Safety stock refers to a company’s additional inventory as a buffer to minimise the risk of supply shortages or stockouts. These shortages can occur due to various factors, such as forecasting errors, unpredictable lead times for raw materials, or changes in supply and demand.
Determining the appropriate amount of safety stock to maintain can be challenging. On one hand, holding excess inventory can lead to increased costs. On the other hand, inadequate safety stock levels can result in lost sales opportunities due to the unavailability of stock.
Inventory managers recommend maintaining safety stock levels equal to 10% to 20% of cycle stock or two weeks’ worth of coverage to ensure adequate protection against potential stockouts.
Why is Safety Stock important?
Safety stock is an important tool companies use to prevent the inconvenience of stockouts. By maintaining sufficient safety stock, businesses can avoid relying solely on timely deliveries from suppliers and can also prevent turning away potential customers due to low stock levels. In the event of a stock shortage, safety stock can act as a buffer until the next batch of ordered stock arrives. Here are some reasons why safety stock is crucial for any company:
Protection From Sudden Increases in Demand
Safety stock can protect your business from unexpected spikes in demand and inaccurate market predictions, particularly during busy or festive seasons. This buffer inventory can also be useful when ordered items arrive later than expected at your warehouse. Maintaining adequate safety stock levels ensures your business does not run out of high-demand products, enabling you to fulfil customer requests consistently.
Buffer Stock for Longer Lead Times
Although your supplier may consistently deliver your products on time, there is always the possibility of unexpected production or shipment delays that could cause your items to arrive later than anticipated. For instance, a bottleneck at your supplier’s end or delivery disruptions caused by adverse weather conditions could cause delays. In such situations, safety stock can serve as a valuable buffer, helping to prevent stockouts and ensuring that you can continue to fulfil customer orders while you wait for the requested stock to arrive.
Avoiding Price Fluctuations
Market changes can cause the price of your goods to increase unexpectedly. Such changes may arise from a sudden shortage of raw materials, a rise in the cost of raw resources, unanticipated spikes in market demand, new competitors, or government regulations. Maintaining sufficient safety stock can help you avoid the expense of buying the stock at higher prices without sacrificing sales during such unforeseen events.
Stockouts Increase the Lead and Cycle Times
Stockouts can lead to longer lead times and production cycles in manufacturing. If a component runs out, production may halt, which can be inefficient and result in increased labour expenses. Splitting a production run can also introduce an undesirable stop-and-start phase to the operation, even if another item can be produced while waiting.
Lack of Inventory Leads to a Bad Consumer Experience
Stockouts can negatively impact customer satisfaction ratings, although certain types of businesses may be affected more than others. For example, a clothing producer may not be significantly impacted by running out of a particular colour of shoes. However, a B2B company that relies on a small number of high-value contracts could experience significant harm if a potential deal falls through due to a shortage of components.
How to Calculate Safety Stock?
Knowing how much safety stock to maintain is important to reap its benefits effectively. Insufficient safety stock can lead to lost sales, while excess safety stock may result in higher holding costs. You can use a formula to determine the ideal quantity of safety stock for your company.
While each safety stock calculation method may require slightly different inputs, they all rely on your understanding of your lead time. Lead time refers to the time interval between initiating an order and completing the delivery process.
General Safety Stock Formula
The general safety stock formula is the most commonly used formula for determining safety stock levels. It helps determine the typical amount of safety stock that should be maintained to avoid stockouts. However, this formula does not account for changes in seasonal demand.
To calculate the safety stock, you need to know four values:
- The maximum number of units sold in a single day
- Maximum lead time
- The average number of units sold in a day
- Average lead time
The calculation takes place as follows:
First, multiply the maximum daily usage by the maximum lead time. Then multiply the average daily usage by the average lead time and, finally, calculate the difference between the two to determine the safety stock level.
Time-based Safety Stock Calculation
This approach involves determining safety stock levels for a set period based on the product’s anticipated future demand. It combines predicted demand based on statistical techniques with actual demand derived from sales orders.
However, it’s important to note that this method cannot account for uncertainties in the business environment. If your products sell slower than expected, you may carry extra stock you don’t need.
Fixed Safety Stock Calculation
Production planners use a fixed estimate for safety stock levels. This method does not involve using a specific formula; instead, planners determine safety stock levels based on the maximum daily usage over a particular time period.
Once the fixed safety stock levels are established, they are generally not modified unless determined by the production planner. If a particular item is no longer needed, the fixed safety stock level can be set to 0.
However, if there is a sudden increase in demand for a product and there is insufficient safety stock, it may not be possible to fulfil all orders.
What Risks does Holding Safety Stock Entail?
Two risks should be considered despite the apparent benefits of having safety stock.
Higher Costs
Owning safety stock is expensive. You must first invest funds to buy the products. Second, increasing inventory levels necessitate larger warehouses and more employee handling, raising insurance costs.
Increased Deadstock
Holding safety stock makes the dead stock more common. Some inventory types have a shelf life or value if not sold within a specific time range. Foods, beverages, and medications, for instance, can expire. Other products, such as toys or consumer gadgets, may malfunction, fall out of trend, or become unnecessary.
Companies must carefully weigh the danger of a possible stockout against keeping extra inventory that might never be sold.
Conclusion
Safety stock is an essential component of supply chain management. It is a buffer against unexpected supply and demand fluctuations, production delays, and other unforeseen events. By maintaining sufficient safety stock levels, businesses can avoid stockouts, reduce lead times, and improve customer satisfaction. However, it is essential to maintain a balance between holding enough stock to cover potential stockouts and keeping holding costs low. Different methods and formulas are available for determining the optimal amount of safety stock, depending on the business’s unique needs and characteristics. Having an effective safety stock strategy is vital for businesses to maintain their competitive edge and ensure the continuity of their operations.
