The Monthly Metric: Safety-Stock Level
Amid global trade turbulence, climate disruptions of increasing frequency and severity and a once-in-a-century pandemic — few elements of supply chain management have been impacted in recent years more than inventories.
Delayed deliveries, product shortages and empty shelves caused by the coronavirus (COVID-19) have sparked debate on the future of the just-in-time manufacturing and inventory model, as many companies consider carrying excess inventory, or safety stock. A survey conducted last fall by Gartner, the Stamford, Connecticut-based global research and advisory firm, found mixed results, as 43 percent of respondents indicated they are investing more in safety stocks, and 46 percent reported no change.
While companies will likely continue to evaluate safety-stock levels in preparation for the next unexpected global crisis, most have to keep excess inventory as a buffer against the ebbs and flows of consumer demand and supplier delivery times, two of the most variable dynamics in business, even under normal conditions. And that’s where this month’s metric — safety-stock level — comes in.
“The safety-stock level essentially takes a look at the volatility of a company’s weekly or monthly demand over the next year,” says Tracey Smith, MBA, MAS, CPSM, president of Numerical Insights LLC, a boutique analytics firm in Charlotte, North Carolina. “So, (the metric) tries to help find a balance in how much money should be tied in inventory while minimizing the risk of running out of its most popular sellers.”
Meaning of the Metric
A zero safety-stock level, in which the last of the available items go out the door as a new shipment arrives, suggests lean-inventory principles on steroids. But, as Smith says, “That’s risky, because demand is never constant in the real world.” In fact, demand variability is one of the biggest challenges for supply management professionals, as Smith discussed with The Monthly Metric in 2018.
Safety stock is a necessity, but the level should not be determined arbitrarily. The figure is calculated using a product’s daily usage and lead time, based on historical data and accounting for seasonal peaks. A product’s maximum usage is multiplied by its maximum lead time, and its average daily use multiplied by its average lead time. The latter product is then subtracted from the former.
For example, if a product’s maximum daily usage is 18 units per day with a maximum lead time of 25 days, and its average use is 12 units a day with an average lead time of 15 days, its safety stock level is 270 units:
(18 x 25 = 450) – (12 x 15 = 180) = 270
The safety stock level can be used with the average daily usage and lead time to determine the reorder point, the inventory level at which another product order should be placed with the supplier. Using the above example, if the safety stock level is 270, a new order should be placed when inventory reaches 450 units.
270 + (12 x 15 = 180) = 450
There are few safety-stock level benchmarks, as every company, product and supplier are different, but it can be a useful calculation in supplier evaluation, Smith says: “It’s less about having a fixed benchmark and more about where have (the figures been) before? How do your suppliers perform? Obviously, when you calculate safety stock, it’s going to be different if you have a supplier that can get you goods within three weeks versus three months.”
The safety-stock level calculation can be based on a year or a quarter of historical purchase and supplier delivery data, which can be an issue for some companies. At smaller organizations without an ERP system, data remains on paper or cannot easily be extracted. Organizations that input data manually typically calculate their safety-stock and reorder-point levels less often, Smith says.
“Some companies are blessed with an automated or almost-automated calculation, so they can see when their supplier delivery times start to drift or get longer,” she says. “Most companies don't have that, so they have to extract purchase and delivery information to be able to calculate real lead times. And until you do that, you might not discover that the supplier that said it delivers in nine weeks is actually taking 12, which can have a (dramatic) impact on your calculations.
“If a company is (entering data manually) and carries a lot of items, it will have to play the prioritization game. Since it likely can’t extract all that information on every part it carries, it might have to focus on the top sellers or most critical items.”
Lessons From the Pandemic
Even for organizations with advanced historical data collection, the lead-times chaos brought on by the coronavirus (COVID-19) pandemic made calculating safety-stock level and reorder point an inexact science. In the May Manufacturing ISM® Report On Business®, the average lead time for production materials was 85 days, the highest figure since ISM began collecting that data in 1987.
With semiconductors, aluminum and plastics among commodities with high-profile shortages, even technology companies, automakers and health-care providers with the most up-to-date supplier delivery data must take their best guesses.
“(Since) those lead times no longer apply, (some companies) are not quite sure what lead times are going to be, so that does impact safety stock and reorder points,” Smith says. “And there are two problems — at the same time, they’re trying to deal with disruptions and possibly trying to find additional suppliers. They also have to use a judgment call at this point for what lead time should be put into the system to recalculate safety stock and reorder point.”
Safety-stock level will be one of the metrics most impacted if there is a shift from JIT principles. As the Gartner survey results suggest, the jury is still out on if there will be a new inventory model, and what it will look like. Carrying extra inventory still ties up cash flow — and, as Smith notes, procurement departments are primarily measured by cost savings and inventory management.
"It's a matter of how much a company can tolerate putting additional money into inventory,” Smith says. “If it can’t, the decision is already made. It’s going to have to take the risk that the (current) safety-stock levels will be sufficient, and an additional factor is that companies have shareholders. They have to consider the preferences of shareholders versus those of the supply chain versus finance versus the executives.
“So, it’s all about finding a balance.”
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