Safety Stock 101: How to Find Right Safety Stock Formula
A strategic supply chain management system is vital to the success of any product-based operation. It can lead to increased customer satisfaction, reduced operational costs, and steady cash flow for your business. Consider this: an unexpected delay on a shipment of car parts can cost an auto assembly plant $20,000 per minute. With data-based safety stock calculations, they could drastically reduce the likelihood of unexpected delays.
The successful execution of a supply chain management strategy is complex. You have to roll all of the people, processes, and technology together to get the right product, in the right quantity, to the right customer, at the right time.
Safety stock plays an important role in mitigating some of the supply chain risks inherent in your business. In order to help your business stay ahead of unexpected events, safety stock inventory gives you the buffer you need between a potential stock-out and inventory arrival.
Our Safety Stock 101 guide covers:
What is safety stock and how can it improve your inventory management?
How to use the safety stock formula
Finding your safety stock based on historical data
Common pitfalls to avoid when setting safety stock levels
BONUS: Before you read further, our team has put together a simple safety stock calculation excel that helps you identify how much inventory to carry for each of your products. Download safety stock formula excel here.
What Is Safety Stock Inventory And How Can It Improve Your Inventory Management?
Safety inventory, also known as buffer stock, is the extra inventory you order. It’s the stock you need for when the inevitable happens. Whenever demand is greater than expected or there’s a delay from your supplier, safety stock ensures a customer doesn’t walk out the door empty-handed and disappointed.
Stock-outs, or the moment that your product is out of stock, present a $1 trillion problem. Retailers worldwide lose $984 billion worth of sales due to unavailable items. North American businesses claim a whopping $144.9 billion of that figure. The fact that consumers won’t wait until a business does stock and inventory replenishment to its shelves further compounds the issue.
The Internet is an easy scapegoat. Rather than wait, many customers turn to Amazon when they can’t find a product. We can’t blame eCommerce though. Customers are only using a new tool to act on the old behavior.
According to a 2004 study published by Harvard Business Review, 21% to 43% of shoppers went to another store when they couldn’t find a product rather than looking for a substitute in the same store. Whether customers are turning to the Internet or brick-and-mortar stores isn’t the issue. It’s the fact that they’re turning away, period. And they’re turning away because stockouts erode customer trust.
How Does an Empty Shelf Chip Away at Customer Trust?
Consider your average customer. When they get in their car and make a trip to the store, they make a trade-off. The time they could have spent doing something else goes towards visiting your store. They believe, based on your advertisements or your store category, that you’ll have the desired item in stock. If it isn’t there, they’ve essentially wasted their time. They’ll look elsewhere, find a substitute, or go without.
Ordering extra product, or safety quantity, is one way you can avoid stock-outs. Safety inventory is the buffer room in your inventory that protects you if:
- demand surges one week
- a supplier’s shipment is delayed by a couple of days
- your equipment breaks down
Safety stock inventory is different from your cycle stock, which is the stock you expect to sell based on your demand forecasts.
But, safety inventory isn’t a band-aid solution for stock-outs. A common pitfall for inventory managers is ordering too much inventory. This introduces new and expensive problems. A significant surplus means higher carrying costs on things like rent, wages, and insurance. There’s also the cost of potential damage, spoilage, and theft.
But how do you end up with too much or too little safety inventory? Oftentimes, it’s because you’ve used an undisciplined approach to calculating the safety stock formula.
Some choose an arbitrary percentage, say 15%, and order that much extra product at each inventory reorder point. Worse still, others choose to go with their gut and guess each month.
Ideally, all companies should adopt a math-based approach to determining safety stock. This means applying and customizing safety stock formulas to meet business needs based on historical data. To take this approach, companies must pull the following information from their Supply Chain Software:
- Expected product lead times: The number of days within which suppliers promise to fulfill orders
- Actual lead times: This is the number of days it takes for suppliers to actually fulfill orders
- Customer demand: How many units of your product you sell in a given time period
In addition, businesses should also know their desired service level. In most B2B relationships, this is formalized in service level agreements. For B2C companies, senior management determines this number by balancing the cost of stock-outs or unfulfilled promises against the cost of losing customers.
With this information in hand, your business is one step closer to properly setting its safety stock levels.
Safety Stocks Protects You from Unexpected Events and Inventory Stockouts: Download our safety stock calculation excel template to calculate your safety levels, so you know how much of each product to stock.
Calculating the Level Of Extra Stock: How to Use the Safety Stock Formula
When it comes to calculating safety inventory, it doesn’t pay to go with your gut. It may cost you.
Guess too high, and you’re left with extra inventory and all of the costs associated with managing it.
Guess too low, and you’ll have stock-outs which can lead to dissatisfied customers.
Using a safety stock formula lends legitimacy to your logistics strategy. It’s also a more compelling way to present your reasoning to management.
While there are variations, we’ve provided the simplest safety stock calculations below as well as a step-by-step guide on how to implement it.
Safety Stock Equation = Z × σLT × D avg
Let’s break this safety stock formula down to understand its component parts.
