The Smart Forecaster
Pursuing best practices in demand planning,
forecasting and inventory optimization
We frequently encounter confusion about the process of setting safety stock levels. This blog hopes to clarify the issue.
Safety stock is a critical component in any system of inventory management. Indeed, some inventory software treats safety stock as the key decision variable in the quest to balance inventory cost against item availability. Unfortunately, that approach is not the best way to strike the balance.
First, realize that safety stock is part of a general equation:
Inventory Target = Average Lead Time Demand + Safety Stock.
Average Lead Time Demand is defined as the average units demanded multiplied by the average replenishment lead time. Example: If daily demand averages 2 units and the average lead time is 7 days, then the average lead time demand is 2 x 7= 14 units. Keeping 14 units on hand suffices to handle typical demand.
But we all know that demand is random, so keeping enough stock on hand to cover the average lead time demand invites stockouts. As we like to say, “The average is not the answer.” The smart answer is to add in some safety stock to accommodate any random spikes in demand. But how much?
There’s the problem. If you try to guesstimate a number for the safety stock, you are on thin ice. How do you know what the “right” number is? You may think that you don’t have to worry about that because you have a good-enough answer now, but that answer has a sell-by date. Lead times change. So do demand patterns. So do company priorities. That means today’s good answer may become tomorrow’s blunder.
Some companies try to wing it using a crude rule of thumb approach. For instance, they may say something like “Set safety stock at an additional two weeks of average demand.” This approach is seductive: It only needs simple math, and it is clear. But for the reasons listed in the previous paragraph, it’s foolish. Better to get a good answer than a convenient answer.
You need a principled, objective way to answer the question that takes account of the mathematics of randomness. More than that, you need an answer that is linked to the key performance indicators (KPI’s) of the system: inventory cost and item availability.
Simple logic gives you some sense of the answer, but it doesn’t provide the number you need. You know that more safety stock increases both cost and availability, while less safety stock decreases both. But without knowing how much those metrics will change if you change the safety stock, you have no way to align the safety stock decision with management’s intent for striking the balance between cost and availability.
Rather than flying blind, you can back into the choice of safety stock by first finding the right choice for inventory target. Once you’ve done that, the safety stock pops out by a simple subtraction:
Safety Stock = Inventory Target – Average Lead Time Demand.
Often times, companies will state that they don’t carry safety stock because the safety stock field in their ERP system is blank. Nearly always, safety stock is built into the targeted inventory level they have established. So, using the above formula to “back out” how much safety stock you are building into the plan is quite helpful. The key is not just to know how much safety stock you are carrying but the link between your inventory target, safety stocks, and its corresponding KPI’s.
For instance, suppose you can tolerate only a 5% chance of stocking out while waiting for replenishment (inventory texts call this interval the “period of risk.”). Software can examine the demand history of each item and work out the odds of stockout based on the thousands of different demand scenarios that can occur during the lead time. Then the right answer for the inventory target is the choice that leads to no more than a 5% stockout risk. Given that target and knowing the average lead time demand, the appropriate safety stock value falls right out by subtraction. You also get to know the average holding, ordering and shortage costs.
That’s what we mean by “backing into the safety stock.” Start with company objectives, determine the appropriate inventory target, then derive the safety stock as the last step. Don’t start with a guess about safety stock and hope for the best.
Our customers have usually settled into one way to manage their service parts inventory. The professor in me would like to think that the chosen inventory policy was a reasoned choice among considered alternatives, but more likely it just sort of happened. Maybe the inventory honcho from long ago had a favorite and that choice stuck. Maybe somebody used an EAM or ERP system that offered only one choice. Perhaps there were some guesses made, based on the conditions at the time.
In a highly configurable manufacturing environment, forecasting finished goods can become a complex and daunting task. The number of possible finished products will skyrocket when many components are interchangeable. A traditional MRP would force us to forecast every single finished product which can be unrealistic or even impossible. Several leading ERP solutions introduce the concept of the “Planning BOM”, which allows the use of forecasts at a higher level in the manufacturing process. In this article, we will discuss this functionality in ERP, and how you can take advantage of it with Smart Inventory Planning and Optimization (Smart IP&O) to get ahead of your demand in the face of this complexity.
Managing inventory, like managing anything, involves balancing competing priorities. Do you want a lean inventory? Yes! Do you want to be able to say “It’s in stock” when a customer wants to buy something? Yes!
But can you have it both ways? Only to a degree. If you lean into leaning your inventory too aggressively, you risk stockouts. If you stamp out stockouts, you create inventory bloat. You are forced to find a satisfactory balance between the two competing goals of lean inventory and high item availability.