Computer systems maintain the stock of inventory items with parameters such as minimum and maximum quantities. Some of these parameters are objective – that is, there is one right or optimum answer. For example, an economic order quantity balances the actual cost of a product, inventory carrying costs, and costs of purchasing to determine the specific replenishment amount that results in the lowest total cost of each piece of the product.
Other inventory parameters are subjective in nature. There is no one best answer. Safety stock (also known as safety allowance) is one of these. Safety stock provides protection against stock-outs due to unexpected demand for a product or delays in receiving a replenishment shipment from a supplier. It is insurance. Like many other types of insurance there is no “right” or optimum amount. If you talk to three different life insurance agents, they will probably suggest you buy three different amounts of insurance. When you are determining safety stock quantities you have to ask yourself, “how much do I want to invest in preventing stock-outs?”
The answer will probably be different for various products you stock. In determining the safety stock amount, 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 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 advance 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. However, there are some products both you and your customers always expect on your shelves. These are what my original mentor Alan “Buddy” Silver referred to as “painful backorder” products. When you are told they are out of stock, you often get a pain in your stomach.
Though it is evident that some items need more safety stock than others, most distributors maintain safety stock quantities with some general rules that apply to all stocked products. Typical safety stock policies include:
- We will maintain safety stock equal to 50% of lead time usage.
- We will keep a one month supply on hand as safety stock.
The result is that some products have too much safety stock (unnecessarily tying up funds, suppressing turnover, and taking up too much warehouse space) while other items have too little safety stock (resulting in additional stock-outs and disappointed customers.
We have developed a simple way to measure the effectiveness of your safety stock quantities. To perform this analysis you will need the following information for each of the items you stock:
- Actual usage for each of the previous several months. We are using five months in this example from one of our customers.
- The demand forecast (i.e., predicted usage for each of these months).
- Your method for maintaining safety stock. In this example we are expressing safety stock as a number of months’ supply.
- The replacement cost per piece for each item. In this example the unit cost of the item is $21.46.
For each month we subtract actual usage from the forecast:
| Prev-01 | Prev-02 | Prev-03 | Prev-04 | Prev-05 | |
| Forecast | 147 | 171 | 145 | 192 | 182 |
| Usage | -157 | -173 | -327 | -180 | -155 |
| Ending Balance | -10 | -2 | -182 | 12 | 27 |
In the Prev-02 and Prev-03 months, usage exceeds the forecast and safety stock would be required to prevent stock-outs. Would one month’s safety stock be adequate to avoid out-of-stock situations?
| Prev-01 | Prev-02 | Prev-03 | Prev-04 | Prev-05 | |
| Forecast | 147 | 171 | 145 | 192 | 182 |
| Usage | -157 | -173 | -327 | -180 | -155 |
| 1 Month SS | 147 | 171 | 145 | 192 | 182 |
| Ending Balance | 137 | 169 | -37 | 204 | 209 |
One month’s safety stock will prevent a stock-out in month Prev-02 but not in month Prev-03. What if we were to maintain two months usage as safety stock?
| Prev-01 | Prev-02 | Prev-03 | Prev-04 | Prev-05 | |
| Forecast | 147 | 171 | 145 | 192 | 182 |
| Usage | -157 | -173 | -327 | -180 | -155 |
| 2 Month SS | 294 | 342 | 290 | 384 | 364 |
| Ending Balance | 284 | 340 | 108 | 396 | 391 |
Two months’ safety stock will prevent stock-outs during this period, but at what cost? The average investment in two months’ safety stock would be $7,184.82, while the average investment in one month’s safety stock would be half this amount. In deciding how much safety stock you want to maintain, perform this analysis for all of the items in your inventory to see how many total potential stock-outs you will experience with the various levels of safety stock. Also note when all of the resulting ending balances for a product represent a very high level of inventory. These products probably have fairly predictable usage and consistent lead times. You can probably reduce the safety stock for these items and still maintain your desired level of customer service.
The customer who supplied the data for our example has 1,738 items in inventory. One month’s safety stock for each item would cost $3,071,143 and would result in a total of 1,157 stock-outs out of 8,690 opportunities (1,738 products * 5 months = 8,690). This results in an out-of-stock percentage of 13.3% (1,157 stock-outs ÷ 8,690 opportunities = 13.3%) or an in-stock percentage of 86.7%. Two months’ safety stock for each item would cost $6,142,286 and would result in 557 stock-outs – an out-of-stock percentage of 6.4% (557 stock-outs ÷ 8,690 opportunities = 6.4%) or an in-stock percentage of 93.6%.
With this information the customer began to fine-tune their investment in inventory. They examined the stock-outs of painful backorder items and selectively increased the safety stock until there were no out-of-stock situations. They implemented a corporate policy that these “core” products would always be available and would never be out of stock. For some of these products the safety stock quantity represented a one-month supply, for others a 1.5-month supply, and for some up to a 2.6-month supply.
For a second group of “moderately important” products, the customer examined several safety stock investments and corresponding projected in-stock percentages and decided to maintain a 93 percent in-stock percentage. Buyers set the safety stock quantities so that projected stock-outs only occurred in 7% of the months. Again, they examined the projected ending balances from the analysis to best allocate the funds available for safety stock. For a third group comprised of “less important” products, the customer compared various investments and resulting stock-outs and decided on an 80% in-stock percentage.
Your investment in safety stock is subjective. There is no “right” answer. But with some simple tools and analysis you can make an informed decision that will ensure that the funds you make available for safety stock are invested as wisely as possible.