What is safety stock and how do you calculate it?
In a perfect world, you’d never have to worry running out of stock. No unpredicted surge in your product’s popularity leaving your supplier unable to match demands, no breakdowns of production machinery needing days of repair, no snowstorms or typhoons (or other weather related troubles affecting your stock)… basically, nothing unexpected happening. Now, if only that was possible…
Well, we live in the real world, and supply chain problems happen.
As a retailer, how do you handle these incidents? Stop selling until everything goes back to normal? Of course not. Backordering works, but if you’re in a business where everything’s about instant gratification, you risk losing out on sales and customer loyalty. So what can you do to guard against unexpected incidents and keep your customers happy?
The answer lies in safety stock. Safety stock is like a small emergency warchest you can break out when the going gets tough and it looks like you’re on the verge of selling out. You’d want to have enough in it to help you weather the storms when they roll around, but not so much that the carrying costs end up straining your finances. While this sounds like common sense, the trick is to decide on how much safety stock to carry.
There’s the temptation to stock enough to last you until a fresh shipment (or two) comes through, but always remember that the more you stock, the higher your carrying costs become. Just think about it; whatever you sell doesn’t just have to cover its own carrying costs - it has to cover the carrying costs of the safety stock as well.
How to calculate safety stock ?
1. Multiply your maximum daily usage by your maximum lead time in days.
2. Multiply your averare daily usage by your average lead time in days.
3. Calculate the difference between the two to determine your Safety Stock.
Its easy! All you need to get started are your purchase and sales orders history. To give an example;
Let’s say there’s a business based in the United States (N’s Handmade Shawls) selling sustainably produced handwoven cashmere shawls by craftsmen in Mongolia. On an average, it takes about 55 (average lead time in days) days to get the shawls from Mongolia to the United States. N’s Handmade Shawls sells about 10 shawls a day (average daily usage), and on weekends and bank holidays, they can sell as many as 14 (maximum daily usage). Unfortunately, in Mongolia they have dust storms, which results in longer lead times, up to 60 days (maximum lead time in days).
So for N’s Handmade Shawls, their safety stock levels would be:
(14 x 60) - (10 x 55) = 290
This means N’s Handmade Shawls would need to have about 290 units of safety stock on hand at any time (especially during spring when dust storms are rife). With 290 units in their safety stock warchest, selling about 78 shawls a week (10 per day on weekdays and 14 per day on weekends), N’s Handmade Shawls will have enough stock to last just over three and half weeks.
Your safety stock’s there to protect you against all the fluctuations in demand and lead time, buffering you against all unexpected occurrences - from a surprise boom in popularity to broken looms and subsequent delays.
Depending on what you’re selling, you may need to pay attention to seasons. For example, if you’re like N’s Handmade Shawls, you may see a spike in demand around Christmas. Maybe N’s Handmade Shawls tend to fly off the shelves come December as they make great Christmas presents, tripling demand. So for December, N’s Handmade Shawls would need to ensure that they’ve got enough safety stock to cater to this expected tripling of demand.
However, once the peak season’s over, it’s time to start reducing your safety stock levels. Always remember: more safety stock = higher carrying costs. After the holiday season has passed, there’s going to be a lot less people shopping for sustainably sourced handmade cashmere shawls.
Safety Stock levels and Reorder Point
So now you’ve know exactly how much safety stock you need to keep on hand. When it’s time to decide your reordering quantity, you shouldn’t keep your safety stock behind a glass case that reads “Break in case of emergency”. Instead, it should be a quantity that exists in your order management software, especially since it’s a key part of the reorder point calculations
Read next: Introduction to Backordering