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We have designed Retail Financial Model Templates , E-Commerce Financial Model Templates and Food and Beverage Financial Model Templates which are ready to use and you just need to enter the inputs in the yellow cells and get the desired financial model as well as the calculations of safety stocks.
After reading this article, you should be Apple to learn:
- What is Safety Stock
- Needs to maintain safety stock
- How much safety stock is required
- Safety Calculation Methods
- The best formula to use
- Risks associated with safety stock calculations
- FREQUENTLY ASKED QUESTIONS
What is Safety Stock
It is the minimum level of inventory that a company maintains to avoid inventory. Security actions help meet market demands.
There are many business sectors such as manufacturing sector, service sector, trading sector, etc. Inventory management or inventory management is primarily concerned with manufacturing activities when a company purchases stock (raw materials and packaging materials) and puts them into production to produce finished goods Inventory which are then sold to earn income for the business. If we return the process of sales to raw materials, we have learned that sales are closely linked to the management of raw materials.
Inventory management or raw material management is essential for a manufacturing company due to its direct relationship with sales. If the company has enough stock for production, it can meet market demands for its products.
Needs to maintain safety stock
For small retailers, safety stock might be a smart guess, but for a large manufacturing setup, relying on it is not recommended. Considering all the uncertainties in the market, such as variation in demand and supply, change in delivery time, change in supplier, change in manufacturing output, safety stock is the tool to mitigate inventory risk.
Safety stock absorbs all the uncertainties and improves the level of customer confidence and satisfaction. The uncertainties faced in receiving each next stock delivery are also referred to as lead time. Safety stock is a buffer or cushion to protect the business from storage issues during the delay.
A sudden change in customer demand, poor adherence to the schedule by suppliers can put the entrepreneur in distress if he did not use the safety stock. Safety stock is insurance against such conditions.
Let’s discuss this with specific scenarios in light of some uncertainties.
- Uncertainty in reconstitution time: A restaurant needs different components to make a cake. Delay in the delivery of any item may result in a shift in the cake delivery schedule. At festivals, suppliers may deviate from their schedule deliveries and there is a risk of stock shortages and distribution of delivery channels. Production delays due to suppliers can lead to problems with deliveries to customers, which will have a huge impact on a company’s revenue. The safety stock is there to insure the restaurant against such conditions.
- Uncertainty in demand: In the markets, there are certain products which have constant demand such as foods, kitchen items and other household items, but some products are seasonal such as soups have higher demands in winters rather than summers and especially when there is a rainy season, the demand is unexpected. Thus, you cannot predict the actual demand. To cover these uncertainties, security actions can protect a business against loss of revenue and customers.
How much safety stock is required?
The level of safety stock depends on many factors. An average is taken for each component to tackle variations.
Here are some factors that decide the level of security:
- Lead Time Calculation: Lead Time: Lead time is the period in which a process begins and ends such as from a purchase requisition until the delivery arrives. In case of constant lead time, it is very easy to calculate the safety stock, but in case of variation in delivery times, we must consider only the deviations to calculate the optimal lead time. If the lead time is minimal, the safety stock quantity will be low and vice versa.
- Level of demand: The level of demand must be calculated in relation to the delivery time. If the reorganization time is bi-weekly, the product request should be checked for two weeks. If the reorganization time is monthly, the demand calculation will cover four weeks. If a product has a constant demand, the safety stock level could be easily calculated. But if there is a variation in demand for each week of the month, taking an average of different demands for each week will be more appropriate. If the product demand is high, the safety stock will be high because the production of the product should not stop at any time to meet all delivery deadlines.
- Level of Service Established by a Company: Safety stock also depends on the level of service established by a company. Service level is a measurable term and used to measure a company’s performance in terms of percentage. This is the percentage of demand from customer requests. The higher the service level, the higher the safety stock level will be. Keeping a higher level of service without any special needs can increase the risk of holding inventory costs. This is why managers consider various factors when defining their level of service.
When all the above factors are calculated, we can easily calculate the optimal level of our safety stock.
Safety Calculation Methods
There are different methods used to calculate safety stock.
Here are some of the methods used to calculate safety stock:
- The basic formula of security security
This method only considers the sales quantity and the number of days needed to hold the stock. For example, if you sell 50 products per day and are willing to hold inventory for a week, the calculation will be;Safety Stock = 50 (products) x 7 (days) = 350 units
- Mean maximum formula
This formula aims to calculate the maximum average number of units required at a time. This formula is based on four factors which are average lead time, maximum lead time, maximum sales and average sales. This calculation is difficult in the event of a long period of delay.The formula below summarized the calculations:
Safety Stock = (Maximum sale x maximum lead time) – (average sale x average delivery time)
- Normal distribution with uncertain demands
This formula assumes that the lead time is constant and that the demand for the product is uncertain. It is the standard deviation in the requests multiplied by the root of the average delay. This method is more appropriate when the demand for a product is uncertain.The following will be the formula:
Safety Stock = Z x standard deviation of demand x √ee
(where z is the service level)
- Normal distribution with uncertain delay
This calculation method is based on three factors and is used when there is uncertainty in the inventory delivery time. It is calculated using the service level multiplied by the product of the average sales and the difference in the delivery time.Here is a mathematical representation of the formula:
Safety Stock = Z x Average Sales x Standard Deviation of Delivery Time
(where z is the service level)
IMPORTANT NOTE: A company involved in manufacturing or retailing, safety stock calculations are important to avoid excessive inventory reducing the cost of holding, avoid inventory slowdown, etc. and in the same way, also maintain stock to avoid shortage to ensure continuous sales. We have designed Free Safety Stock Calculator In Excel / Google Sheet. You just need to make a copy of the sheet and include the yellow cell numbers and see the safety stock levels.
Download Safety Stock Calculator in Excel
The best formula to use
The correct formula for calculating safety stock depends solely on the data available. As already discussed in each method, if the volume of data available is less than the basic formula will be the right choice. If there is uncertainty in demand or delivery time, the last two formulas are best suited for the calculation. Therefore, it is purely related to the source data to decide which method is the most appropriate.
Risks associated with safety stock calculations
Despite being so useful for business leaders, security actions have some risks associated with them.
Here are some risks that should be considered when calculating safety stock:
- To reduce the cost of holding inventory, some managers reduce the safety stock to zero. This will reduce a company’s inventory and on-hand inventory. But as discussed here, the level of service is tied to the level of safety stock. With the reduction in safety stock, there is a risk that the level of service will also decrease.
- When calculating security actions, there is a risk that the business owner uses the general formula. The nature of companies and their stock data are different from each other. Using the general calculation method may ignore the nature of the data and will result in an inaccurate safety stock level.
- Take an example of soup served in the restaurant. If security actions are calculated with a standard formula, which assumes constant demand, the result is stock in winters and wasted stock in summer. In short, the standard calculation ignores seasonal demands.
FREQUENTLY ASKED QUESTIONS
Q. What is buffer stock?
Q. What are the factors that affect the security level of security?
- Nature of inventory.
- Run the cost against the cost of maintaining inventory.
- Restocking time or delivery time.
- Number of suppliers.
Q. Can a company have no safety stock?
A. A company with a just-in-time inventory policy can rely on zero security actions. Stock is ordered only when needed and no stock is held by the company. It is a policy where raw materials are very expensive, and demand is scarce.
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