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HOW TO CALCULATE SAFETY STOCK

As an eCommerce business owner, here are the top reasons why you should know about safety stocks?

  • Safety Stock helps your business cover the demand during the replenishment lead time.
  • It helps in avoiding stockouts.
  • A trade-off between the safety stock holding cost and stock-outs cost helps in optimizing inventory.

Typically, it is suggested that the primary objective of inventory management is to minimize the cost of inventory. That’s because it has a direct impact on the return on assets that a business earns. As a result, many companies consider investing in the stock inventory as an element of cost. However, this approach to managing inventory is not completely correct. 

The primary objective of inventory management must not be to minimize investment in the stock inventory. Rather, it must be to determine an inventory level that both enhance customer service level and maximize the companies’ financial performance.

Today, increasing global supply chains, more dynamic product life cycles, and multi-channel distribution has made traditional inventory management practices obsolete. As a result, truly successful companies are adopting new inventory management technology. Such technology not only helps them in reducing inventories, but it supports them in enhancing customer service level.

Note that the customer service level in inventory management refers to the expected probability of not hitting a stock-out during the next replenishment cycle. In other words, it refers to the expected probability of not losing sales.

Thus, the customer service level of a company depends on the level of stocks. This means an e-commerce business needs to maintain enough safety stock levels. The safety stock levels of an e-commerce business must be high enough that it:

  • Covers vendor’s delivery times,
  • Meets customers’ demand, and
  • Maintains moderate carrying costs

In this article, we will discuss what is safety stock level and how to calculate safety stock level for an e-commerce business. Besides this, we will also learn why safety stock is important for e-commerce businesses to avoid stockouts.

What is Safety Stock?

Screenshot 2022 01 17 at 10.59.27 AM
Image Source: SAP

The Safety Stock is defined as the level of inventory that a business needs to carry or maintain to avoid situations like stock-outs and backorders. It is basically a buffer to a business’ on-hand inventory or the extra inventory that is over and above customers’ demand.

In other words, safety stocks are inventories in excess of the average demand. E-commerce businesses need to maintain the safety stock inventories to avoid stock-outs. Such stock inventories are needed to cover the demand during the replenishment lead time. An e-commerce business may depend on safety stock when the actual demand exceeds expected demand, or when the lead time exceeds the expected lead time. 

So, to calculate safety stock levels, a business needs to work on sales forecasts. This is because the level of safety stock that an e-commerce business needs to maintain depends on its sales forecasts.

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Remember, while calculating the safety stock level, the aim of a business should not be to calculate the exact level. This is because safety stock is an estimated figure that depends on sales forecasts which are rarely exact figures.

Thus, the determination of safety stock level protects an e-commerce business against higher than expected demand levels. It is not intended to eliminate all stockouts—just the majority of them.

Also, in the case of an e-commerce business, safety stock is a function of the supply cycle time and transportation time. This means the inventory shortfall risk will increase with the increasing variability in supply and delivery time.

Though the safety stock levels may avoid stockouts for an e-commerce business. But maintaining such stock levels may also lead to influencing the cost for the firm. That is, maintaining the safety stock may reduce the cost of stock-outs. But it increases the holding cost of inventory for the business.

Therefore, it is important that a business must consider a trade-off between the holding cost and stock-outs cost.

What is Safety Stock Formula?

There are various formulas to calculate Safety Stock levels. The Safety Stock formula that an e-commerce business must use depends on the stock volume variability, lead time, type of business, etc. 

As mentioned earlier, the estimation of safety stock level is not intended to eliminate all stockouts. The main objective behind determining such stock levels is to avoid the majority of stockouts. 

image

Image Source: MIT 

Consider the image above. It demonstrates safety stock designed for a 95% service level. As is evident, a business may not need to maintain safety stock for 50% of the replenishment cycles. For another 45% of the replenishment cycles, the safety stock will be sufficient. But in approximately 5% of the replenishment cycles, the business may expect a stockout. 

Likewise, safety stock designed for a 98% service level would result in fewer stockouts. However, a business will have to maintain more safety stock in such a case. The ideal situation is when the business will maintain a balance between inventory costs and customer service. 

Using the following safety stock methods and equations, a business can find safety stock levels to achieve its desired customer service levels.

