Properly Setting Minimum and Maximum Stock Quantities (Part 2)
By Jon and Matt Schreibfeder

Note for our Readers using Epicor ERP Systems – Jon and Matt will be speaking at both the Epicor Insights Convention in Las Vegas and the Prophet 21 User Group Connect Conference in Dallas. Please let us know if you will be attending these meetings. We would love to have a chance to meet you!

Last month, we began a discussion of properly maintaining replenishment parameters for stocked inventory items. That is, deciding when to replenish your inventory of products and how much to order from your supplier. This month, we are going to discuss a critical element of the minimum quantity: safety stock. That is the “insurance inventory” you maintain to prevent stockouts due to unusual usage or delays in receiving a replenishment shipment from the vendor.

If safety stock quantities are too low, they will not provide adequate insurance to protect customer service. If safety stock quantities are too high, part of your inventory investment will be tied up in non-productive stock. This excess inventory will not contribute to your efforts in achieving the goal of effective inventory management.

There is a simple, best practice analysis that will help ensure that the safety stock quantity you maintain for each item is “just right”. It is called residual inventory analysis, and the steps are:

1. For each item, the forecast quantity, actual quantity sold or used and the safety stock quantity for each of the previous three months.

2. For each item in each month, add the safety stock quantity to the forecast to equal the planned total available stock for the month:

Forecast + Safety Stock = Planned Total Available Stock for the Month

This is the quantity you are intending to sell or use plus your insurance stock to cover unanticipated demand or delays in receiving replenishment shipments.

3. Subtract from this quantity, the actual usage quantity for the month. The result is called “residual inventory”.

Planned Total Available Stock for the Month – Usage = Residual Inventory.

4. Convert the residual inventory quantity into a number of day’s supply, divide the monthly forecast by 30:

Residual Inventory ÷ (Forecast ÷ 30) = Residual Inventory Day’s Supply

In a specific month, if the residual inventory is less than a minimum number of day’s supply (three or four days is a typical number) the forecast plus safety stock quantity probably was not adequate to meet actual usage resulting in a potential stockout. Why not base this analysis on zero day’s supply? Because you might have experienced some lost sales because the on-hand quantity was not adequate to meet a customer need (e.g., they wanted 5 pieces but you only had one piece of the item in stock) and the customer didn’t place an order.

5. Calculate how many potential stockouts occurred during the previous three months and divide this quantity by the number of possible stockouts. For example:

12,000 products with sales in 3 months = 12,000 possible stock outs
600 residual inventory values less than a three day supply (potential stock outs)
Potential Stockout percentage = 600 ÷ 12,000 = 5%

The customer service level is the inverse of the stockout percentage or 95%. This means that 95% of the time you should have adequate stock to meet customers’ expectations of product availability.

Most organizations cannot afford the inventory to maintain a consistent customer service level for all items near 100%. But some items are more important in satisfying customer needs than other products and require more safety stock. If residual inventory analysis shows that a product consistently has a residual inventory quantity representing more than an “x” day (typical value is 21 day) supply, consider reducing the safety stock quantity for this item and invest the money saved in additional safety stock for a critical product that has recently experienced one or more stockouts.

In today’s competitive environment, it is critical to make sure that every dollar invested in inventory is contributing to achieving the goal of effective inventory management. Maintaining accurate anticipated lead times and fine-tuning safety stock quantities with residual inventory analysis are valuable tools in this effort.