How to Calculate Safety Stock and Effectively Avoid Stockouts
Whether you run an e-commerce site, or own a brick-and-mortar store, optimizing your safety stock levels will help you avoid running out of stock. Doing so will also help you use your financial resources in the most effective way possible.
If you don’t maintain adequate safety stock levels, you may miss out on possible sales if demand increases or if there’s a delay on the manufacturer’s end. On the other end of the spectrum, if you overstock your inventory to prepare for these scenarios preemptively, your money will be tied up. That cash could have been used to invest in other areas of your business, such as marketing.
The solution is to calculate the safety stock levels you’ll need to meet customer orders. In this article, we’ll explain what safety stock is and why it’s important in the context of e-commerce order fulfillment. We’ll also take you through the step-by-step process of calculating the safety stock levels for all of your goods.
What Is a Safety Stock?
Safety stock is the additional stock of products you hold in case of an increase in product demand, emergencies, or supply chain failure, at which point you may have less inventory than you need to fill customer orders.
Typically, companies take all possible measures to predict future sales, forecast inventory and demand, and then manage their inventory accordingly. In an ideal situation where sales are always the same, and the lead time on orders isn’t a problem, things would be predictable and, therefore, easier to manage. However, the reality is that the supply chain is ever-dynamic and can face delays due to many reasons.
Safety stock allows businesses to create a cushion in their stock levels to ensure that they don’t run out of a product. It’s crucial for all companies — especially those in the e-commerce sector — regardless of the industry.
Here are some of the main reasons why it’s essential to have adequate safety stock on hand:
Minimize stockouts. Every time you run out of inventory, you know exactly how many sales you couldn’t make. Safety stock enables you to maximize your income. Simply put, the key benefit of calculating safety stock is that you can prevent stockout scenarios.
Utilize warehouse. The easy way to prevent stockouts is by ordering bulk quantities of the product. However, that would take up more of your storage space and jack up your inventory holding costs while tying up money you could invest elsewhere. Calculating the optimal amount of safety stock allows you to make the most of your available storage space and financial resources.
Forecast demand. The method you use to determine how much safety stock you should hold at all times can also be used for demand forecasting. This way, you can better predict an increase in sales throughout the year and plan accordingly.
Keep up with seasonal trends. The maximum daily usage metric (more on this later) indicates the highest number of products you’ve sold in a day. This could include the maximum number of sales on a specific day, like Black Friday. So, for example, even if you predict you’ll sell as much on Black Friday as you did last year, you can determine the safety stock you’ll need to keep on hand for the upcoming event. This way, you’ll be able to maximize your revenue on one of the busiest shopping days of the year.
Now that we have a better understanding of safety stock levels and why they’re important, let's take a closer look at how to determine safety stock.
How Do You Calculate Safety Stock?
Here are the three steps you need to follow to calculate safety stock levels for all of your products:
Step #1: Gather Data About Each SKU
Businesses that order products daily should start by gathering data about each SKU. More specifically, find out your:
Max daily usage
Average daily usage
Max lead time
Average lead time
If you place orders less frequently, find out the above-mentioned values for your specific timeframe. So, for example, if you order products weekly, you can determine safety stock using maximum and average weekly usage and maximum and average lead times.
It’s also important to keep in mind that average daily usage and average lead time are simply averages – not estimates or exact values. By analyzing your sales and lead times over the past few weeks (or months), you can use averages to get a better idea of what to expect.
So, if you’re selling 75 items on an average day (based on past sales) and you need four days to replace the inventory from your supplier, you’ll be using 75 and four as the respective averages to use in the formula.
Maximum daily usage and maximum lead time are determined by the maximum sales in your records and the longest lead time you’ve experienced. Remember to take into account holidays like Black Friday and Christmas.
If the average daily usage is 75 items and at most you’ve sold 100 items on your busiest day, you’ll be using 100 as the maximum daily usage in the calculation. In the same way, if restocking inventory has taken up to six days at most (even though the average is four days), six will be the maximum lead time you use in the formula.
Step #2: Calculate Max and Average Values
Next, we’ll multiply the maximum lead time by the maximum daily usage
(Max daily use * Max lead time)
This calculation will tell you what’s the worst that can happen. In other words, it represents a scenario where you’ve sold the maximum items you’ve ever sold on a single day and, at the same time, are facing the longest possible lead time.
Next, we’ll multiply the average lead time by the average daily usage.
