Safety stock is defined as the extra stock that is preserved by a business entity to minimize the risk of a shortfall in their existing stocks. Safety stock, also known as buffer stock, is an important part of inventory management. It helps to protect organizations from supply chain disruptions and unexpected increases in demand, ensuring that there is always an adequate supply of goods when needed.
It can be because of uncertainties in understanding the actual demand for the product or because the company was unable to gather the necessary raw materials to make the item. The additional quantity is held by most companies in inventory to act as a shield in case the demand exceeds the estimated sales figures.
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What is Safety Stock?
Safety stock is the additional inventory that an organization keeps so that they do not run out of stock of a particular product. It can be calculated using the Safety Stock Equation, which takes into account the average daily demand, lead time, and desired service level. It is important to strike the right balance when determining how much safety stock to keep, as too much of it can result in increased inventory cost.
Most business houses have it in place that helps them to continue daily operations to the need and demand for the product. It is important to keep such stock because it decreases the risk of disruption. It is the safeguard between plausible and tangible demand and is kept diligently by organizations to meet unexpected production as well as customer demands.
Cycle stock is a type of safety stock inventory that is maintained to meet expected demand for standard items, such as everyday items or products with regular seasonal sales cycles. It is important to have enough cycle stock on hand to prevent stock-outs, but not so much that it ties up capital and leads to overstocking.
Importance of Safety Stock
If you have launched a new product, safety stock becomes a necessity until you can understand the market trends in better terms. The amount of such stock a business holds on to has a direct impact on the company. Too many leads to high costs and too little in lost sales hence maintaining a balance.
Remember, you cannot always predict the correct quantity to hold on to. It is determined by several factors like lead time variability, forecast accuracy, and service level. Each place has a demand pattern of its own, and you have to adjust it accordingly.
Examples of Safety Stock
Remember if an organization fails to keep an adequate safety stock, it can mean a loss in sales figures. It is thus necessary to maintain a balance so that you do not have to incur any loss.
Suppose a company has a team to research the market demand, and it has estimated that the demand for an umbrella is nearly one thousand units every month. As a precaution, the company can decide to have one hundred units as safety stocks because the demand is never constant. It can easily increase the quantity of safety stock during peak periods and reduce it during lean ones.
Organizations can keep reduced levels of safety stock if they have similar types of items in stock. Suppose a company deals in both raincoats and umbrellas. It can then keep the safety stock of one item less than the other as it can easily direct its customer towards the other stock. If it is raining and a customer asks for a raincoat, and you do not have it at hand then you can remind him about the advantages of an umbrella and sell it to him.
How to calculate safety stock? Different Formulas
There are different ways of safety stock calculation to calculate safety stock and understand how much safety stock is needed. Let’s go through all of these-
Basic Safety stock formula:
The general formula for Safety Stock = (Max daily usage Max lead time in days) – (avg. daily usage * avg. lead time in days)
In addition, various formulas revolve around the following variables-
- Z = orders your brand expects to fulfill
- D avg = average demand for a product
- ?LT = standard deviation of lead time
Let’s now go through other formulas-
Average – max safety stock formula:
For companies with shorter lead times, the average–max formula is ideal for calculating safety stock. This approach calculates the average amount of units you will need to have available at any given time. To use this method and determine your safety stock, apply this easy-to-follow formula:
Safety stock = (maximum sales maximum lead time) – (average daily sales average lead time)
Standard deviation formula:
Calculating your safety stock can be a daunting task, especially when you are dealing with multiple uncertain variables (e.g., demand or lead time). The standard deviation formula is the perfect solution to determine your safety stock in this scenario:
Safety stock = Z ?LT D avg
EOQ safety stock formula:
Economic order quantity (EOQ) is a highly beneficial inventory that allows companies to reduce their overhead costs associated with orders, transportation, and storage. To find the optimal amount of stock for your brand, use this formula:
EOQ = square root of [(2 setup costs demand rate) / holding costs]
Variable demand formula
Brands that experience seasonal fluctuations in demand but have consistent lead times can benefit from the variable demand formula when calculating safety stock. To get started, use this simple equation:
Safety stock = (standard deviation of demand) * (square root of average delay)
Heizer & Render’s safety stock formula:
Heizer & Render’s safety stock formula is an excellent choice for businesses with large fluctuations in supplier deliveries. To use this equation, employ the following:
Safety stock = Z score * ?LT
Fixed safety stock:
Fixed safety stock allows businesses to establish a stable inventory level for each SKU. In other words, it’s an allocated number of buffer units that you retain per SKU. The following formula will help you calculate your fixed safety stock:
Fixed safety stock = number of days average daily usage = number of days maximum daily usage
Variable lead time formula:
If you are looking for a reliable way to calculate safety stock when demand is consistent but lead time varies, use the variable lead time formula. This equation takes this fluctuating factor into account and can be calculated using the following formula:
Safety stock = Z average sales ?LT
Greasley’s safety stock formula:
Greasley’s method is based on supplier lead time and the instability of demand. It produces one of the most precise calculations available. To determine your safety stock using Greasley’s formula, employ this equation:
safety stock = Z score standard deviation in lead time (?LT) average demand (D avg)
Reorder point safety stock formula:
You can easily determine the ideal point to reorder inventory by utilizing a reorder point (ROP). You must replenish your items when stock levels reach their lowest tolerable threshold. To calculate the necessary safety stock accurately, use this formula:
Reorder point = (average stock depletion * average lead time) + available safety stock
Time-based safety stock calculation:
Accurately determining your brand’s safety stock levels requires time-based calculations based on future demand forecasts over a fixed period. To perform these assessments, you must have:
- Previous data on sales and product demand: To get a better understanding of your sales, you should be able to obtain data from your preferred point-of-sale system related to both items that were depleted and those sold out completely. This information is invaluable in helping you track progress and determine where improvements can be made.
