Safety stock is an additional quantity of an item held in inventory in order to reduce the risk that the item will be out of stock. Safety stock simply is inventory that is carried to prevent stock outs. Stock outs stem from factors such as fluctuating customer demand, forecast inaccuracy, and variability in lead times for raw materials or manufacturing and there are additional holding costs associated with safety stock. However, the holding costs could be less than the cost of losing a customer if the customer’s order cannot be filled.
Some operations managers use gut feelings or hunches to set safety stock levels, while others base them on a portion of cycle stock level— 10 or 20 percent, for example. While easy to execute, such techniques generally result in poor performance. A sound, mathematical approach to safety stock will not only justify the required inventory levels to business leaders, but also balance the conflicting goals of maximizing customer service and minimizing inventory cost. If you carry too much inventory, you tie up money in working capital; if you don’t carry enough inventory, you face stock outs.
The safety stock needed to give a certain level of protection simply is the standard deviation of demand variability multiplied by the Z-score—a statistical figure also known as standard score. For example, to satisfy demand with a 95 percent confidence level, according to statistical analysis, it’s necessary to carry extra inventory equal to 1.65 standard deviations of demand variability. This is equivalent to a Z-score of 1.65.
Another alternative to carrying safety stock is to consider a make-to-order (MTO) or finish-to-order (FTO) production environment. If lead times allow, MTO eliminates the need for most safety stock. Meanwhile, FTO allows for less differentiation in safety stock than finished-product inventory, which lowers demand variability and reduces safety stock requirements. FTO and MTO also are well suited for situations where customers are willing to accept longer lead times for highly sporadic purchases. In the end, safety stock can be an effective way to mitigate demand uncertainty and lead time variability while still providing high service levels to customers. But before proceeding with a plan, first understand how to determine appropriate levels of safety stock—and what degree of protection they provide. (Clara)