Safety stock is the additional number of units of stock held by a company to mitigate several market risks. Without safety stocks, the company could have negative customer experience, lost revenue, lost market share and long-term customer value. However, a higher safety stock strains the organization in the form of higher working capital requirement. Safety stocks help in mitigating several risks as below:
- A Sudden spike in demand
- Offset inaccurate forecasts
- Longer than expected lead times to delivery (from the supplier)
- Quality issue rejects of stock, leading to stock-outs
- Increase in manufacturing or production time
- Transportation strikes or non-availability of transport
- Warehouse space issues due to which inbound gets delayed
So, how does one calculate the safety stock needed for an item?
The answer is that there is no one definite way of calculating the safety stock required. One shouldn’t use the available formulas blindly as the specific case of each company x product x market is very different.
Method 1: Let’s start with intuition (I love intuition!).
Intuitively, safety stock is designed to cover for maximum delays in delivery from the supplier. So, what can be the maximum delay from a supplier that you want to guard against – it is the maximum lead time minus the average lead time from the supplier.
So, the most common formula for safety stock is:
(Max Daily Sales * Max Lead Time) – (Average Daily Sales * Average Lead Time)
Re-order Point = Lead Time Demand + Safety Stock
Method 2: EOQ Formula (For a full blog post on EOQ refer this link)
A toys company deals in one single toy and procures from a single supplier and has an annual demand of 4000 units of a single toy. The cost of placing an order is Rs. 50 each time with the annual costs of holding the toy being at 40 % of the purchasing cost. The company purchases the toy at Rs. 120 per unit. How much should the company order at a time?
EOQ= √ (2*CO *D)/CH
EOQ= 28.87 units
Method 3: Formula used in SAP ERP system
A buffer stock or safety stock has to be designed to cover various deviations. A delay in any of the lead times mentioned below affects the procurement pattern.
- ordering lead time
- manufacturing lead time
- transportation lead time
- stock conversion lead time (inward lead time or QC clearance lead time)
Moreover, the determination of safety stock depends on the forecast accuracy. Higher the accuracy, lower the safety stock requirement. Hence, we have the below
R = Relationship between forecast accuracy and service level (Service Factor)
W = Delivery time (in days) / Forecast Period (in days)
MAD = Mean absolute deviation (parameter for forecast accuracy)
Now, if replenishment lead time is greater than the forecast period by factor W then:
Safety Stock = R x Sq.rt. W x MAD
Safety Stock = R x W x MAD
Method 4: Safety stock should cover supply and demand variability
Safety stock should have two components: supply safety stock and demand safety stock.
Demand safety stock = k*sd(forecast error)*sqr rt(lead time)
k = factor for number of std deviations required for given service level (refer link)
Supply safety stock = k*std dev lead time
Total safety stock = sqrt( demand safety stock + supply safety stock)
As you saw from the above methods, there is no one clear way of calculating safety stocks. It depends on a whole range of parameters such as lead times, forecast periods, order cycle times, forecast accuracy, service levels, lead time variances and others. Therefore, it is very important to test and observe the trends of all variables periodically to ensure that the best safety stock values are used by the firm.