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Safety Stock 101: What You Need to Know in 2019

By Ruthie Bowles logiwa-blog-author | Tags: Inventory Management Warehouse Management

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, 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 gives you the buffer you need between a potential stock-out and inventory arrival.

BONUS: Before you read further, our team has put together a simple safety stock calculator that helps you identify how much inventory to carry for each of your products. Download it here.

What Is Safety Stock And How Can It Improve Your Inventory Management?

Safety stock, 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 restocks 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 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 stock outs 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. 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 stock, is one way you can avoid stock-outs. Safety stock 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 is different from your cycle stock, which is the stock you expect to sell based on your demand forecasts.

But, safety stock 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 stock? Oftentimes, it’s because you’ve used an undisciplined approach to calculating safety stock.

Some choose an arbitrary percentage, say 15%, and order that much extra product at each 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 warehouse management system:

  • 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 calculator 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 stock, 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 formula below as well as a step-by-step guide on how to implement it.

Safety Stock = 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

15

15

0

13

15

+2

12

15

+3

14

15

+1

16

15

-1

16

15

-1

18

15

-3

11

15

+4

15

15

0


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.

0.5

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 Stock 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

 

44.6 units

Common Pitfalls to Avoid When Setting Safety Stock Levels

Setting Your Safety Stock to Zero

Some supply chain managers choose to forego safety stock 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.

Taking a Textbook Approach to Safety Stock Formulas

At first, it’s important to get into the habit of using the safety stock formula. 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 = Z × σLT × D avg) is the most straightforward method of calculating safety stock. It balances the cost of missing service levels versus paying extra for safety stock. 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 stock for products where stock-outs are less likely to lead to customer turnover.

Moreover, your safety stock 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 Stock 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 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. 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 formula for certainty.

Accurate Safety Stock Equals Fewer Stock-outs And More Happy Customers

Understanding safety stock 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.

Ruthie Bowles

Written by Ruthie Bowles

Ruthie is a content marketing consultant for Logiwa. Her specialties include small business development and inventory management.