Robert Crellin
Supply chain consultant
Safety stock inventory is the additional level of inventory businesses hold in order to minimise the risk of stock out. However, being overly cautious can quickly result in costly excess and obsolescence: both of which will erode margins. So what factor should you take into account when determining the optimal level of safety stock inventory?
One of the major discount supermarkets made headlines this week as one of their popular “special buys” sold out in less than a minute. While this sounds as though the product was a roaring success, the short supply left many customers disappointed. Consequently, should the retailer have invested in more stock to cover this unexpected demand?
The answer to this question is: probably. The problem is that there are many examples of businesses that have been over cautious and over-protected their availability at great cost.
Take for instance, the rise and fall of “fidget spinners”: a playground fad that swarmed across playgrounds in just a matter of days. In fear of missing out on an opportunity to profit, many businesses invested heavily in safety stock inventory to maximise their sales potential. Given that sales of this simple gadget accounted for 17% of the total toy sales last month, this seemed like a sensible decision. However, sales have since flopped and show no sign of recovery. Consequently, these businesses are left stuck with this safety stock inventory!
Ultimately, the optimal safety stock inventory is all about striking a balance between service levels, investment in stock and risk.
Even for the most accurate demand forecasts, actual demand will always vary to some extent. Likewise, your suppliers will not always deliver your orders exactly on time or in the exact agreed quantities. The purpose of safety stock inventory is to protect against demand and supply volatility in order to achieve the target service levels.
While there are many factors that can influence the requirement for safety stock inventory there are four key areas which must be accounted for:
Imagine that demand for a product was consistently 100 units a month. Ensuring you have enough stock to satisfy this demand would be easy. However, the reality for many items is that demand will vary significantly month to month. Even if the average monthly demand was a hundred units, actual demand could vary and thus, without the optimal level of safety stock the business would be plagued by stock outs and excess.
In simple terms, for any given service level, products with relatively stable demand patterns, the need for safety stock may only be minimal. However, for products with more sporadic demand patterns, the need for buffer stock will be much higher.
Another key purpose of safety stock inventory is to cover for uncertainty during the cover period. This is the time between making an order and actually receiving the goods. For products with really short lead times such as just 1 day this is not so much issue. After all, you only need to cover demand for 1 day. Even, if you receive an unexpected order during the cover period, this will only be an issue for one day until the new order is received.
However, for items with long lead-times such as goods sourced from the Far East, the level of risk is likely to be far greater. Given that it could take up to 12 weeks for an order to be shipped over, there are far more days of demand to cover and more opportunity for things to go wrong. As a result, in order to maintain availability until the inventory can be replenished the need for safety stock increases.
Determining how best to cover for supply volatilities can often be a difficult decision. After all, who should pay the price for supplier performance issues? Should you really have to invest in additional inventory to cover your suppliers late deliveries?
In the same way demand deviates from what was expected, there will always be some deviation in the anticipated lead time and the actual delivery times. The causes of these deviations are, in many cases, unforeseen and unavoidable. However, these supplier issues can still have a detrimental impact on customer service levels. As a result, some amount of safety stock should be established to mitigate the risk of stock outs.
However, if supplier lead times are consistently wrong, investing in additional safety stock may be not be the best approach. After all, safety stock inventory is only a short-term solution to cover for uncertainties in supply and thus will not improve the situation in the long term.
If a supplier always takes 3 weeks longer to deliver than what was agreed, the question should be asked, is the promised lead time realistic in in the first place? With this in mind, instead of investing in safety in this instance, the business should investigate the root cause of the issues and renegotiate the contract accordingly.
Service level targets, it their purest form is a description of a business’s corporate goals to the inventory strategy. In essence, you are deciding to what extent you want to satisfy your customer’s needs based on your stock capacity.
Although a common expectation of the business, maintaining 100% availability across the entire product range is not possible. Thus, management must determine to what extent they want to satisfy demand. While establishing an optimal service level can provide a margin boost, if the service level target is inappropriate, this will result in an unacceptable number of stockouts or crippling excess.
Service levels are a major driver of safety stock inventory as the higher the service level, the greater requirement there is for stock to ensure availability.
After all, when you decide to make an investment in safety stock, you are essentially committing valuable working capital. For products of strategic importance, this is probably not a problem. However, for slow moving items or items of relatively low importance to the business or customer, the money locked into these products could be better invested elsewhere across the business.
Given that the relationship between service levels and safety stock inventory is exponential, it’s vital that the service level target is well aligned with across key products within your business; whether this is by product category of based on customer importance, or a combination.
We have already highlighted the volatile nature of supply and demand. However, just because uncertainty exists, this does not necessarily mean you will go out of stock. There are certain circumstances that negate the need for a product to have a level of safety stock inventory. But in what situation would a product have a natural layer of protection?
The relationship between safety stock, lead times and supplier reliability is clear, however the impact of order quantities is often overlooked. Imagine if the minimum order quantity for a product was the equivalent one entire year’s demand. This would mean that you would only have to make one order per year. So, even if the product was subjected to high levels of volatility, the high level of inventory that results from the MOQ would mean that you always have plenty of time to respond should stock levels start to fall. Instead of holding safety stock, the order moment could be brought forward.
Determining the right level of safety stock is easier said than done. However, when assessing your own safety stock situation, you must ask two questions: Do you have enough stock to meet demand? Do you have too much?
There is a fine line between too much and too little. However, our simple guide to setting service levels will help you define more suitable safety stock levels. Click here to read full article
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