Business developments can be hard to predict; for instance, a customer could place an unexpectedly large order for one of your products. That should be great news for you–but only if you’re prepared to fill the order on time. That’s where safety stock comes in.
Forecasting precisely how much inventory you’ll need is always a difficult proposition; safety stock, by acting as “buffer inventory,” allows businesses to build up some margin for error. The downside, of course, is that holding inventory–let alone extra inventory–is expensive.
Some studies have pegged it at 20–40 percent of the cost of stocked merchandise. Making matters worse: That’s an ongoing, recurring cost, not a one-off purchase. But holding safety stock is absolutely critical. As supply-chain expert Bill MacDonald puts it, “safety stock is a necessary, but potentially very expensive, evil.” The key is to figure out just how much safety stock one should carry.
One way to determine how much safety stock a business needs is by looking at four mistakes businesses should avoid, as outlined by the OPS Rules Blog.
- Mistake 1: Setting safety stock to zero. This obviously cuts costs, but it also decimates service levels.
- Mistake 2: Relying entirely on a textbook safety stock formula. Formulas can be good guidelines; however, every business is unique. One way a formula might mess up is if your product has a high failure rate and you need to re-deliver lots of units.
- Mistake 3: Decreasing safety stock as supplier lead time decreases. If a supplier has “an average lead time of 15 days with a standard deviation of 10 days,” you still need have 25 days of safety stock rather than 15, even if the supplier’s supposed lead time is 15 days.
- Mistake 4: Assuming safety stock will eliminate stock outs. Safety stock has two goals: to deal with variability in supply and demand, and to sustain service levels. Safety stock can cut down on stock outs, but since we’re dealing with variability, it can’t completely eliminate them.
So, how do you optimize your safety stock levels? BusinessBee writer Lisa Poulsen offers a strategy called the Reorder Point Formula. It depends on three factors:
- Safety stock
- Average daily usage, or “the quantity of each item you sell on a normal distribution day”
- Lead time in days, defined as “the period between the point of ordering stock and when it is delivered”
The formula is R = [(S + D) x L)], where R is the reorder point, S is your current safety stock, D is the average daily usage, and L is the lead time in days.
Let’s say your company sells carburetors and currently has 250 carburetors as safety stock and sells 50 per day. Your supplier delivers new carburetors every 2 days. Therefore, your reorder point R would be (250 + 50) times 2 days, or 600 carburetors.
As mentioned above, no formula is perfect, but this one is a good guideline for maintaining proper levels of inventory to meet your customers’ needs. Try it out and tweak it as you go to figure out just how much safety stock you really need to maintain.