24 Mar What is Safety Stock? (Definition, Formulas, Best Practices) 2022
It’s nearly impossible to predict with 100% certainty the amount of stock that’ll be needed for a particular sales period. This is a difficult problem to solve because demand forecasting that does not use advanced analytics is not very precise.
Perhaps the greatest risk a retailer faces when using approximate demand is lost sales, due to understocking in-demand products.
Why is this such a big deal?
Look at it this way, in 2020 retailers faced over $70 Billion in lost sales in North America alone!
As if that wasn’t enough, empty shelves erode consumer loyalty. Customers are forced to switch to the more reliable competitor, leading to overall lost market share.
Even supplier relations are strained as retailers push for last-minute inventory replenishment. Replenishment is often time-sensitive, as retailers need to have inventory in time to meet demand.
No use restocking valentines’ chocolates on February 15th.
Safety stock calculations depend on the retailers’ needs, ranging from paper and pen formulas to advanced analytics software.
So what is safety stock and how can it be optimized?
What is safety stock?
Safety stock refers to ‘back-up’ inventory; retailers purchase and hold to avoid out-of-stocks.
Retailers are very motivated to avoid losing sales to out-of-stocks, but determining how much inventory will be enough to mitigate the uncertainties of supply and demand is not simple.
To be safe, when planning inventory, a retailer will purchase an additional quantity of the product. Also known as buffer stock, this inventory is meant to protect the retailer from lost revenue and maintain a consistent shopping experience for the consumer.
Having safety stock on hand means that you, the retailer, can replenish inventory while demand is still high, without incurring additional costs.
There are many benefits to having a healthy supply of safety stock, here are three examples:
1. Responding to sudden spikes in demand from customers
A spike in demand can happen unexpectedly. For instance, a new fashion trend sparked by an influencer could create demand over certain clothing items.
Having ‘back-up’ stock ensures you can take advantage of an increased sales opportunity, and avoid turning away customers due to stock-outs. Buying you time to re-order new stock.
2. Buffers stock for longer lead times
In retail, timing is extremely important. You don’t want to miss sales opportunities, because it took too long for the product order to be fulfilled by the vendor.
Buffer stock allows you to account for vendor lead times. Once in-store inventory is running low, a replenishment order can be placed, and ideally you have enough buffer stock to last until that order is fulfilled, without incurring out-of-stocks.
3. Offers protection against unpredicted market fluctuations
Unpredicted shifts in market dynamics due to shortages of certain raw materials, increases in oil prices, and changes in government regulations can lead to higher-than-usual costs.
As a result, retailers may have to pay more for ordering new product inventories from the manufacturers or for increased freight deliveries from the vendors. Worse, some products may simply be unavailable.
In such situations, safety stock will protect you from purchasing inventories at less favorable and inflated prices.
Of course you cannot simply order an arbitrary amount of ‘just in-case’ inventory.
You need to know how to calculate safety stock, so that you actually have enough to meet demand without going overboard and incurring over-stock costs.
Figuring out what is safety stock and what is overstock requires precise calculations.
A poor safety stock strategy can bring more harm than good.
Risks of poor safety stock strategy?
Every retailer has specific parameters they work within when managing inventory. As such, the approach to finding an optimal stocking level formula varies from retailer to retailer.
A poor approach can be costly, Here are four common risks to watch out for when making safety stock decisions:
1. Setting safety stock to zero
Setting safety stock levels to zero means that the retail plans to bring just enough inventory to stock in-store shelves.
This is a choice often made to save money on upfront costs; purchasing, transportation, storage. They may also be trying to avoid over-stocks which lead to drastic markdowns that cut deep into the revenue.
However, setting safety stock levels to zero is a mistake. Retailers often don’t realize that the amount they are losing in lost sales is higher than their overstock fees.
Remember, out-of-stocks lead to a decreased service level, which ends up costing the companies much more in the long run.
2. Using a textbook safety stock formula
The dreaded one-size-fits-all approach to calculating optimal stocking level formulas.
Every vertical and retailer has distinctive variables that impact their supply chain: demand, replenish periods, order quantities, vendor lead times, and numerous other factors.
Standard safety stock formulas are a great place to start. They provide a quick generalized look at your business situation.
However, for accuracy and precision, retailers use more advanced solutions like analytics software to account for their business specific factors.
3. Misunderstanding the role of lead times
This is a mistake often made by supply chain professionals as a result of misinterpretation of lead-time concepts.
Simply put, safety stock is put in place to prevent stock-outs when there is significant variability in your demand and supply.
Changes in manufacturers’ lead-time will affect your cycle stock, the inventory you purchase and allocate to meet forecasted demand (the in-store inventory). It does not necessarily impact the safety stock directly.
You should monitor your inventory level frequently by looking at the standard deviation time.
For instance: Suppose your supplier has a lead-time of eight days and a standard deviation of three days. You will need to ensure three days of safety stock, which is the variable.
4. Not managing expectations
There is a misconception that having enough safety-stock will prevent all stock-outs. In reality, buffer stock can prevent the majority of stock-outs, but not all of them.
There are many reasons for this, but key among them is the relationship between safety stock and service level. This is because as service level values reach above 95%, the safety stock number will increase exponentially in order to meet that customer demand.
