What Is Safety Stock and How Do I Calculate Safety Stock Levels?
March 10, 2023
In the world of inventory and supply management, there are several phrases that business owners must wrap their heads around to maintain consistent profits. Safety stock is one such crucial concept. It has a significant impact on revenue but is often not correctly calculated or taken into account by small business owners.
If you don’t maintain safety stock, you will likely experience frequent stockouts. And if you don’t have the items they want, customers will happily take their business elsewhere. Fortunately, there are proven methods to minimize such circumstances.
Calculating safety stock well in advance can account for unexpected changes in demand and minimize the effects of supply disruption. Before discussing how to correctly calculate safety stock, we break down the concept:
What Is Safety Stock?
Safety stock is extra inventory that is a safety net between forecasted stock numbers and actual customer demand. This buffer stock is often kept on hand in warehouses and is readily available for deployment in case of demand surges and emerging trends.
Safety stock doesn’t necessarily refer to finished goods. It could also include the storage of raw materials in order to counter delays from suppliers.
Why Is Safety Stock Important?
Businesses must have a steady stream of readily available products at hand. Stockouts can have a serious impact on customer loyalty.
According to a Harvard Business Review report, only 7% to 25% of customers continue shopping after discovering their desired item is out of stock. As many as 43% of customers go to other stores to find what they want.
The report estimates that the total loss due to stockouts could be as much as 4% for a typical retailer. This number is exceptionally high, especially for small business owners.
Despite this high figure, the report estimates that 8% of companies worldwide continue to face stockouts.
Other than financial losses, safety stock is important for these reasons:
Manage Demand Forecast Inaccuracies
Miscalculations in demand forecasts are quite common. They’re usually made worse when experiencing disruptions in supply and facing unexpected demand. The effects of these inaccuracies often spill over to disruptions in other forecasts, such as staff scheduling.
With ideal safety stock levels, it becomes easier to make more accurate forecasts in the future. This offsets some of the losses in revenue or steps backward in customer loyalty.
Reduce Supplier Costs
When faced with a sudden demand for an out-of-stock product, the onus usually falls on the supplier to ship more inventory at a faster pace. This has a butterfly effect on various operational expenses.
Administrative and warehouse payroll is likely to increase. And coupled with the fact that suppliers often charge premiums for urgent deliveries, these added costs could have a massive impact on a small business.
Stay Ahead of the Competition
When customers look elsewhere for products that are out of stock, they’re essentially being pushed right into the hands of competitors. Calculating and maintaining the right amount of buffer stock will protect your business’s market share and improve customer satisfaction, leading to long-term success.
Reduce Staff Hours
Having a steady supply of safety stock saves a lot of paperwork and time spent on communication between teams and warehouse duties. You can avoid rushed emails, requests to suppliers, and the complex invoice processing involved in urgent orders. This, in turn, can save your small business a significant amount of money, and your administrative and warehouse staff will not waste time on unnecessary time-consuming tasks.
Now that we have a general idea of safety stock and its importance, it’s time to understand the metrics behind this concept.
What You Need to Calculate Safety Stock
There are several ways to calculate safety stock, ranging from extremely easy to highly complex. Each method has certain pros and cons—the one that best suits your business depends on your selling model.
But before we get to the formulas, let’s begin by understanding some critical concepts:
Calculating Lead Time
In simple terms, the lead time is how long it takes for a product to go from the raw material stage to being ready for the shelves. Everything in between—approvals, administrative functions, inspections, and deliveries—is included in lead time.
This sounds straightforward enough, but to eventually get to the safety stock, you will need to calculate the standard deviation in these lead times. And to find that, it’s important to first find the variance.
This may sound complicated, but it’s simple enough once you understand how:
Let’s assume that the lead time you have in five instances are 1, 2, 3, 4, and 5.
To arrive at the variation, use the following formula:
[(1-3)(1-3) + (2-3)(2-3) + (3-3)(3-3) + (4-3)(4-3) + (5-3)(5-3)]
with 5 being the total number of lead times taken into account, and 3 being the mean.
When you calculate this, you get:
(4 + 1 + 0 + 1 + 4) = 2
Essentially, in this example, 2 would be your variance.
