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!

Safety stock and effective inventory management

Theoretically, it should be easy to determine when to reorder a stocked item from a supplier. If you know that customers will order ten pieces of the product each day, and you know that it will take seven days to get the shipment from the vendor, you should reorder the product when there are seventy pieces on the shelf.
This quantity is appropriately called the "order point." But the order point formula contains one more element: safety stock. Safety stock provides protection against running out of stock during the time it takes to replenish inventory. Why is this protection necessary?
* Demand is a prediction based on past history, trend factor(s), and/or known future usage of a product. The item's actual usage will probably be more or less than this quantity. Safety stock is needed for those occasions when actual usage exceeds forecasted demand. It is "insurance" to help ensure that you can fulfill customer requests for a product during the time necessary to replenish inventory.
* The anticipated lead time is also a prediction, usually based on the lead times from the last several stock receipts. Sometimes the actual lead time will be greater than what was projected. Safety stock provides protection from stock outs when the time it takes to receive a replenishment shipment exceeds the projected lead time.
The safety stock quantity allows you to satisfy customer demand for the product until the replenishment shipment arrives from the supplier
How Much Safety Stock Do You Need?
When a replenishment shipment arrives, the available quantity is usually somewhere in the shaded area of the graph. Notice that the safety stock quantity is in the middle of the shaded area. Half the time you will use some or all of the safety stock before the replenishment shipment arrives. The other 50% of stock receipts will arrive before you use any of the safety stock. On average, the full safety stock quantity is always on the shelf when the replenishment shipment arrives. It is, on average, "non-moving" inventory.

A distributor puts inventory in her warehouse to sell it to customers. Profits from these sales are necessary to pay the distributor's expenses and provide a return on her investment. With this thought in mind, it seems as though it would not be a good idea for a distributor to intentionally have non-moving inventory in stock.

On the other hand, keep in mind the goal of effective inventory management:"Effective inventory management allows a distributor to meet or exceed his (or her) customers' expectations of product availability with the amount of each item that will maximize the distributor's net profits."
Safety stock is, in reality, an expense of doing business. But it is necessary to ensure good customer service. To maximize profits, we must carefully control all expenses, including safety stock. Therefore, we want to achieve our customer service goals with the least possible amount of safety stock.