Safety Stocks: Its Importance and Calculation

Do you remember the childhood days when we used to keep all our extra savings from the pocket money, in another pouch? So that we can use it to spend on some special occasions.

In this article, we are talking about Jon (definitely not the King of the North) who is a mushrooming retailer. He, for long, cherished the state of running OUT-OF-STOCK as a result of persistently good sales on various marketplaces. But he now is in a state of FOMO (fear of missing out) a good number of orders for the same reason.

He researched on consumer behavior when they see ‘out-of-stock’ once or often; thus found more reasons to fear. Here are some:

 

 

Much for the course correction, Safety Stocks have become a necessity for him.

Jon, smart enough to roll on, researched well on safety stock, and being a blogger himself, shared everything a retailer must know about it.  Hence without wasting any time, let’s understand what knowledge Jon shares on safety stock, its importance, and calculation.

 

What is Safety Stock?

Safety stock is basically the extra inventory beyond consumers demand. Sellers and merchants know this term well and hence it’s essential for Jon and all of them to have it, and know exactly what quantity is required to be kept as safety stock.

Managing inventory nowadays is not a cumbersome process. If you’ve got an excellent inventory management software to help you determine how much safety stock is required to lower the risks of unexpected stock-out and demand situations, just like Jon, you are rolling!

 

demand-forecasting safety stock graph

 

The above graph shows that with the help of demand forecasting, you can determine the estimated amount of safety stock. As the sales of a company rises the demand also rises.

So to know what value of safety stock to be kept, you need to forecast the maximum demand and average demand. Now the value difference between both can be used as safety stock.

 

Safety Stock Calculation

For safety stock calculation, there are certain terms that Jon advises the retailers of today to know that are used in the safety stock formula:

Max daily usage, Max lead-time, Avg daily usage, Avg lead-time

 

The formula goes this way for the safety stock calculation,

 

safety stock formula

 

3 (Jon-ey) Methods for calculating Safety Stock

Every business has its own methods of calculating safety stock. However, these methods are basically classified into three different styles; statistical based calculation, time-based calculation, and fixed safety stock

 

Statistical based calculation

It is a mathematical approach (which Jon hated the most, but fell for it has it filled in his pockets), which uses mathematical theories of probability to calculate the level of safety stock, to prevent stock-out circumstances.

Statistical-based safety stock calculation has its own benefits and drawbacks. “Although this statistical method is purely based on accurate mathematics, predicting business is not always as accurate,” says Jon.

Many times situations may occur that cannot be forecasted, even if you have done your homework analysing the demands.

For example, using the statistical method, there are chances that it may calculate a specific item to have as a  safety stock even when the item is no longer in market-demand or manufacturing.

 

Time-based calculation

In the time-based calculation of safety stock, the stocks required for a fixed period is calculated. Whatever method is practiced to calculate safety stock, in time-based calculation stocks are monitored periodically to ensure accuracy and satisfies the need it is intended for.

Jon forecasted that there will be demand for 100 cases of part A to be consumed each day. In that scenario the safety stocks count for a week for Jon would be 700 cases. That’s how time-based method is used by demand forecasting for a particular material in the coming days.

Using time-based calculation method there are chances that you purchase or carry a large amount of unwanted capital tied up in safety stock. Especially when the products are slow moving. Which eventually increases the safety stock carrying expenses and acquire more space in your warehouse, becoming excess stock.

 

Fixed Safety stock

In this method, companies set a fixed level of safety stock for their goods. Your production manager/planner would determine that level or value for the safety stock rather than relying on a quantity by a statistical calculation. This value of safety stock remains constant until the production manager manually changes it.

As per Jon, when it comes to safety stock, retailers must know 2 essential things which increase the efficiency of keeping safety stock for your inventory:

  • Reorder level/point
  • Economic order quantity (EOQ)

 

Economic order quantity (EOQ)

Economic Order Quantity (EOQ) is a method of calculating the quantity of the stock that needs to be re-ordered, considering the demand for that particular item/product and your inventory holding costs.

EOQ is a term that is much related to safety stock and also has an answer to the questions; what quantity of stock should I re-order to replenish my inventory?

It’s basically an ideal quantity a company should purchase for its inventory.

 

Determining the economic order quantity, Jon can easily minimize the cost of inventory and safety stock. The economic order quantity formula,

economic order quantity formula

 

The economic order quantity formula can be utilized for calculating a specific re-order level, which is a specific level of inventory that triggers the need to place an order for more units, for avoiding the circumstances of stock outs.  