- Demand forecasts for the upcoming season, quarter, and so on: Don’t forget to employ various demand forecasting methods, such as trend projection and market research, to foretell your product’s future demands. This can help you better plan for the future of your business!
Reasons for Carrying Safety Stock
- If a company is involved in the manufacturing process, then it becomes imperative to keep safety stock because the lead time can be much longer and you will not be able to meet consumer demand at the right time.
- There is a great gap between forecast and actual demand. Safety stock absorbs the variability of demand and improves the service level adequately. With more Safety Stock, businesses can protect themselves from unexpected customer demand and supply chain disruptions while decreasing their inventory costs and increasing profits.
- An important reason for holding on to safety stock is that it prevents complete stock-out during a sudden demand for that product. You can handle an inaccurate forecast with your existing safety stock in place.
- Safety Stock acts as a buffer when inaccurate planning or miscommunication and mismanagement result in a delay of products. For example, your supplier might not be able to ship due to some problems in the transit, or he might not have got a hold of your order at a certain time and was unable to dispatch it as per your requirement. It is such circumstances that help you to keep your business going so that you do not lose out to competitors.
- Safety Stock helps to keep the supply chain running smoothly between the warehouse and the customer. If the line is disrupted, an organization will not be able to meet the constant demand of its customers. It will lead to dissatisfaction and can also result in a lack of customer loyalty.
The Disadvantage of keeping Safety Stock
1) Varying Demand And Supply
The demand and supply are not constant, and you can only assume them. It is impossible to predict accurately how many units you will sell every month, and this is why a company keeps some units in hand as safety stock so that they can take them out immediately if the demand rises. Although this concept is a good idea in terms of customer satisfaction, it can also become a bit dicey for the business because you are blocking a certain chunk of your cash for creating safety stock.
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Suppose you have one thousand units of a particular winter garment, but you were able to sell only three hundred units. The rest seven hundred units have to be stored and kept properly for one year when winter arrives.
The money you have spent on the safety stock could have been utilized for some other important expense. Hence be diligent and make sure that you are holding only that much quantity that can be utilized in the peak period easily.
2) Holding Costs
Keeping too much safety stock will increase the holding costs of a company, for instance, inventory storage, spoilage, interest expense, and obsolescence costs.
It is important to keep only a limited supply of safety stock based on your estimations of the previous years and predictions for the current year. Review it at regular levels so that you can limit the amount of your holding cost.
What can happen if you have Less Safety Stock?
a. Unfulfilled customer demand:
Safety Stock should be adjusted according to customer demands, as levels that are too low can result in unfulfilled customer orders. This can lead to customer dissatisfaction and reputational damage.
b. Supply chain disruption:
Safety Stock should also be adjusted according to lead times, as too low levels can cause supply chain disruptions. This can lead to a decrease in sales, increased costs from extra expediting, and potential damage to reputation.
c. Lost sales:
Safety stock should also be managed with customer expectations, as low levels can result in reduced sales. This can lead to decreased profits, increased costs from extra expediting and warehousing, and potential damage to reputation.
d. Increased inventory costs:
Safety Stock levels should be regularly reviewed to ensure they are appropriate for the business’s goals. If Safety Stock is set too high, it can lead to increased costs of inventory and decreased profits.
Risks of Poor Safety Stock Strategy
a. Ensuring Zero Safety Stock:
Safety stock is a buffer that protects businesses from unexpected demands. If levels are set to zero, then any small variation in customer demand can result in a stock-out. This can lead to lost sales, customer dissatisfaction, and reputational damage for the company.
b. Using Textbook Safety Stock Formula:
Safety stock levels should be calculated on a case-by-case basis, depending on demand and lead times. Safety stock should not be blindly set using a textbook Safety Stock formula; the variability of customer demand, lead times, and inventory cost should all be considered.
c. Misunderstanding Lead Times:
Safety stock should be adjusted according to the lead time. If levels are too low, it could result in a stock-out at the end of the lead time. Safety Stock should be increased to account for any variability in lead times.
d. Not Managing Expectations:
Amount of safety stock should be managed in tandem with customer expectations. For example, if Safety Stock is too low to meet customer demands, it should be communicated to the customer. Safety Stock levels should also be regularly reviewed and adjusted according to the business’s goals.
Having enough safety stock plays a vital role in protecting businesses from unexpected customer demand and supply chain disruptions. Safety Stock level should be carefully calculated based on user demand, lead times, and inventory cost.
It should also be managed with customer expectations and regularly reviewed to ensure it is set appropriately for the business’s goals. If their levels are not managed properly, it can lead to unfulfilled customer demands, supply chain disruptions, lost sale, and increased inventory costs.
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