Theoretically, it should be easy to determine when to reorder a stocked item from a supplier. If you know that customers will order ten pieces of the product each day, and you know that it will take seven days to get the shipment from the vendor, you should reorder the product when there are seventy pieces on the shelf:
| Demand per Day | Lead Time | Usage During Lead Time |
| 10 pieces | 7 days | 70 pieces |
This quantity is appropriately called the “order point.” But the order point formula contains one more element: safety stock. Safety stock provides protection against running out of stock during the time it takes to replenish inventory. Why is this protection necessary?
- Demand is a prediction based on past history, trend factor(s), and/or known future usage of a product. The item’s actual usage will probably be more or less than this quantity. Safety stock is needed for those occasions when actual usage exceeds forecasted demand. It is “insurance” to help ensure that you can fulfill customer requests for a product during the time necessary to replenish inventory.
- The anticipated lead time is also a prediction, usually based on the lead times from the last several stock receipts. Sometimes the actual lead time will be greater than what was projected. Safety stock provides protection from stock outs when the time it takes to receive a replenishment shipment exceeds the projected lead time.
The following diagrams illustrate how safety stock is used:
Projected Lead Time = 8 Days
Demand = 1 piece/day
On Order with Vendor = 0
The dotted line in the graph represents the available quantity (On-Hand – Committed) of the item. A replenishment order is placed on the first of the month as the available quantity available reaches the order point (“A” in the graph). In this example, there is none of the product currently on incoming replenishment orders. Therefore, at point “A,” the item’s available quantity equals its replenishment position.
The actual usage of eight pieces during the lead time is consistent with projected demand. The shipment arrives on the 9th of the month. As the stock receipt is processed, the available quantity on the shelf is equal to the safety stock quantity. The protection provided by the safety stock was not needed.
The product again reaches the order point on the 11th of the following month (“B” in the following graph):
Projected Lead Time = 8 Days
Demand = 1 piece/day
On Order with Vendor = 0
Another order is placed with the supplier. But the vendor is temporarily experiencing manufacturing problems and the shipment arrives two days late (“C” in the graph). If it weren’t for the safety stock, we would have run out of the product.
Shortly after the shipment arrives, a customer orders 10 pieces of the product. You experience more than a week’s usage in just one day. The available quantity falls to “D” in the following graph. A replenishment order is issued that day, but the available quantity is already below the order point.
The safety stock quantity allows you to satisfy customer demand for the product until the replenishment shipment arrives from the supplier on the 29th of the month (“E” in the graph). Again, safety stock prevented a stock out.
How Much Safety Stock Do You Need?
Take a look at this graph:
When a replenishment shipment arrives, the available quantity is usually somewhere in the shaded area of the graph. Notice that the safety stock quantity is in the middle of the shaded area. Half the time you will use some or all of the safety stock before the replenishment shipment arrives. The other 50% of stock receipts will arrive before you use any of the safety stock. On average, the full safety stock quantity is always on the shelf when the replenishment shipment arrives. It is, on average, “non-moving” inventory.
A distributor puts inventory in her warehouse to sell it to customers. Profits from these sales are necessary to pay the distributor’s expenses and provide a return on her investment. With this thought in mind, it seems as though it would not be a good idea for a distributor to intentionally have non-moving inventory in stock.
On the other hand, keep in mind the goal of effective inventory management:
“Effective inventory management allows a distributor to meet or exceed his (or her) customers’ expectations of product availability with the amount of each item that will maximize the distributor’s net profits.”
Safety stock is, in reality, an expense of doing business. But it is necessary to ensure good customer service. To maximize profits, we must carefully control all expenses, including safety stock. Therefore, we want to achieve our customer service goals with the least possible amount of safety stock.
The Conventional Ways of Calculating Safety Stock
There are two common conventional methods for calculating the safety stock quantity for a product:
- Percentage of Lead Time Demand
- Days Supply
As we discuss the various methods for calculating safety stock quantities, we’ll refer to two variables, “forecast demand” and “usage.” Forecast demand is a prediction of how much of a product will be sold or otherwise used in a particular month, and usage is the quantity that was actually sold or used.
Percentage of Lead Time Demand
Retired inventory consultant Gordon Graham long advocated that, for most items, 50% of lead time demand provides an adequate safety stock quantity. Let’s look at an example:
| Demand/Day = (390/30) = 13 pieces |
| Projected Lead Time = 8 days |
| Demand During the Lead Time = (8 x 13) = 104 pieces |
| Safety Stock = (104 x 50%) = 52 pieces |
The thirteen pieces per day is multiplied by the projected lead time of eight days resulting in a lead time demand of 104 pieces. Safety stock is half this amount, or 52 pieces. This quantity represents a four day (4 days x 13 pieces/day) reserve.
