Calculating Safety Stock: How to Avoid Stockouts and Minimize Inventory Carrying Costs

Brandon Ginsberg
Brandon Ginsberg
CEO | ApparelMagic

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In retail, safety stock management is essential since demand changes and new trends appear fairly frequently. Running out of stock can be a costly issue. In North America alone, stockouts result in $144.9 billion worth of lost sales.

By anticipating customers’ needs and expectations, companies can quickly refill their shelves, place advance orders for products, or have an emergency supply of inventory on hand. Knowing how to calculate safety stock will help you manage your inventory more effectively, cut expenses, and increase productivity and income.

In this post, we provide an answer to the question “What is safety stock?”, why it is important, discuss how to calculate safety stock, and more. 

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What is Safety Stock?

Any business could run out of products, which is why you must take measures to ensure that your company remains operational regardless of what happens. 

Your company should ideally never have to worry about running out of inventory, but this is not always the case. There are many situations that might lead to a stockout, including a surge in customer demand, issues in supply chain management, supplier inability to deliver what and when you require, equipment malfunction, or simply bad weather impeding deliveries.

Safety stock is extra inventory that is ordered and kept on hand in case demand exceeds expectations. It reduces the risks and effects of stockouts, enabling your supply chain to continue operating normally even after cycle stock is exhausted.

The Importance of Keeping Safety Stock

There are several reasons why companies should always have safety stock on hand. Here are some of the most important ones: 

Prevent stockouts. Safety stock can help businesses lower the possibility of running out of a particular product and keep operations going while the company finds, buys, and distributes this inventory. 

Offset demand uncertainty. Demand fluctuations are one of the most important reasons for keeping a safety stock. Seasonal effects, abrupt changes in consumer preferences, panic buying, or a competitor’s departure are just a few of the many factors that might affect demand spikes. Safety stock allows companies to restock while still satisfying the increased demand.

Reduce the consequences of supply issues. Unexpected disruptions in supply like a lack of raw materials, operational shutdowns, production problems, and political or legislative measures, can have a significant effect on your stock levels. These delays affect the entire supply chain, influencing things like delivery timelines and store disruptions. Safety stock helps to lessen the effects of supplier issues and keeps the supply chain going until the issue is resolved or the company has secured a new supplier. 

Make up for inaccurate forecasts. Demand forecasting is typically reliable, but unexpected changes can cause it to be inaccurate. Maintaining safety stock ensures consistency and enables decision-makers to make more precise estimates and forecasts. 

Boost efficiency. Safety stock ensures more efficient operations even when there are supply problems, including on-time deliveries, more effective warehouse staff, and reliable, consistent inventory levels for forecasting and reporting needs.

Enhance customer satisfaction. Customers who know that a business will always have the products they need in stock are more likely to return and spread the word about the business. This pays off greatly in the long run and helps your company grow. 

Common Safety Stock Risks and Challenges

Safety stock is a valuable tool when it comes to preventing stockouts, but it can also have some disadvantages that inventory managers need to take into consideration when developing their safety stock strategy.

Safety stock is static

Classic safety stock is referred to as static, which means that it doesn’t increase as the business expands. As a result, the number of units designated as safety stock may not be sufficient when the company grows. Inventory managers should periodically analyze safety stock levels and bottlenecks and make any required adjustments.

Excess safety stock

Although carrying safety stock is important to prevent sales losses due to stockouts, there is no getting around the fact that it requires an additional monetary investment. Having too much safety stock can result in a lack of space for current cycle stock or new items. Additionally, it is a sizable corporate expense because holding fees frequently account for about 20% of the overall cost of the inventory.

Setting safety stock to zero

This is a common strategy that supply chain managers use to reduce the expenses associated with keeping too much inventory on hand. This is particularly common when a sudden increase in demand levels out and returns to normal. While setting safety stock to zero resolves the problem of having too much inventory, the risk of not having a buffer to manage future changes in demand or supplier delays is re-ignited, which can be even more expensive. 

Overuse of safety stock

While safety stock is a good defense against stockouts, it is not a solution for all your inventory problems. To balance the dangers and expenses of stockouts with those of having too much stock on hand, supply chain managers must determine the ideal quantity of safety stock for each product.

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Calculating Safety Stock

Follow the following steps for calculating safety stock:

1. Calculate Lead Time

Lead time is the period of time that passes between the start and end of a production process or the time it takes to restock your inventory. Simply said, you need to consider how long it takes to make a buy request, have it authorized, email suppliers, receive deliveries from suppliers, examine products, put them on shelves, or update online inventory levels.

To calculate the average lead time, you must include lead time variables. This means that lead times won’t always be consistent. To keep track of this, make a table with the following categories:

  • Expected lead time of a specific product
  • The actual time it took to replenish the order for a specific product
  • The difference (variance) between the expected and actual times. 

Positive figures in your variance category indicate that there were more days than anticipated. If the category contains negative values, the delivery came earlier than predicted. Using these figures and their respective definitions, you can determine the standard deviation for your lead times. 

To do this, add up all the variances, then divide the sum of variances by your portion numbers, i.e., the lead times of the most recent shipments (for example, if you have seven past shipments in your portion, you will divide the sum by seven). The average estimated time should then be added to this result.

2. Calculate Demand

In order to calculate the market demand average, you need to start with a specific time period. The best time frame is determined by how quickly you can place a product order again. This can be a week or two, a month, or even longer.

Take the total sales volume for your time period and divide it by the number of buying days to determine the demand average. For instance, in a one-week timeframe, there would be 7 buying days. 

3. Establish Your Desired Service Level

The service level factor involves balancing inventory costs against the cost of stock out to determine the appropriate service level for a certain product. Higher service levels mean that more safety stock is needed.

To determine safety stock, you can use the normal distribution chart to choose a set of numbers that correspond to the percentage of your targeted service level.

4. Calculate Your Needed Safety Stock

Once you’ve determined your average lead time, average demand time, and desired service levels, you can finish the calculation and determine your safety stock using the previously mentioned safety stock formula:

Z × σLT × D avg = Safety Stock

Where:

Z is the desired service level

σLT is the standard deviation of lead time

D avg is the average demand. 

The Bottom Line

Keeping safety stock has a number of benefits, one of the most important ones being the ability to continue running your business even when there are problems in the supply. However, it is crucial to avoid keeping too much safety stock on hand because doing so might do more harm than good for your company.

Formulas can assist in finding the ideal balance, but determining and achieving the ideal safety stock level necessitates a thorough knowledge of the entire supply chain. Inventory management software like ApparelMagic removes the need for manual processes, enabling businesses to reduce disruptions, maximize sales, achieve an optimal safety stock level, and boost profits.

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