1. Basic Safety Stock Formula

The basic safety stock formula calculates the safety stock level based on the average sales per day and the number of safety days a business wants to maintain.

Accordingly, the Safety Stock Formula is,

Safety Stock = Average Sales Per Day * Number of Safety Days

Safety Stock Example

Say, for instance, ‘Zapin’ is an e-commerce store selling consumer electronics to customers. Suppose ‘Zapin’ sells 1000 SKUs of consumer electronics per day and has 10 days to replenish the stock with additional SKUs. Further, ‘Zapin’ wants to maintain safety stock of 5 days.  Accordingly:

Average Sales Per Day = 1000 SKUs

Number of Safety Days = 5 days

Lead Time = 10 days

Safety Stock = Average Sales Per Day * Number of Safety Days = 1000 * 5 = 5,000 SKUs

Reorder Point = Safety Stock + (Average Sales Per Day * Lead Time) = 5,000 + (1000*10) = 15,000 SKUs.

Say, the EOQ  level is 25,000 SKUs.

This means you have a safety stock of 5,000 SKUs and you have a reorder point of 15,000 SKUs. As a result, when your inventory level reaches 15,000 SKUs, that’s when you need to place an order of 25,000 SKUs. Since the lead time for ‘Zapin’ is 10 days, ‘Zapin’ will consume 10,000 SKUs during the transit time.  ‘Zapin’ will then be left with 5,000 SKUs when it will receive 25,000 SKUs.

This safety stock example demonstrates the basic method. In this method, a business will have to calculate the safety stock levels manually. This means it is time-consuming. 

2. Average – Max Formula

This is the general formula for safety stock calculation. In this method, safety stock is nothing but the difference between maximum reorder level and minimum reorder level.

The maximum reorder level is the level of inventory above which an e-commerce business cannot hold inventory. It is the maximum capacity of goods that a business can stock in its store. 

Likewise, the minimum reorders level is the level of inventory that an e-commerce business must always maintain during the normal course of its business. It is basically a precautionary level of inventory that demonstrates that the supply of goods may take more than the normal lead time.

Thus, to calculate safety stock under this method, the maximum level of inventory is calculated by multiplying the maximum number of units sold in a single day with the maximum lead time. Maximum lead time is nothing but the longest time it has taken the supplier to deliver the stock.

Likewise, the minimum level of stock is calculated by multiplying the average number of units sold in a day with the average lead time. 

Accordingly, the safety stock formula is:

Safety Stock = (Maximum Sale * Maximum Lead Time) – (Average Sale * Average Lead Time)

Safety Stock Example

Let’s consider the previous example to understand this formula. Say ‘Zapin’ sells 360,000 SKUs over a period of 12 months. This means it sells 30,000 SKUs in a month and 1000 SKUs of consumer electronics per day. The maximum sale in a day was 1200 SKUs. Further, the number of deliveries was 15 during the past 12 months and the average time for each delivery was 12 days. The maximum time of delivery recorded was 15 days.  Accordingly:

Total Sales over 12 Months = 360,000 SKUs

Sales in a month = 30,000 SKUs 

Average Sales Per Day = 1000 SKUs

Maimum Sales Per Day = 1200 SKUs

Average Lead Time = 12 days

Maximum Lead Time = 15 days

Safety Stock = (Maximum Sale * Maximum Lead Time) – (Average Sale * Average Lead Time) = (1200*15) – (1000*12) = 18000 – 12000 = 6,000 SKUs

Reorder Point = Safety stock + Average Sale * Average Lead Time =  6,000 + 1000*12 = 6,000 + 12,000 = 18,000 SKUs

The major challenge with using this safety stock formula is that it does not consider the service level. Also, such a method may impact the numbers for businesses having very long lead time periods.

3. Normal Distribution Method 

The normal distribution method is also called King’s Method. This method considers a normal distribution that is a probability bell curve. 

The bell curve demonstrates that most values are close to the mean or the average value. It also showcases that fewer values exist at extreme distances from the mean value. Plus, the total number of values occurring above the average values is close to the total number of values occurring below the average value.

Moreover, the distribution along the bell curve is symmetrical. This means that a business is as likely to sell the average quantity of goods as it is to sell more than the average quantity.

