Getting to know safety stock
When managing inventory, safety stock plays a pivotal role in satisfying customer demand, forecasting accurately and maintaining healthy profits.
But how do you maintain the correct stock levels?
This is where safety stock comes in. We’ll examine some of the safety stock formulas you could use to manage appropriate inventory levels, reduce risks and maximise sales.
What is safety stock?
Safety stock is extra inventory held by a business to mitigate the risk of stock shortages or ‘stockouts’. These stock shortages can be caused by forecasting errors, variable lead times for raw materials and fluctuations in supply and demand.
The trick lies in deciding how much safety stock to carry. On the one hand, the more inventory you hold the higher your costs become. But on the other hand, too little safety stock results in loss of sales through stock unavailability.
Some inventory managers use a general rule of thumb that stock levels should equal 10%–20% of cycle stock or two weeks’ worth of coverage.
Why should businesses hold safety stock?
Running out of stock is an expensive problem. According to a study by IHL Group, stockouts result in $984 billion worth of lost sales worldwide, with Asia Pacific companies alone losing $520.7 billion.
Here are 7 reasons businesses should hold safety stock:
Stockouts increase cycle and lead times
Stockouts increase manufacturing production cycles and lead times. Running out of a single component can stop production, which is inefficient and potentially increases labour costs. Even if you can manufacture another item while you wait, splitting a production run adds an unwanted stop-and-start stage to the process.
Stockouts result in poor customer experience
Stockouts frustrate customers and impact customer satisfaction levels, although some business types are affected more than others.
For example, running out of one shoe colour variation might not affect a clothing manufacturer significantly. In comparison, a B2B business, like an aircraft manufacturer, that relies on a small number of high-value sales could be dramatically affected by not fulfilling a potential deal due to a shortage of components.
Stockouts result in lost revenue
As well as annoying customers, stockouts also result in lost revenue. If your product is out of stock when a customer wishes to buy it, then they’ll likely go to one of your competitors.
Safety stock provides a buffer for sudden demand spikes
Sometimes the demand for products increases unexpectedly. For example, at the start of the coronavirus pandemic, customers were panic buying, which led to a shortage of products like toilet rolls and dried pasta on supermarket shelves.
A fixed safety stock provides a buffer for such demand spikes, so you won’t have to lose business or upset customers.
Safety stock mitigates the impact of supply chain disruptions
Supply chain disruptions such as natural disasters, shipping delays or the unavailability of raw materials can affect your suppliers and customers. But with sufficient safety stock, you can mitigate the impact of supply chain disruptions and meet your sales requirements.
Safety stock reduces administrative costs
As well as keeping the supply chain running smoothly, safety stock also reduces administrative costs, including the time spent on communication, paperwork and warehouse duties.
With an adequate buffer in place, supply chain managers won’t need to rush to reorder additional stock and can avoid the administrative burden of extra order and invoice processing. Also, warehouse activities aren't interrupted with unexpected deliveries and restocking pick locations.
Safety stock compensates for inaccurate forecasting
Although demand forecasts are usually reliable, they’re not 100% error-free, so maintaining sufficient safety stock compensates for any forecasting inaccuracies or fluctuations.
Inaccurate stock forecasts also have a knock-on effect on other business forecasts. For example, a stockout impacts revenue forecasts if sales reps cannot meet targets.
How do you calculate safety stock levels?
It’s best to use a formula to help you calculate the optimal amount of safety stock for your business.
There are several ways of calculating safety stock levels. However, they all require lead time – that is, the time from the initiation of an order to the completion of the delivery process.
General safety stock formula
The general safety stock formula is the most common method of calculating safety stock levels. It calculates the average safety stock you need to hold during a stockout scenario, but it doesn’t consider seasonal demand fluctuations.
To calculate the safety stock, you need to know four values:
maximum daily usage (the maximum number of units sold in a single day)
maximum lead time (the longest time it takes the vendor to deliver the stock)
average daily usage (the average number of units sold in a day)
average lead time (the average time taken by the vendor to deliver the stock).
The calculation is as follows:
multiply the maximum daily usage by the maximum lead time
multiply the average daily usage by the average lead time
calculate the difference between the two to determine the safety stock level
Time-based safety stock calculation
In this method, you calculate safety stock levels over a specific period based on the future forecast for the product. It includes a combination of actual demand from sales orders and forecasted demand based on statistical methods.
Keep in mind this formula can’t predict business uncertainties, so you may potentially end up carrying unwanted excess stock if your products move slower than forecasted.
Fixed safety stock calculation
Production planners use the fixed safety stock calculation. They calculate safety stock levels based on the maximum daily usage over a period, but without using a particular formula.
The fixed safety stock levels remain unchanged unless the production planner decides otherwise. You can even set the fixed safety stock level to 0 for items you want to depreciate. But if there’s a sudden demand spike for an item with minimal safety stock, you might not be able to fulfil the orders.
What are the risks in holding safety stock?
While the advantages of safety stock are clear, there are 2 clear risks in holding safety stock to consider.
Holding safety stock costs money. First, you have to purchase the goods, which ties up capital. And second, higher volumes of inventory require more warehouse space and staff handling, which incurs additional insurance costs.
Increased dead stock
Holding safety stock also increases the incidence of dead stock. If you fail to shift some types of inventory within a specific timeframe, it can perish or lose value.
For example, foods, beverages, and medicines can expire. Other goods, like toys or consumer electronics, can break, go out of fashion, or become redundant.
Companies need to carefully balance the risk of a potential stockout against holding excess stock that may never sell.
Use inventory management software to handle safety stock levels
You can use inventory management software to manage and calculate optimal safety stock levels for each product or SKU.
The software automatically handles supply and demand fluctuations. Plus, you can set the minimum stock level for each product and receive an alert when your inventory drops below the threshold.
Inventory management software also allows you to set up automated product reordering to reduce admin. You need to determine the reorder point for each item based on the safety stock level and the average quantity used between ordering the stock and receiving it in the warehouse. Every time the stock level hits the reorder point, the system automatically creates a new purchase order.
Try MYOB’s inventory management software FREE for 30 days and take control of your stock levels.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.