How to Calculate Safety Stock Using Standard Deviation

Don’t let stock-outs tarnish your business’s reputation. Discover the best safety stock calculations to ensure you never miss a sales opportunity again.

Running out of stock is bad for your business and, most importantly, your customers. Getting your inventory planning wrong can lead to missed sales opportunities and a damaged reputation. To avoid these unwelcome scenarios, businesses have a vital ally in the form of safety stock!

In this post, we’ll unlock the power of calculating safety stock to help you meet your inventory optimization goals.

1 What is safety stock?

Safety stock is the additional amount of stock you must order to protect your business from experiencing the risk of stock-outs and accounts for variability in lead times, production issues, and unexpected fluctuations in demand. Safety stock enables businesses to optimize inventory and deliver the agreed inventory quantity to the customer on time.

2 Formula to find out your safety stock

Calculating safety stock involves considering various factors such as lead time, demand variability, and the desired service level you want to achieve. The formula commonly used to determine safety stock is

Safety Stock = (Z-score x Standard Deviation of Demand during Lead Time) + Average Demand during Lead Time

Basic safety stock formula: Safety stock =(Z * σ * √LT)

• Z: represents the Z-score based on the desired service level (fill rate)
• σ: is the standard deviation of demand (where you assess demand fluctuations)
• LT: is the lead time (how long items take to arrive from the time of placing the order with the supplier)

When would you use this formula? When you want to maintain your set fill rate % or standard service level. Using this safety stock formula, you need to consider the standard fluctuations in demand and the lead time.

3 Alternative safety stock formula

Periodic review model: Safety stock = (Z * σd * √(T + L))

• σd is the standard deviation of demand during the review period.
• T is the review period
• L is the lead time

When would you use this formula? When your business follows a periodic inventory review approach to managing inventory, the review period is either weekly or monthly. This formula helps assess how much demand fluctuates during the review period, the duration of the review process, and the lead time required to restock.

Economic Order Quantity (EOQ) with safety stock: This formula combines the EOQ model with safety stock to minimize total inventory costs.

The EOQ is calculated by taking the square root of 2 X the annual demand for a product X the cost of placing an order divided by the cost of holding one unit of inventory for a year. This formula helps businesses find the ideal order quantity that minimizes inventory costs.

By combining the EOQ formula and safety stock, your business can optimize its ordering quantities to achieve cost efficiency while mitigating the risk of stock-outs due to unexpected demand spikes or supply disruptions.

4 Example of manual safety stock calculations

If you’re not using inventory management software that automatically calculates the math for you on a product-by-product and warehouse basis, here are some basic considerations:

• Calculate the forecast accuracy per group of products. You can’t obtain the product level with this approach but start by looking at your total sales vs. expected sales per product group. This indicates whether this is predictable and can be categorized as a Very High, High, Medium, or Low error per group.
• Estimate the supplier’s reliability per preferred supplier. Go through your suppliers with your team and categorize each supplier’s reliability (quantity and date delivery) into Very Bad, Bad, OK, Good, and Excellent.
• Create a schedule of all products per warehouse that you want to carry safety stock for. Ensure to include the lead time, preferred vendor, and product group for each. Add to that your ABC classification done earlier.
• Create extra sheets for the forecast accuracy estimate per group and the supplier list and reliability so that you can create a VLOOKUP in Excel later for this.
• In these additional sheets, allocate a percentage to each category created for the supplier risk and forecast accuracy. These will be applied later to the safety stock calculation, so enter as a fraction. For high supplier risk, you would use 0.9, for example, as a factor. For low-risk, use 0.5. For forecast error, a high error could be 0.9 and a low error of 0.5.
• Allocate a fraction against the ABC category you created and set, for example, the A category where you want the highest protection at 0.9 and the C category at approximately 0.7.
• Update the main schedule per product per warehouse to look up the fractions for ABC, supply risk, and forecast risk, and then add in a calculation that takes the Lead Time in days or months and multiply this by the fractions you just looked up. This is your safety stock in days or months that you can now apply to the forecasts to calculate the buffer needed.

