No matter the size and model of your business, one of the significant modern-day issues it will face is stock and inventory management.
The storage of stock units fluctuates from time to time depending upon the market trends, customer demands, and the retail landscape. Acting according to these factors can help your business function efficiently and cut down on wastage.
Certain retailers go with their gut instinct in terms of the inventory, but best believe, this can backfire anytime and cause you to lose potential customers.
Using a safety stock formula to regulate your inventory can help you make decisions regarding inventory management with the help of backed-up data, thus expanding your overall sales.
Table of contents
- What is safety stock?
- Why Do You Need a Safety Stock?
- Why Use the Safety Stock Formula?
- How do you calculate Safety Stock?
- Formula 1: Basic Safety Stock Formula
- Formula 2: Average – Max Formula
- Formula 3: Normal distribution with unpredictable demand
- Formula 4: Normal Distribution with lead time uncertainty
- Formula 5: For normal distribution with uncertain demand and independent lead time
- Formula 6: Normal distribution with uncertain demand & 'dependent' lead time
What is safety stock?
Now a safety stock isn't some complicated action or function. It simply refers to extra inventory withheld by the seller to meet unexpected customer demands. Safety stock is the additional stock held apart from your normal stock levels for your everyday operations. The core purpose of safety stocks is to prevent stockouts.
Why Do You Need a Safety Stock?
Apart from stockouts and the primary consequences of not accumulating enough stock, unpredictable demands and uncertain lead time are two issues that can be tackled with the help of safety stock. Let's see how?
- Unpredictable demands
Every seller will have their set of products that sell well any time of the year and will have certain products that keep shifting gears in demand from time to time. When the supply and demand for a product are consistent, stocking large quantities of safety stock isn't really necessary.
Whereas products that are difficult to predict in terms of demand require increased quantities of safety stock.
- Uncertain Lead time
Lead time is the basis for all inventory and stock-based requirements for manufacturers that put together products using various components.
Delay of production due to lack of supplies and problems faced due to postponement of customer delivery dates can have a significant impact, posing as a threat to disrupt the whole manufacturing line and affect your lead time. To combat unexpected deliveries, a safety stock formula will help you to compromise unexpected delays and help you to produce consistent output.
Why Use the Safety Stock Formula?
Lack of stock can directly affect your trade-in in multiple ways. The price you will have to pay due to inventory stockouts will definitely emphasize the importance of safety stocks. Some of the critical factors that take a hit include revenue, gross profit, losing customers, a dip in the market share, and even cracks in the relationship between retailers & suppliers.
To sum it up, the market is already vying to look for the one that is ready to provide and act. If you fail to meet the requirements, customers are always willing to get to the one that does meet their needs.
The effort you put in to predict your safety stock can save you a few extra bucks and also help you to run your business seamlessly.
How do you calculate Safety Stock?
Implementing standard deviation is probably the first thing to do when you work with uncertainties and different variables. This can help you determine the consumer market's disparities in supply & demand.
So how do you find the standard deviation?
- From a set of data, find the average.
- Find the sum of the average value & the initial data set.
- Divide the sum value with the sample proportion to attain variance.
- The sum of variance and the average value will give you the standard deviation.
Now implement the standard deviation in the equation given below.
Z × ΣLT × D AVG
- Z will be the desired service level
- σLT will be your standard deviation of lead time
- D avg is denoted as demand average
Calculating safety stock is a simple four-step process. Let's break it down:
1 | Calculation of Lead Time
Lead time is denoted as the timeframe between the start and end of a process starting with the lead time. If you find your lead time to be consistent, you may skip this part. But, this isn't the case for most.
The three key numbers to derive are
- Expected time- The anticipated lead time of an individual product.
- Actual time: The real-time taken to replenish every order.
- Variance: Variance is the difference between real-time and the expected time.
To figure the standard deviation,
- Find the sum of the variances
- Divide the sum of the variances with a sample portion
- Add this value to the average expected time and you have your standard deviation. (σLT)
2 | Calculation of Demand
To determine the demand average, start by calculating the time frame. The time taken between initial order and reorders is a decent period.
For example, If an individual product is reordered once every two weeks, the time frame will account for two weeks worth of sales.
