t face a stockout scenario. A lower score means you’ll have higher chances of running out of stock. For instance, if you select a Z score of 2.33, there is a 99% chance that you won’t face a stockout situation.
Greasley’s formula takes both lead time and demand fluctuations into account, which provides a more accurate way of calculating safety stock. But it doesn’t take into account stock which is still in production and not yet ready for sale.
Using Greasley’s formula, safety stock is calculated by multiplying average dem (Davg) (average demand is the total total quantity of a material required each day over a fixed period) with the desired service factor (Z score) and the standard deviation in lead time (𝜎𝐿𝑇).
Safety stock acts as a defense against unexpected circumstances. Calculating safety stock accurately is crucial to avoid losing sales due to stockouts or supply chain interruptions. Like many other kinds of business decisions, there is no one-size-fits-all formula that will work for all businesses, so choose the method that works the best for your business.