When it comes to retaining safety stock, several companies are concerned about its impact on their inventory holding costs. Unfortunately, some companies believe retaining emergency stock is simply too expensive and doesn't justify holding inventory to capture opportunistic sales.
However, is having safety stock really about capturing opportunistic sales, or is it more about ensuring the company meets its obligations, better services its customer base, and protects its market share? Ultimately, a company needs inventory. Calculating exactly how much inventory to carry is key.
To provide insight into how this decision can be made easier, we’ll review four steps to determining the safety stock on a product with a high inventory turnover rate. Now, most companies immediately equate safety stock with Min/Max inventory. However, maintaining an emergency stock is a mechanism that can be used across multiple inventory strategies, whether they are Min/Max, JIT (Just in Time), or Push-Pull. It’s such a vital part of a company’s supply chain that not having a safety stock on products with high inventory turnover rates, is just bad business.
Safety Stock Protects Against Lost Sales Cost of Inventory
Several companies are unaware that lost sales are a direct cost of inventory. It's a direct cost of managing inventory one that can be measured by lost sales, lost gross profit, lost customers and lost market share. In addition, companies that ignore these costs often rush parts in to meet demand when encountered with an inventory stock out. Once that happens, the company's inventory costs increase due to overtime and expedited freight. So, what are the critical steps to determining your safety stock?
- Determine variances in replenishment time
- Determine daily consumption
- Determine safety stock based on daily consumption
- Use delivery times as a buffer
1. Determining Variances in Replenishment Time
It’s essential to define and track the variances within your replenishment times. Your replenishment time is defined by those processes involved in having products available and ready to ship to your customers. Determining the variance in these times is essential because it means you must have enough inventory on-hand to cover that replenishment time. In essence, if you had to wait for your replenishment to kick in, you’d be left with a stock out and lost sales.
The above outline provides some insight into what this might look like. First, your company needs time to develop a purchase requisition and place the order with your vendor. Second, your vendor needs time to process the order and prepare it for shipping. Third, there is the actual transit time from their location to your facility. Fourth, there is a time needed by your internal processes to receive and inspect the product. Finally, you need time to process the shipment and repackage it – if needed.
Variances occur in replenishment times because each of these five steps can experience delays – people unavailable or sick, damage to shipment during transit, improper receiving, processing delays etc. Our focus is on determining the variances between the expected and actual replenishment times. This will give a more accurate depiction of the number of days we should retain inventory for our safety stock. Here’s an example of these variances based on an expected replenishment time of 6 days.
- Total the variances and divide by the number of shipments: (5+3+5-1-2) / 5 = 10 / 5 = 2
- Standard replenishment time is 8 days (6 +2)
2. Determine Daily Consumption
The purpose of this second step is to determine the daily consumption of the product in question. This will determine the quantity that must be retained in inventory to cover the 8 days from step 1. For example, let’s assume a company had the following data (below) on four straight weeks of sales in August. Now, if your company was concentrating on B2C (business to consumer) sales, you could be open 7 days a week, which in turn would mean you had 30 “buying” days. Or, you could be focused on B2B (business to business) sales and be open Monday to Friday – hence 5 buying days for the week. In our example, we’ll use the 5 buying days a week. Over 4 weeks, that would give us 20 buying days for the month. Here are the volumes sold during the four weeks.
- Total consumption during month: 500 + 600 + 700 +750 = 2550 units
- Determine daily consumption by the number of “buying” days: 2550 Units / 20 buying days = 127 units purchased a day
3. Determine Safety Stock Based on Daily Consumption
Now, this third step is rather simple. The goal is to determine the safety stock based on daily consumption. This involves taking the 8 days and multiplying it by the daily consumption of 127 units.
Safety Stock: 8 days X 127 units/day = 1016 Units
Our safety stock is well below the monthly sales volume of 2550 units. This allows us to minimize the impact of the company’s inventory holding costs on safety stock. Most companies apply a monthly inventory holding cost of 3%. Having this safety stock below our monthly sales totals ensures we mitigate our financing costs of inventory.
