Q&A: investment in safety stocks worth its money?

Something unexpected could always happen and customers never buy exactly what we expect. For instance, some customers buy more, some buy less, some switch to other products while other customers are completely new to us. As a result, when forecasting demand, there is always a degree of uncertainty. To manage this ambiguity, you have to hold some form of safety stocks. If you could be a 100% sure that your forecasts were accurate, safety stocks would be a waste. However given the various influences on demand patterns, deciding how much safety stock to hold is an important decision. After all, while safety stock can help ensure you meet demand boosting profits, holding excessive amounts of safety stock can be a huge drain on resources.

In order to calculate appropriate safety stock levels, a target service level based upon the extent to which you want to cover the uncertainty in demand is required. While you may hope to achieve service levels of 96% or even 98%, such targets can result in high levels of safety stock. So although from a sales perspective, attaining a service level of 99.9% could seem to be a very realistic target, few businesses have enough money to invest in safety stock for every item across a whole product assortment.

The solution here is to choose wisely and categorise products. For example, whereas for some products, holding high levels of safety stocks is exactly what the business requires, for others, holding very low safety stock or even none at all is the right decision.

When looking at which products require high safety stocks, there are a range of variables which must be taken into consideration. For instance, there is the level of uncertainty which can be measured as the deviation from historical demand. The associated inventory costs must also be considered; whereas safety stocks for expensive items naturally have a higher value, safety stocks for lower priced products can be held for a relatively lower cost. Finally, lead times can have an impact as longer lead times increase the requirement for safety stocks.

Approach

To apply this in practice, creating classes is one of the best means of finding the balance. Through carrying out ABC analysis, it is possible to highlight which products require a high service level. A-items for example, are products which should never run out of stock. However in order to form the basis of this ABC analysis, the Key Performance Indicators (KPIs) must be decided upon.

Essentially there are two main objectives which determine the KPIs: on one hand the focus can be on the profit margins of a product or the turnover, if this data is easier to acquire. Alternatively however, the financial aspect can be put to one side and customer satisfaction can be used as the foundation on which to build KPIs. Typically, order lines or transactions can be used indicate customer satisfaction levels.

In order to manage the cost associated to safety stock, Slim4 uses demand classes to offer a very hands on approach. Another option is to carry out an XYZ classification analysis over the standard deviation of the demand or on the number of transactions.

Once you have built a classification, you can set up a matrix and assign target service levels accordingly.

You can also apply some +1% or -1% for special products classified as Super A, or items which are very expensive or of strategic importance to the business.

Once you have classified your products and setup a matrix you can utilize the Slim4's What if functionality to find out what your investment in safety stocks for will be. This in turn will enable you to adjust every group, until you achieve the perfect balance between total investment and target service level.

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