Calculating Safety Stock
Safety stock is normally required by companies to ensure that they have sufficient quantities of material in stock. The safety stock is there to provide coverage for unexpected customer demand, damage in the warehouse, or required due to quality issues found in production. However, there are situations where companies do not require inventory to be in stock.
Out of Stock Versus Stock Out
These “out of stock” situations should not be confused with the highly undesirable “stock-out” predicament where customer’s orders cannot be shipped, or production is halted due to lack of lack of components. The “out of stock” situation is beneficial to companies when the company has no demand for certain items, and zero inventory means no warehouse costs.
When supply chain professionals determine the optimum level of safety stock, there are a number of scenarios that they will consider. Many companies look at the costs involved in having a certain level of safety stock.
The costs include the initial purchase of the stock from the vendor, the cost of storing the material in the warehouse and the potential depreciation of the material over time, especially when considering material that has a finite shelf life.
Cost of Safety Stock
However, there's a cost associated with having a situation where the material is not in stock. Stock-outs can cause non-monetary results such as loss of customer satisfaction when items cannot be shipped on time.
Whereas the cost of a production stoppage can be calculated when a production line stops and has to be retooled for a new order when the stock-out of a component occurs. There are three techniques that are used to calculate safety stocks; statistical based, fixed quantity, and time period based.
The statistical method to calculate safety stock is based on the premise that is possible to mathematically calculate the level of safety stock to prevent a stock-out situation.
The traditional method used to statistically calculate safety stock is the used of the normal distribution or bell-shaped curve. In a normal distribution curve, the mid-point of the curve is the forecast, which represents the average value.
As the curve moves away from the center there is a deviation from the average and the probability of a high deviation from the forecast is represented by a smaller and smaller percentage. For example, a 48% deviation from the forecast may represent a 2% possibility.
There are pros and cons of selecting a statistical-based safety stock. Although the statistical method is based on accurate mathematics, predicting business is not always as accurate. There are always situations that occur that cannot be forecast.
For example, a statistical method may calculate an item to have a safety stock even when the item is no longer required in manufacturing. In addition, some business methods employed by companies to improve efficiencies in the supply chain may work against the mathematical equations used in calculating safety stock.
Just-In-Time techniques can adversely affect the requirements of safety stock and render the calculation inaccurate.
Companies can decide to have a fixed value for the level of safety stock for some materials. It will require a production planner to determine a value for the safety stock rather than rely on a quantity determined by a statistical calculation. The value that is determined by a planner will remain the same until manually changed.
When the actual inventory level reaches or falls below the safety stock level, this will trigger a replenishment order for a quantity of material. The quantity of material on the replenishment order is determined by demand.
The fixed safety stock level can also be set to zero when a company wants to phase out an item if it is being superseded or the finished good is no longer being manufactured.
Time Period Based
The time period based safety stock level is used to calculate the stock required over a fixed period. For example, if manufacturing demand requires 100 cases of part A to be consumed each day, the safety stock for a week would be 700 cases. The time period based safety stock is therefore determined by the forecast for the material in future periods.
The forecast will include usually include a combination of actual demand from sales orders placed by customers and a forecast based on a statistical calculation. Whatever method is used to calculate safety stock, it should be monitored periodically to ensure that it is accurate and satisfies the need it is intended for.
Having safety stock in a warehouse has a cost associated with it and unnecessary safety stock costs you and your company money and is a scenario that should be avoided.
Updated by Gary Marion, Logistics and Supply Chain Expert.