Stockouts are a common problem among online merchants. It can also be very costly, as your company loses sales and consumers when there are stockouts. A negative customer experience will make them shop elsewhere and are unlikely to return. Stockouts also affect the effectiveness of the supply chain as a whole. Thankfully, there’s a simple solution to avoid this situation. By calculating safety stock, you can improve your internal stock management.
Stock management is one of the major concerns in contemporary production and retail. Different items should be stocked at other times to enhance efficiency and cut costs. It should also depend on shifting demand, new trends, and the state of the retail industry as a whole.
A safety stock estimate may be nothing more than a gut instinct for some business owners or an “educated guess .” It’s not ideal since it may result in supply shortages that annoy customers and result in lost sales.
Utilizing a safety stock formula enables you to manage your inventory based on data, increasing sales and profitability.
Although running out of supply is inevitable, it need not disrupt your operations. Calculating safety stock and having enough products on hand ensures the supply chain smoothly flows despite delays.
The Importance of Having Safety Stock
Safety stock is excess inventory that a manufacturer or merchant keeps on hand in case of sudden demand spikes. It’s extra stock over the standard item quantity typically held for daily operations.
Between anticipated and actual demand levels, these products serve as a buffer. To prevent delivery delays, you can use safety stock for raw materials and finished products. Increased safety stockpiles may be necessary during supply constraints to prepare for missed or erratic supplier deliveries.
In 2020 when eCommerce grew exponentially, over $70 billion in US sales were lost due to stockouts. That’s why the buffer that safety stock offers is essential for efficient inventory management. Effective inventory control goes beyond keeping track of current stock levels. It can analyze past, present, and future market situations and account for supplier lead times.
Companies must coordinate safety stock to keep inventory levels following supply and demand. Doing this makes inventory management easier and more reliable. When times are tough, and it appears that you are about to sell out, you can use your safety stock as a cushion. You’ll want enough inventory to support you through crises but not too much that the carrying costs impact your budget. But choosing how much safety stock to carry is tricky, despite being common sense.
Understanding Safety Stock Formulas
There are several safety stock formulas, but they all work similarly to decide how much product you should order. Consider the following when choosing the right one for your business.
First, you must have complete sales history and accurate inventory details to create a precise demand forecast. You can attempt to estimate, but remember that a poor one might result in errors and unnecessary inventory. That data should be easily accessible if you’re using inventory management software. But it might not be easy to locate this data if you’re only utilizing spreadsheets.
Average Max Method
(Maximum Daily Usage x Maximum Lead Time) – (Average Daily Usage x Average Lead Time) = Safety Stock
The average max formula involves a couple of variables:
- Maximum daily use – the highest number of items sold during a peak period.
- Average daily usage – average daily sales
- Average Lead time – the average period from the point a business places an order to restock its supplies until the supplier delivers them.
- Max lead time – the maximum number of days the supplier takes to deliver the stock since placing its order.
This method is excellent for smaller businesses due to its simplicity. The drawback is that average lead time isn’t easy to calculate at times since it can be unpredictable. On top of that, outliers can significantly skew your results.
Let’s assume your business sells 25 items daily, with a lead time of around 10 (ten) days. However, during peak seasons, you can sell up to 40 items per day. And it might take up to 18 days for merchandise to reach your customers due to delays in inventory shipment.
The calculation is as follows: (40 x 18) – (25 x 10) = 470
Your safety stock level is now 470 units. To account for delivery delays or periods of strong demand, you must stock 470 additional items.
The “King” Formula
Z × σLT × D avg. = Safety Stock
The King formula offers a more precise method of determining safety stock by considering lead time and demand changes. It’s useful for bigger businesses with higher product volumes and more diverse supply and demand.
While this formula may look intimidating at first, all it requires is some basic algebra and familiarity with variables. You can input this data into a spreadsheet to make computations easy.
The following is a breakdown of the main parts of this equation:
- Z – desired service level
Before refilling your inventory, the service level specifies the predicted likelihood of avoiding an out-of-stock issue.
More safety stock is needed the higher the targeted service level. This can be a risk due to added costs to handle increased supply.
Although it depends on the product sold, most retail businesses try to maintain normal service levels between 90% and 95%. You must utilize a standard distribution chart to convert your intended service level into a number that can be used in the safety stock calculation. Concerning the service level you intend to achieve, this will assist you in determining your service factor.
- σLT – the standard deviation of the lead time
Simply put, lead time is between the start and end of a process. A purchase requisition’s submission & approval, contacting suppliers, vendor delivery, incoming inspection, and shelf-positioning time are all potential factors in this process.
The expected time, the actual time, and the variance are the three crucial figures you want to note.
- Expected time: The anticipated lead time for a product
- Actual time: The time it took to fill each order
- Variance: Difference between actual and expected times
You can use a standard deviation calculator to help in your computations.
To illustrate, let’s say you have the following lead times for two shipments:
|Expected Time||Actual Time||Variance|
First you add up your variances, 5 + -2 = 3. Divide this number by your total number of shipments (in this case, two) 3 ÷ 2, giving you a value of 1.5. Add this to your average expected time, 5 + 1.5 = 6.5. This number will be your standard deviation for lead time.
Finally, we have a D avg. It’s the average level of demand over a specific period. Finding the average daily demand is most frequently used to determine safety stock needs. To do this, tally up all sales made within the specified period, then divide that total by the number of days in the time frame.
Let’s assume a time frame of three weeks. During this period, you sold a total of 5000 items. You can divide 5000 by 21 (number of days in three weeks) to get 238, which is the average level of demand in three weeks.
We then input each variable into our equation to complete our example. Your business wants to achieve a 96% service level which converts to 1.75 when using a distribution chart.
1.75 x 6.5 days x 238 units = 2,707 safety stock value
Our calculation shows that to fulfill the demand for sales over an average lead time of six days and maintain a service level of 96%, we must have 2,707 units of safety stock on hand.
Because we know that it will only continue for six days, you can use 2,707 units as your starting point for further orders. Place another order once your inventory reaches this point, reducing the likelihood of a stockout.
Always keep in mind that restocking involves more factors than merely safety stock. Safety stock only determines how much to add to the overall inventory and provides a reorder point.
Strengthening Your Business with Safety Stock
Consider the quality and volume of your data before selecting the best formula for your safety stock. A solid and trustworthy data collection to work from is essential since data is a crucial component in each of these computations. If not, your calculations can be off, creating more problems than they resolve.
For companies with low sales volumes of 100 or fewer, it is best to use the “average max” method. In essence, your goal is to determine the average maximum number of units you’ll ever require. If you can fulfill a large volume of items but encounter uncertainty in your lead times and demand, then go with the King formula.
Not every product will need a safety stock buffer; keeping so much inventory on hand can be detrimental to a company. The simple solution is that you should set a safety stock level for any product or component that you can’t afford to run out of. However, this has to be a well-informed choice that a company or business must take.
Management of safety stock is essential for both manufacturers and retailers. It can help lower the likelihood of supply shortages and reduce inefficiency, client dissatisfaction, lost sales, and decreased revenues.
There is no one-size-fits-all formula that will work for all organizations, so pick the approach that works the best for you. Like many other business decisions, there isn’t always a clear-cut decision.
You can calculate safety stock correctly each time with careful planning and preparation and profit from having a comprehensive inventory for your company. With ZhenHub, we provide the tools that allow greater control and visibility over your eCommerce logistics. Manage your orders and get real-time insights through our shipping software. Simplify your logistics operations, no matter where you are, by signing up now.