Imagine that you are an entrepreneur celebrating your third year of business selling candles. Sales have been increasing, and profits are higher than ever. However, you start to notice that you are having trouble keeping an accurate inventory due to the sudden change in demand. Some candles are selling out before new shipments arrive while some are overstocked taking up valuable inventory space, and it is costing you money. After doing research, you decide the best way to improve inventory operations is begin factoring safety stock into your ordering process.
Determining inventory level is one of the most challenging tasks faced by entrepreneurs and Operations Managers. When managing inventory, the goal is to satisfy product demand while maintaining an efficient stock supply. Too much inventory incurs extra holding and capital cost (money tied up in inventory that cannot be used for anything else). Not having enough inventory impacts the ability to manufacture goods or provide customers with product. In order to successfully manage inventory levels, learning how to use the safety stock formula is essential.
Safety stock is simply extra inventory beyond expected demand. Entrepreneurs and Operations Managers carry safety stock to prevent stockouts, caused by changes in customer demand, incorrect forecast, and variability in lead times for raw materials. Calculating all of these variables can become a bit complex, partially because there are multiple formulas for determining safety stock and how to factor it into order quantities. However, in this article, I will provide the most comprehensive explanation the safety stock formula and how it fits in the ordering process.
Why Use Safety Stock formula?
Factoring the cost of inventory stockout is important for understanding the role safety stock plays in the ordering process. It is not uncommon for managers to rely on gut instinct or an educated guess to determine how much extra inventory to keep. Without properly calculating safety stock, the likelihood of a stockout drastically increases.
Over time, stockouts result in loss of revenue, gross profit, customers, and market share. If you can not meet the demand of your customers they will find someone else who will. Taking the time to use the safety stock formula not only saves you from these costs, but also increases the efficiency of your storage space. The result: increased revenue and higher service level. Service level is the probability that the amount of inventory on hand during the lead time is sufficient to meet expected demand - that is, the probability that a stockout will not occur.
The uncertainty of supply and demand makes it difficult to calculate the amount of stock needed to satisfy customers needs while avoiding stockouts. When dealing with uncertainties and multiple variables, the best way to calculate safety stock is to use standard deviation for determining variations in supply and demand.
Calculating Safety Stock
The definition of standard deviation is a quantity calculated to indicate the extent of deviation for a group as a whole. Which, in layman's terms, means you: first find the average of a set of data, second calculate the sum of the average and the data set, third take the sum and divide it by the sample proportion to get the variance, then fourth add the variance to the average. The sum amount will be your standard deviation.
With this definition in mind, the formula for calculating safety stock is given by the equation.
Z × σLT × D avg,
where Z is the desired service level, σLT is the standard deviation of lead time, and D avg is demand average. Don’t be intimidated, the simplest method for calculating safety stock only requires a four-step process to calculate these variables.
1 | Calculating Lead Time
Lead time is the time between initiation and completion of a production process, or the time it takes in total to replenish stock. The total time it takes between submitting a purchase requisition, approval time, emailing vendors, delivery time from vendor, incoming inspection time, and the time it takes to put on the shelf determine lead time.
Depending on the vendor service used, lead times can be constant or variable. Lead times are considered constant if the total time to reorder and restock is always the same. If lead time is constant, you have an established lead time and can move on to the next stage in calculating safety stock. However, having such stability in lead time is rare. More often the lead time is variable, meaning that products production or delivery time are not always the same. It is because of this lack of consistency that we have to find the standard deviation of lead time to gain an accurate measurement. Let's take a look at the table shown below.
As you can see, the table is broken down into three categories: Expected Time, Actual Time, and Variance. The expected time is the average lead time for a product. Actual time is the real time it took to complete each order in the sample portion provided. In this example, the expected lead time to restock is 6 days while the actual time is varied. The variance column is the difference between expected time and actual time. Positive numbers are the number of days over the expected time and negative numbers mean that the delivery arrived earlier than the expected time. With this information, we can find the standard deviation in lead time.
To find the standard deviation, first add up the variances,
5 + 3 + 5 + -1 + -2 = 10.
The sum of the variances, in this example, equals 10. Next, divide the sum of the variances by the sample portion
10 ÷ 5 = 2.
