Demand & Inventory Planning

Safety Stock: How to Calculate and Best Practices

Demand & Inventory Planning
January 26, 2022
7 min read

Learn how to calculate how much safety stock you should carry to protect against stockouts without inflating your inventory carry costs.

What Is Safety Stock?

Inventory is typically categorized in one of two ways. It is either cycle stock, which is the inventory that a merchant plans to sell through within a certain period of time. Or it’s safety stock, which is backup stock that a merchant plans to hold on to as a buffer against stockouts and missed sales opportunities.

What Is the Purpose of Safety Stock?

Safety stock protects against stockouts, and with the current state of the supply chain, stockouts have been top of mind for merchants and consumers alike. In fact, concerns around low inventory levels were front-page news during the holiday 2021 shopping season. According to a 2022 consumer survey, 48% of consumers encountered a stockout notification while shopping.

The real risk of a stockout, especially for emerging brands, is the risk of losing a long-term customer. Of those 48% of shoppers that experienced a stockout while holiday shopping, 33% shopped for a similar product from a different brand, and 36% opted for a completely different product altogether.

Safety stock protects merchants from stockouts in two distinct cases:

  • Unexpected spikes in demand: This was perfectly illustrated by the panic-buying early in the COVID-19 pandemic and the lifestyle changes that came about later in the pandemic as consumers transitioned to life at home.
  • Unexpected delays from suppliers: While factory shutdowns and freight delays have been another characteristic of the pandemic, supplier delays can be caused by any number of factors, from inclement weather to raw material shortages.

Another important purpose of safety stock is to protect margins in the following two instances:

  • Price fluctuations: If your products are evergreen and you can afford to hold excess inventory, it may make sense to purchase safety stock when prices are low. That way if prices jump up unexpectedly, you can hold off on your replenishment order to see if prices level out.
  • Transportation costs: During the holiday 2021 shopping season, for example, some merchants may have been forced to pay for expedited transportation methods to get inventory on the shelves in time for holiday sales. With enough safety stock, you can weather transportation slow-downs without risking stockouts or having to expedite a replenishment order.

How Much Safety Stock Do I Need?

While it is important to have a certain level of safety stock, there is risk involved in carrying too much. The primary risk is increased inventory carry costs, which is an especially important consideration now, when warehouse vacancy rates are at historic lows and storage costs are high.

Ideally, storage costs should not make up more than 12% of your monthly expenses. Otherwise, it may be time to think about liquidating inventory, running a promotion, or eliminating SKUs from your catalogue altogether to save on storage costs.

Ultimately, the amount of safety stock you carry will depend on your risk tolerance as a business. A higher tolerance for the risk of running out of inventory means you can carry inventory levels that require the least amount of capital expenditure. High-risk inventory planning leads to higher profits and frees up capital to invest in other areas of the business. On the other hand, a lower risk tolerance means your top priority will be insuring against stockouts. A low-risk approach requires greater capital expenditures but usually leads to greater customer satisfaction.

A good starting point to determining how much safety stock you need is by using a standard safety stock formula.

Safety Stock Formula

There are four key variables you’ll need in order to calculate safety stock.

  1. Maximum Daily Usage: You may be accustomed to talking about your Average Order Volume (or AOV), but maximum daily usage is an outlier. You should do an audit of your sales history over a fixed period of time and find the largest quantity sold in a single day.
  2. Average Daily Usage: This number is similar to AOV, which is often used by warehouses to estimate labor needs and plan warehouse layout, slotting, and pick paths. It’s the average number of units you typically sell through in a day.
  3. Maximum Lead Time: This is the maximum amount of time it could take to receive a replenishment order from a supplier. It’s important to think of the worst case scenario when finding your maximum lead time to ensure enough safety stock.
  4. Average Lead Time: This is the average number of days it takes to receive a replenishment order from your supplier.

With all of the variables in place, the formula for safety stock is to multiply Maximum Daily Usage by Maximum Lead Time and then subtract the Average Daily Usage multiplied by the Average Lead Time.

(Maximum Daily Usage x Maximum Lead Time) – (Average Daily Usage X Average Lead Time)

Should I Carry More Safety Stock?

In light of ongoing supply chain disruptions, many merchants may be considering carrying more safety stock. Between China’s Zero COVID Policy, freight delays, and a truck driver shortage, it may feel riskier than ever to carry lean levels of inventory. On the other hand, warehouse space is limited, and storage rates are historically high, so carrying excess inventory is costlier than ever.

One tactic to increase safety stock without significantly increasing inventory carry costs is to carry fewer SKUs overall. When looking at your sales history, you will likely find that you have a few top performing SKUs that significantly drive the profitability of your business. It may be wise to increase the quantities of those SKUs while eliminating your slow-moving SKUs entirely.

By carrying fewer SKUs you will significantly reduce your warehouse footprint, allowing you to carry greater quantities and keep more safety stock on hand. When analyzing your SKU catalogue and determining which SKUs you may want to discontinue, it’s important to find the right balance between specialization and having the variety of choices that your customers expect.

Automated Safety Stock Calculations

For many small to mid-sized merchants, the time it takes to calculate safety stock can be prohibitive. Finding the variables alone is time consuming, and in order to get the most accurate measure, it’s important to re-evaluate those measurements regularly to monitor for changes in demand.

Partnering with a tech-enabled 4PL like Ware2Go gives merchants of all sizes access to automated inventory reporting tools and a dedicated support team to advise them on SKU count, reorder points, and inventory distribution to improve service levels without sacrificing margins.

If you’re looking for a fulfillment partner with an intelligent inventory management solution, talk to one of our fulfillment specialists today.

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