Why Using Safety Stock is Necessary for Your Business
Any company that sells physical products will always be open to interruptions in their supply chain. Eventually, someone is going to miscalculate the demand for a product or something will go wrong in a shipment, causing everything to arrive late.
Being out of stock on an in-demand item is the fastest way to lose customers to your competitors. And during the holidays or when specific trends are rising, being the only seller of a hot product can make gaining long-term conversions easy.
But it's hard to measure how well items are going to sell, and impossible to predict when things won't get shipped on time. You need a solution that keeps a supply available at your warehouse, and your customers happy.
Safety stock does just that, compensating for any unexpected variability from your customers or suppliers. When you need a few extra units to cover incorrect calculations or supplier mistakes, it helps buy time while you order additional stock.
But you can't just blindly estimate safety stock. Safety stock formulas can help you figure out exactly how much merchandise you'll need, helping you to order just the right amount to keep orders flowing without incurring extra costs. If you always struggle to find a balance between continually running out of stock and having too much of it, it might be time to adopt a safety stock formula. We'll tell you everything you need to know about these formulas, as well as how you can automate these calculations to get much more precise estimates.
What is Safety Stock?
Safety stock is extra inventory you purchase to reduce the risk of dealing with a stockout. Safety stock is the best way of accounting for variability in demand and lead time uncertainty. Many companies use it, from manufacturing companies using raw materials to retail sellers of consumer goods.
But is buying more goods than planned a good idea? What if it doesn't sell? Why not adjust your cycle stock to compensate?
Benefits and Importance of Safety Stock
Despite inventory management myths that state the contrary, safety stock is essential for your business. Even with the best data analysts in the world, it's impossible to correctly predict customer desires or unexpected mishaps along the supply chain.
When these events inevitably occur, safety stock gives you some emergency padding. Without it, you’ll fall behind your competitors the moment something unexpected comes up.
Running a business that sells physical goods is all about inventory optimization. It can take months or years to get that supply chain ecosystem running smoothly and on time. Safety stock prevents your sales from coming to a complete standstill when delivery or manufacturing is slower than planned. It can also be used while you work to implement a system that can help crunch numbers for inventory replenishment.
In summary, these are the main benefits of safety stock:
- It prevents you from running out of stock, especially on particularly popular items.
- It protects you from unexpected circumstances, like disruptions in supply or sudden spikes in demand.
- It gives you the flexibility to order more products when your company makes a demand forecast error and underestimates the popularity of a product.
- It keeps customers happy and prevents lost conversions.
Overall, its most substantial impact is on customer satisfaction. A customer who leaves your website because you're out of their preferred item will likely never come back for it. Similarly, if you are forced to cancel or delay fulfillment because you are out of stock, it ruins their experience with your brand. They'll give their money to someone else instead.
There's also a chance they'll never return to your store, period. That one purchase might be all your competitor needs to convert them into a loyal, long-term customer. And if that customer decides to tell others about the mishap, it could have long-lasting effects on your reputation.
Safety stock will mitigate these issues, preventing or stopping them entirely. If you want to avoid the damaging effects of stockouts, you should begin factoring it into your inventory carrying costs. Scrambling to reorder more stock from your vendor prevents you from compiling inventory purchases to maximize discounts. It also puts a general strain on your team. That isn’t a cost-effective approach to managing your inventory.
Everything You Need to Know About the Safety Stock Formula
There are multiple safety stock formulas, but each uses similar methods to determine how much additional merchandise you should order. Here’s what you need to know before choosing one.
First, you’ll need access to your sales history and statistics to make an accurate forecast. You can estimate if necessary, but remember that a bad estimation can lead to inaccuracies and overstocking. If you are using inventory management software, that information should be readily available - it might be a bit harder if you’re relying on spreadsheets.
These are the terms you’ll need to know to calculate safety stock.
- Lead time: The time it takes from you ordering a shipment for it to reach your warehouse.
- Daily Usage: How many products per day you sell.
- Service Level: The desired level of service represented as a percentage. Here it refers to the probability of avoiding a stockout.
- Demand: In this case, how many items you sell in a certain period is your demand.
- Average: The central value in a set of data. An average can help you understand how your products typically sell or how often you usually get a shipment.
- Standard Deviation: In a safety stock formula, it often measures the variance of your lead time.
Also, keep in mind the difference between cycle stock and safety stock. The former is the inventory expected to be bought by consumers, while safety stock is a sort of margin of error to dip into when things go wrong. Their calculations should be kept separate.
Knowing all that, let’s get into the safety stock formulas.
Methods for Calculating Safety Stocks
Various methods of estimating safety stock exist, each with their pros and cons. We'll explain the benefits of two of them and let you try both to see what fits best. We'll also explain how some inventory management software can help with these calculations.
The first and most straightforward method for manually calculating safety stock levels is this simple formula.
(Maximum Daily Usage x Maximum Lead Time) - (Average Daily Usage x Average Lead Time)
Let's say your company sells an average of 10 products per day, and your lead time is about 14 days. However, during peak periods, you sell up to 15 products per day, and delays in inventory shipment mean it can take up to 18 days for products to arrive at your warehouse. Here's the formula in action:
(15 × 18) - (10 × 14)
This makes your safety stock level 130 -- you’ll need to keep 130 extra stock on hand to compensate for delays in shipping or periods of high demand.
