The Basics of Safety Stock Calculation - As published by Josiah
The purpose of implementing safety stock is to provide buffer in maintaining inventory agility. Accurately determining future customer demand is dependent on accurate demand forecast. However, forecasts are hardly ever 100% accurate hence safety stock is employed. But just how much stock should be held as safety stock? Well here, we hope to answer that question.
Some inventory decision makers do not fully recognise the consequences that having the wrong safety stock settings could have on their organisation’s performance. While the total opportunity cost could be measured, the costs that come from dis-satisfied customers cannot be totally quantified. Below we discuss various methods that can be applied in proactively and effectively managing safety stock settings to produce the best possible results. An in-depth and comprehensive understanding of safety stock is essential in getting the best result when making a final decision on safety stock levels.
The truth is that there is no generic answer to the question “How much should be set aside as safety stock?” and neither should the answer be “whatever quantity the planner or inventory decision maker feels like”. It is common to find that demand planners and managers set aside 1 to 3 months’ worth of supply as safety stock. This generic method of managing safety stock invariably results in either holding too little inventory or holding too much inventory. As everyone knows, different stock keeping units has different production cycle time, procurement lead times, demand variability, and different shelf lives— to mention a few. Therefore, the answer to the above question must incorporate a number of critical variables to arrive at the most appropriate safety stock setting.
Many demand solution software can do most of what have been discussed in this article. However, allocating the responsibility of calculating safety stock entirely to the system is not recommended. One of the reason being that demand management software unlike humans do not take into consideration some external variables, also their best performance depends on the knowledge level of their users. Additionally, some small or medium business are not able to afford the implementation of an expensive demand management system. So it is essential that managing safety stock be assigned to a safety stock subject matter expert. Below is an example of a simple and basic way of calculating safety stock, however, other variables that must be taken into consideration is discussed in my second article.
Example 1 (simple safety stock settings, addressing stock-outs)
Let us say you run a business that sells washing detergents. Along with a list of other brand names you sell is an OEM label named “ABC Detergents”. And let us say that your historical sales data for the last 6 to 12 months indicate that you sell on average 200 units (6kg) of ABC detergents daily, each unit sells for $30. It takes 4 weeks from the day of placing an order with your supplier to the day your other is delivered, and your planning cycle (the frequency with which your planner review replenishment) is once a fortnight. Recently you noticed you regularly experience stock-outs for a week before new delivery arrives, moreover your customers have been complaining about your stock-outs and you want it fixed as you are losing customers to other competitors, not to mention the $6000 daily lost sales totalling $30k for the total period of stock-outs. The simplest and basic way of calculating safety stock settings to fix the problem above is as below:
LT: 4 weeks
PC: 2 week
SS qty=6000 units
In the example above, your Average Daily Demand is 200 units, your Lead-Time is 4 weeks which equals to 20 working days, and your Planning Cycle is 2 weeks. So in principle you need to hold 6000 units as safety stock to cover the entire supplier’s lead time. There are, however, as already mentioned, more to safety stock calculation than the above. Depending on the service level agreements with your customers an extended calculation might be in order, this is discussed later in details.
Example 2 (simple safety stock settings, addressing excess inventory)
In a different case, the historical sales data (6 to 12 months) for another detergent named “DEF detergent” indicate you sell an average of 500 daily, your lead time is 1 week and your planning cycle is once every week. Your planner has decided to hold 1month’s worth (11,000 units) to avoid stock-outs. Using the simple calculation already provided above you will see that just too much inventory is being held. Here we have the calculation as follows:
LT: 1 week
PC: 1 week
SS qty=5000 units
The calculation above indicates that by holding 1 months’ worth of demand you are holding too much inventory. A portion of the profits generated from this product may have been lost to the inventory holding cost generated from the excess inventory held—wrong safety stock setting being the culprit. Also from the simple calculation above, we can see that just because a product generates a greater number of sales does not necessarily mean it should hold a greater number of safety stock. Using the calculation above will help minimise obsolesces and product write-offs, reduce inventory holding cost, and release working capital that can better be utilised in another project. In the next article, we give attention on an extended analysis of safety stock. Depending on your business, applying the advanced safety stock calculation could be essential in keep your business running effectively, efficiently, and lean.
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