Show
Fraz Rafique FCMA Fraz Rafique FCMAGroup Chief Financial Officer at RAQAM InternationalPublished Dec 25, 2016 I have often seen people using easy methods of calculating safety stocks which, though easy to calculate, most often don’t fulfil the purpose of maintaining safety stocks. So, to understand the calculation of Safety stocks, it is important to understand what are safety stocks and what purpose they serve? What is the importance of calculating reasonably correct safety stocks? What are the consequences of not maintaining Safety stocks? What if we maintained safety stocks more than what is required? Let us first find the answers to the above questions and then we will look into the methods of calculating the safety stocks. Safety stocks are required to be maintained to provide safety against the “stock outs” in case actual demand is more than what was forecasted during the lead time or in case where actual lead time is more than the estimated lead time. Whenever actual lead time exceeds the predicted one, there is every possibility that stocks reserved for consumption during the lead time would not be enough resulting in stock outs which in turn results in the loss of revenue. So, decent safety stock calculations should consider the probability of lead time being greater than what was predicted. However, more emphasis is usually laid on the demand variability (actual demand being more than the forecasted one) during the stock calculation. This is because, as said in theory, forecasts are never accurate. During my six years’ experience in Group Multiple, we use to forecast demand for every quarter, and well, it has never been accurate. On the other hand, 8 out of 10 times, lead time was as predicted. So, in technical terms, safety stock is defined as the stock used to compensate for demand and/or lead time variability. There may be some other uncertainties involved e.g., supply variability, quality problems, inventory accuracy problems (physical stock not matching with computerized inventory records). However, whether they should be accounted for in the calculation of safety stocks or not depends on the extent to which such uncertainties are probable to happen. In our (Group Multiple) case, we are working with leading brands all over the world, so supply variability and quality problems are rare and negligible. Probability of physical stock not matching the computerized records depend upon the nature and extent of internal controls applied. This may be a useful consideration in environments where such controls are weak or non-existent. However, I have ignored any such considerations in my calculation of safety stocks. Having understood the concept of safety stocks, let us look at the consequences of not maintaining the safety stocks. If as an inventory manager, you are not maintaining safety stocks, you are at risks of “stock outs” most of the times. Stock outs not only results in the loss of revenue at the time when the stocks are not available, but it can be fatal to the company’s competitive position as well. In today’s competitive business environment, where competitors are more vigilant and ready to pounce on any opportunity made vacant, stock outs mean that you are giving your competitors to come in and fill the supply gap created by your stock outs. This may hamper the long-lasting brand loyalty which your marketing team and brand manager have created by heavy investments in brand development. For most companies, this is unacceptable and they require their inventory managers to be more accurate in managing inventories and avoid stock outs. However, life would be easy if inventory managers are required to avoid stock outs at any cost. Unfortunately for inventory managers, this has not been the case. I being finance head, have been called at numerous occasions by CEO of the company who almost every now and then enquires about excess inventory levels. Why so much inventory has been maintained? I don’t want to see more than 15 days’ stock in my warehouses….., and bla bla bla. From where does my CEO got the figure of 15 days I never understood. However, the point is that there are financial costs involved in maintaining high stock levels. So, the core job any inventory manager is to maintain a balance in stock outs and stock levels. What is meant by the balance in my last sentence? Well, the answer is not universal. It depends on the management’s behavior. We will come back to this point when we will discuss the safety stock calculations in my next article. Explore topicsSafety 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 of any production disruption. Let 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
Reasons for Carrying Safety StockCarrying buffer stock is necessary for a business for the following reasons. Unforeseen Supply VariationNo 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 disruption in the global supply chain, resulting in the closure of many businesses. Inaccurate Demand EstimationNo 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 SatisfactionThe 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 DeliveriesIf 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 StockThere is a formula for the safety stock that helps you 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). For calculation, you can use Safety Stock Calculator ExampleLet 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. The average lead time is 55 days in the above example, while the maximum lead time is 60 days. The average daily usage is ten shawls, while the 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 of 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. This means the company must always strive to minimize its stock-out costs and carrying costs. Safety stock does put more burden on the company, in terms of costs and storage. However, it acts as insurance, helping the company meet 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. Visit for a brief introduction to various Inventory Management Techniques. Alternative for Just-in-TimeWith 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. Quiz on Safety Sock. Let’s take a quick test on the topic you have read here. RELATED POSTS
What is the purpose of safety stock Mcq?Explanation: The purpose of safety stock is to control the likelihood of a stockout due to the variability of demand during lead time. Stockouts contribute to the direct loss of any type of business.
What is the key reason to hold safety stock?Safety stock is the extra product inventory companies keep on hand to reduce the chances of stockouts. It acts as buffer inventory in case demand becomes higher than expected or your supplier fails to deliver items on time.
Is safety stock needed?Setting safety stock levels is a necessity for any business that wishes to add resilience to their inventory management processes and supply chain planning. Business that calculate and carry the right levels of safety stock will be able to: protect against unforeseen supply variations.
What does safety stock include?Safety stock is excess inventory that acts as a buffer between forecasted and actual demand levels. This inventory is maintained so that a company has sufficient units on hand to meet unexpected customer and production demand.
|