Further, the width of the curve demonstrates the average demand and its variability. Such variability is characterized by a statistical property called standard deviation. This is denoted by sigma. Accordingly, the narrow the bell curve, little is the variability in average demand. Likewise, the wider the bell curve, the greater is the variability in average demand.

The following is the typical normal distribution curve. It demonstrates that for a normal distribution, 68.26% of the data falls under one standard deviation of the mean ( ± 𝛔), 95.45% of the data falls under two standard deviations of the mean ( ±2𝛔), and 99.73% of the data falls under three standard deviation of the mean.

Screenshot 2022 01 21 at 10.26.04 AM

Thus, an e-commerce business can set a service rate at which it wants to maintain safety stock. In return, such a distribution will indicate the safety factor that a business can use to calculate safety stock.

Safety Stock Example

Let’s consider the above example. The following table showcases the normal distribution for ‘Zapin’ where the service rate is the only factor that varies. Accordingly, the following are the service rate coefficients at different levels of service rates.

Normal Distribution
Service RateZ = Coefficient of Service Rate
99.99%3.719016482
99%2.326347874
98%2.053748909
97%1.880793606
96%1.750686073
95%1.644853625
94%1.554773595
93%1.47579103
92%1.405071561
91%1.340755033
90%1.281551564
89%1.226528119
88%1.174986792
87%1.12639113
86%1.080319342
85%1.036433391
84%0.9944578841
83%0.9541652535
82%0.9153650877
81%0.8778962945
80%0.8416212327
79%0.8064212461
78%0.7721932134
77%0.7388468486
76%0.7063025626
75%0.6744897502

Say ‘Zapin’ wants to set an average service rate of 50%. This means there is no need for ‘Zapin’ to maintain safety stock. That’s because it has a 50/50 chance of selling more or less than the average next month.

However, if ‘Zapin’ sets the service rate at 90%, the normal distribution will give a multiplier coefficient of 1.28 to meet 90% of the demand.

Now, there can be three scenarios when it comes to considering the variability factors. The variability can occur in the following ways:

  • Variability in demand only
  • Variability in lead time only
  • Uncertainty in demand and lead time independently
  • Uncertainty in demand and lead time-dependently

I. Normal Distribution When Only Demand is Variable

The first method under normal distribution is used when the average demand is the only factor that is uncertain. Thus, the safety stock needed to give a certain level of protection simply is the standard deviation of demand variability multiplied by the Z-score and the square root of average delay time. Note that the Z score is nothing but a statistical figure also known as the standard score.

Thus the safety stock formula is:

Safety Stock = Z * Standard Deviation in Demand * Average Lead Time

If we look at the normal distribution table above, it is clear that to satisfy demand with a 95% confidence level, it’s necessary for ‘Zapin’ to carry extra inventory equal to 1.65 standard deviations of demand variability. This is nothing but a Z-Score of 1.65.

Likewise, to satisfy demand with a 50% confidence level, ‘Zapin’ need not carry any safety stock inventory. Thus, in this case, the Z-Score would be 0. 

Further, if ‘Zapin’ wants to satisfy demand with an 84% confidence level, it’s necessary for it to carry extra inventory equal to 1 standard deviation of demand variability. Thus, in this case, the Z-Score would be 1. This means that 84% of the time, there will be enough inventory.

The above table also showcases the relationship between the desired service levels that ‘Zapin’ wants to maintain and the level of Z-Score. It showcases that higher service levels require disproportionally higher Z-scores. Accordingly, the safety stock required would also be disproportionately higher. 

Further, the above safety stock formula answers the question how do you calculate service level from safety stock?

