Blog Credit: Abby Jenkins, August 24, 2021 (Safety Stock: What It Is & How to Calculate | NetSuite)
Revenue lost from stockouts is often coupled with the loss of customers who find the items elsewhere and often never return to the business. Stockouts also reduce the supply chain’s overall efficiency.
Running low on stock is an inevitability, but it doesn’t have to disrupt business. Learning how to calculate safety stock and keeping adequate amounts on hand ensures that the supply chain runs smoothly despite stocking delays and temporary outages. However, there are some essential guidelines that operational decision-makers need to understand to optimize safety stock in a way that supports overall business objectives.
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What Is Safety Stock?
Stock inventory usually consists of cycle stocks, or the inventory that is expected to be sold within a given period, and safety stock. Safety stock acts as a buffer amount that accounts for uncertainties such as:
- Excess demand
- Supplier delays
- Inaccurate demand or inventory forecasts
- Failure to place timely reorders
- Financial constraints
Safety stock mitigates the risks and consequences of stockouts, allowing your supply chain to proceed as usual even after cycle stock runs out.
How Can Safety Stock Improve Inventory Management?
Effective inventory management relies on the cushion that safety stock provides. Tracking current stock levels accurately while considering present and future market conditions and accounting for supply lead times is just the start of effective inventory control.
Excellent inventory management requires coordinating cycle stock and safety stock to ensure that inventory levels stay in line with demand and supply, making inventory management straightforward and more consistent.
Why Do Businesses Need Safety Stock?
Running out of stock is an expensive issue for businesses across the globe. Stockouts result in $984 billion worth of lost sales worldwide, with North American companies alone losing $144.9 billion, according to a study by IHL Group.
There are several reasons businesses should have safety stock on hand, and it can quickly prove its value when the unexpected strikes. Below are many of the biggest reasons to have this extra inventory.
10 Reasons to Keep Safety Stock
Fluctuations in demand are among the primary reasons to maintain safety stock. Many factors can influence spikes in demand, including seasonal impacts, sudden shifts in customer trends, panic buying or a competitor’s departure. Safety stock gives companies enough breathing room to replenish stock while meeting this increased demand.
Safety stock can help companies reduce the risk of completely running out of a certain product and prevent operations from coming to a halt while the business locates, purchases and delivers this inventory. That process can take days, or even weeks, making safety stock an invaluable bridge that keeps the business running while resolving the stockout.
Unexpected disruptions on the supplier side, such as raw material shortages, production issues, legislative or political measures and operational shutdowns, can have a major impact on your inventory levels. These interruptions have far-reaching impacts on the rest of the supply chain, including delaying the completion of other product components, derailing customer delivery schedules or causing retail disruptions. Safety stock mitigates the impact of supplier interruptions and lead time uncertainty and keeps the supply chain moving until the disruption passes or the company has found a new supplier.
Beyond keeping each step of the supply chain running smoothly, safety stock also cuts down on time spent on communication, paperwork and warehouse duties. Supply chain managers won’t find themselves frequently scrambling to find and reorder additional stock with an adequate buffer in place, avoiding all of the calls, emails, rush requests and invoice processing that comes with it. Likewise, warehouse staff isn’t unexpectedly unloading trucks and restocking racks, which can interrupt other day-to-day warehouse activities.
Maintaining adequate safety stock ensures consistency and allows decision-makers to develop more accurate forecasts across the organization. Although demand forecasts are usually reliable, sudden changes can cause them to become inaccurate. The effect of stock disruptions compounds in other forecasts, such as supply chain staff scheduling. These issues are especially troubling when stock disruptions cause a loss of revenue or customers as sales and other financial forecasts become invalid.
A lack of inventory can result in lost revenues, but that isn’t the only cost that businesses incur. Increased administrative and warehouse payroll costs are also likely, as is the risk of suppliers charging a premium for rushed delivery. These costs may not be a big problem if the stockout results from higher demand expected to continue. However, for stockouts caused by disruptions or other issues, the cost may not be recouped quickly, if at all.
Safety stock is one of the best ways to sustain customer satisfaction and loyalty. If customers can rely on a company to always have what they need in stock, they will not only keep coming back but likely provide valuable word-of-mouth advertising as well. That pays off in a big way over the long term and helps your business grow.