These steps will help you calculate a safety stock for each product. The calculation will depend on the supplier’s performance and forecast accuracy. Of course, this is not the ultimate formula. This is just a starting point to improve your safety stock calculations.

Watch how Netstock optimizes your inventory

5 Tips for calculating safety stock

• Keep safety stock dynamic: A common mistake in handling safety stock is using a “set-and-forget” approach. It’s essential to regularly review your safety stock levels because things like supply and demand risks, forecasts, and business goals can change. While checking safety stock levels daily would be ideal, it’s better to use a reliable automated inventory management solution to support your inventory planning.

“Being able to adjust safety stock based on statistical modeling using history and forecast deviation instead of just a number of days coverage has improved our inventory fill rate from 90.9 to 98%” – Senior Sales and Operations Manager – The Little Potato Company

• Not all stock requires safety stock: By classifying your inventory, you can identify the high-performing and most profitable items, items that significantly contribute to your revenue and customer satisfaction. These are the items you need to ensure you have sufficient safety stock in place. In contrast, low-value or slow-moving items may require less safety stock or none, allowing you to allocate resources more efficiently to protect your core business and optimize inventory costs.

“Once Netstock was implemented, item classifications were defined, enabling Quality Foods to focus on their revenue spinners and not waste time on the slow movers. Netstock automatically sets and adjusts the safety stock and builds the forecast based on the key customer targets set during the implementation phase” – Quality Foods

6 When to use safety stock

There are two reasons for holding safety stock:

1. To mitigate against forecast risk

When it’s impossible to forecast future demand with 100% accuracy

2. To mitigate against supply risk

when suppliers are late with deliveries or don’t deliver the total stock quantity.

In a perfect world, you can only expect zero safety stock if your future demand is 100% stable and there are no delays or challenges with your supply.

Let’s explore three other scenarios where you’ll need safety stock:

When your supplier is late

Your supplier agrees to a 7-day lead time. However, it’s day 9, and you’re still waiting for the stock to arrive! There could be a number of reasons for the delay, such as the supplier’s machine shut down at the plant or the supplier needing help to secure a truck for delivery. That means you do not receive the stock when you expect it, which could lead to stock-outs or potential stock-outs.

When your supplier doesn’t deliver in full

You’ve ordered 100 water pots because your customer is hosting a big garden show. They are due to pick up the order tomorrow, so your incoming delivery today needs to be received and checked as soon as possible. Your supplier delivers the stock, but they’ve short-supplied you. Instead of showing up with 100 water pots, only 50 arrive. Why? That question is for your supplier. But for now, we’re going to be out of stock.

Dealing with unpredictable demand

Imagine your product is gaining popularity on social media. Unexpectedly, the demand for your usually moderately selling product surges. While the sudden increase in sales suits your business, the unanticipated rush can lead to running out of stock because you weren’t ready for the stock to be sold so quickly.

7 How safety stock improves inventory management

• Mitigates uncertainty: Safety stock acts as a buffer against unexpected fluctuations in demand and supply, reducing the risk of stock-outs during unforeseen events.
• Enhances customer service: Safety stock helps maintain high service levels and customer satisfaction by ensuring product availability, leading to repeat business.
• Supports seasonal demand: Businesses can meet peak demand periods, such as holidays or seasonal trends, without overloading inventory during the rest of the year.
• Optimizes replenishment: Safety stock allows for smoother inventory replenishment by accounting for lead time variability, helping to streamline supply chain operations and reduce operational disruptions.
• Cost savings: Using safety stock wisely, businesses can prevent excess stock of less important items, which means spending less on storing and managing inventory and focusing resources where they matter most.

Maintaining an appropriate safety stock level is crucial for SMBs. Insufficient safety stock can hurt your business, and on the other hand, excessive safety stock can tie up capital and increase carrying costs. Adopting the right safety stock formula for your business is important, and yet, it’s a complex process with many moving variables that need to be considered. Investing in an inventory management solution will help to automatically ensure you order the right amount of safety stock for the right products to meet demand!