Anything from demand volatility to machinery repair to natural disasters can cause demand and supply estimates to go awry. Safety stock is extra or buffer stock held by businesses to avoid stockouts or shortages in such circumstances.
Advantages of carrying safety stock
Following are just some of the advantages of carrying safety stock:
- Forecast inaccuracies: No business is able to forecast the inventory levels needed or the stock available at a particular point in time with 100 percent accuracy. Neither is it able to prepare for every contingency. Safety stock helps businesses avoid stockouts or shortages in raw material or finished goods, thereby ensuring the smooth functioning of supply chains.
- Variability in demand and lead time: Safety stock ensures that businesses are not caught unaware by sudden variations in supply or demand. It also helps protect against issues caused by variability in lead time.
- Warehouse errors: If businesses use outdated tools for inventory management, they may have incorrect inventory count. They commit to orders based on this faulty information. Similarly, inventory kept in warehouses may suffer wear and tear. In all such cases, safety stock can save businesses from loss of revenue and reputation.
- Manufacturing or supplier glitches: The supply chain is affected when machines break down or suppliers face problems in delivering materials. Safety stock keeps the production cycle going in such times.
- Prompt delivery: It is essential to carry safety stock to ensure that products are delivered on time or even before time to customers.
Disadvantages of carrying safety stock
While carrying safety stock is prudent, too much inventory also can cause problems. Businesses would have to spend a lot of money and effort to hold enough safety stock to cover all possible contingencies.
Regardless of how important safety stock is to a business, it requires inventory carrying costs, which are usually estimated to be 20 percent. However, this may be an underestimated value.
Carrying costs depends on many variables, such as warehouse rent, wages, security costs, and stock loss due to damage or obsolescence. Besides, it is not a one-time payment; businesses must pay it periodically.
The optimal amount of safety stock
Although aiming for better customer service levels could avoid stockouts, it means carrying more safety stock. Businesses should calculate safety stock carefully to balance their inventory levels. Below are a few common methods used in the industry:
- Based on demand variability: If good historical data is available and businesses face only demand variability, the safety stock needed to protect them is equal to the standard deviation of demand variability multiplied by Z-score.
Safety stock = Z × √PC/T1 × σD
where Z = Z-score; PC = performance cycle or total lead time; T1 = time increment used to calculate standard deviation of demand; and σD = standard deviation of demand.
- Based on variability in lead time: When businesses are troubled by variability in lead time, the safety stock equation changes accordingly.
Safety stock = Z × σLT × Davg
where σLT =standard deviation of lead time and Davg = average demand, the total monthly sales divided by the number of buying days.
- Based on variability in both demand and lead time: When demand variability and lead time variability are caused by the same factors, safety stock is sum of the two individual calculations.
Safety stock = (Z × √PC/T1 × σD) + (Z × σLT × Davg)
When they are caused by different factors and both are normally distributed, safety stock is lower than the sum of the two individual calculations.
Safety stock = Z × √(PC/T1 × σD2) + (σLT × Davg)2
Vanguard offers a few more precise approaches to calculating safety stock.
If businesses calculate safety stock correctly, they can save money and effort expended to manage stockouts or overstocked inventories. They should use a robust inventory management system that monitors stock levels during demand, supply, and market changes, and keeps them secure.