The Chartered Institute of Management Accountants (CIMA) has defined Inventory safety stock as “The function of ensuring that sufficient goods are retained in stock levels to meet all requirements without carrying unnecessarily large stocks.” In simple words, safety stock is an excess quantity of a good that gets stored in the warehouse to prevent a stock-out situation. It serves as a safeguard against fluctuations in demand.
What is Safety Stock?
The aim of safety inventory is to make a balance between sufficient stock and overstock. The stock maintained should be sufficient to meet the production requirements to maintain an uninterrupted production flow. Insufficient stock not only stops production but also causes a loss of revenue and goodwill. On the other hand, inventory requires some funds to purchase, store, and maintain materials with a risk of being outdated, stolen, etc. Therefore, let's learn the fundamentals of safety stock.
Inventory Stock- Out
Stockout occurs when an inventory item could not get supplied due to insufficient stock in the store. The stock-out situation costs the organisation in financial and non-financial terms. Due to stock out, an entity loses overheads costs and profit and reputation due to non-fulfilment of commitment. Though it may not be a monetary loss in the short term, it could be a reason for financial loss in the long term. This is where the role of buffer stock in inventory management is important.
Depending upon the industry in which one operates, different methods can be adopted to ensure inventory control and safety of the stock.
It may include the following methods:
- Setting up of quantitative levels
- Using ratio analysis
- Employing relative classification
- Physical control
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Quantitative levels
This level lies between the minimum and the maximum levels. It is present so that before the material ordered is received into the godown, there is optimum quantity in-store to meet both normal and abnormal consumption situations. In simple words, it is the level at which fresh order should be placed for replenishment of stock.
Also Read: Income statement – Definition, Importance and Example
Safety stock calculation formula
Risk of Loss (ROL) =Maximum Consumption × Maximum Reorder Period
Maximum Consumption= The maximum rate of material consumption in production activity
Maximum Reorder period= The maximum time to get the order from supplier to the stores
It can also be calculated alternatively as below:
ROL= Minimum Stock Level + (Average Rate of Consumption × Average Re- order period)
Minimum Stock Level= Minimum Stock level that must be maintained all the time.
Average Rate of Consumption= Average rate of material consumption in production activity. It is also known as normal consumption/ usage.
Average Re-order period = Average time to get an order from supplier to the stores. It is also known as the normal period.
(i) Re-Order Quantity: Reorder quantity is the number of materials for which the store department raises a purchase request.
While setting the quantity to be re-ordered, consideration is given to maintaining the minimum stock level, reorder level, minimum delivery time, and cost. Hence, the quantity should be where the total carrying cost and ordering cost are at a minimum. For this purpose, an economic order quantity gets calculated.
(ii) Economic Order Quantity (EOQ): The size of an order for which the total ordering and carrying cost is minimum.
Ordering Cost: Ordering costs are the costs that are associated with the purchase or order of materials like the cost to invite quotations, documentation works like preparation of purchase orders, employee cost directly attributable to the procurement of material, transportation, and inspection cost, etc.
Carrying Cost: Carrying costs are the costs for holding/ carrying of inventories in the store like the cost of the fund invested in inventories, cost of storage, insurance cost, obsolescence, etc.
The Economic Order Quantity (EOQ) gets calculated as below:
EOQ = Square root of [(2 x demand x ordering cost) / carrying cost]
Economic Order Quantity (EOQ) is also known by the Wilson formula. It is used to determine the least costly number of units to order. The idea is to reduce the cost of ordering and to hold the stock, at the same time, meeting demand-side requirements.
Annual Requirement (A)- It represents demand for raw material or Input for a year.
Cost per Order (O)- It represents the cost of placing an order for purchase.
Carrying Cost (C)- It represents the cost of carrying average inventory on an annual basis.
Assumptions underlying E.O.Q: The calculation of the economic order of material to be purchased is subject to the following assumptions:
(i) Ordering cost per order and carrying cost per unit per annum are known, and they are fixed.
(ii) Anticipated usage of material in units is known.
(iii) Cost per unit of the material is constant and is known as well.
(iv)The quantity of material ordered is received immediately, i.e. the lead time is zero.
(iii) Minimum Stock Level: It is the lowest level of material stock, which must be maintained in hand at all times so that there is no stoppage of production due to the non-availability of inventory.
It gets calculated as below:
Minimum Stock Level formula = Re-order Stock Level - (Average Consumption Rate × Average Re-order Period)
(iv) Maximum Stock Level: It is the highest level of quantity for any material which can be held in stock at any given time. Any quantity beyond this level causes an extra expenditure due to engagement of funds, cost of storage, obsolescence, etc.