That formula is straightforward, which makes it great for smaller businesses. The downside is that average lead time can be hard to figure as it's so variable, and outliers can seriously skew the numbers. Large companies may need a better formula to compensate for more products and a wider variety of supply and demand.
Using the "King" Formula
What if you’re targeting a certain level of service? The more complex “King” formula can help you calculate this number. Here it is:
Z × σLT × D-avg
In this formula, Z is your target service level, σLT is the standard deviation of your lead time, and D-avg is the average demand for a product. This one requires a little more algebra, but it's just a matter of filling in the variables.
Service level (Z) is the target probability of avoiding a stockout. The majority of products have a service level of 85%-90%, with crucial goods going to 95% and more. The higher the service level, the more you’ll need to spend.
To use it in this formula, you’ll need to convert it to a service factor using a NORMSINV function. Use this calculator or the NORMSINV feature in Excel and round it to the nearest hundredth decimal. So if you want a service level of 95%, you'll have a service factor of 1.64.
Next is σLT, the standard deviation of lead time. Because suppliers rarely deliver products at the same intervals, you'll need an accurate representation of the delivery variance.
To calculate the standard deviation, you need your expected lead time and the actual time the shipments took. Then write down the variance of each shipment, which is how many days over or under the expected time it took. Positive numbers are late, and negative numbers are early.
Add the total variances and divide the result by how many shipments you measured. Then, add this to your expected time, and you have your standard deviation.
Let’s say you expect a shipment in 14 days, but it took 15, 12, 17, 14, and 19 days (or a variance of 1, -2, 3, 0, and 5). This leaves you with a standard deviation of 15.4.
Last you must calculate average demand. Pick a time interval, such a week or a month, or your typical lead time. List how much you've sold during each interval. Add up the total sales volume and divide it by how many days you measured.
If you sold 1500 stock in a month, your demand average is 50 (on average, you sell 50 units per day).
Now let’s plug all the examples we gave into the formula.
1.64 × 15.4 × 50
And that leaves you with a safety stock of 1,262.8, or 1263. If you want a 95% service level, get shipments about every 14 days, and sell on average 1500 products per month, that's about how much you'll need.
This formula is a little more complicated, but it's very useful. The main issue is that only established businesses will have the statistics necessary to get accurate results. This formula also assumes that lead time varies, but demand doesn't, which isn't always true.
Making a forecast error by overestimating the target service level can do severe damage. It's better to buy too little than to waste hundreds of products, so be moderate with your estimations until you've gotten the hang of purchasing extra stock.
There are plenty of more complicated safety stock formulas, but these two calculations are a great place to start.
But spreadsheet formulas and calculations can become limiting, especially if you want to scale your business quickly. Inventory management software has advanced significantly in the last decade, and some tools can help consolidate data. Using metrics like lead time, projected forecasts, and buffer days, they provide actionable recommendations to inform your safety stock process.
For example, Skubana has automated features that use this data to estimate the amount of units to reorder, as well as automatically creates purchase orders that you can adjust. It can also calculate your daily usage for each product, giving you accurate data for your adjustments.
Applying the Safety Stock Formula to Your Business
Some big questions remain: How do you know you're using the safety stock calculation correctly? And is safety stock even right for your business?
No formula is perfect, and the real world is much more variable than what standard deviation can capture. You should never rely on the exact number output by the safety stock formula.
Instead, start small. If your current surplus level is zero, don’t jump up to 5000 extra units. Make gradual adjustments as you gather more data, and use the number you get as a guideline, not a rule. Eventually, you’ll reach optimum levels.
Are you still wondering if your business will benefit from safety stock, or when the right time to apply the formula is? Almost any company that sells physical goods should make use of safety stock. If applied correctly, it can have huge benefits on customer satisfaction and keep the sales flowing.
But there are a few cases where it might not be the best investment.
- Brand new startups and businesses still in the early growth stages should probably avoid purchasing it -- at least excessively. At this point, you haven't been in operation long enough to accurately calculate supply and demand. Overestimating how much you'll need could cripple your finances.
- Struggling businesses should also be wary unless stockouts and customer dissatisfaction is a contributor to your lack of funds. When money is tight, focus on doing what you can to revive your business instead of purchasing inventory that might go to waste. If you are at this stage, now might be an excellent opportunity to evaluate if automation tools could address your stockouts.
- Sellers of perishables such as food must be extra careful. There's certainly a place for safety stock in these types of businesses, but buying too much can be especially devastating.
And what if your supply chain has always run smoothly for years? Shipments are never late, you rarely run out of stock, and you’re making a decent profit. Adding safety stock could be disruptive.
It would be a valid choice to only purchase it when you start to notice potential issues with stockouts, rather than preemptively. Still, remember that events like sudden customer demand, weather disasters, or supplier failure can occur without warning and at the worst possible time.
Before you begin implementing safety stock, consider how well established your business is. Think about your current profits, the shelf life of your products, and how smoothly your supply chain runs as it is and if safety stock is necessary.
Improve Your Supply Chain with Safety Stock Inventory
As a business, you need to turn a profit, so buying extra supply may seem counterintuitive. But upsetting customers by constantly running out of stock will ultimately do more harm to your finances and your reputation.
With proper inventory management, safety stock is a solid investment. Use the safety stock formula to keep things running smoothly for you, your supply chain, and your customers.