The standard deviation in lead time is further calculated as the square root of your variance. Which in this case would be 1.41.
Demand levels depend on the number of times a product is re-ordered over a specific period and the number of actual sales made within the same period.
To determine the average demand, add up your sales volume over a certain period (let’s say a month) by the time (in this case, 30 or 31 days).
The service level, which is usually expressed in percentage, is the expected probability that you will be able to satisfy all inventory requirements within a particular period.
For example, if your service level is set to 90% for a particular item, it indicates that you can fulfill 90% of orders of that item on time, while there may be delays in 10% of orders due to stockouts. As such, the service level is directly linked to customer satisfaction, and your ability to complete deliveries on time.
To determine service levels based on the number of units sold, simply divide the quantity delivered on time by the total demand, and multiply by 100 to find the percentage.
Maintaining high stock on all items leads to higher operation expenses. So, companies must weigh the trade-off between opportunity costs and operation costs. This is why service levels are often set to certain rates for individual items—those with the highest demand have the highest service levels.
In retail, the average service level is usually set between 90% and 95%, with the fastest-moving items going as high as 98%. In contrast, call centers have an average service level of 80% of calls answered within 20 seconds.
Formulas To Calculate Safety Stock
Method 1: The Basic Safety Stock Formula
This formula involves taking the number of products sold in a day and multiplying it by the number of days’ worth of safety stock you estimate is required. This is the most straightforward calculation.
For example, a retailer sells 10 items daily and estimates that it’s best to maintain 20 days’ worth of safety stock based on historical demand. By simply multiplying 10 x 20, the needed safety stock is 200 units.
This very basic formula doesn’t take into account any other variables, such as lead time or demand fluctuations. However, you can use it to get a general idea of the number of units you need to keep on hand and work from there.
Method 2: Standard Deviation Safety Stock
When dealing with variables, it’s better to use the standard deviation method of calculating safety stock.
The formula is expressed as Z × σLT × D avg
Z is the number of orders a company expects to fulfill or the service level.
σLT represents the standard deviation of the lead time (as discussed earlier).
D avg represents the average demand within a given period.
Method 3: Average–Max Formula
When dealing with short lead times, the average-max formula is a great way to arrive at optimum safety stock levels. This formula is not recommended if you are calculating for long lead times.
This formula calculates the average stock units required over a certain period:
(Maximum sale x Maximum Lead Time) – (Average Sale x Average Lead Time)
This is one of the most common formulas for calculating safety stock levels. The only figures you need are average day sales, average lead time, maximum day sales, and maximum lead time.
Method 4: Safety Stock with Variable Demand
If you face demand variations but stable lead times, you can use several figures to arrive at safety stock levels.
The basic formula, in this case, is:
Standard deviation of the demand x the square root of the average delay
Standard deviation of the demand can be calculated like how we calculated the standard deviation in lead time earlier. First, take the average demand over a specified period. Take the average square of differences, and that’s your variability.
Method 5: Safety Stock with Variable Lead Time
When dealing with certain demand levels but variable lead times, this formula can help you arrive at your safety stock levels:
Z x Average Sales x Lead Time Deviation
Here Z is the service factor that corresponds to your desired service level. To find this figure, you must use a normal distribution chart.
To give you an example, for a service level of 90%, the factor would be 1.28; for 95%, it is 1.64; and for 75% it is 0.67. Here is how to convert the service level to service factor. Look for the z-score, commonly denoted as z, corresponding to the one-sided probability (commonly denoted as P( Z <= z ) in the chart) matching your target service level. If the service level is 90%, you would have to look for 0.9 in the probability column. Once you find the corresponding z-score, it is your service factor value to use.
Average sales and lead time deviation can be calculated using the methods provided above.
By using this formula, you can determine how consistent your supply is and whether you can get through with very few safety stock units. If your supply sees massive shifts in variation, you will need to keep more items in hand to meet customer demand over extended periods.
Ideal safety stock levels are a crucial element of inventory management that small business owners must understand and implement. It will help your company grow, keep your customers happy, and lead to more profits in the long run.
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