Sunday, August 17, 2008

Conventional Ways of Calculating Safety Stock

There are two common conventional methods for calculating the safety stock quantity for a product:

* Percentage of Lead Time Demand
* Days Supply

As we discuss the various methods for calculating safety stock quantities, we'll refer to two variables, "forecast demand" and "usage." Forecast demand is a prediction of how much of a product will be sold or otherwise used in a particular month, and usage is the quantity that was actually sold or used.
Percentage of Lead Time Demand
One of the inventory consultants advocated that, for most items, 50% of lead time demand provides an adequate safety stock quantity.
Demand per day is multiplied by the projected lead time resulting in a lead time demand. Safety stock is half this amount. This quantity represents a X day reserve.
This method is easy to understand but it tends to maintain too much or too little safety stock for many items. For example:

Products with long but very reliable lead times and with fairly consistent demand. If we use this method for an imported product with a 12-week lead time, we'll keep six weeks stock in reserve as safety stock. If we usually receive the shipment on time and demand doesn't vary substantially from month to month, we'll have too much safety stock – in other words, too much money tied up in non-productive inventory.

Products with very short lead times and significant variations in demand from month to month. If a product had a one-week lead time, this method will keep a three or day supply of the item in reserve as safety stock. If usage tends to vary significantly from month to month, there probably won't be enough safety stock available to consistently fill customer demand and the company will experience stock outs.

Days Supply
The days supply method allows a buyer to manually specify a number of days supply of a product to hold in reserve as safety stock. Because a buyer usually does not have the time to review the safety stock parameters for every item each month, he or she will probably set the days supply to provide more than enough safety stock. After all, in the eyes of most buyers, excess inventory is usually preferable to stock outs. As a result, the days supply method often results in the accumulation of non-producing inventory.

Remember that the purpose of safety stock is to protect customer service from unusual customer demand during the lead time or delays in receiving a replenishment shipment. Why not base the amount of safety stock maintained for each item on the variations in demand and lead time? The greater the variation in demand and/or lead time, the more safety stock will be maintained for the item. This is referred to as the "average deviation method."
First we need to calculate average deviation. Next we have to calculate the average deviation of the product's lead time.As a final step in determining the safety stock quantity, we'll multiply the average deviation by a deviation multiple. The deviation multiple used is dependent on the customer service level we want to provide to our customers. Customer service level is defined as the percentage of line items for stocked products shipped complete by the promise date. The higher the multiple, the more safety stock we'll maintain, and the higher the customer service level. Please refer to our other articles for a complete discussion of the customer service level.Be careful! Using a higher deviation increases the amount of non-moving inventory on your shelf!

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