Wednesday, September 18, 2013

How much should a company hold to be "Safe"? - the art and science of safety stock

Safety stock, also known as buffer stock, is a term used by supply chain practitioners to describe a level of extra stock that is maintained to mitigate the risk of stock outs due to uncertainties in supply and demand. In the industries where customers' demand are highly unpredictable, companies add safety stock to their inventories as insurance to hedge the risk of volatility. 

However, everything comes with a price. The benefits of safety stock must be evaluated against the potential costs incurred by holding too much safety stock. Safety stock ties up cash which could be used  for the other parts of a company's operations. So getting the optimal amount of safety stock to balance safety and efficiency is really pivotal to a company's development. 

Calculating the optimal amount of safety stock is a blend of art and science. A supply chain guru with more than 20 years of supply chain management experience may easily come up with a number out of intuition. However, as a fresh grad out of management school, how can we get the number in a scientific/mathematical way? 

International logistics provider DHL says the optimal level of safety stock is determined by four factors:
  • Replenishment lead times
  • Forecasting errors
  • Delivery readiness
  • Total storage capacity (i.e., warehousing)
The less the replenishment lead time and the fewer the forecasting errors, the lower the safety stock level should be to meet customers' changing demand. In contrast, the higher the level of delivery readiness, the more the safety stock should be held. In addition, companies with a few small warehouses tend to hold more safety stock than those with a single, large warehouse.

SM masters usually use 3 methods to calculate safety stock: Statistical-based safety stock, fixed safety stock and time-based safety stock. Instead of boring you with dry texts and numbers, I put a video here to walk you through the steps of calculation:

Again, I think the management of inventories is a blend of art and science. No matter how sophisticated we are in playing with numbers, it takes years of experience to judge the right amount of safety stock for different companies. Can anyone think about how the amount of safety stock varies across industries?

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