Maximum Stock Level= Re-order + Level Re-order Quantity - (Minimum Consumption Rate × Minimum Re-order Period)
(v) Average Inventory Level: This is the quantity of material normally held in stock over a period.
It gets calculated as below:
Average Stock Level = Minimum Stock Level + 1/2 Re-order Quantity
(vi) Danger level: It is the level at which normal issues of the raw material inventory are stopped, and emergency issues are only made. It can be calculated as below:
Danger Level = Average Consumption × Lead time for emergency purchase
(vii) Buffer Stock: Some quantity of stock may be kept for a contingency. It gets used in case of sudden orders that stock is known as buffer stock.
Just in Time (JIT) Inventory Management
JIT is a system of inventory management with an approach to have zero inventories in stores. According to this approach, the material should only get purchased when it is required for production.
JIT is based on two principles:
(i) Produce goods only when it is required, and
(ii)The products should be delivered to customers at the time only when they want.
It is also known as the ‘Demand pull’ or ‘Pull through’ system of production. In this system, the production process starts after the order for the products is received. Based on the demand, the production process starts, and the requirement for raw materials is sent to the purchasing department for purchase.
Inventory Control- Based on Relative Classification
(1) ABC Analysis: This system exercises divided control over different inventory items based on the investment involved. Usually, the items get classified into three categories according to their relative importance. These include their value and frequency of replenishment during a period.
(i) A Category: This category consists of only a small percentage, i.e., about 10% of the total items handled by the stores but require a heavy investment of about 70% of inventory value because of their high prices or high requirement or both. Items under this category can get controlled effectively by using a regular system that ensures neither over-stocking nor a shortage of materials for production. Such a system plans its total material requirements by making budgets. The materials stocks are controlled by fixing certain levels like maximum level, minimum level, and re-order level.
(ii) B Category: This category of items is relatively less vital. They may be 20% of the total items of material handled by stores. The percentage of investment required is about 20% of the total investment in inventories.
(iii) C Category: This category of items does not require much investment; it may be about 10% of total inventory value, but they are nearly 70% of the total items handled by the store. For these categories of items, there is no need of exercising constant control. After ascertaining consumption requirements, orders for items in this group may be placed either after six months or once a year. In this case, the objective is to economize on ordering and handling costs.
Using Ratio Analysis
(i) Input- Output Ratio: Inventory control can also be exercised using input-output ratio analysis. The input-output ratio is the ratio of the quantity of material input to production and the standard material content of the actual output.
This type of ratio analysis enables a comparison of actual consumption and standard consumption, thus indicating whether the usage of the material is favourable or adverse.
(ii) Inventory Turnover Ratio: Computation of inventory turnover ratios for different items of material and comparison of the turnover rates provides useful guidance for measuring inventory performance. A high inventory turnover ratio indicates that the material in the question is a fast-moving one. A low turnover ratio indicates over-investment and locking up of the working capital in inventories.
Physical Controls
(i) Two Bin System: Under this system, each bin gets divided into two parts –
(I)The quantity equal to the minimum stock or even the re-ordering level, and
(II) The other part is to keep the remaining quantity.
Materials get issued out of the larger part. Fresh order is placed as soon as it becomes necessary to use quantity out of the smaller part of the bin.
(ii) Establishment of a system of budgets: To control excessive investment in the inventories, it is necessary to know in advance about the inventories requirement during a specific period. The exact quantity of various types of inventories and when they would be required can be known by carefully analysing production plans and production cycle. Based on this, the inventories requirement budget can be prepared. Such a budget will discourage unnecessary investment in inventories.
(iii) Continuous Stock Verification: The checking of physical inventory is an essential feature of every sound system of material control. The system of continuous stock-taking consists of physical verification of items of inventory. The internal audit department may do the stock verification but are independent of the store and production staff. Stock verification gets done at an appropriate interval of time without prior notice. The element of surprise is essential for effective control of the system.
Safety Stock Calculation: Three Different Methods
There are six different safety stock formulas so you can choose the best method to suit your business
1. Basic Safety Stock Method
Under this method, the number of items sold in a day and the number of days the company intends to hold the stock is taken into account.
2. Average – Max Method
The following calculation gets deployed:
(Maximum sale x maximum lead time) – (Average sale x average lead time)
3. Normal Distribution
Under this method, we use statistical tools. The formula is:
Standard deviation of the demand x the root of the average delay
Also Read: Cost Sheet – Meaning, Example & Format
Conclusion
Safety stock determination is a vital aspect of inventory management. It will help to reduce the chance of stock-outs, which would lead to inefficiency and dissatisfied customers. We are unaware of the actual future demand. Hence, it isn't easy to accurately ascertain the actual sales figure in the future. We use different tools and methods to determine the same. Based on one's experience and understanding, one can make modifications and adjustments to the actual results to get the most accurate safety stock.
