Author: Daniel J. Sperling
Inventory planning is a crucial yet challenging discipline within supply chain management. Safety stock (or buffer stock) is the amount of carried inventory to prevent shortfall of materials. The calculation of the ideal safety stock is often volatile, uncertain, complex, and ambiguous. So where do I need to start to setup my inventory ideally? Simply put, a clear understanding of lead times, target service levels, the demand and consumption situation and further business specific factors need to be considered.
But let us take a few steps back and takea business perspective. Why is it so important to have an ideal inventory level? The answer is easy. Inventory levels that are inaccurate, have a large impact on business costs and revenues. Carrying too little inventory puts your business at risk of stockouts, while too much inventory leads to too much tied up working capital. Both scenarios have financial impacts. On the one hand, due to certain materials being not available, production needs to halt and causes downtime costs. On the other hand, not fulfilled customer orders, can manifest in additional fees, penalties, or in the worst case, the entire loss of customers. Maintaining a well calculated safety stock can prevent stockouts based on the desired service Level and optimize working capital.
Understanding (Target) Service Levels
The term service levels relates to the customers perspective and how a business is willing to serve its customers. While looking at the definition, service level depicts a percentage of how many stockouts a business is willing to risk. A service level of 95% states that the business is willing to accept 5% stockouts during replenishment cycles. Service levels can be adjusted as required. But it is important to keep in mind, that a higher desired service level, requires a significantly higher safety stock level. In safety stock calculations this factor is described asR-Factor (or Z-Factor). The R-Factor is determined by the inverted standard distribution. Safety stock is not designed to protect a business from all stockouts, just the majority of them.
How Much Risk Is Acceptable – Protecting Against Variability
Calculating the ideal safety stock level requires solid knowledge about the variabilities in the supply chain (Figure1). Factors that are widely considered in safety stock calculations are the variability in lead time and the variability in demand during lead time. These two dimensions have the strongest impact on safetystock, yet they are not the only uncertainties. The forecast quality and the amount of replenishment are factors that can be added to adjust the safety stock at a later point in time.
Risk Of Lead Time Variability
A critical to manufacture products, consisting of several components and materials, is the lead time. Industries that are highly affected by lead times suffer the from lead time variability. Without supply, production is delayed or in the worst case can come to a halt. Eliminating or reducing uncertainty of lead time optimizes the ideal safety stock level and ensures a stable production output. Thus having positive effectson the own lead time (output) consistency.
Regarding safety stock calculations, business have different options to calculate the right level. The choice of the right formulais dependenton the business itself, the data available, the target service leveland the desired accuracy. The following approaches provide a selection of calculations.
A: Traditional Approach
Demand (Daily Sales)× Period= Safety Stock(Example: 5,000 units× 30 days (1 month) = 150,000 units/month).
Intended to give a rule of thumb based on the daily sales and the stock level to be present for a certain period (e.g. a month). By simply multiplying the formula provides the number of units necessary over the defined period. The traditional approach serves as a good starting point.
B: Reduction Of Demand Variability
R–Factor × √(Total Lead Time/Period)× σ Demand = Safety Stock
Formula B can be used, when the uncertainty to be only arises from the lead time perspective. Additionally aconstant, reliable demand is required to make this formula feasible. Presuming Demand being the only uncertainty, the formula looks as depicted above.
It’s Not About Mitigating All, But The Majority Of Stockouts
C: Reduction Of Lead Time Variability
R–Factor × σTotal Lead Time× øDemand = Safety Stock
In case of constant demand and varying lead times the formula needs to be adjusted accordingly.
D: Reduction Of Independent Variability In Demand And Lead Time
R–Factor × √(Total Lead Time/Period× σ Demand) + (σTotal Lead Time× øDemand)= Safety Stock
The fourth approach combines the calculation of both uncertainties (B and C) and puts them into relation while considering them independently. It is the most effective basic calculation for todeterminesafety stock levels.
E: Consideration Of Additional Variability In Supply (Delivered Amount)
R–Factor × √((Total Lead Time/Period× σ Demand) + (σTotal Lead Time× øDemand)+ (σSupply Quantity))= Safety Stock
Other factors can be included in the formula to amplify and adjusting the last approach. Only dimensions that have a significant impact onstock–and service levelsare recommended.
Every business is unique and has different requirements towards theinventory. Therefore, there is no out–of–the–box solution. The process of calculating ideal safety stock levels is an iterative process. The formula needs to be tested and adjusted.
Variation in demand becomes more and more predictable throughout artificial intelligence and machine learning. Nevertheless, all that can be achieved is a further reduction of uncertainty. Advancements in forecasting and calculating safetystock may improve, but event of a short falls of stock will still occur. All formulas are restricted by their mathematical possibilities. Extremes such as single deviations that are far off, seasonality or other uncommon events, will offset the result significantly. The previously stated formulas build a foundation and can be enriched with variables and factors that take these into account (e.g. outlier correction). All calculations are only as good as the data they are based on. With insufficient data quality and quantity, the calculations may not provide feasible results and can put inventory planning at risk. It is always recommended to execute validity checks to prevent critical consequences.
Following Up On Safety Stock
Advancingin the topicof stocklevelsand inventory planning, the configuration of reorder points,becomes evident.Extending the topic even more, Economic Order Quantity(EOQ)takes the safety stock calculation a step beyondand is based on the trade–off between order–and stockholding costs. These topics arecovered in other ACOPA whitepapers.
1.“Safety Stock Formula: How to calculate it”, D. Robinson (SKUVAULT). Accessed on May 262021 and viewableat: https://www.skuvault.com/blog/safety-stock-formula/
2.“Crack the Code: Understanding Safety Stock and masterin its equations”, P. L. King (CSCP). Accessed May 10 2021 and viewable at: https://web.mit.edu/2.810/www/files/readings/King_SafetyStock.pdf
3.“Stockout Costs and Effects on the Supply Chain”, M Murray (The balance smallbusiness). Accessed May 25 2021 viewable at: https://www.thebalancesmb.com/stockout-costs-and-effects-2221391
4.“Inventory Optimization with SAP”, M.Hoppe, 2006, SAP Press.
5.„Supply Chain Management Based on SAP Systems: Architecture and Planning Processes“, P. Mertens,etal.,2009, Springer Berlin Heidelberg.