 

Assume, for example, you are having a retail shop which carries women’s top and the sales count touches approx 2000 pieces each year. To hold those units of the top in your inventory it cost you $5/year, and the fixed cost to place an order is $2.

 

The EOQ equation then would be,

eoq-formula

Hence the ideal order quantity to minimize costs and meet customer demand would be 40.

 

Reorder Level

Reorder level is the point from where Jon replenishes his inventory in order to dodge the low inventory level. Below are the graphs, which shows the relation between

i) Annual cost and Reorder quantity.

ii) Max inventory, Reorder point, Safety stock.

Eoq-graph

 

The reorder point formula goes this way;

reorder point formula

 

 

Service level and Safety stocks

In inventory management, the service level is the probability of not going out-of-stock during the next stock replenishment cycle, eventually helping Jon to reduce the count of lost sales.

The service level is determined in business by the level of stocks or orders they receive. This is the only reason why Jon stocks in a quantity that is enough to cover supplier’s delivery times and is adequate enough to cover the customer’s demand. Jon makes sure that the inventory is neither over-stocking nor making his company lose the invested capital because of high carrying and maintenance costs.

Jon maintains a high level of service when it comes to retailing, and so are most of the retailing companies, by setting their goals at 97% as this is the only key towards assuring the client loyalty.

For measuring the safety level and readiness to deliver according to the number of units sold, the formula goes this way:

 

Service level = Number of quantities delivered / Total quantity of demand (by consumers)


Different Criteria for calculating service level

 

The formula of service level
Stock out number of quantities delivered / the total quantity of the demand
Frequency of stock outs number of order delivered / the total quantity of customer sales orders
Frequency of stock outs number of order item delivered / the total quantity of order items
Loss of sales value of quantities delivered on time / the value of the total quantity of the demand
Stock out period number of days with stockout / the total number of days

Source: Hoppe M., 2008 p.339

 

safety-stock-quote

Now let’s dip our toes into understanding the safety stock calculation and what are the scenarios where safety stocks play a vital role in having your business running smooth.

 

Example and Case Study where Safety Stock comes into the picture

Let’s say, your business is selling notebooks. On an average daily selling of those notebooks is around 35. It takes approximately 7 days to replenish the stock again.

Now let’s say exam season has arrived and the demand for notebooks has raised. You observed that on a particular day the number of notebooks sold went up to 60 in a day. Also due to bad weather, your supplier wasn’t able to supply the notebook stock to your warehouse in the estimated time and you received it after 12 days.

So for the notebooks, the safety stock level would be:

Safety Stocks =  (60 * 12) – (35 * 7)

=  475

This means you need to have about 475 unit of safety stocks on hand at any time (particularly when the exam seasons are going or your city’s weather condition changes frequently). With 475 safety stock, you’ll be able to sell at least 35 notebooks per day for more than 12 days (i.e max lead time).

Well, this was just one scenario where safety stock can be used. Now let’s comprehend it a bit more and know what are other situations where safety stocks come into the picture.

 

i) Prices of raw material increases

Safety Stock-cotton

Safety stocks prevent stock outs when there is high variation in demand and supply. But what if the prices of the raw material whose product you sell touch the stars?

So if this type of situation arises and in that instance, if your inventory has got safety stock then you’ve no idea how much money will be saved. Still wondering how this would work? This example would solve all your confusions:

Suppose you are ‘Handmade-Bag’ seller, and because of the government’s new policy, the prices of cotton, leather and other fabrics (raw material) which are required to make a bag have increased. Eventually, it has made a great impact on the prices of the bags you sell.

If the cost of a bag is $10, due to inflation it became $15. Imagine if you have a safety stock of 100 units which were bought at $10 (before inflation).

Your total purchasing amount would be 100*10 = $1000. And if you didn’t have safety stock in the inventory then you had to purchase the bags at $15.

Total purchasing amount would be 100*15 = $1500.

Net loss = $500

I hope the confusion is clear now.

 

ii) The supplier is unable to supply

There are multiple reasons that your supplier may fail to deliver the product on time, some of which are even reasonable and contractually acceptable.

It is possible that some natural disaster prevented sellers from being able to deliver the product. Say, for instance, an earthquake or tsunami has seriously damaged your seller’s factory and the finished goods prior to shipment.

For such cases having a safety stock with you on hand tends to be a business-saving gem.

 

iii) Demand goes beyond expectation

Safety Stock-high-demand

A lovely situation for sellers at the beginning, but eventually becomes unlovely as time progresses.

