How Much Safety Stock Should be Maintained in Inventory?
This year we are discussing the 15 steps you can follow to achieve the goal of effective inventory management. That is, to meet or exceed customers’ expectations of product availability while maximizing net profits or minimizing the total inventory investment. This month we will explore safety stock.
Safety stock provides protection against product availability shortages due to unexpected demand for a product or delays in receiving a replenishment shipment from a supplier. It is insurance. Like most other types of insurance there is no “right” or optimum amount. Setting safety stock levels is a subjective decision. The answer will probably be different for various products you stock. In determining the safety stock amount for a particular product, you have to ask:
- What is the likelihood that this product will experience a stock out?
- How disappointed will customers be if this product is not in stock?
Products are more likely to be out of stock if they experience:
- Inconsistent supplier lead times – If vendor shipments are often several weeks late, you may want to keep some extra stock to “cover” customer demand during these unexpected delays in receiving a replenishment shipment.
- Large fluctuations in sales or usage – You might sell 10 pieces or 1,000 pieces of a product in a month without much notice of when usage will significantly increase.
Despite what your salespeople may tell you, customers probably don’t expect every item to be in stock 100% of the time. Even if you think they have these high expectations, you probably can’t afford to maintain enough safety stock of every item to meet every customer request 100% of the time.
Best practice is to vary safety stock quantities for individual products:
- For some items you will receive a few orders for a relatively small quantity. Safety stock is usually not needed to fill these requests.
- You might need some safety stock if you receive frequent orders for consistent quantities of another product.
- For a product with erratic usage (e.g. sales vary dramatically from month to month), you might want to keep a large amount of safety stock to prevent stockouts in months with large sales. However, because you do not ship unusually large quantities of this product each month, this safety stock may sit in your warehouse and gather dust for a prolonged period of time. Because this inventory is not being sold or used on a regular basis, it does not provide a predictable return on your investment. You must weigh the cost of maintaining this additional inventory in stock against the problem of possibly disappointing a customer.
- “Critical” stock items: products that should always be available. You are embarrassed if these items are not available for immediate delivery, even if you experience unusually
high sales. These “never be out” items require more safety stock if you want to protect your reputation as a reliable supplier.
Though it is evident that some items need more safety stock than others, most organizations maintain safety stock quantities with some general rules that apply to all stocked products. Typical safety stock policies include:
- Safety stock is equal to a fixed percentage of lead time usage (typical value is 50% of lead time usage)
- A specific number of day’s supply is maintained as safety stock (typical value is seven to 14 days)
Either of these methods results in some products having too much safety stock (unnecessarily tying up funds, suppressing inventory turnover and taking up too much warehouse space) while other items have too little safety stock (resulting in additional stockouts and disappointed customers).
Better customer service usually is obtained at a lower inventory investment if safety stock is applied to specific items as it is needed. One way to do this is to calculate safety stock quantities on the average deviation, or difference, between the forecast and actual usage over the past several months.
The deviation method applies more safety stock to those items with a larger deviation (i.e., difference) between actual usage and the forecast. That is, those items that are more likely to run out of stock. To utilize this method, first calculate the difference between the forecast and actual usage over the previous three months. Consider this example:
Month Forecast Usage Deviation
Feb 50 60 10
Mar 76 80 4
Apr 80 70 -10
In February, the demand forecast for the product was 50 pieces and actual usage was 60 pieces resulting in a deviation or difference of 10 pieces. In March, the demand forecast was 76 pieces, and actual usage was 80 pieces, which produced a deviation of four pieces. The average deviation is:
(10 + 4) / 2 = 7 pieces per month
Note that the deviation for April, in which demand exceeded usage, is not considered in our calculation of safety stock. Why? Because if the prediction of what customers want exceeds actual usage, safety stock is not needed! Probably there already is more than enough of the item on the shelf.
The average deviation is multiplied by a deviation multiple. The deviation multiple used is dependent on the customer service level you want to provide. The customer service level is defined as the percentage of line items for the product completely filled, in one shipment, by the promise date. The higher the multiple, the more safety stock you need to maintain and the higher the customer service level. Generally, the following multiples will usually achieve the corresponding projected levels of customer service:
Deviation Multiple | Projected Service Level
2 | 95.0%
3 | 97.5%
4 | 98.5%
5 | 99.0%
If our goal is a 95% customer service level, multiply the average deviation by a multiple of two (7 * 2 = 14 pieces) for most items. A deviation multiple of five (7 * 5 = 35 pieces) should achieve a 99% customer service level for those designated “critical” items. Using this method provides more safety stock to those items whose usage is more erratic.
But be careful! Using a higher deviation increases your investment in stock inventory, often resulting in lower profitability. And it is also a good idea to set an upper limit (in terms of day’s supply of the product) on the amount of safety stock maintained for an item. Most of our clients limit safety stock quantities to no more than a 30 – 45 day supply.
Safety stock is necessary insurance for achieving effective inventory management. But it is also expensive! Best practice is to selectively, and carefully, apply it to meet your customer service level goals. Next month we will continue our discussion of determining the “right” amount of safety stock to maintain for each stocked item.
And a note from Jon:
Just finished two weeks in Burundi, Uganda and Kenya on a mission trip with Inspiring Better Business (IBB), an organization dedicated to “breaking the chains of poverty” by training and guiding people become entrepreneurs with what they have, without taking out loans. The results and success stories are phenomenal! These wonderful people are using their God given capabilities to improve their lives, the lives of their families and their countries. If you want more information, or would like to see about getting involved, let me know or go to InspiringBetterBusiness.com.