Why is it important to do a safety stock calculation?
Today, one of the most challenging tasks that operation managers face is monitoring inventory levels.
A key part of monitoring inventory levels is calculating safety stock. It is the best method to prevent shortages due to unforeseen events, and therefore avoid customer dissatisfaction and loss of revenue.
However, overstocking is also an additional cost! This is why operation managers must manage inventory, stock intelligently, and calculate safety stock as accurately as possible.
Here is a complete guide to what a safety stock is and how to calculate one.
Safety stock definition
A safety stock is an additional inventory that is set up in advance to anticipate stock shortages due to unforeseen events called contingencies.
These contingencies are generally divided into two categories:
- Demand-related contingencies: unexpected arrival of a major customer, sudden high demand due to an unforeseeable event, etc.
Note that some products are by nature quite "unstable" because they depend on factors such as the weather. Therefore, they require a larger safety stock.
- Delay-related contingencies: issues with your suppliers, late delivery, etc.
How to calculate safety stock
It is not required to have a safety stock on all of the items of your inventory. However, before calculating a safety stock you must consider the following factors.
Identify your needs
- What is the storage cost vs. opportunity cost ratio? If keeping stock in a warehouse costs more than losing a sales opportunity linked to this same stock in case of stock shortage, it is better to review your safety stock downwards.
- What are the possible contingencies and are there many? If this is the case, you will have a larger buffer stock.
- What is your desired level of service? The more you want to offer a high level of service to your customers (with shorter delivery times for example) the higher the safety stock level will be.
Apply Pareto’s principle and the ABC method
Businesses use both methods to identify the most valuable products in their inventory, those that require extra attention.
Pareto’s principle
Also known as the 80/20 rule, the Pareto principle can be applied in many fields (sales management, marketing, project management, etc.).
It is based on the following principle:
80% of the effects or results come from 20% of the causes.
In inventory management, this means, for example, identifying which 20 % of items account for 80% of inventory value.
The ABC method
Activity-based costing, also known as the ABC method is based on the same principles as the Pareto rule, but with a more precise breakdown.
Items are divided into three categories, according to inventory value for example:
Number of items | Inventory value | |
---|---|---|
Category A | 20% | 80% |
Category B | 30% | 15% |
Category C | 50% | 5% |
In this example, you should focus your efforts primarily on items of category A.
☝️ Please note that these two methods can be based on different criteria. Instead of using inventory value, you may use the number of sales generated for example. It is up to you to choose what criteria are in line with your objectives.
Pay attention to the quality of your data
To calculate safety stock accurately, it is essential to use precise data.
With ERP or inventory management software, you can access correct and relevant information in a few clicks. These solutions list of features include real-time monitoring of your inventory, an alert system when you reach the minimum stock, detailed history to make forecasts, etc.
🛠️ If you work in a medium-size or a large enterprise, you should use software that is adapted to the complexity of your organization. InventoryCloud, for example, can be used to track and manage inventory located in one or multiple warehouses.
© InventoryCloud
🛠️ If you are a small business, you should not overlook using inventory management software. It can be used to help your business grow more efficiently by managing your stock intelligently.
One example is Erplain, an inventory management system designed for small businesses and SMEs. With this software, you can automate the creation of orders, invoices, and purchases and update your stock level in real-time across your distribution channels.
How to calculate a reorder point
The reorder point (ROP) is the level of inventory which triggers an action to replenish that particular inventory stock.
The reorder point method can be used in parallel to the safety stock method.
However, it must be calculated before the safety stock, in order to preserve the safety stock!
Reorder Point Calculation Formula :
(average sales X lead time) + safety stock
What safety stock formula should you use?
There are many formulas that can be used to calculate safety stock. Here is a list of some of the most used ones.
⚠️ Before going any further, we would like to draw your attention to the following point:
Make sure that you always use the same time units for your data (days, weeks, or months) to avoid miscalculations.
If you have a low sales volume
The basic security stock formula
This calculation requires the following information:
- average sales: for example, 50 products/day,
- the average number of days of sales you wish to have in safety stock: for example 7 days,
- the average delivery time: e.g. 10 days.
