October 10, 2006
Volume 2 Issue 82

Calculating The Right Amount of Safety Stock…Part 1

   In last week’s issue, Issue 81, we talked about a good way to set your reorder point. We said that to figure out your reorder point that you should take the average number of product sold per day and multiply it by the lead time. That number is set as your par value and now you know that you inventory level should stay as close to that number as possible. Now we all know that you don’t sell the same amount of product every week and we also know that the timing of a product reaching your warehouse can some time be a mystery. These are 2 of the major reasons why we need safety stock.

Safety Stock is the stock you keep on hand to help against being out of stock.

   The big question that now arises is exactly how much safety stock should you carry. This calculation is very important because with this extra inventory you will have higher carrying costs. As we explained in Issue 63 & Issue 64, carrying cost is the cost it takes you to keep an item in your warehouse. You need to find the right amount of Safety Stock to fit your needs and not drive carrying costs out the roof.

   There are essentially 3 ways of calculating safety stock. One is depended on the lead time and the other two are dependant on how much customer satisfaction you are willing to give and variations in sales. In this issue we are going to start basic and explain the way that is dependent on the lead time and then next week we will go on and explain the more sophisticated and precise ways. This formula works directly off the reorder point that we explained in Issue 81.

The reorder point is knowing when to reorder your product as compared to the number you have in stock.

   Instead of using hams this time we will use turkey for our example. Let’s say that you sell on average 10 cases of turkeys a day and have a lead time of 5 days. So every 5 day span you can expect to sell 50 cases of turkey.

   The next step in the process is to multiply the average number sold during the lead time, which in this case is 50, by a predetermined percentage of the average number sold during the lead time. In the article by Jon Schreibfeder, he uses 50% for the predetermined percentage because Mr. Gordon Graham, a world renowned retired inventory consultant, had been a long time advocate that 50% was a more than safe number to use. So if you take 50 cases sold and multiply by 50% you get a safety stock of 25 cases of turkey.

   Once you calculate your initial reorder point and the safety stock that fits you best it is very easy to calculate your new adjusted reorder point that includes your safety stock.

This adjusted reorder point is the level of inventory you should always have in you warehouse to help prevent you from out of stocks.

   As you can probably already see this method is easy to use and understand but it tends to maintain too much or too little safety stock for many items. For example:

1.  Products with long but very reliable lead times and with fairly consistent amount sold.

                 If you import a product and for example it has a lead time of 50 days and you consistently sell 5 pieces a day.  According to the above formula you would need to carry and extra 125 pieces of products as a safety stock.

    5 pieces (sales per day) x 50 days (lead time) = 250 pieces sold in 50 day lead time

250(Sold in 50 days) x 50% (% of # sold in lead time) = 125 Pieces (Safety Stock)

    250 Pieces(sold in 50 days)+125 Pieces(Safety Stock)=375 Pieces(Adj.Reorder Point)

         As you can see from the example, if you used this particular formula you would be holding 375 pieces of a product that you know consistently only sells 250 in 50 days. Since your lead time is very consistent or even early you can see that holding 125 extra pieces is a waste of money.  Let's say that you reorder your product and it comes 5 days early, in 45 days instead of 50. This means that you will have 5 days worth of stock from the original inventory and 50 days of stock from the new inventory.

5 pieces (your sales per day) x last 45 days  = 225 (pieces sold  last 45 days)

225(Pieces sold last 45 days)-375 Pieces (Adj.Reorder point)=150 Pieces (In inventory)

375 Pieces ( New Inventory) + 150 Pieces (Old inventory) = 525 Pieces in inventory

      Since sales stay consistent you will be selling 275 in the next 55 days. That leaves you with 250 pieces of extra stock when you should only have 125 pieces. If you were to follow this formula you would end up carrying 2 times the amount of safety stock that is necessary!! 

2. Products with very short lead times and significant variations in amount sold.  

             This is the other end of the spectrum. If you have an item with a very short lead time let’s say 3 days and the sales are very inconsistent, let’s say 2 cases one day then 7 cases the next, then 5 cases the next, then you may run into having a shortage problem. Let’s say that you find the average sales of a day to be 4 cases. According to the formula you would have to have 18 cases as a safety stock:

    4 cases (sales per day) x 3 days (lead time) = 12 Cases sold in 3 day lead time

12 (Sold in 3 days) x 50% (% of # sold in lead time) = 6 Cases (Safety Stock)

12 Cases (sold in 3 days) + 6 Cases (Safety Stock) = 18 Pieces (kept in stock)

   This is all good and well but remember, your sales are not consistent everyday. Let’s say for example that in a 4 day period you sell 6 cases on the first day, 10 cases on the second day, 4 cases on the third day, and 2 cases on the forth day. 

7 Cases (first day) + 2 Cases (second day) + 5 Cases (third day) = 14 Cases Sold

Now it is the third day and time to reorder. You place your order then end the day as usual. The next day comes and you get an order for 5 cases. You only have 4 cases to give the customer and will be out of stock for the next two days till the product comes in.  

            This method of calculating safety stock is good for those of you that want a simple but still effective way to try and minimize out of stocks. Although there are some problems with the above formula there has been proven success in lowering out of stocks and raising customer satisfaction. Safety Stock is an expense of doing business that is necessary to ensure customer satisfaction. We all know to maximize profits we must carefully control all expenses, safety stock is no exception. Therefore, we want to try and achieve the highest level of customer service with the least possible amount of safety stock. In next’s week’s issue we will be discussing 2 more ways to calculate safety stock by looking at variations in sales and customer satisfaction.       

Maximize Customer Satisfaction By Investing In Safety Stock

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