A 100% service level would translate into always having the stock, unfortunately demand fluctuates. If you were able to always account for all variabilities you wouldn’t need safety stock in the first place.
Finding the right balance between the cost of holding inventory and service level is the key.
What is a good safety stock level?
Safety stock needs are specific to the retailer, the business, and service level expectations. As such, establishing a good safety stock level is done primarily by calculating sales demand and lead times.
How are safety stocks calculated?
There are several safety stock equations retailers use to determine what is a good safety stock level for their inventory mix.
Using a safety stock formula helps retailers figure out a bull-park quantity of safety stock. This may not be the most accurate approach, but it’s a cost effective option for smaller retailers.
Before getting started, retailers need to know their vendor lead times – how long will it take between placing a purchase order, and having that order arrive in your warehouse?
Of course, having a good demand forecast goes a long way toward achieving accuracy with safety stock formulas.
These calculations can be done manually on spreadsheets using a safety stock equation, however as a retailer grows this approach is hard to scale. Additional channels, vendors, and a multitude of influencing factors require advanced analytics solutions to handle and accurately compute.
Whether you are a small retailer or a global omnichannel retailer, knowing how to calculate safety stock is vital.
How to calculate safety stock: safety stock formulas
Which is the optimal stocking level formula for your business?
That will depend on numerous factors such as the size of your business, the quality of your data, your inventory mix, and so on.
Let’s review 7 of the most common formulas used to calculate safety stock:
The basic safety stock formula
The simplest method to calculate safety stock is to decide how many days of inventory you would like to have available on hand and multiply that by the amount of daily product sold.
Safety stock = (number of stock sold per day) x (days worth of stock on-hand)
E.g: (100 widgets/day) x (10 days) = 1000 widgets in safety stock
The lead-time calculation is the average amount of inventory sold per day and multiplies it by the product’s average lead-time in days.
Safety stock = Average daily usage x lead-time (days)
Average-max safety stock formula
Safety stock = (Max. daily usage x Max. lead-time in days) – (Avg. daily usage x Avg. lead-times in days)
This formula is best suited for retailers when their products have short lead times, as it doesn’t account for long lead-times variables.
Heizer Renders Formula
Safety stock = Z-score (Daily usage) x Standard deviation of lead-time
Z-score is your desired service factor, and the standard deviation of lead-time is the frequency by which the average lead-time differs from the actual lead-time.
This formula is ideal when there are significant variations in the supply from your vendors’ end.
Safety stock = Avg. Demand x Standard deviation of lead time x Z-score
Unlike the Heizer Render formula, Greasley’s method takes demand fluctuations into account. It’s deemed as a more accurate way of calculating safety stock.
Safety stock with EOQ
Economic order quantity (EOQ) is the ideal amount of stock retailers should purchase to minimize costs such as ordering, transportation, and storage.
Safety stock (EOQ) = √D x S / H
“D” is the demand for stock. “S” is order costs. “H” is the holding costs per item.
Inventory position safety stock formula
Safety stock = Inventory on hand – Backorders + Inventory currently on order
This formula helps retailers monitor net inventory while the resulting value should be higher than the reorder point to avoid running out of stock.
Selecting the optimal stocking level formula
The optimal stocking level formula depends on the needs of the retailer, and the particular factors that will impact stock.
Some considerations for choosing a formula:
- How much inventory are you managing?
- Is your inventory primarily evergreen or seasonal?
- Are you seeing unexpected sales spikes throughout the year?
- How consistent are your lead times?
Probably the greatest impact on your safety stock calculations, regardless of formula, is the quality of your data..
The main goal of a good safety stock level is to absorb the variability of demand. When executed correctly, it should be based on an accurate demand forecast that’ll closely resemble the one from the real demand.
Next Steps for creating a safety stock system
Be clear about your goals. Are you just looking to avoid as many out-of-stocks as possible, or save on storage costs? Perhaps you want the optimal approach that will maximize your GMROI.
Step 1: Determine if a safety stock formula is sufficient in achieving your goal.
A simple formula may work if you are a smaller retailer, or if you have especially consistent sales levels. However, with every additional sales channel, vendor, and inventory increase the complexity of safety stock grows.
Using Excel spreadsheets to manually calculate safety stock for every SKU at every location requires significant amounts of time and commitment. The outcomes are usually far from desirable as there is room for error which can be extremely costly for your business.
Step 2: Evaluate the quality of your data.
Accurate lead times and demand forecasts are primarily important, but not the only elements impacting safety stock.
If you are an omnichannel retailer there are many factors to consider, such as, where inventory is stored, inter-store transfers, inventory returned to store, and so on.
Your data should reflect these and all relevant factors that influence inventory levels.
Step 3: Seek an advanced analytics solution.
If a formula is not going to cut it, find a retail analytics vendor that provides a unified and AI-powered inventory management solution.
The ideal safety stock optimization solution is able to account for every relevant factor across all sales channels. Providing optimal safety stock recommendations at location and SKU level.
This means you can ship customers’ orders on time and maximize sales while ensuring your supply chain process is streamlined economically. What is safety stock, if not a way to increase service level?
If you’re looking to learn more about how advanced analytics work, the Ultimate Guide to Retail Analytics (Definition, Types, Examples, Tips), or ask an expert.