Finally, add this number to the average expected time
After this step, you will have the standard deviation for the lead time. In this example, we have just discovered that the standard deviation for lead time is 8 days. 8 days signifies the average amount of time it takes to restock, after taking into account the variability in the actual time that orders have been received in the past. 8 days is also the amount of time that our safety stock will have to hold us over until new product arrives. Now that we have the first part of the equation it's time to move on to the second step.
2 | Calculating Demand
To calculate demand average you first have to determine what time frame you want to account for. The amount of time between reorders is usually a good time frame. If a product is reordered once every two weeks then demand should be calculated in two-week increments. If product is reordered once a month, the time frame will account for one month’s worth of sales. Let’s take a look at the table below:
This table is expressed by two columns, Weeks and Sales Volume. The time frame of this example is one month broken down into weekly increments. Sales Volume highlights the number of units of a product sold each week.
To determine the demand average simply take the sum of the total Sales Volume and divide it by the number of buying days. In this example, the sum of sales volume is 2550 units and the number of buying days is 30.
2550 ÷ 30 = 85 units
Now that we know that the average demand is 85 units per day, it is time calculate safety stock.
3 | Calculating Safety Stock
After calculating the lead time and the average demand for your product, we now have all of the pieces needed to complete the formula. Remember the formula for safety stock is Z × σLT × D avg. We now know that the standard deviation of lead time is eight days and that the demand average is 85 units a day. To find the safety stock multiply these two numbers.
8 days × 85 units = 680 units
This equation tells us that we need 680 units in inventory to meet the demand of sales over the eight-day period that is required to reorder the product. 680 units is also the reorder point since we know that it is only enough to last the eight days once inventory reaches this level it is time to place another order and avoid any possibility of stockouts.
If your business involves delivery, you can also account for the time variable associated with how long it will take to deliver. For example, say you know it takes two days to deliver your product. Tell the customer it takes a maximum of four days to deliver your product even though you know it will only take two. This gives you two extra days which allows you to discount your safety stock. Instead of covering 100% of 680 units, you're going to cover 75% = 510 units which covers up to 6 days instead of eight. With this flexibility in delivery time, you can use the extra time to your advantage and save money on inventory.
4 | Service Level
You may have noticed that we did not calculate the service level (Z) in the equation. That is because our service level in the above example has already been assumed at 100% which in the equation is expressed as
1 × 8 days × 85 units = 680.
We were calculating for the event that 100% of the demand will be met and that all of the inventory will be sold. However, this is not always the experience that sellers have. Calculating for 100% service level can result in a surplus of inventory depending on the market and other variables.
For example, if you had a product that is specific to an event like a local festival, and you know that the festival is this weekend it is beneficial to calculate for 100% service level. Since you know demand will be high, and based on last years sales, you know that this is a sell out item. But, if you plan to stock this item over a month's period, demand will begin to dwindle, and you will need to calculate for a lower service level to prevent overstock. You will need to use a normal distribution chart in order to determine a more accurate service level.
Looking at the normal distribution chart we can determine what our service factor is according to the service level we want to reach. For example, If you are trying to maintain a service level of 84% your service factor will be 00.99. This number will serve as your service factor, or (Z), in the equation.
So continuing with this example, if you calculate for a 75% service level the equation looks more like
Safety Stock = 00.67 × 8 days × 85 units.
Your inventory is now at 455.6 units instead of 680 units. Of course, you can not sell 0.60 of a product so when dealing with safety stock calculations always round your numbers. So 456 is the amount of safety stock you will need during the month to satisfy demand.
Service level is very important to keep in mind during every reorder. Demand fluctuates during different times of the year. The higher the service level, the higher the probability that inventory will be on hand. Calculating service level is determined by a number of factors, including carrying cost of the safety stock and lost sales if customer demand cannot be met.
Implementing Safety Stock Formula
Overall, this formula is great for forecasting inventory and calculating variable changes in supply and demand. Understand that safety stock calculations are designed to help Operations Managers avoid stockouts when ordering inventory. Remember, there are more variables that go into the ordering process than just safety stock. Safety stock simply calculates the amount extra stock that should be added to overall inventory and gives an indication on when to reorder.
Calculating safety stock correctly can save considerable amounts of money otherwise missed from stockouts or wasted in overstocked inventory. Using a software management system, such as SkuVault, to keep detailed accounts of sales and ordering process increases the accuracy and ease of calculating safety stock. Entrepreneurs and Operation Managers who understand their product and have data on past sales can expect higher inventory efficiency and higher revenue returns. Use this chart to reference your products and calculate your safety stock today.