Being unable to meet demand and losing customers often also means losing market share. Mitigating the risk of stockouts is a significant part of sustaining customer satisfaction and reducing the risk of losing ground to competitors.
Safety stock allows for more efficient operations, even during supply disruptions. Suppliers aren’t rushed, warehouse staff isn’t over-worked, delivery drivers stay on schedule and there are steady, trustworthy inventory numbers for reporting and forecasting purposes.
Stockout situations often result in urgent reorders, but most suppliers don’t like to be rushed because it can disrupt their operations and customers. Keeping safety stock on hand reduces the need to put in rush orders and provides suppliers with a steady workload. Likewise, companies that work with retailers can maintain good relationships by keeping the items they sell in stock.
How to Calculate Safety Stock
Safety stock is about more than just having a few extra units available. Different formulas help inventory managers determine how much safety stock they need and calculate some critical variables.
Basic Safety Stock Formula
This short version of a safety stock formula takes the number of products sold per day and multiplies it by the number of days’ worth of safety stock necessary. So, a company selling 200 items per day that wants seven days’ worth of safety stock would multiply 200 by seven, meaning it needs a safety stock of 1,400 units. This formula doesn’t take variables such as demand and lead time into account, so it’s best for ballpark figures.
Standard Deviation Safety Stock Formula
This safety stock formula is helpful when dealing with multiple uncertain variables. It is expressed as Z × σLT × D avg.
“Z’ represents the number of orders that a company expects to fulfill in the given period.
“σLT” represents the standard deviation of the lead time, but calculating it requires some complicated math. Fortunately, standard deviation calculators allow users to input their variables and determine the standard deviation of a data set. For safety stock, the variables to enter are the lead times for each inventory order within the given period.
“D avg” represents the average amount of demand within a given period. For safety stock purposes, it’s most common to find the average daily demand. To do this, add the number of sales made in the given period and then divide that figure by the number of days in that period.
Average – Max Safety Stock Formula
This formula is best suited for short lead times, as it doesn’t take long-lead-time variables into account. It calculates the average maximum number of units that are needed at any given time.
(Maximum amount of sales x Maximum lead time) –
(Average amount of sales x Average lead time)
Safety Stock with Variable Demand Formula
The safety stock with variable demand formula is best for situations where the lead time is reliable, but the demand varies.
The standard deviation of the demand x the square root of the average delay
As with the standard deviation, there are online tools that can accurately calculate the average of a set of numbers and calculate the square root of a figure. To find the average delay, take the supplier orders that took longer than average to arrive, add those figures together, and then divide the resulting sum by the number of orders that took longer than average to arrive.
Safety Stock with a Variable Lead Time
This calculation is for situations where demand is stable but lead-time fluctuates:
Z x Average sales x σLT
As before, “Z” represents the desired service level and “σLT” represents the lead time deviation (see the standard deviation formula for more information on how to calculate those).
These equations provide additional information to supplement safety stock calculations. They can be used to ensure that each aspect relating to safety stock is accounted for.
Safety Stock with EOQ (Economic Order Quantity)
Economic order quantity (EOQ) is the ideal amount of stock a business should purchase to minimize inventory costs. It’s useful when a company wants to minimize costs such as ordering, transportation and storage. The formula is written out as:
EOQ = √DS/H
“D” represents the demand for stock in a given period, “S” is the costs of these orders, and “H” represents the holding costs per item within the period.
Reorder Point Formula
This calculation helps companies determine the inventory level that would require dipping into safety stock:
Reorder Point = (Average stock depletion in given period x Average lead time) + Available safety stock
The reorder point is the optimum time to reorder stock before it’s entirely gone, reducing the risk of stockouts.
Inventory Position Safety Stock Formula
This formula helps companies monitor net inventory, which is stock on hand minus any backorders:
IP = Inventory on hand – Backorders + Inventory currently on order
The resulting figure should be higher than the reorder point to avoid running out of stock.
How to choose the right safety stock formula
Knowing which formula to use can depend on several factors, including:
- How fast the inventory moves
- Current and forecasted demand
- Current and forecasted sales volume
- Supplier lead times
The basic safety stock formula is a good starting point for most businesses as it provides a serviceable ballpark estimate when specifics about the above variables are unknown. For companies with a better idea of these inventory particulars, the more complex formulas are of greater use to pinpoint safety stock levels.