This method is easy to understand but it tends to maintain too much or too little safety stock for many items. For example:
Products with long but very reliable lead times and with fairly consistent demand. If we use this method for an imported product with a 12-week lead time, we’ll keep six weeks stock in reserve as safety stock. If we usually receive the shipment on time and demand doesn’t vary substantially from month to month, we’ll have too much safety stock – in other words, too much money tied up in non-productive inventory.
Products with very short lead times and significant variations in demand from month to month. If a product had a one-week lead time, this method will keep a three or day supply of the item in reserve as safety stock. If usage tends to vary significantly from month to month, there probably won’t be enough safety stock available to consistently fill customer demand and the company will experience stock outs.
Days Supply
The days supply method allows a buyer to manually specify a number of days supply of a product to hold in reserve as safety stock. Because a buyer usually does not have the time to review the safety stock parameters for every item each month, he or she will probably set the days supply to provide more than enough safety stock. After all, in the eyes of most buyers, excess inventory is usually preferable to stock outs. As a result, the days supply method often results in the accumulation of non-producing inventory.
A Better Way of Maintaining Safety Stock
Remember that the purpose of safety stock is to protect customer service from unusual customer demand during the lead time or delays in receiving a replenishment shipment. Why not base the amount of safety stock maintained for each item on the variations in demand and lead time? The greater the variation in demand and/or lead time, the more safety stock will be maintained for the item. This is referred to as the “average deviation method.”
Let’s look at an example. We’ll consider the variation or deviation in demand as the difference between the forecast demand of a product in a month and the actual usage in the past three months (it is common to use three to six month’s history in this calculation). Consider an item with the following forecast demand and usage history:
| Forecast Demand |
Actual Usage |
Deviation | |
| January | 50 | 60 | 10 |
| February | 76 | 80 | 4 |
| March | 80 | 70 | -10 |
In January, the demand forecast was 50 pieces and actual usage was 60 pieces, resulting in a deviation or difference of 10 pieces. In February, the demand forecast was 76 pieces and actual usage was 80 pieces, which produced a deviation of four pieces. The average deviation is:
Note that the deviation for March, in which demand exceeded usage, is not considered in our calculation of safety stock. Why? Because if our prediction of what customers want exceeds actual sales, we certainly don’t want to add more safety stock to inventory. We probably have more than enough on the shelf already.
Next we have to calculate the average deviation of the product’s lead time. In calculating this amount, we’ll just look at the last three stock receipts from the primary source of supply. Why so few? Well, a lot of things can occur over extended periods of time that will affect the lead time for an item. For example:
- Your vendor can add or shut down production lines.
- Freight carriers can use different routes.
- The availability of the raw materials needed to make the product may change.
Here are the three most recent stock receipts for the item along with the anticipated lead time for the product when the purchase order associated with the stock receipt was entered:
| Date of Receipt | Anticipated Lead Time |
Actual Lead Time |
Deviation |
| June 15th | 10 days | 17 days | 7 days |
| April 20th | 8 days | 13 days | 5 days |
| February 2nd | 8 days | 6 days | -2 days |
As with our analysis of demand and usage, we will not consider any stock receipt whose actual lead time was less than its anticipated lead time – in other words, any time we received the item early. The average lead time deviation of the remaining two stock receipts is six days:
The six days is multiplied by the current anticipated demand per day to determine the anticipated usage during the six-day period. Demand per day is calculated by dividing the current monthly demand by the number of work days in the month. For example, say the current monthly demand is 90 pieces and the current month has 18 work days. The demand per day is five pieces; multiplied by the six-day deviation equals 30 pieces. The 30 pieces is added to the demand deviation to determine the total safety stock for the item:
As a final step in determining the safety stock quantity, we’ll multiply the average deviation by a deviation multiple. The deviation multiple used is dependent on the customer service level we want to provide to our customers. Customer service level is defined as the percentage of line items for stocked products shipped complete by the promise date. The higher the multiple, the more safety stock we’ll maintain, and the higher the customer service level. Please refer to our other articles for a complete discussion of the customer service level.
Generally we’ve found that the following multiples provide the corresponding level of customer service:
| Deviation Multiple | Resulting Customer Service Level |
| 2 | 95% |
| 3 | 97% |
| 4 | 99% |
If our goal is a 95% customer service level, we’ll multiply the average deviation by a multiple of two (37 x 2 = 74 pieces). Be careful! Using a higher deviation increases the amount of non-moving inventory on your shelf. In our example, the difference between a safety stock quantity derived using a deviation multiple of two or three is an additional 37 pieces!
Yes, this is a more involved way of calculating safety stock than the conventional methods previously discussed. But it reflects the variations in market conditions, and therefore better predicts if a particular product needs more or less safety stock. And, if your computer system calculates your replenishment parameters, you won’t have to worry about performing the calculations.
However, you will have to properly assign deviation multiples to each item, in each warehouse, in order to meet your overall customer service level goals. We’ll discuss that process next month.