Let's take, for example, one month is broken down into weekly increments. Say that the whole sum of sales volume is 3000 units and the number of buying days is 30.
Demand average calculation: 3000 ÷ 30 = 100 units
This is how you calculate demand.
3 | Initiate Service Level
The last parameter to check when calculating safety stock is the service level. The service level decides the apt service level for an individual product by bringing the inventory costs and the cost of stock out to an equilibrium. The higher the service level, the more safety stock would be necessary.
You will need a standard distribution chart to convert your service level to a value through which you can calculate the safety stock. This will help you derive your service factor based on the service level you are in. your service factor will be depicted as (Z) in the equation.
4 | Calculation of safety stock
All you have to do now is multiply the three values you have derived, and you'll have your safety stock derived.
01.28 x 8 days × 100 units = 1024 units
Your inventory now has 1024 units. The equation has derived the number of units you will need to meet your consumers' needs over a lead time of 8 days with a 90% service level. This can also act as your reorder point.
Safety stock is a common value to help you to calculate extra stock that you will need to add to your inventory and gives you a heads up on restocking.
6 Different Formulas for calculating safety stock
Now the process hasn't concluded just yet. As you've learned to calculate safety stock, you will now have to find out if the particular formula works for your module. Yes, there are six different formulas to cater to other modules. Using the right ones can best suit you with ease.
Formula 1: Basic Safety Stock Formula
The traditional formula considers the number of products you sell on a given day and the number of days of stock you intend to accumulate through a given period.
Formula- Products x days worth of stock.
E.g., 80(Products) x 6 days worth of stock. This gives you 480 required units for the given product.
Formula 2: Average – Max Formula
It is easily one of the most common methods that most businesses go ahead with. However, the one downside of the average-max formula is the 'lead time' issue. If your lead time is significantly longer, then this might not be the best method to go ahead with.
Formula- (maximum sale x maximum lead time) – (average sale x average lead time)
Formula 3: Normal distribution with unpredictable demand
When you're uncertain about the demand for your product but have a consistent lead time, you can implement this formula.
Formula- Standard deviation of demand x the root of average delay
To derive the standard deviation in demand, you will first have to calculate the average demand. Upon computing the average demand, calculate the variability in demand by taking the square value of each month's difference and then the squares' average in conjunction. The square root of the deviation would be your standard deviation, depicting the sales variability.
To calculate lead time variability, use the same unit of measure as the demand variability. To derive lead time variability, find out the average lead time, then calculate the square root of the average of 'squared differences.' Finally, implement the values in the formula to derive your safety stock.
Formula 4: Normal Distribution with lead time uncertainty.
Suppose you are particular about the product demand and only have issues with figuring out your lead time. Then implementing this formula might be a good option.
Formula- Z x average sales x lead time deviation
Here, Z will be your desired service level. Again, you can check the table in the previous segment to get a clear idea.
When your lead time variation is small-scale, your supple is pretty consistent, so your safety stock levels are pretty low, too, and vice versa.
Formula 5: For normal distribution with uncertain demand and independent lead time.
Let's say you are uncertain about your demand and lead time together. Then this formula might be of the best use for you in this case. Remember that the demand and lead time work independently in this case.
Formula- Z * sqrt((Average LT*(Demand Standard Deviation) squared + (Average Sales * Lead Time Standard Deviation) squared)
Safety stocks are crucial for this case when lead time and sales are unpredictable, and there's a great deal of uncertainty being involved in this scenario.
Formula 6: Normal distribution with uncertain demand & 'dependent' lead time
In the previous scenario, both demand and lead time were functioning independently. But, for this scenario, both the factors are dependent on each other, so there's a slight variation in the formula. Implementing this formula might be the best case if your demand is affecting your lead time or the other way around.
Formula- Z * Demand Standard Deviation * Sqrt (Average LT) + Z * Average Sales * Lead Time Standard Deviation
Keep in mind that when more variability and uncertainty are involved in a scenario, there's more need for safety stock.
Conclusion
Safety stock pretty much acts as a defense mechanism for your inventory stockout. Drawing up your safety stock beforehand can help you save your sales and run your supply chain seamlessly. If you're wondering which method to go ahead with for your business decisions, there really isn't one method that can cater to all. You will have to find out which one of those methods works for you and bring the best out of your business. Good luck!
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