Safety stock formula:
average sales X number of safety days
Here is the calculation with the information listed above:
50 x 7 = 350
Therefore, the safety stock amounts to 350 units.
The reorder point amounts to 850 units. ➡️ (50 x 10) + 350 = 850 units.
☝️Keep in mind that this method is fairly basic. However, to use it efficiently, you must have good knowledge and experience with your stock. This will allow you to estimate the average number of days of sales as accurately as possible.
The Average - Max formula
This calculation requires the following information:
- average sales: for example, 50 products/day,
- the average delivery time: e.g. 10 days,
- the maximum sale: for example 90 products/day,
- the maximum delivery time: for example 15 days.
Safety stock formula:
(max sale X max delivery time) - ( average sales X average delivery time)
Here is the calculation with the information listed above:
(90 x 15) - (50 x 10) = 850
The safety stock amounts to 850 units.
And, the reorder point amounts to 1350 units. ➡️ (50 x 10) + 850 = 1350.
If you have a high sales volume: formulas including a normal distribution
For higher sales volume, it is recommended to use formulas based on the normal distribution, also known as a Gaussian distribution.
Some prerequisites
- Choose your safety factor. This is obtained thanks to the principles of the laws of probability. It is calculated on Excel with the formula NORM.S.INV. And, there are also ready-made tables presenting the safety coefficients according to the desired service rate.
Example of a normal distribution table :
© abcsupplychain
💡 We recommend using the ABC method seen above to assign the appropriate level of service to each of your products. This will allow you to adapt to time constraints and specificities, such as the seasonality effect.
- Calculate the standard deviations :
- of your sales,
- of your lead time.
These data are, among others, are obtained with the "STDEV" formula on Excel.
Example of a table with sales and lead time data, with standard deviations:
© abcsupplychain
💡In the example above, the average sales and standard deviations are calculated over a 12-month period. However, if some of your items experience strong seasonality, opt for a specific period, to the weeks or months in the same period of the previous year.
Normal Distribution with uncertainty on demand (and stable lead time)
Before getting to the heart of the matter, please know that our next calculations are based on:
- a safety factor of 1.65, corresponding to a service level of 95%,
- sales and lead time data with standard deviations from the table listed in the example above.
Safety stock formula:
safety factor X standard deviation of sales X sqrt of average lead time
Here is the calculation with the information listed above:
1.65 x 141.4 x 5.9 = 1376.5
The safety stock amounts to 1377 units.
And, the reorder point amounts to 2502 units. ➡️ (32.9 x 35) + 1377 = 2501.5
Normal Distribution with uncertainty on the lead time (and stable demand)
Safety stock formula:
safety factor X average sales X standard deviation of lead time
Here is the calculation with the information listed above:
1.65 x 32.9 x 4.35 = 236.1
The safety stock amounts to 236 units.
And, the reorder point amounts to 1388 units. ➡️ (32.9 x 35) + 236 = 1387.5
Normal Distribution with uncertainty on demand AND lead time
Safety stock formula:
safety factor X sqrt ((average lead time X (standard deviation of sales)² + (average sales X standard deviation of lead time)²)
Here is the calculation with the information listed above:
1.65 x √ ((35 x 141.4²) + (32.9 x 4.35)²) = 1400.32
The safety stock amounts to 1400 units.
And, the reorder point amounts to 2552 units. ➡️ (32,9 x 35) + 1400 = 2551,5.
Find the balance in your supply chain
You now know the main formulas needed to calculate safety stock.
However, you should keep in mind that freezing stocks in warehouses can generate additional costs. Therefore, it is always advisable to counter at the same time certain fundamental problems that cause unexpected stock shortages, such as the reliability of your suppliers.
Moreover, good stock management is a balancing act. You need to constantly assess the balance between profitability and customer satisfaction. And, there are many methods (Wilson's formula for example), as well as many software that can help you manage your processes and make your supply chain efficient!