There are several reasons like:

  • Product’s craze has suddenly grown
  • The price of that product falls down
  • The need for a product rises
  • Price of the product is going to rise in future

In such cases, your calculation of keeping a particular stock in inventory may get altered and the risk of low-level in the inventory for that selective product arises.

Having safety-stocks on hand, in these types of unexpected rise in demand, earns you more profit by achieving your consumers need.

Now let’s look at the real like example with a case study, where safety stock was proven to be an asset – defining better logistics, improving inventory holding cost, reducing lead-time and much more.

 

CASE STUDY

 

Internal Scenario of Company

Jon, and his company, nowadays have shown a great interest in becoming leaner and being competitive in the market. There certainly are different areas within the company wherein improvement is necessary to make the entire chain lean, leveraging from its benefits.

Of all the areas, the most important is “inventory” that the company has, which must always be efficient according to the lean inventory principles. Here, safety stock is one of the main drivers.

The company mentioned in this case-study has always tried really hard to manage its inventory efficiently across the supply chain. On the journey towards efficiency and being lean, safety stocks of this particular company have stolen the spotlight.

Cost minimization is the biggest target to be achieved for this company by having a safety stock efficient model in place.

The company about which we are talking about is owned by our expert Jon.

Jon’s company is a manufacturer and a global leader in the aerospace industry. The main highlight in this company is the high demand variability and long lead time, compared to the other competitors.

As said, Jon’s company is a multi-stage manufacturer. There are different stages involved in the process such as:

  • Tiers of suppliers
  • Procurement
  • Manufacturing
  • Assembling
  • And most importantly, customers.

There are two manufacturing plants (MFs) that Jon’s company has. Based on their tasks, the procurement department is responsible for getting the raw materials or unfinished parts through various other suppliers to the manufacturing plant or the production line.

Here, Jon’s supplier can definitely be a representative of an external or internal manufacturing entity. To be noted – the procurement’s location is basically different than that of the manufacturing unit.

The manufacturing unit mainly has two important customers – the Assembly (ASSY) and Aftermarket (AFM) before the final product goes out to the end-customer. The ASSY and AFM can either be from the internal chain or from the external supply chain, depends.

case-study-flow

If at all the availability of the parts (right ones at the right time) is assured for the internal customers, there are 90% chance that the end-customers will get an on-time-delivery as well.

How can this availability be guaranteed? The best way is to have optimum safety stock level maintained, which can also minimize the logistics costs.

For Jon’s company, to apply the safety stock model in place, it was difficult to obtain appropriate input data that can achieve desired results.

However, they found many results of the databases which had all the data related to inventory and stock. That assisted the company with past data, documentation & reports. With the help of operational and strategic support personnel in Jon’s company. All the integrated logistics departmental personnel passed in the required information for getting in the safety stock model to action.

 

Safety stock in action

The inventory strategy at the company for the manufacturing parts with high cost and low volume is the MRP system. Based on this, a safety stock strategy is necessary for this particular category of parts. Suppliers’ support cannot be reliable always, and hence safety stock comes into action for backing up this variability.

As per company rules, whenever there are changes in the supply chain – such as demand or entrance of new competitors, introduction of a new product or the retirement of an older one, the safety stock’s count should always be re-evaluated. Jon has decided to run the checks every quarter.

Jon’s company has also designed their safety model in a way that whenever the safety stock is in the upstream stage, there will be tons of savings in the carrying or holding costs. On the other hand, if the safety stocks are kept in the downstream stages, a lot of lead time will be saved.

 

Conclusion

Jon says, “Safety stock acts as a cushion when you fall from the high-rise building of unexpected elements in the market.” Thus having that cushion in your inventory, especially when there is high fluctuation rate, could help a seller to bypass many or any unwanted circumstances.

Jon says, there is a thin line between safety stocks and excess-stock. Hence to determine the perfect quantity, efficient calculation of the safety stocks is a necessity, which is only possible if there is a good analytical & report generating tool available for demand forecasting.

But always remember, the more the safety stock, the higher would be the carrying and maintaining cost. Therefore, if you master the art of determining what level of safety stocks should be kept in your inventory, good sales are just numbers which would keep on increasing.

Abhishek Biswas

Abhishek Biswas

A Listener, who speaks less and writes more. Will choose Pizza over anything. Doing non-technical pieces of stuff, with a degree in a technical field. Has stage fear thus prefers "Stealth-mode" conversation, also the Content Curator at Orderhive. . . . <<--- In the picture, I'm looking at my happy belly ;)

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