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Protect yourself from stockouts with safety stock

September 01, 2020

The activity of your business is dependent both on the demand of your customers but also on the activity of your suppliers responsible for providing you with the products that you will then resell to your customers. A simple delay in delivery from your suppliers or a sudden high demand from your customers can be enough to weaken your level of service, and thus put your business at risk.

To remedy any malfunctions in all of your Supply Chain processes, you have the possibility of setting up a safety stock, which you must know how to properly set up and manage, in order to fully benefit from it without negatively impact your business.

What is the safety stock?

The safety stock, also called buffer stock, is a part of your stock reserved to act as a buffer. It is intended to compensate for a sudden out of stock or any malfunction in your supply chain, which could be detrimental to your business.

There are two types of hazards for your Supply Chain:

Hazards caused by uncertainty about deadlines: it could be a problem with your suppliers (delivery delays, etc.) or production problems (production delays, etc.),

Risks caused by uncertainty about your demand: it can be a sudden strong demand, or demand for products considered unstable, which is directly linked to the seasonality of the products, which will require a safety stock more consequent to overcome this uncertainty.

Your safety stock therefore corresponds to a part of your stock totally immobilized, and used only in the event of a critical situation.

Before calculating your safety stock

Prerequisite

Not all of your products require safety stock. If you do not have any doubts about this product, then keeping a stock is unnecessary, and can cause you more harm than if you did not.

First of all, you should therefore start by identifying the products requiring special attention on your part, for which it is necessary to set up a safety stock.

For this, you will need to focus on 3 criteria:

The ratio of storage costs to opportunity costs: as you know, immobilizing inventory is an operation that can cost you money: you will not have any entry of money on the products set aside. On the contrary, losing sales due to a lack of stock is also detrimental to your business, financially, but also to the level of service offered to your customers. You will therefore have to compare the cost of storage with the possible losses that you could incur. If the immobilization of your stocks for a product costs you more than possible losses, then you will have to think about reducing the safety stock, or even eliminating it,

List the hazards linked to the product: a product facing a lot of hazards (whether they relate to lead times or demand) will require a larger safety stock, unlike a product with low hazards which will require more safety stock. low,

Define a level of service to offer to your customers: if you want to offer a high level of service to your customers (delivery in one working day for example), you will need to have a high level of safety stock in order to have the resources needed to enable you to make your sales, even in exceptional circumstances.

This process should be carried out for each type of product present in your stock, in order to prioritize your products in the establishment of safety stocks.

Become aware of the risks

Before setting up a safety stock, you should be aware of the risks posed by the immobilization of these products.

Indeed, as we have already mentioned above, the safety stock should only be used to cover any contingencies that could disrupt the activity of your Supply Chain. This part of your stock should not be used to hide possible problems in your supply chain. You need to find and deal with underlying problems, rather than using your safety stock as overstock, as this could prove to be much more expensive.

Calculate your safety stock

Determine which products require special attention

Pareto law

In order to define the products in your stock that will require special attention, you can apply Pareto's law:

ABC method

"80% of the results come from 20% of the causes"

If you apply this law to your stock, it means that only 20% of the product references in stock represent 80% of the total value of your stock. It is these products that you should know how to identify, because they are the ones that require special attention. Indeed, these products being those which have the most value in your stock, they require a great vigilance: you will have to make sure to never be out of stock on these products, in order not to cause great losses for your company.

Derived from Pareto's law, the ABC method consists of a more precise breakdown of your product references, into three distinct categories, in order to determine their value in your stock.

By performing this division of your items, you will then have to give your priority attention to products in category A, because they represent 80% of the value of your stock. Category B products will require moderate attention and Category C products will require little attention. But be careful, this does not mean that you should not take care of those 50% of products which represent 5% of the value of your stock.

Finally, in order to be able to define the level of importance of your products, you will need to know how to define the objectives of your company. Indeed, each company will not choose the same criteria for dividing up its stocks, depending on whether its objective is, for example, turned towards its turnover, or towards the level of service provided to its customers.

Calculate the order point

The reorder point (also called replenishment point) corresponds to a quantity threshold for your products which, once reached, triggers a replenishment. It defines the alert stock (minimum quantity) of a product. It is placed before the safety stock, and thus makes it possible to start a replenishment and to receive the products before reaching and consuming the safety stock, which, we remind you, should only be used in the event of emergency.

The control point is calculated as follows:

Order point = (average sale x delivery time) + safety stock

It can be illustrated as follows:

The different calculation formulas

In order to be able to correctly calculate the reorder point for your products, you will need to start by calculating the safety stock needed for your products. To ensure that you do not have too little or too much safety stock, there are several methods available to you to determine the optimal amount to hold in your safety stock.

Simple formula

Using the simple formula requires 3 types of data:

- The average number of products sold,

- The sales period you want to cover with your safety stock,

- The average delivery time of your supplier.

The simple formula is:

Safety stock = average sale x period covered by safety stock

Let's take an example :

You sell an average of 25 products per day, and you want to cover 7 sales days with the safety stock, knowing that your supplier delivers to you on average in 15 days.

Safety stock = 25 x 7 = 175

Reorder point = (25 x 15) + 175 = 550

While this calculation method turns out to be very simple, you should nevertheless note that it requires perfect control of your stock in order to be able to determine the number of sales days you wish to cover with your safety stock.

Average and maximum formula

For this formula, you will need 4 types of data:

- The average number of products sold,

- The average delivery time of your supplier,

- The maximum number of products sold,

- The maximum delivery time from your supplier.

