SCM Fundamentals: Safety Stock
Safety stock is a buffer against risk and uncertainty. It is designed to reduce or eliminate stock outs due to unforeseen events in your supply chain. If you do not hold enough safety stock you risk a shortage situation with your customer. Safety Stock creates demand because you need to produce enough stock to meet the total estimated and actual demand from orders, forecast etc PLUS bring you back up to at least the safety stock level.
As I said safety stock is used to safeguard against unexpected events. Therefore, the higher the level of uncertainty in either your demand or your supply the higher the level of safety stock you need to hold. There are two real types of uncertainty in this case. Uncertain Demand and Uncertain Leadtime.
Uncertain Demand: Products will have varying levels of demand certainty from their customer. Some items are quite stable and regular in their demand. For example, Toilet Paper is often cited as a product that has fairly stable demand. Statistically there are x number of people in the world and they all go to the toilet on average y number of times and each time they use z squares of toilet paper. However, that is at the very highest level of total toilet paper used. As we saw in the forecast articles once you start to fragment the demand into individual products and markets you will find that uncertainty will increase. Specific market difficulties, fashions, trends etc can impact on the demand. Promotions by your competitors. Even government policy can impact on demand (e.g., certain countries ban flushing toilet paper because they pump the sewage straight into the local river or sea and when these policies came in, they impacted on sales). And of course, in March 2020 we saw people stockpiling toilet paper in advance of lockdowns due to Covid 19. So even something with very predictable demand can have uncertainty in parts of that demand.
Uncertain Leadtime. This is mainly about lead time from your supplier but there can also be lead time from you to your customer. Supply Chains increasingly operate a just in time approach. So, the lead times from location to location are closely studied. However, there are things that can impact on this. Weather is an obvious one. Anyone who lives on an island will know that bad weather impacts on ferries. I live and work in Ireland so as a supply chain manager I am very used to checking the forecast for winter storms (and even summer storms thanks to climate change) that stop the ferries to and from Ireland. And that is a relatively short transit time from Ireland to the UK or Europe. If you are shipping product by sea from China to the US you could be looking at weeks or even months of transit time depending on how much you pay for the shipment. Relatively small issues could add up to long delays in these deliveries. And again, more macro level events can impact on leadtime. Changes in trade policy (as between the EU and UK) or international tensions can all cause uncertainty in leadtime as people try to work out the new average leadtime. Again using the example of Ireland the impact of Brexit saw businesses very worried about leadtimes through the “land-bridge” of the UK. So companies responded to this risk of a stockout by building stock.
To illustrate this here is a simple example. An item opens up with 1100 units in stock. We have orders with our suppliers for 1000 units to be delivered in week 5 and another 1000 for delivery in week 10. Demand for this part varies between 100 and 400 a week depending on production requirements.
Based on the current plan the system reports that everything looks OK. We run to zero stock in Week 4 and Week 9 but isn’t that what we want to do? Have no stock. After all Inventory is listed as one of the wastes we all learn about in College.
- Over Production
- Unused Talent
- Extra Processing
You have probably come across this list. It may even be on posters around your factory. And top of the list is often Inventory. Evil Inventory. And I cannot argue with these. They are all wastes. However sometimes the cost of eliminating the waste down to zero is more than the cost of the waste itself. And in the case of Inventory, you can only eliminate it if you have perfect information. And I can tell you right now you will never have perfect information. Now that is going to be a hard sell to management. They will likely tell you to do better with the information you have. I would probably tell you to go back and really study the information and only when I was convinced that you fully understood all the information available its impact and it’s shortfalls would I accept your safety stock calculation.
But for the moment lets demonstrate this by going back to our simple example. Let us say in week 2 the forecasted demand was incorrect. Instead of 200 units the demand is 400. Could be for any number of reasons. A customer forgot to order. A salesperson underestimated the forecast. A competitor had a gap in supply. In just one of the 18 weeks the forecast is higher than expected by 200 units. The result is we now have out of stock situations on three occasions on this product. This could have serious impact on the business.
So how do we prevent it?
Well ideally, we would fix the forecast but usually you do not know it is incorrect until after the fact. We could pushout orders and rearrange production, but this is likely to impact on other customers. We could ask the suppliers to increase their deliveries and expedite them to ship them earlier. However, this is a reactive situation, and we can’t keep pulling in favours or pressurising suppliers.
So, we need an option that gives us some protection from small inaccuracies, and this is where Safety Stock comes in.
In this example we have set the Safety Stock to 400 units. Safety stock is a buffer that ideally, we would not use or dip into but in this case, we do that when the forecast is 200 units higher than expected that means we dip as low as 200 units in stock. But by using safety stock we are ensuring there is no risk to the business. We could modify the safety stock down to maybe 300 or even 250 but again when doing that you have to be sure that the inaccuracy in the forecast in week 2 will not re-occur. So, this is where it is important that safety stock is used as a safety net but every time you dip into it you should investigate why. You should not use it as a mask to hide problems.
The previous methods of calculating your forecast accuracy and error can be helpful to calculate your safety stock due to demand uncertainty. However, you must also hold stock to allow for supply issues. You may have a 100% accurate forecast from your customer but if your supplier is highly unreliable then you need to hold safety stock of components and finished product to allow for this.
So, all that means you will end up with what is referred to as a target service level for the customer. For example, you may decide to meet all orders on time and in full 98% of the time. That will result in you being able to calculate a target safety stock level. There are many formulas for calculating safety stock. This is a statistical calculation, and this isn’t a statistics course but here is a basic one that will give you the idea.
Company Policy: Here there is a set rule by the company to hold a certain amount of safety stock in days or weeks.
Safety stock = Average Daily or weekly Sales * Company policy in days or weeks
It is very much a blunt instrument but it has the benefit of being easy to calculate and often it is based on the knowledge of those who know the business well so it can give a reasonable level of protection (you would hope).
One other simple way to calculate it is to look at the Max values and the average values. Specifically, for Orders and Leadtime.
(Max Demand * Max Leadtime) – (Average Demand * Average Leadtime) = Safety Stock
This is just one simple example. There are more complicated statistical models that are out there, but this should give you the idea. However, an important message I want to get across to you as a planner or planning manager is don’t blindly trust the data and the systems and their calculations. Understand them and check them. You can have the most expensive ERP system in the world that works well 364 days of the year but the moment there is bad data in it and you don’t catch it YOU will have to answer questions about it to more senior management.
Also, another thing to bear in mind about safety stock is that it is important when calculating the safety stock that you assess the impact of a stockout. If the impact is low, then you can hold lower safety stock. However, if the risk is high then you will hold less safety stock. For example, many supermarkets will fine suppliers the cost of lost sales if they short the supermarket. The risk vs cost of safety stock is an important consideration. And to be honest it all comes down to the importance of the customer to your business.
Now that we have spoken about Safety Stock, I want to encourage you to think about it more in terms of Safety Time. The concept is the same. We want to hold a certain amount of buffer against uncertainty. But instead of calculating that by units of stock we use time. That means the calculations that happen in the ERP systems etc are all more dynamic and change as the forecast etc changes. This is a concept most people get even though they use the name Safety Stock it is usually referred to in terms of days, weeks etc.