The last thing any business wants is stock-outs. When businesses encounter stock-outs, they can lose up to half of their intended purchases. On average, abandoned purchases can lead to a 4% loss in revenue. At a first glance, this may not seem like a big loss. Except, in the grand scheme of things, repeat stock-outs can eventually lead to a decrease in customer loyalty and cause further losses for your business. For this reason, it’s crucial to understand how to calculate safety stock.
In this article, we will discuss what safety stock is, the formula to work it out, as well as the factors that affect the need for excess inventory.
What Is A Safety Stock?
Safety stock refers to an additional quantity of a particular product which is stored to prevent stock-outs. Think of it as a safety net that is there to ensure that your business doesn’t face an out-of-stock situation.
What Are The Benefits Of Safety Stock?
At a minimum, your warehouse should contain stock that is expected to be sold within a given period. If you want to safeguard your business against uncertainties, however, it’s wise to have a safety stock.
1. Continuing To Fulfil Orders When Demand Spikes
Seasonal demand is no longer the only factor businesses have to consider when determining safety stock levels. It’s important to make sure that your business is prepared for a sudden surge in demand.
Market forecasts are often inaccurate and you may find that certain items are more popular than expected. But with safety stock in place, you can continue fulfilling demand.
2. Ensuring Supply Chains Run Smoothly
Even the most consistent suppliers can experience delays. If this happens, safety stock can cushion longer lead times. That way, you can continue meeting demand until your emergency stock arrives.
3. Mitigating The Effects Of Price Fluctuations
Inflation, fluctuations in market demand and even regulation changes can impact the cost of goods. Buying stock at higher prices will likely decrease your profit margins. With buffer stock, you can delay this and continue to meet consumer demand.
4. Maintaining High Levels Of Customer Satisfaction
Arguably, the most important reason to have a safety stock is to keep customers happy. If you consistently fulfil customer demand, you can expect a steady stream of customers to return for more.
How to Calculate Safety Stock: The 5 Different Methods
Having too little safety stock can lead to a loss of sales. Having said that, too much safety stock can result in increased holding costs. For this reason, it’s important to understand the five different ways to calculate safety stock.
1. The Standard Formula
This formula is the most commonly used method to determine safety stock. Using this formula, safety stock is calculated in three steps.
Firstly, multiply the maximum lead time by the maximum number of items sold in a single day. Then, multiply the average lead time by the average number of items sold in a day. Finally, subtract the product of the second calculation from the first.
Whilst this formula is pretty straightforward, the downside is that it doesn’t take into account fluctuations in demand or lead time. So, it’s a good idea to be cautious when using this formula.
2. Fixed Safety Stock
This method is usually used by production planners, who will determine the safety stock to hold based on the maximum items sold in a particular period. However, this is all based on judgement, as opposed to a particular formula.
This means that the value for fixed safety stock can be set to zero to mitigate the issue of having too much stock. Though, this could ultimately lead to further inventory issues later down the line.
3. Calculations Based On Forecasted Demand
This is a time-based calculation that looks at the actual demand from sales orders and the future forecast for the product over a period of time.
There is an element of risk that comes with using this time-based calculation, as it does not consider changes in the market.
4. Greasley’s Formula
This formula offers a more accurate representation of required safety stock levels, as it takes into account both fluctuations in lead time and demand.
Using this formula, safety stock levels are determined by multiplying the average demand required each day for an item over a fixed period by the standard deviation in lead time and the desired service factor (the level the business can tolerate stockouts of the item).
The higher your desired service factor score, the less likely you are to run out of stock. Nonetheless, it’s important to bear in mind that Greasley’s formula does not take into account stock that is still in production and cannot be sold yet.
5. Heizer and Redner Formula
Using the Heizer and Redner formula, safety stock is calculated by multiplying your desired service level by the standard deviation in lead time. The standard deviation in lead time refers to the distribution and extent to which the average lead time varies from the actual lead time.
This formula is ideal for businesses who frequently deal with lead time variability, as it provides a more accurate picture of what your actual lead time is and how often you deal with shipments that are very late. Although, this formula does not consider changes in demand so should be used with caution.
Which Safety Stock Formula Should You Use?
We understand that it is not always easy to know which safety stock formula you should use. Generally speaking, the standard formula is a good starting point for most businesses, as it offers a rough idea of your average stock levels. In particular, it’s useful for those who don’t know the specifics on variables that will offer more detailed insights, such as average lead time.
If you’re looking for quality data, however, the general formula may not be the right method for you. In order to choose the method that will work best for your business, you will need to consider the following factors:
- The lead times of your supplier
- How quickly items are old
- The current and forecasted demand
- The current and forecasted sales volume
The Pitfalls Of Safety Stock: A Process Of Trial And Error
While safety stock acts as an extremely valuable defence against stock-out scenarios, there are a few factors you need to be aware of when calculating safety stock levels.
1. Adjusting Safety Stock
As your business grows, the required safety stock levels will also change. With this in mind, it’s important to remember that this is a static calculation. It’s wise to regularly review and adjust your safety stock levels to ensure you can continue meeting demand.
2. Increasing Costs
Although carrying safety stock is necessary, it’s a considerable business expense. For example, you may require additional storage to house safety stock. Consequently, this may increase your overall inventory costs.
More than that, safety stock will reduce your amount of available cash. This means your business will have less money to spend on new products.
3. There Is No One-Size-Fits-All Formula
Every business is different. Therefore, general formulas may not work for businesses with different operational strategies or even those across different industries. In order to get a more reliable calculation, it’s a good idea to tweak standard formulas slightly based on your specific requirements.
4. Focusing On Lead Time
As lead time improves, you may decide to decrease safety stock levels. But it’s important to keep in mind that there are a host of other factors that can also impact your stock levels and create issues for your business.
5. Relying Heavily On Safety Stock
It’s important to find a healthy medium between having too much stock on hand and dealing with stock-outs. After all, safety stock is merely a buffer to stock-out scenarios, not the only solution. Below we will discuss some complementary solutions to safety stock.
Economic Order Quantity (EOQ) And Safety Stock
Economic order quantity is another factor that influences the safety stock level. It’s the ideal quantity a business should order to reduce ordering, transportation, storage and overall inventory costs.