The formula is as follows:

Safety stock = (maximum sale x maximum time) - (average sale x average time)

We keep the same example:

You sell a maximum of 80 products per day and the maximum lead time from your supplier is 20 days.

Safety stock = (80 x 20) - (25 x 15) = 1225

Order point = (25 * 15) + 1225 = 1600

Be careful, however, with this formula, extreme delays or high sales levels which are exceptional can distort the formula. You should therefore be careful to cap your data with a percentage.

Normal law

Normal law, or Gauss's law, can be applied when calculating the safety stock. It makes it possible to calculate the quantity of stock to be kept aside for the safety stock by taking into account the uncertainties of certain criteria.

Prerequisite

Before any calculation with the normal distribution, you will have to start by choosing your safety coefficient. This is based on the level of service you want to provide to your customers.

To calculate the safety factor, you can use Excel and the LOI.NORMALE.STANDARD.INVERSE function. The only variable is your service rate.

For example, if you want to obtain a 95% service rate on one of your products, then you will need to use 1.64 as the safety factor in your calculations.

To choose the service rate to apply to your products, you will need to use Pareto law or the ABC method.

You will also need to calculate the standard deviations of your sales and lead times. To do this, still using Excel, use the STDEV formula.

You can thus represent your sales data, and calculate the standard deviations of your sales and lead times. To calculate your standard deviations, you can rely on a period of one year. Be careful, however, if this is a product with high seasonality, it will be better to focus on a more specific period.

Normal distribution with uncertainty on demand

The first of the four normal distribution formulas is used when you have uncertainty about demand, and your lead times are stable and predictable.

The formula is as follows:

Safety stock = coeff. safety x sales standard deviation x √ (average lead time)

Let's go back to our example. As a reminder, here is the data that we will use in all the following examples:

We want to get a 95% service rate, so our safety factor is 1.64. Our average lead time is 15 days and we sell an average of 29.7 copies of our product per day. The standard deviation of our sales is 130.5 and the standard deviation of our lead time is 1.3.

Safety stock = 1.64 x 130.5 x √ (15) = 829

Reorder point = (29.7 x 15) + 829 = 1275

Normal law with uncertainty about time limits

You can use this formula when you have reliable forecasts on your demands but uncertainties on your lead times.

The formula is as follows:

Safety stock = coeff. safety x average sales x standard deviation lead time

In our example:

Safety stock = 1.64 x 29.7 x 1.3 = 63

Reorder point = (29.7 x 15) + 63 = 508

In this formula, the more you have unstable lead times, the greater your safety stock will be.

Normal law with uncertainty on demand and time (independent)

This formula will apply to you if you have uncertainties about the deadlines and about your request, but these two uncertainties are independent.

The formula is as follows:

Safety stock = coeff. safety x √ ((average lead time x (standard deviation of sales) ²) + (average sales x standard deviation lead time) ²)

In our example:

Safety stock = 1.64 x √ ((15 x 130.5²) + (29.7 x 1.3) ²) = 831

Reorder point = (29.7 x 15) + 831 = 1277

Normal law with uncertainty on demand and lead times (dependent)

You should use this formula if you have both demand uncertainties and lead time uncertainties, and these two uncertainties are related (whether lead time causes demand uncertainties or vice versa).

The formula corresponds to the sum of the normal distribution with uncertainty on the demand and the normal distribution with uncertainty on the delays:

Safety stock = (safety factor x sales standard deviation x √ (average lead time)) + (safety factor x average sales x standard deviation lead time)

Points to watch out for when calculating your safety stock

So that the calculation of your safety stock is optimal and allows you to correctly manage your stocks, you will have to be vigilant on several points:

When using your data in your various safety stock calculations, you should be careful to always use the same unit of time. For example, you will not be able to choose to express your average sales over a month and your average replenishment time in days. This point is essential to obtain correct results that are consistent with your situation,

The safety coefficient does not take into account the seasonality of products as a whole, using the normal law for the safety stock of products subject to high seasonality is therefore not recommended, in order to avoid unpleasant surprises, unless to focus on a specific period of the year to better predict sales,

All the formulas presented above do not make it possible to predict extreme situations which are very exceptional.

Choose the right formula for your stock

Among all the formulas at your disposal to calculate your safety stock, you will have to choose the formula most suited to your situation:

  • If you have small sales volumes, the first two formulas will be the most suitable (simple formula and medium and maximum formula),
  • In case of higher sales volumes, then you will have to use the formulas of the normal distribution. To make your choice among the four formulas, you will have to identify the point which is unstable in the management of your stocks and supplies. In the event that demand and supply are both unstable, then you will need to identify whether these two instabilities are related or not.

In order to avoid a shortage of stocks and thus not miss sales, you will need to optimize your safety stock to be able to react in the event of a major crisis. However, safety stock should not be used to hide anomalies in your inventory management. You will therefore need to be on constant alert in order to diagnose your Supply Chain, and ensure that the forecasts concerning your requests and replenishments are updated in order to have a reliable safety stock calculation.

Other calculation formulas can help you optimize your inventory management and thus allow you to reduce costs due to the downtime of these products:

  • Wilson's formula: this formula allows you to optimize the quantity and frequency of your orders, in order to reduce your working capital requirement (WCR) and thus reduce your safety stock,
  • ABC XYZ Classification: This formula helps you better determine your target service rate based on demand and other uncertainties.

The best solution today remains to equip yourself with a software solution, allowing you to have an overview of the various parameters influencing your inventory management.

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