What is the Safety Stock Formula and how do you calculate it?
Why is it important to do a safety stock calculation?
Today, one of the most challenging tasks that operation managers face is monitoring inventory levels.
A key part of monitoring inventory levels is calculating safety stock. It is the best method for stock control to prevent shortages due to unforeseen events, and therefore avoid customer dissatisfaction and loss of revenue.
However, excess inventory is also an additional cost! This is why operation managers must manage inventory, stock intelligently, and calculate safety stock as accurately as possible.
Here is a complete guide to what a safety stock is and how to calculate one.
Safety stock definition
A safety stock is an additional inventory that is set up in advance to anticipate stock shortages due to unforeseen events called contingencies.
These contingencies are generally divided into two categories:
- Demand-related contingencies: unexpected arrival of a major customer, sudden high demand due to an unforeseeable event, etc.
Note that some products are by nature quite "unstable" because they depend on factors such as the weather. Therefore, they require a larger holding cost.
- Delay-related contingencies: issues with your suppliers, late delivery, etc.
How to calculate safety stock
It is not required to have a safety stock on all of the items of your inventory. However, before calculating a safety stock you must consider the following factors.
Identify your needs
- What is the storage cost vs. opportunity cost ratio? If keeping stock in a warehouse costs more than losing a sales opportunity linked to this same stock in case of stock shortage, it is better to review your safety stock downwards.
- What are the possible contingencies and are there many? If this is the case, you will have a larger buffer stock.
- What is your desired level of service? The more you want to offer a high level of service to your customers (with shorter delivery times for example) the higher the safety stock level will be.
Apply Pareto’s principle and the ABC method
Businesses use both methods to identify the most valuable products in their inventory, those that require extra attention.
Pareto’s principle
Also known as the 80/20 rule, the Pareto principle can be applied in many fields (sales management, marketing, project management, etc.).
It is based on the following principle:
80% of the effects or results come from 20% of the causes.
In inventory management, this means, for example, identifying which 20 % of items account for 80% of inventory value.
The ABC method
Activity-based costing, also known as the ABC method is based on the same principles as the Pareto rule, but with a more precise breakdown.
Items are divided into three categories, according to inventory value for example:
| Number of items | Inventory value | |
|---|---|---|
| Category A | 20% | 80% |
| Category B | 30% | 15% |
| Category C | 50% | 5% |
In this example, you should focus your efforts primarily on items of category A.
☝️ Please note that these two methods can be based on different criteria. Instead of using inventory value, you may use the number of sales generated for example. It is up to you to choose what criteria are in line with your objectives.
Pay attention to the quality of your data
To calculate safety stock accurately, it is essential to use precise data.
With ERP or inventory management software, you can access correct and relevant information online in a few clicks. These solutions list of features include real-time monitoring of your inventory, an alert system when you reach the minimum stock, detailed history to make inventory forecasts, etc.
🛠️ If you work in a medium-size or a large enterprise, you should use software that is adapted to the complexity of your organization. InventoryCloud, for example, can be used to track and manage inventory located in one or multiple warehouses.
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