How to Calculate Safety Stock: A Step-by-Step Guide
One of the most first things to know about running a business is that your inventory is an important part of keeping your company alive and thriving. When your inventory is well-stocked and flowing, customers are happy, revenue is coming in, and your business is growing. If stock ever falls behind, however, it can lead to a serious disaster. Imagine if the supply chain gets a little tangled: your customers may order items that are no longer in stock and have to wait a prolonged time for their goods, or worse, receive the wrong items. If this were to happen, it could jeopardize the trust built between your customers and you, which could lead to less business, less revenue coming in, and possibly the end of your company. One way to avoid all of this is to simply know how to calculate your safety stock so that your business is protected no matter what happens. Every business should have this safety net in place both as a cautionary business measure and as a way to ensure that your customers are never left hanging or unsatisfied. Don’t have your safety stock calculated yet? Not to worry–this step by step guide will show you everything you need to know about safety stock and how to calculate it for your business’ unique inventory levels.
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What is Safety Stock?
The best way to think of safety stock is as a safety net for your inventory. Ideally, your business should never have to worry about running out of stock, but this is not a reality. Demand can increase, problems can arise in the supply chain, your supplier may be unable to deliver when and what you need them to, machinery may break, weather may hinder deliveries, and on and on. In short, no business is totally safe from running out of stock, which is why you must take precautions now to keep your business running no matter what happens. This is where safety stock comes in.
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Safety stock is just extra inventory that is ordered and stored beyond excepted demand. Safety stock is carried in order to prevent issues caused by something known as stockouts. A stockout refers to changes in customer demand (usually when demand is higher than what is expected for a certain product), an incorrect forecast of supply and demand, or variability in lead times for raw materials. Safety stock is meant to keep your business going no matter what happens, but calculating how much safety stock your particular business will need can be a little tricky. There are many variables involved and the equation can get a little confusing. Luckily, there are a few ways to accurately calculate safety stock, as well as a comprehensive formula you can use to get perfect results every time.
How to Calculate Safety Stock
You may think that just eyeballing your safety stock needs and making an educated guess on how much extra stock to keep would be enough to keep things on track but this is one of the most dangerous things you can do. In fact, if you do not properly calculate safety stock, you can actually increase the risk of a stockout. If a stockout happens, it can only be downhill from here. If your customers find that your business is not meeting demand, they’ll easily find another establishment that can. With this in mind, you should take calculating safety stock very seriously to avoid problems that could take a long time to fix. When you do calculate safety stock, however, you can look forward to increased revenue and a much higher service level.
Service level refers to the likelihood that the amount of stock you have on hand during lead time will be enough to meet your expected demand. In other words, a high service level means that a stockout won’t easily occur. So, how do you calculate safety stock? Let’s break it down:
To calculate safety stock you must do the following:
- Find the average of a set of data
- Calculate the sum of the average and the data set
- Divide the sum by the sample proportion to get the variance
- Add the variance to the average for the final result
The equation looks like the following: Z × σLT × D avg
To break this down further: Z represents the desired service level, while σLT is the standard deviation of lead time, and D avg is the demand average. It may sound a little complicated, but it can be done fairly easily with a little help. Let’s get started.
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Step By Step
1. Calculating Lead Time
Lead time refers to the time between the initiation and completion of a production process, i.e. the amount of time it takes to replenish our inventory. In short, you have to think about the total amount of time it takes to submit a purchase requisition, have that requisition approved, email vendors, deliver products from vendors, inspect products, and put the product on shelves (or update online stock levels). To calculate the lead time for safety stock, however, you have to think about lead time variables. This simply means that lead times usually won’t be the same from cycle to cycle. To keep track of all this, create a table with the following three categories:
- Expected time: the expected lead time of a certain product
- Actual time: the actual, real-time it took to replenish the order of a certain product
- Variance: the difference between the actual time and the expected time
If you have positive numbers in your variance category, they represent the number of days over the expected times. If you have negative numbers in the category, these mean the delivery arrived earlier than the expected time. With these numbers and meanings in tow, you can then find standard deviation for your lead times. To do this, add up all the variances. Then, take the sum of the variances and divide them by your portion numbers (meaning the lead times of the past few shipments–if you have 5 past shipments in your portion, you would divide the sum by 5.) Next, add this result to the average expected time. Now, you have the standard deviation for the lead time.
2. Calculating Market Demand
To calculate demand average, you must begin with a certain time frame. This can be a week or two, or a month or beyond. The best time frame to work with is how quickly a product is reordered. To calculate demand average, then, you have to take the sum of a total sales volume in your time frame and divide it by the number of buying days. In a two week period, the number of buying days would be 14.
3. Establish Your Desired Service level
Before you can finally determine safety stock, you must consider Z or the service level. To do this correctly, you have to balance inventory cost vs. the cost of a stockout.
4. Figuring Needed Safety Stock
Now that you have your lead time and average demand time calculated and your desired service levels established, you can complete the equation and calculate your safety stock. Remember that Z represents service level, σLT represents the standard deviation of lead time, and D avg represents demand average. When you have all the accurate variables, you can plug them into the calculation, and learn exactly your safety stock should be for your unique business. Before we move on to our example, let’s recap each of piece of our equation:
Z: In the retail industry, the typical desired service level is 90%. In some cases, higher priority products may reach a service level of 95%. To get a decimal number of your desired service level, refer to a distribution chart. A normal distribution chart will show at 90% service level converts to a service factor of 01.28 – this number will represent Z in the equation.
Z = 01.28
σLT: To calculate demand average, you must begin with a certain time frame. This can be a week or two, a month, or beyond. The best time frame to work with is how quickly a product is reordered. To calculate demand average, then, you have to take the sum of a total sales volume in your time frame and divide it by the number of buying days. In a one week period, for example, the number of buying days would be 7.
σLT = 7
D avg: Say in a one week period, you have a sales volume of 500 units with volume increasing by 100 units each week. This means that week 1 would be 500 units, week 2 would be 600 units, week 3 would be 700 units, and week 4 would be 800 units. You would then calculate the total number of sales volume for the whole month, or 500+600+700+800=2600.
You would then divide the sales volume by the number of buying days, which is 30.
2600 ÷ 30 = 86.7 units
D avg = 86.7 units
As we move forward, you would plug each number into the appropriate place and the final equation will look like the following:
Safety Stock = Z x σLT x D avg
Safety Stock = 01.28 x 7 days x 86.7 = 776.8 units
This calculation may seem a little confusing, but with careful planning and preparation, you can calculate safety stock accurately every time. To learn more about working with business stock and inventory, start a free trial with Finale Inventory today.