What Is Z?
Z represents your desired service level. You have to determine this level for each product. This number represents a company’s inventory costs for a certain product versus the missed opportunities due to a stock out. As such, this number varies for each company since the cost of missed opportunities varies from company to company.
Unfortunately, there is no easy “plug and play” approach to determining your service level. This is highly specific to your business and your customers, and it’s an instance in which data is your best friend. As a starting point, ask yourself what customers are willing to put up with. If you know how many delays or “screw-ups” it takes to lose a customer, you can set a target to avoid this.
Generally speaking, the service level in the retail industry is 90%. High-priority items get a service level of 95%.
Once you have your percentage, you will need to express it as a factor to use it in your formula. The easiest way to do this is to go into excel and use the following formula (=NORMSINV (X%)) or you can refer to a service level factor table.
For this example, let’s say your desired service level is 92%. Your service factor is 1.41.
What Is σLT?
σLT is the standard deviation of lead time. To find the standard deviation of lead time, you’ll need historical data on your lead times (to calculate your average lead time) and your actual lead times. The more data you have, the closer to reality this number will be.
For example, let’s say your average lead time (expected lead time) is 15 days. The following is the data you have on the last 10 orders.
|Actual Lead Time (in days)||Expected Lead Time (in days)||Deviance|
To find the standard deviation, first, find the difference between the expected lead time and the actual lead time. This is expressed in the third column.
Add up the deviations to find your standard deviation.
Standard deviation = 5
Divide this by the number of orders.
Add this number to the average expected time spanning 15 days.
Your standard deviation of lead time is 15.5 days.
What Is D AVG?
D avg is the demand average. To find your demand average, you’ll need to decide on a time period, typically the amount of time between orders. For this example, let’s say you re-order every month. Check your records to see how much product you go through in that time frame.
|Time Frame||Units Sold|
|Week 1||400 units|
|Week 2||500 units|
|Week 3||375 units|
|Week 4||620 units|
Add up your units sold and divide it by 30 days.
1,895 / 30
Your demand average is 63.2 days.
Finding Your Safety Inventory Based On Historical Data
Once you have these variables, you can plug them into your formula.
|Safety stock =||Z × σLT × D avg|
|1.41 x 0.5 days x 63.2 units|
Common Pitfalls to Avoid When Setting Safety Stock Levels
Setting Your Safety Stock Inventory to Zero
Some supply chain managers choose to forego safety inventory altogether by setting it to zero. They figure if they can’t anticipate fluctuations in demand and lead times, they’ll focus on what they can control — their inventory costs — and keep those as low as possible by only ordering cycle stock.
This can be a costly mistake. The money you save likely won’t compensate for the money you can lose from dissatisfied customers who stop frequenting your business.
Free Download: Download our safety stock calculation excel template to calculate your safety inventory levels, so you know how much of each product to stock.
Taking a Textbook Approach to Safety Stock Formulas
At first, it’s important to get into the habit of using the safety stock calculations. Going from a gut-based, inventory management approach to a math-based approach is a significant improvement on its own. But eventually, it’s important to evaluate whether there are other variables to consider that can optimize your safety stock calculations.
For instance, the formula we provided earlier (Safety Stock Formula = Z × σLT × D avg) is the most straightforward method of safety stock calculation. It balances the cost of missing service levels versus paying extra for inventory. But there are still opportunities to optimize the formula for your business.
For example, if a manager takes a one-size-fits-all approach to service levels and plugs 95% in for all of his or her products, only changing the demand average or standard variation in lead time, he may be missing out on cost savings opportunities.
On the other hand, if you determine different service levels for products that vary in priority, you can maximize your cost savings opportunities by minimizing safety stocks levels for products where stock-outs are less likely to lead to customer turnover.
Moreover, your safety stock calculation formula can be tweaked altogether by accounting for variations in your supply chain that often impact your business such as your reorder period, upstream failure rates, and order quantity requirements.
Assuming Your Safety Stocks Level Decreases as Supplier Lead Time Decreases
Depending on the product, you may see a supplier’s lead time go down for a variety of reasons. Or perhaps you take measures to decrease that lead time. Whatever the case, some supply chain managers assume you can lower your safety stock inventory as well. However, this isn’t always true.
While a decrease in supplier lead time leads to a decrease in your cycle stock, it may not necessarily lead to a decrease in your safety stock level. Other variables such as your service level and your demand average are important. Even if you think your hunch is correct, run the numbers and use your safety stock calculation formula for certainty.
Accurate Safety Stock Level Equals Fewer Stock-outs And More Happy Customers
Understanding safety stock calculation and actually calculating it will save your business money. Oftentimes, business owners seek quick and easy solutions for cost savings, but the best cost savings strategies — those that don’t require a cut to customer service or an increase in prices — require upfront work.
Regularly reviewing your inventory data, lead times, and demand average will provide insights into what your current processes are costing you, how to eliminate inefficiencies, how to ensure your shelves are stocked, and above all, how to keep your customers happy.