Safety Stock Calculation For Your Wholesale & Distribution Business
When you’re running a busy wholesale and distribution business, you face the risk of stockouts every day. Despite your best efforts in forecasting sales and adjusting for seasonal demand, you cannot completely predict or have any control over the supply and demand for your products. You are just a player in a complex supply chain. The next best thing is to allow a margin of error and provide extra stock to minimize out-of-stock situations.
Here, we’ll cover what is meant by safety stock first. Then we’ll discuss a couple of reasons why it matters to your business. Next, we look at one easy way of calculating safety stock for the small and medium-sized business owner. Finally, we illustrate everything with a comprehensive and easy-to-understand example.
What is Safety Stock?
Safety stock doesn’t refer to the first aid kit that you keep in the office. It commonly describes the additional stock that you keep in your inventory to reduce the risk of stockouts. It’s best to see them as a form of insurance against out-of-stock scenarios. You pay a little premium in the form of extra stock and use it as a hedge against stockouts. However, we’ll see that this premium comes with carrying costs as well.
Why is Safety Stock Important?
Keeping safety stock is critical for your business. In addition to smoothing out unexpected swings in demand and supply, buffer stock also influences the optimal inventory level, stocking of time-sensitive goods and plays a part in new product launches. Get this number right and you’ll be able to enjoy consistently higher sales and a better level of customer satisfaction.
1. Upswings in Demand
You can never know when demand for a particular product goes ballistic due to viral marketing or an Internet meme. Faux furry sunglasses anyone? These short-term bursts in demand will drain your available stock, cause a stock out for that product, and may even impact your suppliers who are facing backorders that their production schedule cannot meet. It takes time, after all, to replenish stock from your suppliers. And your customers may not be understanding to wait and see. Most will simply take their purchases elsewhere.
2. Drops in Supply
As a wholesaler and distributor, you’re just part of an intricate supply chain. You are wholly dependent on your suppliers, both local and overseas, to produce and ship the goods that you carry. This means that you’re also vulnerable to any impact that your suppliers face. For example, late summer is the tropical typhoon season in North Asia. The damage and closures caused by major storms can close down factories, damage infrastructure and put a stop to air and road transport.
Also, you may be carrying a product that has very long lead times for manufacturing. As opposed to mass-produced, fast-moving goods such as mobile phone covers, you may be dealing with products of a higher value, complicated to produce and whose supply is limited. Hand-made timepieces come to mind. You’ll want to make sure that you have a buffer stock of a few watches because it may take a year to produce one mechanical timepiece.
3. Optimal Inventory Level
Keeping additional buffer stock introduces all the usual risks of overstocking. Spending too much on safety stock means that cash is tied up in inventory. And it costs money to store and carry goods. Plus, you’re exposed to the dangers of loss, damage, theft, obsolescence and expiry dates. Alternatively, carrying too little stock means stockouts, lost sales and very unhappy customers who will shift their purchases to your competitors. This will mean a poor customer experience and loss of market share for you. As you can see it is a balancing act to arrive at a stock level that will not tip you into risks.
4. Time-Sensitive Products
On a related note, overstocking also presents a risk if you deal with goods that are perishable or have expiry dates. Fresh fruit and vegetables, packaged foodstuffs, and medicines come to mind. Seasonal goods and products riding on the latest fad are also examples. They may spoil or go obsolete while acting as buffer stock or you may be forced to clear rapidly expiring goods if you hold too much in safety stock. On a conservative note, you probably want to keep a low buffer stock in cases like these.
For example, Christmas is the busiest time of the year for retailers, wholesalers and distributors. How your Xmas sales perform can make or break your entire year’s sales. This means stock needs to be in place and a sufficient buffer must be provided to meet demand up to the last minute. So if you’re dealing with Christmas trees and decorations, you need to make sure that you have enough stock in the month before Christmas Day, but not too much to be left holding seasonal decor that no one wants until another year has passed.
5. New Product Launches
For businesses dealing with a completely radical product category that is new to the market, it’s best to carry some safety stock until demand can be reasonably forecasted. For example, consumers may need time to warm to the idea of a self-propelled mountain bike that can be used on water. It’s a game changer but it’s also anyone’s guess what the initial demand will be like when the bikes are released during the spring season before the summer holidays. You’ll need a couple of quarters to accurately gauge demand and thus the ideal level of stock to keep for these water bikes.
How to Calculate Safety Stock?
So just how much stock should you keep to be considered safety stock? Much can be written about calculating safety stock and it can get very complicated and academic. You want to aim for a Goldilocks number, one that is not too hot and not too cold. Even when you do arrive at a number, it takes the passage of time to truly arrive at your magic buffer stock number.
Here, we suggest a simple formula that any business owner can understand and use. And you don’t need a fancy spreadsheet to use it.
Safety Stock = (Max Daily Sales * Max Lead Time) – (Avg Daily Sales * Avg Lead Time)
The formula is simply the difference between your average sales and maximum sales, allowing for production and shipping time. You only need to grab your sales and purchase order history, preferably at least a year’s worth, to make this formula work. The more data, the merrier the formula.
A completely fictitious example is in order here.
A. Furry Beer Can Coolers from Australia
Let’s say that you’re a wholesaler that deals in furry beer can coolers from Australia. For some reason, they sell like hotcakes as sunburnt tourists buy them in the dozen as souvenirs. They come in various designs based on Australian marsupial animals such as the koala, kangaroo, wombat and possum. They’re all artificial, of course, as no animal was harmed in the production of the beer coolers.
On a good hot summer’s day, you can ship out about 128 of these beer can coolers to your retail customers. But in reality, you sell an average of 64 coolers because of seasonal factors. It takes about 30 days to make them in the Australian factory and then ship them to your warehouse. Sometimes labour strikes by truck drivers increase this lead time to 45 days.
B. Safety Stock Calculation Formula
From this we can glean the following figures:
Maximum Daily Sales = 128 units Average Daily Sales = 64 units Maximum Lead Time in Days = 45 days Average Lead Time in Days = 30 days
We then plug these figures into the simple formula:
Safety Stock = (128 * 45) – (64 * 30) = 5,760 - 1,920 = 3,840 units
C. Safety Stock Implementation
So the formula suggests that you should carry about 1-2 month’s worth of safety stock to cover for days where sales spike and typical ordinary days. However, like any inventory management metric, you need to see the safety stock formula in the context of your business and seasonal sales.
In this example, you might want to err on the high side of 3840 units in the hot summer months when tourists buy them in the dozens. For the cooler winter months, you could conservatively cut the safety stock in half to about 1920 units and still provide for any beer-drinking contingencies in autumn and winter.
So use your common sense when dealing with inventory metrics. The numbers that are produced may not be a cure-all but it’s a good jump point to start with and tweak as you go along. For the furry beer can coolers, you might want to adjust the units in the hundreds without impacting your future sales too much.
Keeping safety stock should be an integral part of running your wholesale and distribution business. You have seen that buffer stock helps to smooth out spikes in demand and supply.
They also have an impact on time-sensitive goods, new products and maintaining an optimal inventory level. There are various ways to calculate safety stock but ultimately your historical sales and purchase data will help here.
So how much safety stock do you plan to keep today?