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October 24, 2006 Comparing The Ways That Safety Stock is Calculated In Issue 82 & Issue 83 we explained two very different ways to calculate how much safety stock is needed for an item. Just as a reminder, in Issue 82 we explained a very simplistic way to calculate safety stock. All we did was take your average sales per day and multiply that by your lead time for the item. Then you multiplied that number by our predetermined percentage of the average number sold during the lead time and get your safety stock number. We said that although this is simple and easy to understand it doesn’t work in 2 major instances: Products with long but very reliable lead times and with fairly consistent amount sold and Products with very short lead times and significant variations in amount sold. We then said in Issue 83 that a better way to calculate your safety stock is to have it directly related to historical sales and lead times. In this issue we are going to take 1 product and figure out safety stock using both methods to see how much money you are actually saving. For our example we are going to use an imported ham with the following information:
First let’s calculate the amount of safety stock using the simple short way: 5 Cases (Average Sales Per Day) x 60 Days (Average Lead Time) = 300 Cases (Amount sold in Average Lead time) 300 Cases (Amount sold in Average Lead time) x 50% = 150 Cases Safety Stock 300 Cases (Amount sold in Average Lead time) + 150 Cases Safety Stock = 450 Cases (Adjusted Reorder Point) As you can see from the calculations above you would be carrying 150 cases of safety stock and have an adjusted reorder point (that we talked about in Issue 82) of 450 Cases. Now let’s take a look at calculating safety stock using your historical sales and lead times. We know from Issue 83 that we first need to find the average difference between the forecasted amount and the actual amount. Since our lead time is 60 days (or 2 months) we will combine the sales of the two months in our calculations.
2 (January – February Difference) 1 (Total Amount of Positive Differences) = 2 Cases (Average Sales Difference During Lead Time From the historical sales numbers you can see that the average difference in the actual sales during lead time and the forecasted sales is 2 cases. This stat is showing that imported ham is very consistent in sales every month. Along with consistent sales the imported hams also have a very reliable lead time. Let’s take a look at the last 3 stock receipts to calculate what the average difference in lead time is:
1 (Difference in December) + 2 (Difference in February) 2 (Total amount of positive differences) = 2 Days (Average Lead Time Diff.) Since the difference came out with a half a day we will round up to the next whole day so we do not under calculate. Now that we know both of our differences we can start to calculate our safety stock. 5 cases/Day (Forecasted sales) x 2 days (Average Lead Time Difference) = 10 cases (Sold when inventory is late) You now know that you sell an average of 10 cases of imported ham in the average time that your inventory is late. Now you take that number and add it to your average difference in sales per month. Since our lead time is 60 days or 2 months we need to take that into account for our example. 10 Cases (Sold when inventory is late) + 2 cases (Average Lead Time Diff. in 2 months) = 12 Cases of safety stock Also in Issue 83 it was shown that you can link your safety stock to the customer service level you want to achieve. For this example we are going to choose a 97% customer service level. We then can figure out our adjusted order point using the statistical way.
12 Cases of safety stock x 3 (Deviation multiple for 97% customer service level) = 36 Cases 300 Cases (Amount sold in Average Lead time) + 36 Cases Safety Stock = 336 Cases (Adj. Reorder point) Now that we have our reorder points lets set up a situation and see how much each of these ways is costing you:
First let’s figure out how many extra cases we have on hand. To do this all you have to do is subtract the amount you sold by the amount you have to reorder. When you using the simple method it shows that you get 140 cases: Simple Approach 450 Cases (Adjusted Reorder Point) – 310 Cases (Sold in July-August) =140 Cases Extra Now when you compare that to the extra amount when calculated by the historical value method you see that is a lot less: Historical Value Approach 336 Cases (Adj. Reorder point) – 310 Cases (Sold in July-August) = 26 Cases extra Since we know the average weight of the Hams and we know how much we bought them for we can figure out exactly how much more the simple approach of calculating safety stock will cost you: 40 lb/case (Average weight of ham) x $3.00/lb ( Average Buying Price) = $120/case 140 Cases Extra (From simple approach) x $120/case = $16,800 (Money spent on unmoved products) 26 Cases extra (Historical Value Approach) x $120/Case = $3,120 (Money spent on unmoved products) $16,800 (From Simple Approach) - $3,120 (From Historical Value Approach) = $13,680 As you can see from the example by using the Simple Approach to calculate your safety stock you would be spending over $13,500 dollars more than if you would have used the Historical Value Approach. Using the Historical Value Approach not only will cost you less but also keep in mind the customer satisfaction level you want to achieve. This approach will give you extra money in the bank to allocate to different products. Wouldn’t it be nice to have extra money in the bank to be able to spend on growing your business? In next week issue we will be showing you how a Food Oriented Software Package can help you with these calculations and give you a even more precise safety stock number to save you even more money. Looking At Historical Values When Finding Safety Stock Can Cost You Less To Unsubscribe
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