Safety stock inventory Q&A

How do I calculate perfect safety stock levels?

To work out the perfect safety stock levels for your business, you need to analyse the cost of holding excess stock and weigh this up against the risk (and impact) of running out of stock.

Here are some simple pointers to assess your safety stock requirement:

1.  Determine the lead time:

How long will it take for your supplier to get your goods to you once you’ve placed an order?

The longer this period, the greater the risk of disruption and uncertainty. If your lead times are extremely short, the need for safety stock is less urgent.

However, if your lead times are measured in months, chances are, your safety stock level will need to be higher.

2. Determine the demand variability:

Is it likely that this product will go the same way as fidget spinners and drop off a cliff? Or does the item in question have longevity? You can calculate demand variability by analysing historical sales data or using statistical forecasting methods.

3. Calculate the service level:

How important is the product to your customers? To answer this question, businesses set the service level targets. The higher the target service level, the greater the requirement for safety stock.

However, some products are more important than others. Therefore, it makes sense to prioritise your investment in safety stock in the products that matter most.

4. Apply the right safety stock formula:

How do you currently assess your safety stock levels? Do you stick a finger in the air? Or do you use the data to make a rational decision? There are several safety stock formulas that you can use.

Here is a quick summary of some of the main formulas:

How do the mechanics of safety stock work?

One of the most common is the service-level-driven approach. Taking a deeper look at the equation can explore some of the permutations of the model and the intimate relationship between service levels and safety stock.

As highlighted in the table below, the formula in question is:

In the next section, we will get a little bit technical. But stick with us …

What is Z-score?

A Z-score (or standard score) is a term which represents the number of standard deviations a data point is from the average. To achieve a higher service level target, you must be able to cover a greater level of deviation to reduce the risk of stockouts.

Hence the Z-score increases as the target service level is increased.

You can look up the appropriate Z-score based on your desired service level in a standard normal distribution table:

What is Standard Deviation of Lead Time Demand?

The next step is to consider the standard deviation of demand during the lead time. This represents the statistical measure of the variability in the demand for a product during the lead time from suppliers.

It quantifies the degree to which the demand for a product can fluctuate or deviate from its average value during the lead time. To calculate this, look at historical sales data or use statistical forecasting methods.

A higher standard deviation suggests a greater level of uncertainty or variability in the demand, while a lower standard deviation indicates more stability in the demand patterns.

What is Average Lead Time Demand?

The final piece in this puzzle is the so-called average lead time demand.

Average lead time demand refers to the average level of demand you anticipate during the lead time. This, of course, is the duration between placing an order for a product and receiving it from the supplier or manufacturer.

To calculate the average lead time demand, you typically consider the historical or expected demand for the product over a specific period to estimate the amount of demand you can expect during this period.

Something important to mention here is that this isn’t a one off. You need to be performing this analysis on an almost constant basis. It’s not just for when you introduce a new product or go to market. You should be perpetually monitoring and adjusting as demand patterns and lead times change over time.

How does uncertainty in demand impact the requirements for safety stock inventory?

It should be common sense, but let’s detail it anyway.

If you have lower volatility in your demand levels, it’s less likely you’ll need safety stock. Those businesses who can set their watch by their demand will rarely run out. But they’ll also rarely have demand which falls short either.

Businesses with demand patterns like this are few and far between, if they exist at all. It’s far more likely that your business, and others competing with it, will see constant volatility in demand.

Most businesses have exposure to stockouts and excess. This uncertainty makes the requirement for safety stock a must and getting the calculation over its size incredibly important.

How can lead time influence the need for safety stock?

Safety stock is an incredibly useful tool in covering the uncertainty that arises from variable lead times.

You’ll know how infuriating it is to wait longer for a product than expected after placing an order … even if that’s your usual Friday evening takeaway. When that product is the difference between a profit and a loss however, it’s even more important.

For products with very short lead times this isn’t so much of a worry. This is especially true because, with a shorter lead time, typically comes a shorter variance in volatility. If, for example, you have an order with a 1-day lead time, it’s highly unlikely that a disturbance will push it beyond manageable levels. It does happen, but it’s much less likely.

