Safety stock
Encyclopedia
Safety stock is a term used by logisticians
to describe a level of extra stock that is maintained to mitigate risk of stockout
s (shortfall in raw material or packaging) due to uncertainties in supply and demand. Adequate safety stock levels permit business operations to proceed according to their plans. Safety stock is held when there is uncertainty in the demand level 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.
This strategy is employed when the lead time of manufacturing is too long to satisfy the customer demand at the right cost/quality/waiting time.
The main goal of safety stocks is to absorb the variability of the customer demand.
Indeed, the Production Planning is based on a forecast, which is (by definition) different form the real demand. By absorbing these variations, safety stock improves the customer service level.
By creating a safety stock, you will also prevent stock-outs from other variations :
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 that 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 plan
s. 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 that they require. 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.
. 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.
The 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^2 * Standard Deviation of Lead Time^2)
Notes:
Logistics
Logistics is the management of the flow of goods between the point of origin and the point of destination in order to meet the requirements of customers or corporations. Logistics involves the integration of information, transportation, inventory, warehousing, material handling, and packaging, and...
to describe a level of extra stock that is maintained to mitigate risk of stockout
Stockout
A stockout, or out-of-stock event is an event that causes inventory to be exhausted. Reorder points are often specified in such a way as to reduce the likelihood of stockouts during replenishment, due to the vendor's lead time, which cause interruptions to sales or deliveries.Stockouts are...
s (shortfall in raw material or packaging) due to uncertainties in supply and demand. Adequate safety stock levels permit business operations to proceed according to their plans. Safety stock is held when there is uncertainty in the demand level or lead time
Lead time
A lead time is the latency between the initiation and execution of a process. For example, the lead time between the placement of an order and delivery of a new car from a manufacturer may be anywhere from 2 weeks to 6 months...
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
Material requirements planning
Material requirements planning is a production planning and inventory control system used to manage manufacturing processes. Most MRP systems are software-based, while it is possible to conduct MRP by hand as well....
worksheet. The less accurate the forecast, the more safety stock is required. With a material requirements planning
Material requirements planning
Material requirements planning is a production planning and inventory control system used to manage manufacturing processes. Most MRP systems are software-based, while it is possible to conduct MRP by hand as well....
(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
Lean manufacturing
Lean manufacturing, lean enterprise, or lean production, often simply, "Lean," is a production practice that considers the expenditure of resources for any goal other than the creation of value for the end customer to be wasteful, and thus a target for elimination...
, 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.
Reasons for safety stock
Safety stocks are mainly used in a "Make To Stock" manufacturing strategy.This strategy is employed when the lead time of manufacturing is too long to satisfy the customer demand at the right cost/quality/waiting time.
The main goal of safety stocks is to absorb the variability of the customer demand.
Indeed, the Production Planning is based on a forecast, which is (by definition) different form the real demand. By absorbing these variations, safety stock improves the customer service level.
By creating a safety stock, you will also prevent stock-outs from other variations :
- an upward trend in the demand
- a problem in the incoming product flow (machinery breakdown, supplies delayed, strike, ...)
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 that 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. Various methods exist to reduce safety stock, these include better use of technology, increased collaboration with suppliers, and more accurate forecasting In a lean supply environment, lead times are reduced, which can help minimize safety stock levels thus reducing the likelihood and impact of stockouts.Due to the cost of safety stock, many organizations opt for a service level
Service level
Service level measures the performance of a system. Certain goals are defined and the service level gives the percentage to which they should be achieved...
led safety stock calculation; for example, a 95% service level
Service level
Service level measures the performance of a system. Certain goals are defined and the service level gives the percentage to which they should be achieved...
could result in stockouts, but is at a level that is satisfactory to the company. The lower the service level, the lower the requirement for safety stock.
An Enterprise Resource Planning
Enterprise resource planning
Enterprise resource planning systems integrate internal and external management information across an entire organization, embracing finance/accounting, manufacturing, sales and service, customer relationship management, etc. ERP systems automate this activity with an integrated software application...
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 plan
Sales and Operations Plan
Sales and operations planning is an integrated business management process through which the executive/leadership team continually achieves focus, alignment and synchronization among all functions of the organization...
s. 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 that they require. 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.
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 timeLead time
A lead time is the latency between the initiation and execution of a process. For example, the lead time between the placement of an order and delivery of a new car from a manufacturer may be anywhere from 2 weeks to 6 months...
. 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.
Example calculation
A commonly used approach calculates the safety stock based on the following factors:- DemandDemand- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
rate: the amount of items consumed by customers, on average, per unit time. - Lead timeLead timeA lead time is the latency between the initiation and execution of a process. For example, the lead time between the placement of an order and delivery of a new car from a manufacturer may be anywhere from 2 weeks to 6 months...
: the delay between the time the reorder pointReorder pointThe reorder point is the level of inventory when an order should be made with suppliers to bring the inventory up by the Economic order quantity .-Continuous Review System:...
(inventory level which initiates an order) is reached and renewed availability. - Service levelService levelService level measures the performance of a system. Certain goals are defined and the service level gives the percentage to which they should be achieved...
: the desired probability that a chosen level of safety stock will not lead to a stockoutStockoutA stockout, or out-of-stock event is an event that causes inventory to be exhausted. Reorder points are often specified in such a way as to reduce the likelihood of stockouts during replenishment, due to the vendor's lead time, which cause interruptions to sales or deliveries.Stockouts are...
. Naturally, when the desired service level is increased, the required safety stock increases as well. - Forecast errorForecast errorIn statistics, a forecast error is the difference between the actual or real and the predicted or forecast value of a time series or any other phenomenon of interest....
: an estimate of how far actual demand may be from forecasted demand. Expressed as the standard deviation of demand.
The 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^2 * 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 standard deviation of the demand period to the length of the lead time period.