Safety stock

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Safety stock is a term used by inventory specialists to describe a level of extra stock that is maintained below the cycle stock to buffer against stockouts. Safety Stock (also called Buffer Stock) exists to counter uncertainties in supply and demand. Safety stock is defined as extra units of inventory carried as protection against possible stockouts (shortfall in raw material or packaging). By having an adequate amount of safety stock on hand, a company can meet a sales demand which exceeds the demand they forecasted without altering their production plan.^[1] It is held when an organization cannot accurately predict demand and/or lead time for the product. It serves as an insurance against stockouts.

With a new product, safety stock can be utilized as a strategic tool until the company can judge how accurate their forecast is after the first few years, especially when used with a material requirements planning worksheet. The less accurate the forecast, the more safety stock is required. With a material requirements planning (MRP) worksheet a company can judge how much they will need to produce to meet their forecasted sales demand without relying on safety stock. However, a common strategy is to try and reduce the level of safety stock to help keep inventory costs low once the product demand becomes more predictable. This can be extremely important for companies with a smaller financial cushion or those trying to run on lean manufacturing, which is aimed towards eliminating waste throughout the production process.

The amount of safety stock an organization chooses to keep on hand can dramatically affect their business. Too much safety stock can result in high holding costs of inventory. In addition, products which are stored for too long a time can spoil, expire, or break during the warehousing process. Too little safety stock can result in lost sales and, thus, a higher rate of customer turnover. As a result, finding the right balance between too much and too little safety stock is essential.

Contents 1 Reasons for Safety Stock 2 Reducing safety stock 3 Inventory Policy 4 Calculating Safety Stock 5 References

[edit] Reasons for Safety Stock

Safety Stocks enable organizations to satisfy customer demand in the event of these possibilities:

• Supplier may deliver their product late or not at all
• The warehouse may be on strike
• A number of items at the warehouse may be of poor quality and replacements are still on order
• A competitor may be sold out on a product, which is increasing the demand for your products
• Random demand (in reality, random events occur)
• Machinery Breakdown
• Unexpected increase in demand
• ...and more

[edit] Reducing safety stock

Safety stock is used as a buffer to protect organizations from stockouts caused by inaccurate planning or poor schedule adherence by suppliers. As such, its cost (in both material and management) is often seen as a drain on financial resources which results in reduction initiatives. In addition, time sensitive goods such as food, drink, and other perishable items could spoil and go to waste if held as safety stock for too long. ^[2]Various methods exist to reduce safety stock, these include better use of technology, increased collaboration with suppliers, and more accurate forecasting ^[3][4] In a lean supply environment, lead times are reduced which can help minimize safety stock levels thus reducing the likelihood and impact of stockouts.^[5] Due to the cost of safety stock, many organizations opt for a service level led safety stock calculation; for example, a 95% service level could result in stockouts, but is at a level which is satisfactory to the company. The lower the service level, the lower the requirement for safety stock.

An Enterprise Resource Planning System (ERP system) can also help an organization reduce its level of safety stock. Most ERP systems provide a type of Production Planning module. An ERP module such as this can help a company develop highly accurate and dynamic sales forecasts and sales and operations plans. By creating more accurate and dynamic forecasts, a company reduces their chance of producing insufficient inventory for a given period and, thus, should be able to reduce the amount of safety stock which they require.^[6]In addition, ERP systems use established formulas to help calculate appropriate levels of safety stock based on the previously developed production plans. While an ERP system aids an organization in estimating a reasonable amount of safety stock, the ERP module must be set up to plan requirements effectively.^[7]

[edit] Inventory Policy

The size of the safety stock depends on the type of inventory policy that is in effect. An inventory node is supplied from a "source" which fulfills orders for the considered product after a certain replenishment lead time. In a 'periodic review' inventory policy the inventory level is checked periodically (such as once a month) and an order is placed at that time if necessary; in this case the risk period is equal to the time until the next review plus the replenishment lead time. On the other hand, if the inventory policy is a 'continuous review' policy (such as an Order point-Order Quantity policy or an Order Point-Order Up To policy) the inventory level is being check continuously and orders can be placed immediately, so the risk period is just the replenishment lead time. Therefore 'continuous review' inventory policies can make do with a smaller safety stock.

[edit] Calculating Safety Stock

A commonly used approach is that Safety Stock should be decided based on the following factors:

Demand: the amount of items consumed by customers, on average, per unit time.

Lead Time: the delay between the time the reorder point (inventory level which initiates an order^[8]) is reached and renewed availability.

Service level: the desired probability that a chosen level of safety stock will not lead to stock-out. Naturally, when the desired service level is increased, the required safety stock increases as well.

Forecast error: an estimate of how far actual demand may be from forecasted demand. Expressed as the standard deviation of demand.

Suggested calculation:

1. Z: NORMSINV(Service level) , for example Z=1.64 for a 95% service level

2. Safety Stock: {Z*SQRT(Avg. Lead Time * Standard Deviation of Demand^2 + Avg. Demand^2 * Standard Deviation of Lead Time^2)}

3. Re-order Point (ROP): Average Lead Time*Average Demand + Z*SQRT(Avg. Lead Time * Standard Deviation of Demand^2 + Avg. Demand * Standard Deviation of Lead Time^2)

Notes:

• Italicized section of the ROP formula is safety stock

• The first term in the ROP formula (Average Lead time*Average Demand) is the average demand during the lead time.

• The second (italicized) term is the term that allows for the safety stock. In other words, the optimal safety stock level.

• The sqrt( avgleadtime) is needed to SCALE the std deviation of the demand period to the length of the lead time period.

[edit] References