February 6, 2019 Growing & Complex Businesses en_US Read our complete guide to using the safety stock formula and calculating pipeline stock to prevent stockouts and backorders https://quickbooks.intuit.com/cas/dam/IMAGE/A5OPbuqEG/59570baca18d979cd6e73386c48c5844.jpg https://quickbooks.intuit.com/r/growing-complex-businesses/safety-pipeline-inventory-accounting-for-your-stock/ What is the safety stock formula? A guide for business owners
Growing & Complex Businesses

What is the safety stock formula? A guide for business owners

By Dominic Vaiana February 6, 2019

Safety stock is inventory that a business holds to mitigate the risk of shortages or stockouts. Think of it as a type of insurance for when demand spikes or there’s a material shortage. Businesses can use a safety stock formula to make data-driven decisions about managing inventory levels to maximize profits.

Coming up, we’ll explain how to perform a safety stock calculation and how you can use it to lower your stockout rates. 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.

Why is holding safety stock important?

As a business owner, one of your biggest nightmares is missing out on sales because of stockouts. Not only does this cut into potential revenue, but it can also sever ties with loyal customers you’ve worked hard to build relationships with. That person is now either going to buy from a competitor or not buy at all.

Fortunately, you can sleep easier at night with safety stock, also known as fluctuation or buffer stock.

Keeping extra 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.

How to use the safety stock formula

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 demand 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.

Safety stock calculation: 3 different methods

Using the safety stock calculation above may not be suitable for every type of business. If that’s the case for you, here are three different safety stock formulas that can better align with your business goals.

1. Basic safety stock formula

This method takes into account how many products you sell per day and the number of days’ worth of stock you want to hold at one time.

Example: you sell 100 units per day and want to keep seven days of safety stock. The calculation is 100×7, giving you a safety stock of 700 units.

2. Normal distribution with uncertainty about demand

If demand for your product fluctuates, but your lead time is relatively predictable, this can be a useful method. First, you’ll need to calculate two figures.

The standard deviation of demand:

  • Calculate your average demand (total monthly demand / number of months)
  • Calculate the variability in demand by taking the square of each month’s difference, then the average of those squares together
  • The standard deviation is the square root of the deviation

The root of the average delay:

  • Calculate your average lead time
  • Find the square root of the average of squared differences

Now you’re ready to calculate your safety stock:

(Standard deviation of demand) x (root of average delay)

3. Normal distribution with uncertainty about lead time

If demand for your product is steady but your lead time varies, you can use the following method, which requires some preliminary calculations:

  • Desired service level: this is highly specific to your business. But generally speaking, the retail industry’s service level is 90%, while high priority items are 95%. Once you have your percentage, you will need to express it as a factor to use it in your formula. The easiest way to do this is to go into Excel and use the following equation (=NORMSINV (X%)), or you can refer to a service level factor table.For example, if your desired service level is 92%. Your service factor is 1.41.
  • Lead time deviation: Let’s say your expected lead time is 15 days. The chart below is the data you have on your last 10 orders.

To find the standard deviation, find the difference between the expected lead time and the actual lead time.

Add up the deviations to find your standard deviation: 5

Divide this by the number of orders: 0.5

Add this number to the average expected time spanning 15 days.

Your standard deviation of lead time is 15.5 days.

Once you have these figures, you can plug them into the formula:

(Desired service level) x (average sales) x (lead time deviation)

What are the benefits of using the safety stock formula?

When you run a business that sells physical products, inventory optimization is crucial to success. Using the safety stock formula can help you keep your supply chain running smoothly:

  1. Calculating safety stock plays a key role in preventing stockouts, which causes lost revenue and unhappy customers.
  2. Using the safety stock formula enables you to identify your inventory reorder point with data rather than guesswork.
  3. Safety stock gives you emergency padding for unexpected supply chain disruptions.

What are the risks of using the safety stock formula?

As with any inventory analysis, there are drawbacks to using the safety stock formula. Here are two to consider:

  1. Keeping safety stock increases inventory storage costs and also increases the risk of inventory spoiling or becoming obsolete.
  2. Since supply and demand are not constant, you’ll need to put in a significant amount of time to keep your formula up to date and maintain optimum safety stock levels.

Stock types related to safety stock

There are four additional types of stock that are related to, but different from, safety stock. Let’s take a look at each of them:

Cycle 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

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

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 dependent on each other to operate.

Anticipatory Stock

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 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.

How to incorporate the safety stock formula into your inventory management system

Before we dive into best practices for using the safety stock formula, it’s important to note a few cases where it might not be ideal:

  • Brand new startups that don’t have enough historical data on supply, demand, average sales, and lead time.
  • If money is tight for your business, buying safety stock likely isn’t the best investment, unless stockouts are a major factor in your cash flow problems.
  • Sellers of perishable items such as food should be cautious with safety stock since the risk of spoilage is much higher.

Now, let’s move on to a couple of best practices for businesses looking to use the safety stock formula:

  1. Start small. If your current surplus level is zero, there’s no need to order 1,000 extra units. Instead, make gradual adjustments as you gather more data.
  2. Only purchase safety stock if you start to notice potential issues with stockouts. If operations are running smoothly, there’s no need to increase safety stock levels.
  3. Establish a system to monitor data closely and regularly to ensure your formula is up to date.

Remember, no inventory analysis is perfect. The real world is more complex than an equation. That said, incorporating the safety stock formula can give you a leg up on your competition when demand spikes and provide a much-needed insurance policy against stockouts.

Final Thoughts

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 you can lower your inventory costs and improve your margins without compromising your high service levels.

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Dominic Vaiana is a writer and bibliophile based in St. Louis. In addition to writing for QuickBooks, Dominic has developed content and campaigns for global brands such as Mastercard, GoDaddy, and InVision. Read more