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Safety Stocks Essentials: Understanding, Calculating, and Optimizing

May 13, 2024

To ensure the viability and smooth operation of your business, success relies on both customer demand and the supply chain (backorders from your suppliers). An unforeseen event or disruption can quickly compromise your operations, making safety stocks essential to anticipate any logistical malfunction.

Discover here all the solutions and tips to effectively implement and closely monitor your safety stocks as well as your reorder points, using effective inventory management methods. Learn how to calculate your ideal stock level with a precise formula, ensuring optimal service while reducing delivery times and optimizing sales and the replenishment process.

Understanding Safety Stocks

Safety stocks represent the inventory level that prevents stockouts or shortages caused by unforeseen events. Also known as buffer stock, it remains completely immobilized and is only used in case of emergency. It is used to address any unforeseen or sudden events occurring in your inventory or supply chain that could jeopardize your operations. Your safety stock is fundamental for effective inventory management.

Factors Influencing Your Stocks and Business

Factors Beyond Prediction

Demand Fluctuations

  • Unusual orders;
  • Major new customers with urgent orders;
  • Climatic or circumstantial factors stimulating demand (e.g., sudden need for umbrellas, flip-flops, surgical masks, etc.).

Lead Time Variances

  • Longer-than-expected reordering lead times (components out of stock with production times to consider);
  • Forecasts not aligned with demand (requiring longer processing or returns);
  • Compromised delivery reliability (delivery times, transportation, customs, etc.).

It is therefore in the interest of your business to set up a safety stock to protect against these uncertainties. Consequently, replenishments must be managed intelligently.

Pre-Setup Considerations for Safety Stocks

If you are unsure about the performance of certain products, setting up safety stocks may be unnecessary and tedious. Therefore, you must analyze your stocks to identify products requiring special attention.

Consider the following criteria for each of your products:

Storage Costs vs. Opportunity Costs

The higher the storage costs compared to the opportunity costs, the lower the level of safety stock will be. Conversely, if opportunity costs outweigh storage costs, the level of safety stock will be higher. Although stockouts have a negative impact on the business, overstocking also incurs additional costs!

Incident Frequency Encountered by Your Products

The more incidents your product encounters, the more it will require safety stock.

Level of Service to Customers

If you aim to provide a high level of customer service, safety stock will contribute to customer satisfaction.

You can then use the Pareto principle, especially the ABC method, to identify products to include in your safety stock.

Method for Calculating Your Safety Stock

Several methods are available for calculating safety stock:

  • The "expert" method (or deterministic);
  • The method of normal distribution (or Gaussian Laplace law) or probabilistic.

Here is the calculation of the "expert" method, more suitable for small businesses:

Safety Stock = (maximum daily sales - average daily sales) + Lead Time

EOQ (Economic Order Quantity)

Also known as the Wilson formula, the EOQ involves ordering the appropriate quantity of products to minimize annual inventory management costs. This requires finding a balance between:

  • Acquisition Costs: include ordering costs + transportation costs + delivery costs, increasing with the number of orders. By placing large orders, acquisition costs decrease.
  • Holding Costs: increase with the quantity of stock. By placing small orders, holding costs decrease.

Differentiating Reorder Point from Safety Stock

The reorder point (ROP) differs from safety stock, as it precedes it.

A reorder point corresponds to the minimum inventory level of a product. When reached, it immediately triggers a backorder without impacting the safety stock, which should only be used in case of absolute necessity.

Potential Risks with Safety Stocks

While having safety stocks may seem reassuring, be careful not to use them to mask underlying issues: poor inventory management, inaccurate forecasts and data management, outdated calculation formulas, lack of communication with suppliers, etc.

Also, beware of manual entry of your safety stocks. The risk is that your sales evolve without adjusting your reorder point, thus skewing your backorders. You need a dynamic and scalable formula over time to adapt to seasonality and other parameters. Therefore, it's essential to equip yourself with an inventory management software.

Furthermore, not all safety stock calculation methods account for seasonality. Therefore, isolating the time factor is important for obtaining consistent results, calculating your safety stock per day rather than per month.

However, unforeseen elements can also contradict your calculations.

Lastly, be aware of the quantity of stocks included in your safety stock. Stock immobilization has a cost and can quickly become a problem. Therefore, avoid letting your safety stock become dead stock.

Safety stocks should only be used to guard against uncertainties, stockouts, or shortages that could disrupt your supply chain.

3 Common Mistakes with Safety Stocks

Underestimating Lead Times Impact

Ignoring or minimizing lead times can result in insufficient safety stocks, leading to stockouts and affecting the level of service provided to customers.

Not Revising Stock Levels

Failure to regularly review safety stock levels based on sales trends, product changes, and market conditions is a mistake that can lead to stock obsolescence or, conversely, overstocking.

Implementing Generic Formulas Without Tailoring

Generic formulas may not capture the unique aspects of your products or market dynamics. Customize your formulas to reflect your products’ specificities, seasonality, demand volatility, or specific supply risks for more accurate safety stock calculations.

Other Types of Stocks

Cyclical Stock

This type of stock represents the quantity of products needed to meet demand until the next reorder. Optimal management requires a good understanding of lead times and sales volumes, allowing cost reduction while maintaining a high level of service.

Dormant Stock

Also called dead stock, these are products that are no longer sellable or are obsolete. Effective inventory management involves identifying and minimizing dormant stocks to optimize storage space and reduce financial losses.

In-Transit Stock

This stock includes products in transit from one point to another. Managing this type of stock is crucial for companies with extended supply chains, as it directly affects delivery times and customer satisfaction.

Speculative Stock

Companies may decide to increase their stock in anticipation of increased sales, rising raw material prices, or supply disruptions. Managing this stock requires accurate market analysis and a good sales forecasting method.

Consignment Stock

In this model, the stock remains the property of the supplier until it is sold. This system can help reduce stocks in the company and improve service level management while sharing risks between the supplier and the distributor.

For Effective Inventory Management

The best solution for effectively managing your stocks and avoiding malfunctions or stockouts is to equip yourself with an inventory management software like Stockpit. Get real-time visibility of your stocks and manage all your inventory and purchasing needs by automating the calculation of your safety stocks, reorder points, etc.

Want to learn more? Request a demo.

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