In this case, you’d expect your customer to be fairly understanding of receiving their product a day late, and therefore, safety stock is probably not needed to cover a shortfall.

Compare this with products being shipped from the Far East to the UK however, and both the lead time and the risk is likely to be far higher. Let’s say it takes up to 12 weeks for an order to be received. In this case, there’s far more opportunity for things to go wrong. There are more variables, and the potential increase in lead time is far greater.

Is a customer of yours happy to wait a further 12 weeks on top of the 12 they’re already waiting? It’s probably unlikely.

And even if they do wait, they’re not likely to be happy doing so. Therefore, to continue with the same product availability, you’ll need a greater reserve of safety stock.

Should safety stock inventory cover supplier reliability issues?

It’s easy to blame delivery delays and issues on your supplier. They are, after all, the ones in charge of getting their stock to you, so that it becomes your stock.
But playing the blame game will only get you so far. And it’ll do nothing to instil faith in your customers that you’ll be able to eventually supply the goods they want.

So, should you increase safety stock on the off chance that your suppliers will be unreliable? Probably. There’s no point in telling your customers you’ve been let down by suppliers again. They’ll simply shop elsewhere and perhaps gently ask why you didn’t have a contingency in place.

However, if a supplier is consistently late or regularly fails to deliver your complete order as promised, questions should be asked. Perhaps there are gaps in your data. Or maybe it’s time to address the situation head-on, be that through collaboration or by finding an alternative source of supply.

Why do service levels have such a big impact on safety stock?

Maintaining a 100% service level seems like a fair target. Sadly however, it’s grossly unrealistic, if not virtually impossible.

Of course, it’s only natural to want to offer your customer 100% satisfaction, based on their demand. But aiming for 100% would likely require such a deep reserve of safety stock, you’d be leaving your business open to high levels of risk.

The reason service levels are such a high driver of safety stock is this direct correlation between the two. And it needn’t be a number as high as 100% to increase your risk.

The greater your desire as a business to satiate the demand of your customer, the larger your safety stock needs to be. Yet, the more the risk increases. Ok, leaving your business open to the possibility of a stockout is regrettable – you’re leaving profit on the table and not maximising opportunity – but having hoards of excess waste is just as big a problem.

When you invest in safety stock, you commit valuable working capital. And if this stock never shifts, your cash could be lost for good.

But also, let’s not ignore the stress that high levels of inventory place on your warehouse and logistics operation.

Therefore, it’s important that you challenge your presumptions around safety stock:

What you need to analyse is the strategic importance of those products.

• Do they have a shelf life?
• Are the products likely to sell eventually?
• Are they generally quick moving?
• Is the product a fad or seasonal?
• Could you use the money to invest in other pockets of the business which have lower risk?

What if the risk of a stockout is low?

There are some occasions when the risk of running out of stock is extremely low, like a product with a minimum order quantity that covers the likely customer demand for an entire year.

If your business is only making one order per year, and that demand is steady and unlikely to impact customer satisfaction until many months down the line, it’s less of a problem.

Even if the product shot up in demand and experienced higher levels of volatility, you’d have plenty of time to replenish your stock should levels become low.

You’d also expect to have good damage limitation from lead times, given how far down the line you’d know about the potential of a stockout.

How appropriate are your safety stock levels?

Safety stock, on the face of it, seems like an easy conundrum to resolve: order some, but not so much as to make it a risk. Except that, making a decision of this magnitude with only a guess or estimate based on nothing more than a stab in the dark is a very bad move.

Use the formula above to make a continuous assessment, and you’ll ensure your business is safeguarded against volatility in the market.

There’s not much you can do to stop a war or another pandemic raging through the world. But you can take care of your own business by being well prepared.

By limiting the impact of stockouts and managing your revenue closely, you’ll have a tight control on safety stock and a better outlook for the future.

Essentially, it boils down to these two questions:

1. Do you have enough stock to meet demand?
2. Do you have too much?

There’s a fine line between too much and too little. But luckily, we can help you toe that line.

Speak to one of our experts for free, and we’ll have you on the path to safety stock success in no time at all.