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How to Calculate Safety Stock?

How to Calculate Safety Stock?

safety stock

Is your inventory protected against fluctuating demands and vendor lead times? When was the last time you lost business due to a stockout? Stockouts can occur due to a surge in demand or unpredictable procurement lead times. Knowing which products to stock and how much to reorder is critical for optimizing your inventory and maximizing profits. It is also vital to safeguard your business from variability in consumer demand and lead times. 

 

What is safety stock? 

As the name suggests, safety stock is the additional inventory held by a business to meet an unforeseen surge in demand or unpredictable procurement lead time. The main reason why businesses implement a safety stock strategy is to maintain service levels and prevent stockouts. 

 

Why is safety stock important?

So, how do you plan your inventory levels when there are too many variables? This where a data-driven safety stock strategy can help.

Primarily, having a safety stock strategy can prepare your business against two factors:

Demand uncertainty

Unless you deal in products that sell consistently all year round, it would be impossible to predict how much stock you need to hold. For example, FMCG products are typically in demand throughout the year, making it easier to determine target inventory levels. The demand and supply are more or less consistent for such products and require fewer amounts of safety stock. On the other hand, seasonal products like air conditioners are much more challenging to forecast. To cover an unexpected increase in demand, you would typically need to maintain a more significant amount of safety stock.

Lead time uncertainty

Another reason to use a safety stock strategy is to overcome the impact that vendor lead time delays can have on your business. An unexpected delay at your vendor’s end, in turn, causes your lead times to be affected. Having sufficient safety stock helps you maintain service levels while waiting for products or raw materials from your vendors.

 

How to calculate safety stock?

Step 1: Calculate Standard Deviation of Lead Time 

Lead time is the time measured in days between raising a purchase requisition and restocking the product in your warehouse. It includes the time for purchase order approvals, vendor delivery time, and quality inspections. To calculate the standard deviation of lead time, you will need the following:

  • The Expected Lead Time of a product.
  • The Actual Lead Time it took to replenish each order.
  • The Variance (difference) between actual time and the expected time.

Example

Let’s take a look at JJ Sportswear’s lead time data for the last five purchases of their best-selling product.

Expected Time Actual Time Variance
10 8 2
10 7 3
10 8 2
10 12 -2
10 11 -1

First, let’s calculate the average variance.

Average variance = (2 + 3 + 2 -2 -1) / 5 = 0.8 Days

Next, let’s add the average variance to the average expected time to determine the standard deviation of lead time.

Standard Deviation of Lead Time = Average Expected Lead Time + Average Variance

Standard Deviation of Lead Time = 10 + 0.8 Days = 10.8 Days

 

Step 2: Calculate Average Daily Demand

Before we calculate the average demand, it is important to establish the time frame for the demand data. A good rule of thumb is to use the day sales inventory (DSI) – the time it takes between two reorders.

Week Sales Volume
W1 500 Units
W2 520 Units
W3 510 Units
W5 490 Units

JJ Sportswear typically reorder their best-selling product every month. In the table above, we use JJ Sportswear’s sales volume for one month broken down into weekly increments. To calculate the average daily demand, we simply take the sum of sales and divide it by the number of days in the month.

Average Daily Demand = (500 + 520 +510 + 490) / 30 = 67 Units

 

Step 3: Determine Service Factor

The service level of a particular product determines how much safety stock is required to cover uncertainties in demand and lead time. The higher the service level, the more safety stock is needed.
To calculate the safety stock, we”ll need to convert the service level to a value that we can plug into our safety stock formula. To determine the service factor based on the desired service level, we will use a normal distribution chart.

Service Level Required (%) Safety Stock Coverage Factor Z-Value Service Level Required (%) Safety Stock Coverage Factor Z-Value
70% 0.524 90% 1.282
75% 0.674 91% 1.341
80% 0.842 92% 1.405
81% 0.878 93% 1.476
82% 0.915 94% 1.555
83% 0.954 95% 1.645
84% 0.994 96% 1.751
85% 1.036 97% 1.881
86% 1.080 98% 2.054
87% 1.126 99% 2.326
88% 1.175 99.5% 2.576
89% 1.227 99.90% 3.090

For exmple, if you want to achieve a 90% service, the normal distribution will give you a multiplier coefficient of 1.28 to meet 90% of the demand.

 

Step 4: Calculate Safety Stock

To calculate the safety stock, we simply multiply the three figures we have calculated above.

Safety Stock = Standard Deviation of Lead Time X Average Daily Demand X Service Factor

Safety Stock = 10.08 Days X 67 Units X 1.28 = 864 Units

This means that JJ Sportswear would need 864 units of safety stock on hand to meet 90% of the sales demand over an average lead time of 10.8 days.

 

Common Pitfalls Related to Safety Stock 

Now that we know how to calculate the safety stock let’s look at some of the common pitfalls you’d want to avoid.

Zero safety stock

One common mistake that businesses make during inventory planning is setting a zero safety stock to reduce inventory costs. However, this approach usually results in a decrease in service level and costs the business more in lost sales.

Too much safety stock

The goal of safety stock, as we have seen above, is to prevent stockouts. However, it is common for businesses to be over-optimistic and target a service level of 100%. Having a service level of 100% theoretically means that you’d be able to meet sales demand at all times. But, it also means that you’d have a large amount of safety stock and, therefore, a large amount of money tied up in inventory.

Try out our free safety stock calculator now!

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