Safety Stock and Reorder Point formula

Originally published on Katana MRP blog.

Safety stock describes the amount of inventory a business keeps in the warehouse to protect against spikes in demand or shortages in supply. From a perspective of a manufacturer, safety stock principles can and should be applied for both raw materials and final products to ensure availability of input for production, and goods for delivery. Most manufacturers employ some kind of minimum inventory principles.

In a perfect world, your suppliers always deliver on time and your sales does not fluctuate unexpectedly. So, your company would never run out of stock. In reality, your suppliers run into delivery problems due to various one-off events, from time to time you fail to meet your weekly manufacturing targets, and your sales is affected by seasonal effects and unexpected marketing successes or failures. Also, sometimes unexpected spikes in demand are difficult to forecast. Supply chain is full of surprises. Due to this uncertainty, having some stock in reserve helps you keep your customers satisfied.

However, safety stock comes at a cost. Lean manufacturing principles guide you to eliminate waste, and excessive stock is a waste as there are many costs to holding excess inventory. Examples include renting additional warehouse space, paying salary to people handling the stock, the risk of stock expiring or becoming outdated, and much more. Also, excess inventory means your cash is tied up. Therefore, every manufacturer needs to find a good balance between having enough safety stock to weather the storms, but not so much that it would break your bank.

How to calculate safety stock level?

The calculation is relatively easy in case you have reliable purchase and sales order history available.

Safety Stock = (Maximum Daily Usage x Maximum Lead Time Days) — (Average Daily Usage x Average Lead Time Days)

Let’s say there is a workshop in United States selling hand-crafted backpacks via eCommerce shop to customers globally. The backpacks are produced mainly from leather sourced from Mexico. One pack of leather procured includes material for one ready-made backpack. The business model operates with the following characteristics.

• The production on average consumes 10 packs of leather per day to produce 10 backpacks, however, maximum production capacity allows to consume 14 packs of leather per day
• It takes on average 14 days for leather packs to arrive from Mexico once the purchase order is placed, however, historical data reveals that delays in supply occasionally push the lead time up to 21 days
• It takes on average 5 days to produce one ready-made backpack, however, blockages in production sometimes result in a 10-day production cycle
• On average 10 backpacks are sold per day, however, demand peaks occasionally push the daily sales volume to 30 backpacks per day

Table below sums it up nicely.

Safety stock level for leather packs would be (14 x 21) — (10 x 14) = 154 units and for backpacks (30 x 10) — (10 x 5) = 250 units. As the manufacturing process consumes on average 10 packs per day then the workshop has a bit more than two weeks of raw material inventory available to guard against the unexpected. As the workshop sells on average 10 backpacks per day then the workshop has a bit less than one month of ready-made product inventory available to weather unexpected occurrences.

When calculating safety stock levels pay attention to changes in underlying metrics. Maximum daily usage and average daily usage are not figures carved in stone. They increase as your business grows and they fluctuate depending on whether you are approaching high season or low season. Thus, you should recalculate your safety stock levels from time to time. A good tip to follow would be to revisit these calculations in every 3–4 months.

So now you know how much safety stock you need to keep in your warehouse readily available. However, how to determine when should you place a new purchasing order for raw materials or manufacturing order for a ready-made product? A good reorder point ensures that your business typically does not dip below your safety stock levels and a good safety stock level means that your quantities never hit zero in case the unexpected happens. Therefore, a reorder point is typically a little higher than your safety stock level to factor in the lead time.

How to calculate reorder point?

The formula for calculating Reorder Point builds on the Safety Stock formula explained above with the addition of factoring in the lead time for a new order.

Reorder Point = (Average Daily Usage x Average Lead Time Days) + Safety Stock

Continuing with the example above the reorder point for leather packs would be at (10 x 14) + 154 = 294 units and for backpacks at (10 x 5) + 250 = 300 units. Therefore, once the quantity in the warehouse for leather packs or backpacks hits roughly 300 units, the company should place a new purchasing or manufacturing order respectively.

As the average lead time is built into the reorder point the new shipment of leather packs from the supplier or freshly manufactured backpacks from the workshop should arrive before the quantities in warehouse dip below the safety stock levels. However, in case of production shortages or delays in supply, the safety stock should ensure that the inventory levels will not fall to zero and work in manufacturing can continue and shipments to customers can be sent undisturbed.

Using a production and inventory management software allows a company to set reordering points for each product or material variant that are automatically tracked. Software flags the product and material variants that have dipped below reordering point automatically allowing you to easily identify the areas that require action. Read more on katanamrp.com.

More similar topics and discussions in our BLOG.