Safety Stock Example

Let’s consider the previous example to understand this formula. Say ‘Zapin’ sells 360,000 SKUs over a period of 12 months. This means it sells 30,000 SKUs in a month and 1000 SKUs of consumer electronics per day. The maximum sale in a day was 1200 SKUs. Further, the number of deliveries was 15 during the past 12 months and the average time for each delivery was 12 days. The maximum time of delivery recorded was 15 days.  Accordingly:

Total Sales over 12 Months = 360,000 SKUs

Sales in a month = 30,000 SKUs 

Average Sales Per Day = 1000 SKUs

Maimum Sales Per Day = 1200 SKUs

Average Lead Time = 12 days

Maximum Lead Time = 15 days

Per Month Sales
MonthSales
January20000
February30000
March10000
April40000
May20000
June50000
July20000
August40000
September40000
October30000
November20000
December40000
Total360,000
Average Demand (Per Month)30000
Average Demand (Per Day)1000
Target Service Rate90%
Z= Coefficient of Service Rate1.281551564
Demand Standard Deviation12060.45378
Per Month Lead Time
DeliveryLead Time (in Days)Lead Time (in Months)
1140.03835616438
2130.03561643836
3140.03835616438
4150.04109589041
5110.0301369863
690.02465753425
7130.03561643836
8120.03287671233
9120.03287671233
1080.02191780822
11100.02739726027
12120.03287671233
13130.03561643836
14140.03835616438
15100.02739726027
Average Lead Time120.03287671233
Maximum Lead Time150.04109589041
Lead Time Standard Deviation2.0354009780.005576441037
Normal Distribution When Demand Is Uncertain
Safety Stock FormulaZ * Standard Deviation in Demand * (SQRT) Average Lead Time
Safety Stock2802.489051
Reorder Point FormulaSafety Stock + Average Sale*Average Time
Reorder Point3788.790421

Thus, we have a Safety Stock of 2,802 SKUs and reorder point of 3,789 SKUs as per this method.

II. Normal Distribution When Only Lead Time Is Variable

An e-commerce business can use this formula when there are significant changes in supply on the part of the supplier. 

This method utilizes the standard deviation of the lead time distribution. Hence it gives a more correct picture of the lead time and how frequently the e-commerce business deals with shipments that are delayed for a longer period. 

However, this method does not take into account the seasonal changes in demand.

Under this method, an e-commerce business can calculate safety stock by multiplying the desired service level with a standard deviation in lead time. The standard deviation in lead time is nothing but the extent and frequency with which the average lead time differs from the actual lead time.

Accordingly, the safety stock formula is:

Safety Stock = Z * Average Sale * Lead Time Standard Deviation

As mentioned above, the Z score is the desired service level that an e-commerce business wants to operate at. It indicates the level of confidence about having enough stock at which an e-commerce business wants to operate. 

Safety Stock Example

Considering the above example, the following table showcases the safety stock and reorder point when only lead time is variable.

Normal Distribution When Lead Time Is Uncertain
Safety Stock FormulaZ * Average Sale* Lead Time standard Deviation
Safety Stock2608.471308
Reorder Point FormulaSafety Stock + Average Sale*Average Time
Reorder Point14608.47131

In the per month Lead Time table, it is clear that the more unstable is the lead time, the greater is the standard deviation. As we can see in the above table, the safety stock is of a lower level as the fluctuation in lead time is small.

III. Normal Distribution When Demand and Lead Time Are Variable Independently

This is the scenario where an e-commerce business experiences fluctuations both in demand as well as lead time. However, the uncertainty in demand is independent of uncertainty in supply.

This method calculates safety stock 

Accordingly, the safety stock formula is:

Safety Stock = Z * (Average Lead Time*(Demand Standard Deviation)2 + (Average Sale*Lead Time Standard Deviation)2)

Safety Stock Example

Considering the above example, the following table showcases the safety stock and reorder point when demand and lead time are variable independently.

Normal Distribution When Demand & Lead Time Change Independently
Safety Stock FormulaZ * (SQRT) ((Average Lead Time* (Demand Standard Deviation)2 + (Average Sale * Lead Time Standard Deviation)2)
Safety Stock2803.702731
Reorder Point FormulaSafety Stock + Average Sale*Average Time
Reorder Point14803.70273

Using this method, our safety stock is 2804 SKUs and the reorder point is 14,804 SKUs.

IV. Normal Distribution When Demand and Lead Time Are Variable Dependently

This is the scenario where an e-commerce business experiences fluctuations both in demand as well as lead time. However, the uncertainty in demand and uncertainty in supply are dependent on one another.

Thus, safety stock in this formula is calculated by adding the safety stock levels calculated in the first two formulas under the normal distribution. The first formula considers demand fluctuations into consideration and the second formula considers the lead time fluctuations.

