Safety stock is the extra quantity of a product that a company keeps in inventory to lower the risk of running out of stock for that product. We also call it Buffer stock. It is a significant thing for a retailer. It acts as a buffer, in case the sale of a product is more than the estimates. Or, if a supplier is unable to deliver the product in the expected time. In the case of a manufacturing company, buffer stock could help to minimize the risk from any production disruption.
Lets us understand the safety stock concept with the help of an example. Company ABC uses the EOQ (economic order quantity) model to decide the raw materials it orders. The model requires the company to predict the sales. Since it is a prediction, the actual sales could be more or less than the forecast. So, if the EOQ is 500 units, Company ABC may produce 50 more units as safety stock to prepare for emergencies.
Table of Contents
- 1 Reasons for Carrying Safety Stock
- 2 How to Calculate Safety Stock
- 3 How Much Buffer Stock is Sufficient?
- 4 Importance of Safety Stock
- 5 Alternative for Just-in-Time
Reasons for Carrying Safety Stock
Carrying buffer stock is a necessity for a business because of the following reasons
Unforeseen Supply Variation
No one has seen the future, so there might be scenarios when your supplier is unable to supply the raw materials. For instance, the coronavirus crisis has led to the disruption in the global supply chain, resulting in the closure of many businesses.
Inaccurate Demand Estimation
No matter how much experience a business has, it may not always predict the demand accurately. Thus, if you have a buffer stock, you will still be able to meet the order even if your demand estimates are not accurate.
Ensure Customer Satisfaction
The primary objective of keeping a buffer stock is to keep your customers happy. If you are always able to meet your customers’ expectations, then they will not only keep coming back but will also recommend you to others.
Prevent Chaos in Manufacturing or Deliveries
If you have a buffer stock, you and your workers won’t have to worry about producing more products in an emergency. This way, they can focus on meeting the orders, rather than running around in chaos.
How to Calculate Safety Stock
There is a formula for the safety stock that helps you to determine the optimal number of products you should keep in the buffer. The calculation is relatively simple, and all it needs is that you have purchase and sales records.
Safety stock = (Maximum daily usage * Maximum lead time in days) – (Average daily usage * Average lead time in no of days).
Let us understand the calculation of the safety stock with the help of an example. Company ABC in the U.S. sells handwoven shawls, which it imports from India. It takes on an average of 55 days to get shawls from India, while ABC sells about ten shawls a day. On weekends or holidays, the ABC can sell on average 14 shawls a day. The importer also knows that the lead time had once stretched to 60 days due to the political unrest in India.
In the above example, the average lead time is 55 days, while the maximum lead time is 60 days. The average daily usage is ten shawls, while maximum daily usage is 14 shawls.
Putting the values in the formula (14 x 60) – (10 x 55) = 290
That means Company ABC will need a safety stock 290 units to protect itself against any fluctuations in demand.
How Much Buffer Stock is Sufficient?
The buffer stock is a good thing from a customer satisfaction point of view, but a bad thing for the company’s cash flows. If a company invests too much money in the buffer stock, then its cash flows might get disrupted. Also, you will not want to hold too much inventory so that your carrying or storage costs offset the gain from sales.
So, the best thing is to calculate inventory or the optimal stocking level. However, you must remember that your sales must cover the carrying costs of sold products as well as the carrying costs of the products in the safety stock.
A point to note is that you should not solely depend on the formula, instead use your trade experience as well. For instance, you can adjust the safety stock level obtained from the formula for seasonality. If you believe some months have more demand, then you can carry a bigger buffer stock. And, if you expect the order to be less, you could carry a lower buffer stock.
Also, you should take into account stock-out costs and carrying costs. Meaning, the company must always strive to minimize its stock-out costs and carrying costs.
Importance of Safety Stock
Safety stock does put more burden on the company, in terms of costs and storage. However, it acts as insurance, helping the company in meeting demand at a crucial time.
If a company fails to estimate the safety stock level accurately, it could result in the loss of revenue, customers, market share, and profit. A simple thing that a business must never forget is if you can’t meet the demand of your customers someone else will.
Also, accurately estimating buffer stock helps a company not only with the above things (profit, revenue, etc.) but also boosts the storage efficiency.
Alternative for Just-in-Time
With the advent of technology, many companies now use Just-in-time inventory systems. Under this, the company orders a small amount of product or materials at regular intervals. This concept does away with the need for storage of the product or raw materials.
However, many companies are unable to use a just-in-time inventory system. It could be because of budget constraints, supplies are far away, etc. For such companies, buffer stock is a good option. Under this, they hold more inventory than what they expect to sell. This strategy will ensure that the company always has items at hand to meet any increase in customer demand. 1–3