How to Balance Safety Stock: 4 Myths Dispelled

The supply chain has become a company's most important strategic and competitive weapon. But right now nothing is consistent, and it feels like a shock to the system.

In this current pandemic situation, many companies have no idea how to balance safety stock. Demand changes daily with the wind, but businesses can’t afford to do the same.

Any supply chain decision you make when you come into work each day makes ripples across the entire chain. When those decisions have bad outcomes, it’s almost always attributed to poor safety stock management.

Now is a good time to revisit your inventory management strategy to make sure you are not buying into the 4 common myths about managing safety stock.

Myth #1: Setting safety stock to zero will reduce inventory:

Sometimes safety stock is good. It protects against variability in both demand and lead times. At a time like now, when supply variability is at an all-time high, you need some safety stock.

At the same time, someone from a corner office is ordering you to reduce inventory as part of a higher-level initiative to free up cash. Related: How to Free Up Cash for Your Coronavirus-Stricken Business

Supply chain leaders often reduce safety stock to zero in an effort to achieve this. Their inventory levels do, in fact, go down… but so do their service levels. This unwanted side-effect will end up costing much more than the cost of some extra inventory.

Getting a solid understanding of the relationship between safety stock and service level will go a lot further to reduce inventory than zeroing out safety stock. A supply chain planning solution can effectively illustrate the safety-stock-to-service-level relationship and quickly deliver the data you need to cut inventory 10% to 20% without reducing the service level.

Myth #2: A “textbook” safety stock formula will do:

Textbook models will help you achieve a target service level only if both the lead time and demand are normally distributed.

Right now the ‘normal’ is that there is no normal. This does not take into account the upstream failure rate, reorder period, or order quantity requirements that are part of cycle stock.

Using only a textbook model alone is a bad idea if the upstream failure rate, reorder period, or order quantity requirements are significant business constraints in your supply chain. Which they usually are, even without the curve balls of a pandemic thrown in.

Myth #3: Safety stock declines as average supplier lead time declines:

Changes in your mean lead time and demand affect cycle stock, but not your safety stock.

[Side-note for any newbies reading: The difference between cycle stock and safety stock is that cycle stock provides the buffer between replenishment deliveries and is fairly straightforward. Safety stock is designed to prevent stockouts when there is variability in your demand and supply].

So really, it’s about variability. By reducing the variability, you reduce your safety stock. Here’s an example of how this works from Supply Chain 24/7:

Assume you have to provide a 95% service level for your customer. The demand for your product is 10 per day and forecast error is 2.

Case 1: Supplier A has an average lead time of 15 days and the standard deviation is 10 days.
Case 2: Supplier B has an average lead time of 24 days and the standard deviation is 1 day.

Assuming the receipt period equals the total lead time, which supplier will reduce your safety stock?

In both cases, you have to safeguard your inventory for 25 days, but the safety stock values are different for each of them. When you plug the values into the safety stock equation, Supplier B will have the lowest safety stock. Since you know that the lead time is 24 days, your cycle stock will be ordered in such a way to satisfy the demand for 24 days and you only need to safeguard your supply with a safety stock for 1 extra day, which is the variability here.

But in case of a 15-day lead time with 10-day variability, you are sure that the product will reach you at an average of 15 days. But it may take up to 25 days, so you will order your cycle stock so that it satisfies 15 days demand and safety stock to safeguard for the extra 10 days variability.

So the variability of your lead-time increases your safety stock. The same principle also works in the case of demand. The variability of your demand increases your safety stock.

In an extreme case, if your supplier says they will have no lead time variability and your demand forecaster says she has predicted the demand perfectly, then you will have no use for the safety stock, since you know what amount you need and how long it takes for your supplier to ship it to you. You will order the exact amount you need for each review period which is your cycle stock.

The bottom line is that you don’t need safety stock when there is no variability.

Myth 4: Safety stock eliminates stockouts:

Safety stock is designed to prevent the majority of the stockouts, not all of them. There will always be stockouts.

That’s because you have zero control over supplier lead times and very little control over demand (although, there are ways to use pricing tools to strategically deplete low-demand inventory or increase margins on high-demand inventory).

What you can do is play around with the safety stock equation, looking and customer service levels as a trade-off. Using a cost-of-service analysis tool, you can find the most profitable balance of safety stock between stockouts and overstocks. You can continually refine the forecast to decrease variability and maintain practical service levels that work for you and your customers.

By Praveen Pradman, product manager, Blue Ridge