4. Account for Delivery Times
Several inventory professionals believe that companies should discount their safety stock by approximately 50%, to reduce their financing costs of inventory. This would mean the 1016 units from step 3 would give us a new safety stock of 508 units and cover 4 days of customer demand. However, the issue with this approach is that it’s not ideally suited to products with high inventory turnover rates. Only covering four days leaves a lot of risks should customer demand suddenly spike upwards. Without an inventory of products, you could lose sales. Regardless, if financing costs are a concern, you could go ahead with the 50%. However, try and find a happy median between 50% and 100% of the safety stock. What is the ideal percentage? To answer this question, I’ll show what I advocate my customers use.
Deduct Your Delivery Times: If you want to reduce the financing costs on retaining the safety stock, you could always deduct your lead times or delivery times. For instance, let’s assume you’ve promised delivery times of a maximum of 4 business days. This means you could do 75% of the safety stock, covering 6 days instead of 8. If you encountered an order during a stock-out period (during the 2 days you don’t have stock) you would still have 2 days to catch up to your promised lead time.
Putting it all Together:
- Determine variances in replenishment time: 8
- Determine daily consumption: 2550/20 = 127
- Determine safety stock based on daily consumption: 8 X 127 = 1016
- Account for your delivery times: Cover 75% or 6 days = 1016 *75% = 762.00
Maintaining a safety stock of 762 units will cover 6 days of inventory
Maintaining a buffer stock is essential to successfully running a Min-Max supply chain.
Assessing Safety Stock & its Impacts on Inventory Holding Costs
It's easy to see how holding costs simply shouldn't be a concern in this case. The product has a high inventory turnover rate. Any inventory purchased in a given month is sold in the same month. The whole reason you maintain safety stock is to ensure you mitigate the effects of stock-outs. Of course, there are inventory holding costs associated with maintaining safety stock, but there are also costs of lost sales if you don’t have the inventory. An argument can easily be made that the lost sales cost of inventory can be just as high, if not higher, than a company’s inventory holding costs. In this case, we are selling the product in the same month we’ve purchased it. As such, we are going to pay our invoices at the same time we’ll be paid by our customers.
Determining Reorder Points
There are many arguments as to how inventory should set reorder points. Some espouse an approach where the reorder point equals the replenishment time provided you've discounted your safety stock - such as we have. For instance, in our example, we've decided to cover 75% of the 8 days of replenishment time. Therefore, we've set our safety stock at 6 days of inventory or 762 units. If we follow this approach, we might set our reorder point at 1016 units (8 days of replenishment time). If we did this, it would still allow us to play around with those 2 potentially uncovered inventory days that we determined from step 4.
A = Inventory starts above 2000 units
B = Company places reorder at 1016 units but continues to ship existing inventory for current orders.
C = Inventory is bumped up again to over 2550 units
D = As inventory is depleted, the company again places a reorder at 1016 units, but continues shipping product until D. Afterwards, the inventory is propped up again.
If you want to read more about what these inventory holding costs entail, then please read the following: Sample Inventory Costing Excel Sheet: Graph & Pie-Chart of Expenditures
When it comes to determining safety stock and its impact on inventory holding costs, it’s often a struggle to reconcile those costs versus carrying too much or too little inventory. However, it’s wrong to assume that carrying costs are always higher than the cost of losing sales. Granted, inventory costs money, but it’s also a necessary evil that all companies need to grow profit. When it comes to determining your safety stock, you may have to use trial and error. Over time, you’ll be able to make it more accurate.
In terms of fluctuations in customer demand, this should be addressed through sales forecasts. Accounting for seasonality is an essential part of ensuring that safety stock is representative of future demand. However, companies can also use historical data to support their month-to-month or quarter-to-quarter fluctuations. A combination of both is strongly encouraged.
The four steps I've outlined above are meant to simplify how your company determines its safety stock levels. However, if you want to see a more complex calculation, then take the time to review the following link: Safety Stock Calculation. It is from a site called www.resourcesystemsconsulting.com. The calculation this site uses includes accounting for standard deviation (both in terms of demand and lead time) within your overall safety stock levels.
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