Advanced Safety Stock Calculation - As published by Josiah 

As I mentioned in the first article, there are other factors that contribute in executing the correct safety stock. But before we delve into that, it is important that we understand the difference between safety stock and cycle stock. So we ask: what is the difference between safety stock and cycle stock? Put simply: safety stock is contingency driven while cycle stock is exclusively demand forecast driven. Some demand planners and managers have a hard time accurately differentiating between the two, mixing up safety stock in the cycle stock planning, and as a consequence struggle with reoccurring back orders or end up holding too much inventory. Presented below is an extended or advanced way in calculating safety stock settings[1]

SS=√ [(LT+PC) * FE²] + [ADD²* LT²]

 Where:

   SS: safety stock

                                                                                                                ADD[2]: average daily demand

                                                                                                                        LT: lead time

                                                                                                                       PC: planning cycle

                                                                                                                       FE: Forecast Error[3]

                                                                                                                    SD  : Standard Deviation (applied in LT & FE) 

A closer look at the analysis above reveals that the safety stock calculation has 2 components: supply and demand variables. The demand variable component incorporates forecast error, standard lead time, and planning cycle. While the supply variable component takes into consideration variability in lead-time and average daily demand. The standard rule of thumb is that safety stock settings be reviewed and updated at least once a month to ensure that calculated values are always consistent with current business requirements. Using the advanced calculation require some in-depth data analysis. Demand forecast has to be as accurate as possible, however in the real world this is not always the case, hence forecast errors need to be integrated in calculating safety stock as is seen in the calculation above. This leads us to another essential activity when the advanced safety stock calculation is employed: The Weighted Mean Average Percentage Error analysis, we will discuss about WMAPE in a different article sometimes in the future.

Other Critical Variables that Apply

Industry: Industries vary. The service level required within an automotive industry varies from that which is required in the healthcare industry. As a result, safety stock implementation should incorporate industry variables. Other factors that affect industries are product and demand seasonality

Product shelf life: For organisations that operate in an industry that has short product shelf life. Holding extra inventory would likely result in product obsolesce which ultimately results in huge financial cost to the organisation and defeat the purpose of safety stock altogether.

Competitive priority and objective: Some organisations choose to compete differently from others. For example, an organisation that chooses to compete in cost may want to keep inventory holding cost to a minimum. To that end, they might choose to hold the minimum possible inventory as a trade-off for the low price of their products, with a longer customer delivery time. On the other hand, a company that competes on differentiation, priding itself on its swift customer response time would likely hold enough inventories to avoid stock-outs, lost sales, and lost reputation. The important thing is to understand your industry, market trend, consumer behaviour and then apply relevant variables.

Capacity of your organisation: Inventory storage space is required to house purchased or manufactured products. In any safety stock decision making, a consideration of the storage capacity should be factored in, this should be so especially when the physical dimensions of products are large and space is limited.

Financial standing: inventory costs money and many organisations place a limit on the amount of money to be spent procuring or producing inventories, under such circumstances, getting the calculation right is critical. Getting the calculations right will help avoid holding too much of a particular inventory and not holding enough of another inventory as a result of financial restrictions.

If you are looking to properly set up your safety stock and train your staff to understand the dynamics of safety stock and effectively manage it. Get in touch with us today and we will be happy to assist you

Footnotes

[1] Please note, the above is service level dependent. Service level is constant, unless there is a change in organisational strategic objectives

[2] Average daily, weekly or monthly demand, which ever parameter you may choose to use, for the formula above daily is used.

[3] Average of 3 months and one sided to factor in over forecasted items. Note: to make your calculations consistent, if you choose to use average of 3 months for FE, your ADD must also be average of 3 months.  

Smyna
Supply Chain Consulting

 

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