Safety Stock Definition & Formula for Retailers for 2022
1 How to Calculate Safety Stock
2 Alternative Safety Stock Calculation Methods
3 Why Safety Stock Is Important
4 Potential Risks of Safety Stock
Safety stock is the amount of inventory a retailer needs to have in their possession to reduce the risk of stockouts. It is essentially a safety net for your inventory so you always have product in stock to meet demand, even when small unexpected spikes happen. Safety stock is also called buffer stock or “just-in-case” inventory. Calculating the right amount of safety stock is essential to preventing lost sales due to out-of-stocks and lost capital due to carrying costs and expired inventory.
Some small business retailers keep a week or two of safety stock on hand, many relying on their instincts instead of retail analytics. However, the best method to calculate safety stock is to use a little math. There are a few methods and different safety stock formulas you can use to determine the right amount for your business.
Here’s the basic safety stock formula:
Safety stock = (max daily sales * max lead time in days) – (average daily sales * average lead time in days)
Daily sales refers to sales in dollars, and lead time is how long it takes from the moment you place an order with a supplier to the moment you receive that order.
Here’s an example to show you how to calculate using the basic safety stock formula:
Let’s say you sell specialty pet accessories and treats. While you carry an array of products, you’re really known for your specialty pet beds, so you need to determine the appropriate safety stock for your pet beds—especially because of their popularity.
On average, you sell two pet beds per day. On your best day, you sold 10 pet beds. Your average lead time is two weeks, but it can be as long as four weeks during the busy season. Plugging these numbers into the safety stock formula looks like this:
Safety stock = (10 * 28) – (2 * 14)
Safety stock = (280) – (28)
Safety stock = 252
So, you would want to have 252 pet beds in stock at any given moment.
Alternative Safety Stock Calculation Methods
The method described above is the basic safety stock formula. Other safety stock formulas are more accurate, accounting for variables such as seasonality and standard deviation.
Here are some of the other safety stock formulas you can use:
The standard deviation safety stock formula (also known as the King method) is essentially an upgraded, more accurate version of the basic safety stock formula. Though much more complicated, this method can be helpful if you are interested in leaner operations or looking to avoid excess inventory carrying costs:
Safety stock = Desired service level * Standard deviation of lead time * Demand average
Here’s what each of those variables means:
Desired service level: A business’s target probability that inventory on hand can meet real customer demand. Most retailers aim for a service level between 90% and 95%. To turn this percentage into a number you can use for your calculation, use a standard normal table, where the Z number is your desired service level. So, to maintain a 95% service level you would use 1.7—this number is referred to as the desired service factor.
Standard deviation of lead time: Lead time fluctuates because of a variety of internal and external factors. The standard deviation of lead time accounts for these variations. To get this number, first calculate your average lead time. Then, take the difference of each lead time from the average, square them, find the average of those numbers, and then the square root of that number is your standard deviation in lead time.
Demand average: The average amount of products purchased by customers for a given time period.
Fixed safety stock doesn’t really have a formula or calculation. Fixed safety stock is when you set a number for safety stock and leave it at that—it’s not necessarily based on math. Sometimes, this is intuitive. It’s a less accurate way of calculating appropriate safety stock levels. However, if you have a small operation with stable lead times and predictable, flat demand, this method would work fine for you.
Time-Based Formula
The time-based method of calculating safety stock accounts for the future, including projected demand and sales. This method is ideal if you anticipate high growth:
Safety stock = (projected max daily sales * max lead time in days) – (projected average daily sales * average lead time in days)
Why Safety Stock Is Important
Safety stock is important because it mitigates costly out-of-stocks. Stockouts are an issue for retailers because they cause you to lose sales and create a poor customer experience with longer-lasting negative implications.
When you have an appropriate level of safety stock, you can weather periods of unexpected spikes in demand. But if you have too much safety stock, you may subject yourself to unnecessary carrying costs and aging or even expired inventory. So it’s crucial to find the perfect balance.
Safety stock also informs your reorder point, an important element of inventory management for small businesses. When you pay attention to your reorder point, you’re less likely to fall victim to rush fees and operational mayhem.
While you can forecast demand for your retail business, no predictions are going to be completely accurate. Unforeseen circumstances and elements outside of your control cause spikes and dips in demand—this reality is inevitable for almost every business owner. Safety stock helps you sail through these fluctuations in demand and sales.
Plus, as COVID-19 continues to impact supply chains and shipping, fluctuations in lead time are a lot more likely.
Potential Risks of Safety Stock
While it’s important to have sufficient safety stock, there are some challenges to keep in mind—especially if you have too much safety stock.
Carrying costs: It costs money to hold on to inventory—storage and warehousing costs, employee wages, etc. Generally speaking, carrying costs account for 20%–30% of inventory value. The longer you hold on to inventory, and the more inventory you hold on to, the higher your carrying costs.
Aging or expiring inventory: While some items may be considered “timeless,” a retailer’s stock is not one of them. Even timeless items age on your warehouse shelves. Perishable items expire and become unsellable, while other items may be seasonal or otherwise go out of style. You can pull an inventory aging report to get more insight.
Missed opportunities because your capital is tied up: When you have money tied up in inventory, you can’t put that to other things—like hiring new roles, investing in a new store location, or expanding your product collection, for example.
Changes in lead time: As mentioned above, lead times can fluctuate—especially in a COVID-19 era. If you don’t use a safety stock formula that accounts for lead time variation, you may find yourself stuck in a stockout without a way to restock in a timely manner.
Another risk with safety stock is making it too low—or even being as risky as setting it to zero. If you don’t have any safety stock, regardless of your motivations, this puts you in an extremely risky situation.
Calculating safety stock and ensuring you have enough buffer to make it through unexpected spikes in demand and sales is essential to protecting your retail business. Safety stock mitigates harmful stockouts and keeps your business operations flowing smoothly so you can focus on growing and improving your business instead of putting out fires.