Common Safety Stock Challenges & Risks
Safety stock is a valuable tool to combat stockouts, but it can have some disadvantages. There are a few factors inventory managers need to consider when developing safety stock strategies.
Setting Safety Stock to Zero
Many supply chain managers attempt to combat the costs of having too much stock on hand by setting the safety stock to zero. This is especially common when an unexpected spike in demand subsides and demand returns to a normal level. While it solves the issue of having too much inventory, it reignites the risk of not having a buffer to handle any further fluctuations in demand or supplier delays, which can be even costlier.
Safety Stock Is Static
Safety stock doesn’t grow with the business, meaning the number of units currently earmarked as safety stock may not be enough as the business expands. Inventory managers should review bottlenecks and safety stock numbers regularly and adjust the amount as necessary.
Too Much Safety Stock
Carrying safety stock is often necessary to avoid losing sales to stockouts, but there’s no denying that it reduces the company’s available cash. Having an excess of safety stock can mean less room for current cycle stock or new products. It’s also a considerable business expense, as holding costs often represent 20% or more of the inventory’s total cost. Much of this expense comes from the additional amounts that have to be purchased and increased storage costs and staff hours.
Standard Safety Stock Formulas
The standard safety stock formulas may not work for all industries or operational strategies, especially when there are numerous unknown variables. These formulas should be tweaked to fit individual businesses and situations to provide the most reliable calculations.
Letting Safety Stock Decline
It’s tempting for supply chain managers to decrease the amount of safety stock as average lead times go down. However, besides long lead times, other factors can cause inventory issues, so keeping adequate safety stock should be a priority.
Overuse of Safety Stock
Safety stock is a good shield against stockouts, but it’s not a cure-all for inventory issues. Supply chain managers must determine the optimal amount of safety stock for each item and find a careful balance between the risks and costs of stockouts compared to the risks and costs of having too much stock on hand.
Safety Stock Examples
Here’s how safety stock works in practice: A snow shovel manufacturer knows that demand is low during the warmer months but can fluctuate significantly in the winter depending on several hard-to-predict aspects of the weather. For this reason, the inventory manager can decide to set aside a portion of each type of snow shovel it sells (e.g., heavy-duty for significant snow, metal shovels for ice and more) to ensure that the company can meet demand across the board.
As another example, a bicycle manufacturer was recently featured in a popular biking magazine and experienced a sharp uptick in orders. As the manufacturer fulfills orders, inventory is depleted faster than the average lead time, increasing the risk of a complete stockout. Without safety stock, the company cannot fulfill orders once the regular inventory is gone, leading to lost sales.
Manage and Calculate Safety Stock With Inventory Management Software
Many supply chain managers rely on inventory management software and built-in or complementary demand planning tools to calculate optimal safety stock levels and reduce the chances of having too much — or not enough — buffer inventory. Businesses can also centralize supply chain functions on an enterprise resource planning (ERP) system for better planning and collaboration between operational units. Advanced analytics capabilities offered by leading ERP software can improve forecasts’ reliability, accounting for demand and supply fluctuations. That reduces the chances of holding excess safety stock and can reduce the need for safety stock by optimizing inventory management across the board. In short, this software can perform every task required to calculate and manage safety stock accurately and improve overall operational efficiencies.
There is a myriad of benefits to keeping safety stock, primarily the ability to keep operations flowing even when there are inventory disruptions. However, it’s important to avoid excessive safety stock as too much can hurt the business more than it can help. Formulas can help figure out the right balance, but assessing and achieving the optimal safety stock level requires comprehensive information about the entire supply chain — and inventory management software takes the manual processes out of the equation, sometimes literally, helping companies maximize sales, minimize disruptions, optimize safety stock and drive profits.
Safety Stock FAQs
The optimal level depends on several factors, including inventory velocity, current and future demand, sales volume and supplier lead times. As a rule of thumb, the safety stock amount should be the amount of inventory used per day multiplied by the lead time in days.
While the terms are generally used interchangeably, in some industries, “buffer stock” refers to excess inventory covering variations in demand, while the safety stock definition refers to excess inventory held for supplier delays or other internal variations.
Safety stock is one of the easiest ways to avoid running out of stock and not fulfilling orders. Without it, businesses would lose sales and, ultimately, customers.