February 25, 2017      3 min read

Running out of inventory is a stressful experience. Missing a valuable sale, or having to stop a whole production line is painful, and even more so when the issue is due to a small, unanticipated stock shortage. Safety stock typically refers to a buffer or reserve of critical stock that is held to protect against unforeseen supply or demand pressures. Businesses typically use safety stock to ensure that there is a sufficient amount of stock to continue operations in the event of an adverse inventory impact.

Unless your industry has orders planned out extensively ahead of time, it is very difficult to estimate a business’ inventory requirements for a period with complete accuracy. Even though an inventory model can account for seasonality and customer growth, it is impossible to completely nail down the drivers of demand. Determining which factors will drive customer demand for a product is a somewhat inexact science, and the best a business can do is to make an intelligent guess using historical trends and commonly known information about the period ahead.

Even if every customer orders well ahead of time, such as in the global aerospace industry, there is still supply-side inventory uncertainty. Supply chains are typically complex; while very complicated supply chains can drive efficiency and productivity, they also create additional points of failure. Because a typical supply chain has a number of points of failure, businesses that rely on them are exposed to a heightened inventory risk. Sometimes supplier partners do neglect to meet customer commitments; however, a well functioning supply chain may still be vulnerable to natural disaster, natural resource shortages or adverse international trade events.

For most businesses, the cost of missing sales or halting production is unacceptably high. There is of course a financial cost involved in missed sales or idle time in a factory, but the cost is typically wider – customers expect retailers and suppliers to be reliable, and failing to deliver can damage a business’ reputation. On the other hand, ensuring continuity of supply in challenging conditions can garner significant customer respect. While risk can sometimes be insured against, there is a clear need for continuity, and therefore a need for safety stock.

Although business continuity is crucial, holding safety stock is not without cost. Establishing a buffer of safety stock involves tying up a significant amount of capital in inventory, preventing your business from using that capital for development purposes. And continuing to hold that safety stock involves paying for storage, handling and associated costs such as insurance – the classic inventory holding costs. The problem is therefore one of optimization – what is the right level of safety stock to hold? Ideally, your business would take a risk-based approach here. This involves considering the likely cost of holding safety stock compared with the risk and consequences of being caught short. Holding large inventories of a slow moving product is unlikely to meaningfully contribute to business continuity. On the other hand, it would be advisable to hold some safety stock where the cost is relatively low, but where continuity of supply is perceived to be crucial by a major client.

Management within a business is usually well placed to apply a risk-based approach and determine which inventory to hold as a buffer. That said, where the optimal decision is less clear, inventory management software may be an appropriate tool to analyze and plan safety stock.

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