(Avg daily use * Avg lead time)
This number will tell you how much to order in normal circumstances to restock with average demand.
Step #3: Subtract Max and Average Values
Finally, subtract the average number from the maximum number to determine your safety stock:
Safety stock = (Max daily use * Max lead time) - (Avg daily use * Avg lead time)
This calculation will give you the safety stock level you need to keep on hand to prepare for the worst-case scenario. While it may not be enough to meet an extreme rise in sales, it will enable you to prevent stockouts most of the time.
Why E-Commerce Businesses Run Into Stockouts
Let’s take a look at some common reasons why e-commerce businesses run into stockouts.
Reason #1: Inaccurate Data
You should always make sure you have accurate data when dealing with inventory. Inaccurate data can lead to mismatches between what’s available in your store or warehouse versus what’s been accounted for on paper. Many times, this is because of misplaced items, returns, or variations in shipments.
These issues can make vendors think they’ve adequately stock their inventory, when in reality, it isn’t. As a result, they end up ordering the wrong items or the wrong number of items.
Here are a few actionable tips on how you can address this:
Tip #1: Stay Organized
The first step is to get organized so you can figure out what’s causing discrepancies in inventory data. For example, is the problem originating at the vendor’s end? Are shoplifters part of the problem?
In case the vendor is causing discrepancies (for example, if they aren’t handling deliveries properly) you may want to try out a new schedule for shipments. Similarly, if theft is the issue, you may have to set up security systems to prevent shoppers from stealing products off your shelves.
Tip #2: Inventory Management System
Use an inventory management system to prevent inventory discrepancies. Tracking products manually takes a lot of time, and there’s always the potential for human error. An inventory system lets you automatically update stock levels as you sell items rather than doing it by hand.
An inventory management system is especially useful if you have multiple locations as you’ll be able to centrally manage inventory across several stores. The easiest way to get started is by creating an inventory management system in Excel or Google Sheets.
Tip #3: Regular Stock Counts
To make sure you always have access to accurate numbers, you need to make sure you’re regularly conducting stock counts. To do this, you should count your products and make sure that your physical records match up with what you have in your storage space and at the physical retail stores. You can either use cycle counting or full inventory counts for this.
Reason #2: Failing to Reorder on Time
Businesses often run into this issue when they sell out products faster than they’re able to restock them. Failing to reorder on time can lead to missed sales opportunities.
Here are some actionable tips on how to address this:
Tip #1: Demand Forecasting
Demand forecasting helps you predict product demand so you can figure out when to order which products. One way to do this is by using your judgment to anticipate demand by taking note of different factors such as past sales, stock turnover, promotional campaigns, economic factors, and seasonality of demand.
Tip #2: Consumer Buying Trends
Although past sales data is certainly useful, you should also keep your eye on buyer trends in the market. Are shoppers moving towards newer products? Are any past styles and trends making a comeback? Take note of consumer buying trends and factor them into calculating your safety stock.
Tip #3: Out of Stock Patterns
A research study conducted by Procter and Gamble shows that out of stock scenarios tend to form patterns such as day of the week. Vendors can identify patterns by auditing their stocks and noting the day and times of the week when they commonly witness stockouts.
Reason #3: Poor Communication With Suppliers
Poor communication with suppliers and manufacturers can lead to delays or missed orders.
Here are a few actionable tips on how to overcome this:
Tip #1: Make Sure Everyone Is on the Same Page
Make sure that all orders and deadlines are recorded (either on paper or in your inventory management system) and check to ensure that everyone has the same set of information. This improves decision-making across different departments in your company.
Tip #2: Share Data With Suppliers
Remember to inform your suppliers and keep them in the loop about any problems that arise as early as you can. So, for example, if you find that you’re running low on inventory, don’t wait until the 11th hour to inform your suppliers.
Instead, let them know as soon as possible and then start planning your next order. It’s a good idea to share forecast data with your suppliers and manufacturers, so it’s easier to identify and solve issues related to schedules and reordering.
As a business owner, you want to make sure you can ship customer orders on time and maximize sales while ensuring your supply chain processes are streamlined.
Calculating the safety stock levels of all of your SKUs is a great way to get started. As a result, you’ll be able to minimize stockout scenarios, better utilize your warehouse space, improve demand forecasting, and keep up with seasonal trends. And when you’re ready to grow your business, consider partnering up with an e-commerce fulfillment provider that takes care of safety stock for you.