Effectively Investing in Safety Stock
By Jon and Matt Schreibfeder
In a perfect world, forecasts of future customer demand for every product would be 100% accurate. Replenishment shipments of stocked products would always arrive on-time. But the world isn’t perfect. You might sell or use more of an item than you forecast, or a stock receipt may be delayed. Safety stock, also known as safety allowance, is “insurance” inventory you maintain to avoid stockouts.
How much safety stock you maintain is subjective. There is no “right” answer. But you don’t want to waste money on safety stock that isn’t needed. On the other hand, you want to have enough safety stock to protect your desired level of customer service. In this article, we will explore some ideas for ensuring that you are effectively investing in additional safety stock.
The customer service level is the percentage of line items on customer orders that can be completely filled, on time and in one shipment, from stock inventory. If a customer orders 10 pieces of an item and you ship or deliver all 10 pieces on or before the promise date, you get credit toward the customer service level. Shipping or delivering anything less than the quantity ordered is a failure, even if the customer ordered an unusually large quantity.
A typical customer service level goal is 95% of line items shipped complete and on-time for normal items. If an item is designated as “critical” to customer service (e.g., it could shut down a customer’s business), you might want to set a customer service level goal of over 99%.
However, maintaining this additional insurance inventory can be expensive. For example, let’s say that safety stock of 50 pieces for an item would be adequate to achieve a 95% service level. But it would take a safety stock quantity of 125 pieces to fulfill the occasional large order for the product and achieve a 99.5% customer service level. If the cost of the item is $15 each, the total cost of the additional 75 pieces of safety stock would be $1,125 (75 pieces * $15 each = $1,125).
To see the effect of the increased inventory on profitability, we’ll examine the adjusted margin of a product with the different safety stock quantities. Adjusted margin is similar to gross margin, but takes into account the cost of carrying the average investment in inventory. In our example, we will use an annual cost of carrying inventory of 21%. This means that it costs 21 cents to maintain a dollar’s worth of inventory in your facility for an entire year. To calculate the cost of carrying inventory for your organization, please see the questionnaire in the Resources section of our web site, www.EffectiveInventory.com. Adjusted margin is calculated with the equation:
[Annual Gross Profit Dollars – (Average Invty Value * Annual Carrying Cost %)] ÷ Annual Sales Dollars
Here are some metrics for this item:
- Annual Sales Dollars $27,000
- Annual Cost of Goods Sold Dollars $18,900
- Annual Profit Dollars $8,100
- Gross Margin 30%
- Average Inventory (95% Cust Serv) $4,725
- Average Inventory (99.5% Cust Serv) $5,850
The adjusted margin of the item with a 95% customer service level is 26.3%:
[$8,100 – (.21 * $4,725)] ÷ $27,000 = 26.3%
The adjusted margin of the item with a 99.5% customer service level is 25.5%:
[$8,100 – (.21 * $5,850)] ÷ $27,000 = 25.5%
It is obvious that raising the customer service level will affect the net profitability of the item. But what if by making the item critical, you are gaining the reputation as the most reliable supplier in your market and sales increased by 20%, without the need for additional inventory? The adjusted margin is 26.2% (close to the original 26.3%) and you’ve earned an additional $1,620 in annual gross profits:
- Annual Sales Dollars $32,400
- Annual Cost of Goods Sold Dollars $22,680
- Annual Profit Dollars $9,720
- Gross Margin 30%
- Average Inventory (99.5% Cust Serv) $5,850
[($9,720 – (.21* $5,850)] ÷ $32,400 = 26.2%
Or your customers realize the value of dealing with a reliable supplier. They know you will ensure delivery of critical items when your competitors are out of stock. As a result, you can increase the gross margin on the product to 35% without losing sales:
- Annual Sales Dollars $29,077
- Annual Cost of Goods Sold Dollars $18,900
- Annual Profit Dollars $10,177
- Gross Margin 35%
- Average Inventory (99.5% Cust Serv) $5,850
Note that sales dollars have increased due to higher margin though the cost of goods sold remains $18,900. The adjusted margin is now 30.8%! This is well above the adjusted margin of 26.3% earned with the investment necessary to achieve a 95% customer service level:
[($10,177 – (.21 * $5,850)] ÷ $29,077 = 30.8%
Raising the customer service level by maintaining additional safety stock has the potential to increase your profitability and reputation as a reliable supplier. However, it is expensive. As you increase safety stock be sure to monitor the effect on your sales and profits.
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