MM/U4 Topic 7 The system of calculating maximum minimum order quantity and safety stocks.
Safety stock is important for all commerce businesses — regardless of whether they’re following an inventory Min/Max calculation methodology, or whether they’re dealing with cyclical and seasonal customer demand patterns.
In fact, maintaining safety stock is an essential part of capturing opportunistic sales, retaining business and making customers happy.
Determining your safety stocking levels
Safety stock doesn’t just cover the transit time on shipments from your vendor. It also means accounting for your customers’ average consumption during that period. As important as it is to cover your vendor’s delivery times, and account for daily customer consumption, you must also recognize that holding too much inventory will reduce your company’s gross profit.
Therefore, your safety stock level must be high enough to cover your vendor’s delivery times, sufficient enough to cover your customers’ demand, but not so high that your business loses money because of high carrying costs.
This is where your inventory min max calculation comes in: determining the level that triggers a reorder, and also the maximum order that you should make.
It’s a balancing act for sure, but it does work. Businesses make it work all the time and yours can as well. Here’s an example of how a company can determine its safety stocking levels:
Take into consideration:
(I) Accounting for vendor delivery times
The inventory must incorporate the vendor’s lead time on delivery. Let’s assume Company A has a vendor with a standard transit time of 10 business days. These 10 days would be the time it takes the vendor to deliver product. In this case, Company A would need to account for the 10 business days when calculating their safety stock.
(II) Determining daily customer consumption
For example, Company A currently sells an average 440 units a month. However, it’s wrong to assume that it’s 440 units divided by 30 or 31 days. Instead, Company A must define the number of actual buying days in the month in order to forecast demand.
While most software programs will account for this, it’s possible some businesses may have to do this manually. In this case, we’ll assume there are 4 full weeks plus 2 remaining days at the end of the month. Hence, the number of buying days is 22 and the average daily consumption is 440 units divided by 22 buying days, or 20 units sold each day.
(III) Applying the 50% rule of safety stock
There is no silver bullet when it comes to determining safety stock, but there are formulas that you can use to help you figure out the right amount to keep on hand. To help you get started on determining your safety stock levels, the 50% rule is a generally accepted starting point that businesses use. To continue our example, the vendor’s delivery time averages 10 business days and Company A’s daily sales average 20 units.
Therefore, if Company A was to cover its entire transit time, it would set its safety stock at 200 units. However, Company A also knows that its inventory carrying costs would be somewhat high at this quantity. Therefore, applying the 50% rule of safety stock means Company A could set its safety stock at 100 units. This should allow it to meet the average customer demand for 5 business days.
(IV) Determine reorder points
Up to this point we’ve only determined Company A’s safety stock level. With this final step we’ll determine Company A’s reorder point. Going back to our vendor’s delivery time of 10 days, it makes sense to set Company A’s reorder point to cover this delivery time.