One of a business owner’s nightmares is missing out on sales because of stockouts. Not only does the business owner lose revenue, but they’ve also probably lost a loyal customer they worked hard to build a relationship with. That person is now either going to buy from a competitor or not buy at all. This same feeling applies beyond retail to manufacturers, when production stoppages are caused by a lack of inventory.
Fortunately, if you’re a manufacturing business owner, there are ways to track these two crucial types of inventory, known as pipeline and safety stock, which you can use in your accounting to lower your stockout rates. You’ll also sleep easier at night.
We’ll also explore four additional types of stock that will help you fill the gaps in your inventory accounting. They are simple ways of making sure you stay on top of business, amidst the chaos of growth and complexity. These four types of stocks stand out amongst other inventory classifications and types you can use to lower inventory costs.
What Is Safety Stock?
Safety stock, also called buffer, hedge, or fluctuation stock, is inventory held to hedge against the risk of shortages or stockouts. Think of safety stock as insurance for when demand spikes or there’s a materials shortage.
Keeping safety stock is a delicate balance because it increases inventory and carrying costs, but it plays a key role in preventing stockouts, which causes lost revenue and unhappy customers. The upside to putting the time in to have the optimal amount of safety stock is a high service level with satisfied customers. The formula for safety stock is the difference between your maximum daily usage and lead time, and your average daily usage and lead time:
(Max. Daily Usage x Maximum Lead Time) – (Average Daily Usage x Average Lead Time)
Let’s imagine that you own a store that sells running gear. On the best sales day for your most popular shoe, you sold 12 pairs (which is your max daily usage). The longest time it would take to get a new shipment is 14 days (max lead time). The average number of pairs you sell is 3 (avg daily usage), while the average lead time is 7 days.
(12×14)-(3×7) = 147
The safety stock you should hold for this item is 147 pairs.
Keeping safety stock increases inventory holding costs, but having too little inventory can result in lower revenues and poor Yelp reviews from unhappy customers. Forecasting demand for products is good for inventory management, but safety stock is the buffer in the case those forecasts are wrong.
There are four additional types of stock that are related to, but different from, safety stock: cycle, psychic, decoupling, and anticipatory stock.
Cycle stock is the amount of inventory that is planned to be sold for a certain time period. This could mean the time period between orders, or how long a production cycle takes. Cycle stock is used as a buffer between deliveries of new orders. A quick and easy way to calculate your cycle stock is to subtract your safety stock from your on-hand stock.
Psychic stock is a type of stock used by retail businesses. It’s the inventory used for display to stimulate demand for items. Think of the clothes stores put on mannequins or storefront window displays. Typically psychic stock is calculated by taking the difference between the total inventory on hand and the sum of cycle stock and safety stock.
Decoupling stock is inventory held by manufacturers to prevent production stoppages. Decoupling stock can be thought of as a type of safety stock specific to manufacturers in that it prevents a stock out of any one item from grinding operations to a halt.
By keeping stock for each segment of the manufacturing process in reserve, one part of the process won’t slow down or stop the others. In essence, you are decoupling each part of your manufacturing process from each other so they aren’t dependant on each other to operate.
Anticipatory stock is inventory a business acquires in anticipation of a spike in demand or forecasted trend. For example, a retailer might acquire anticipatory stock in advance of the holiday shopping season. Or an analyst for a manufacturer might order anticipatory stock of raw materials when forecasting a spike in a commodity’s price.
Knowing how much cash is tied up in your warehouse’s safety stock can give you peace of mind, but how much of your cash flow is in raw materials or products that you’ve procured but haven’t received yet? We can answer that question with pipeline stock.
What Is Pipeline Stock?
Pipeline stock, also called transit inventory or goods-in-transit stock, are materials being shipped, often by truck, rail, or air. Pipeline stock is common with manufacturing companies managing supply chains with multiple suppliers and factories, or retail locations with inventory in transit from warehouses.
With complex supply chains that include overseas shipments, materials can be considered pipeline inventory for days or weeks. If the business has paid for the items, it’s considered pipeline inventory until they receive it. Pipeline inventory tracking is useful because it tells a business how much capital they have tied up in inventory that they can’t use or sell yet.
There are two concepts to know for calculating your pipeline stock. The first is lead time, which is how long it takes to receive stock after you order it. Second is the demand rate, which is how many items you sell in between orders for that item. Your pipeline inventory can be calculated by multiplying your lead time by your demand rate.
For example, let’s say the lead time for an item is 3 weeks and you order 50 units per week — your pipeline inventory would be 150 units.
There’s another use formula, called Economic Order Quantity (EOQ), which tells you the ideal amount of stock you should order given a few variables. It helps minimize both inventory and carrying costs. Here’s the formula:
EOQ = square root of (2 x demand x ordering costs) / carrying costs)
Demand (D) is the number of units a business orders for a specific period, usually annually. Ordering costs (S) is the ordering costs per order. Holding cost (H) is the carrying cost per unit.
Let’s say you own a furniture store that sells a high volume of a certain type of chair and you want to figure out your EOQ. Each chair costs $200 and you sell 1,000 per year. You figure out it takes about an hour to process an order, and based on your employee compensation you estimate your order cost is $50 per order. Based on your warehouse costs and insurance, your carrying cost per unit is $5. Based on these numbers your EOQ looks like this:
EOQ = square root of ((2 x 1000 x $50) / 3)
EOQ = 182
So next year, your optimal order for those chairs is 182.
Some business owners overcompensate with too much inventory because they never want to miss out on a sale or have production downtime. It’s an understandable fear, but with advanced inventory management tools, you can lower your inventory costs and improve your margins without compromising your high levels of service.