This, the safety stock formula is:

Safety Stock = Z * Demand Standard Deviation * Average Lead Time+ Z * Average Sale * Lead Time Standard Deviation

Safety Stock Example

Considering the above example, the following table showcases the safety stock and reorder point when demand and lead time are variable dependently. 

Normal Distribution When Demand & Lead Time Change Dependently
Safety Stock FormulaZ * Standard Deviation in Demand * (SQRT) Average Lead Time + Z * Average Sale* Lead Time standard Deviation
Safety Stock5410.960359
Reorder Point FormulaSafety Stock + Average Sale*Average Time
Reorder Point17410.96036

Using this formula, the safety stock level is 5411 SKUs and the reorder point is 17,410 SKUs. As we can see, this formula takes into account both the fluctuations in demand as well as the corresponding changes in the lead time.

Safety Stock Vs Reorder Point

The following table showcases the difference between the safety stock and the reorder point.

AttributeSafety Stock Reorder Point
DefinitionSafety stock is the stock level that a business must maintain in order to prevent material shortages, backorders, or to avoid stockouts. It is a kind of precautionary stock or buffer stock for a business.Reorder level refers to the level of stock at which the supplier needs to add additional inventory in order to maintain the inventory at the optimum point. 
PurposeThe purpose to maintain safety stock is to avoid material shortages, backorders, or to avoid stockouts.The purpose of determining the reorder level is to replenish the inventory during the lead time.
Quantity TypeIt helps the business to determine the minimum quantity of stock that is required by the business to avoid cessation of work.It helps a business to calculate the quantity of stock a business needs to order in a single order.
Stock Level Safety stock is the level of stock that lies below the reorder level.Reorder point is the level of stock that is above the safety stock level.
CalculationTo determine safety stock, one must specify the risk of a material shortage and the desired service level.To determine the reorder point, one must specify the total material including the safety stock for requirements planning.
ComponentsSafety stock covers both excess material consumption within the replenishment lead time and any additional requirements that are expected to occur due to delays in delivery.Reorder point covers material consumption within the replenishment lead time.
FormulaSafety Stock = Z * Standard Deviation in Demand * (SQRT) Average Lead Time + Z * Average Sale* Lead Time standard DeviationReorder Point  = Safety Stock + Average Sale*Average Time

Why Do You Need Safety Stock?

It is very important for a business, especially an e-commerce store, to maintain a sufficient level of Safety Stock. This is because it helps businesses avoid a situation where the customers have to go empty-handed. Furthermore, it also helps them maintain good relations with suppliers as they do not have to pressurize them for speedy supply.

The following are the reasons why safety stock is so important for an e-commerce business.

1. Seamless Supply Chain Functioning

The Buffer stock is the level of stock that helps in the smooth functioning of your e-commerce business’ supply chain. This is because the demand for the near future, say a few days or months, is forecasted already and the products are stored accordingly.

As a result, the business ensures that there is no obstacle in the flow of the supply chain circuit. Also, the business will not have to wait to access more products in case there’s a sudden increase in demand.

2. High Customer Satisfaction

As mentioned above, the Safety stock level ensures that the customers would not have to go empty-handed. This would make customers happy and satisfied since the e-commerce store has the products they have been looking for. Besides this, increased customer satisfaction would mean recurring customers which will certainly have a positive impact on the business revenues and profits.

3. Avoid Stockouts or Backorders

An e-commerce business may experience scenarios where there is a sudden spike in demand. Thus, businesses having sufficient safety stock on hand would not have to experience situations like stockouts and backorders.

Stockout is a situation when a business’ inventory gets exhausted or goes out of stock. Whereas, backorders refer to a situation where a business cannot fulfill a current order as it does not have the product inventory. It indicates that an e-commerce business needs to order more inventory from its suppliers or the stock ordered from third-party suppliers is still in transit.

4. Overcome Price Fluctuations

The change in external factors may have a direct impact on the business. For instance, a change in government policies or an increase in the price of raw materials or merchandise may impact the supply or production of goods. A sufficient amount of safety stock can help a business will not get impacted by such scenarios. Moreover, it will help in making businesses efficiency.

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