Calculating Safety Stock for Better Inventory Management
Executing a successful supply chain management strategy complete with safety stock calculations is a complex endeavor. It requires combining processes, people, and technology to get the correct item, in the right quantity, to the right individual, at the right time.
Accurate stock levels are essential—the right safety stock strategy can reduce operational costs, increase customer satisfaction, and lead to a healthier bottom line for your business. Safety stock can help you stay on top of unexpected events by giving you a buffer between the risk of stocking out and when inventory arrives.
Keep reading as we explain what safety stock is, why it’s essential, and the formulas you can utilize to mitigate some of the supply chain risks inherent in the ecommerce industry.
What Is Safety Stock?
You can’t dive into calculating safety stock without understanding the concept first.
Put simply, safety stock is extra inventory you hold on to in case demand unexpectedly increases. It’s holding additional stock above the typical inventory level that you’d ordinarily have for normal, day-to-day operations.
Why Is Safety Stock Important?
Accurate safety stock can save you from stockouts, which are usually caused by:
- Incorrect stock forecasts
- Changes in consumer demand
- Variability in lead times
Safety stock also benefits ecommerce business owners by mitigating unexpected disruptions in your supply chain, keeping customers happy and preventing lost sales, and lessening the blow if you underestimate the demand for a product.
Customer satisfaction is the most significant benefit here. If a customer leaves your website because the product they came to purchase is out of stock, they may find the product elsewhere and never return.
Also, you can destroy customer loyalty if you sell an item that’s out of stock and must delay fulfillment due to backorders. They may choose to go directly to your competitors next time instead. A safety stock strategy can product you against two external factors: demand uncertainty and lead time uncertainty (both of which you have little to no control over).
Every retailer has a selection of products that sell well year-round and others that fluctuate in demand.
Electric razors, for example, are sold year-round, so it’s easier to predict reorder quantities. As long as there is consistent supply and demand, you may not need to carry much safety stock.
However, a product like a humidifier is much more challenging to forecast. You may typically sell more humidifiers in the cool, dry months, but it’s impossible to plan for a bad cold season. To cover the uncertainty, it’s vital to have more safety stock of humidifiers than you do for electric razors.
Lead Time Uncertainty
If you assemble products or bundles using different products or components, you must know the lead time to determine minimum safety stock requirements.
The automotive industry, for example, uses just-in-time inventory management, relying on parts to arrive just hours before they hit the production line. Production delays with suppliers can negatively impact the entire operation, sometimes causing total shutdowns. Shutdowns lead to changes in lead times. If deliveries arrive later or earlier than expected, a safety stock formula can help you maintain consistent output.
Using a Safety Stock Formula
Safety stock plays an essential role in the ordering process because stockouts directly impact your day-to-day business. Some of the direct impacts that stockouts have on your business include:
- Loss of gross profit
- Loss of revenue
- Loss of customers
- Poor efficiency
- Reduced market share
- Strained supplier and other B2B relationships
Your customers will find someone else to meet their demand if you can’t—whether your competition is down the street or online. To keep your customers happy and operations running smoothly, a safety stock formula is vital. Not only will determining precise safety stock requirements increase your business’s efficiency, but it will also lead to higher service levels and increased revenue
Using a standard safety stock formula isn’t always suitable for every industry, which is why there are several iterations to choose from. Here are several of the most popular so you can choose the method that best suits your operation.
Basic Safety Stock Method
This is the traditional method used to calculate safety stock. It factors in the number of items you sell per day with the number of days of stock you wish to hold. For example, if you sell 500 units of a product a day and want to have three days of extra stock, you will calculate 500 (products) x 3 (days worth of stock), which equals a safety stock of 1500 units.
Average – Max Method
While this formula is standard, it can be challenging to execute if you have a longer lead time. With this formula, your goal is to calculate the average max units of a product you need at any given time.
The formula is: (maximum sale x maximum lead time) – (average sale x average lead time)
Normal Distribution With Uncertainty About Demand Method
When your lead time is stable, but you’re experiencing fluctuations in demand, this method can come in handy: (standard deviation of the demand) x (the root of the average delay)
First, you must calculate the average demand (total monthly demand divided by the number of months). Then, calculate the variability in demand. Do this by taking the square of each month’s difference then find the average of those squares. The standard deviation is the square root of the deviation—this represents sales variability.
You’ll use the same unit of measure to determine lead time variability, which could be days, weeks, or months. Calculate your average lead time and find the square root of the average of squared differences to estimate lead time variability. You’ll use all of these figures to calculate safety stock.
Normal Distribution With Uncertainty on Lead Time Method
If only your lead time fluctuates, you can use another formula: Z x (average sales) x (lead time deviation)
You will most likely have a much lower safety stock requirement if your lead time variation is slight. This is because you know that your supplier is fairly consistent. If your supply levels dramatically fluctuate, you’ll need more safety stock.
Normal Distribution with Uncertainty on Demand and Independent Lead Time Method
If there’s a high degree of uncertainty with demand and lead time, you’ll use this method. Demand and lead time work independently of each other here. In the previous example, the lead time of electric razors doesn’t impact their demand.
So, because these factors are independent of each other, this formula is more complex: Z x sqrt((average lead time x (demand standard deviation) squared + (average sales x lead time standard deviation squared)
Although it’s complex, the above formula can be beneficial when there’s a lot of uncertainty.
Normal Distribution With Uncertainty on Demand and Dependent Lead Time Method
Finally, if demand and lead time are linked, you can use this method. For example, you may use this if lead time causes demand uncertainty or vice versa.
The formula is: Z x demand standard deviation x sqrt (average lead time) + Z x average sales x lead time standard deviation
More stock is typically needed to account for unpredictable variations, so variability can impact sales and sales can affect variability.
Which Is the Correct Safety Stock Formula for Your Business?
You must consider the quality and quantity of your data before determining which safety stock method is best for your business. It’s critical to have a solid and reliable data set to work from to calculate safety stock correctly. If your data isn’t trustworthy, you’ll end up with inaccurate calculations, which will create more issues than it resolves.
The correct formula for your business also depends on sales volume. For example, if you sell over 100 units per month, you may want to consider the normal distribution with uncertainty about demand method. This formula is beneficial when lead time is relatively stable, but you have questions about demand.
If your sales volumes are low, you may be able to get away with using the medium max method to calculate the average maximum units you need at any given time.
Mastering Safety Stock for Fewer Stockouts and Happier Customers
You can’t have accurate safety stock and reorder point numbers without inventory data that you can trust. Centralized data and correct formulas will ensure appropriate levels of inventory, which will keep your customers satisfied while saving you money.
Do you need an automated ecommerce software solution to help stay on top of all of these variables?
Talk with an expert at Flxpoint to learn more! We’ll help you streamline and automate ecommerce inventory and order management so that you can focus more on growing your business.
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