Safety stock is excess inventory that acts as a buffer between forecasted and actual demand levels. This inventory is maintained so that a company has sufficient units on hand to meet unexpected customer and production demand.
The safety stock formula is as follows:
(Maximum daily usage - Average daily usage) x Lead time = Safety stock
Safety stock does not just involve finished goods; it can also be applied to raw materials, to guard against delays in the delivery of materials from suppliers.
Constraint analysis holds that the only safety stock that matters in a manufacturing environment is the inventory buffer located directly in front of the bottleneck operation; this buffer should be sufficiently large to ensure that no variations in the production process upstream from the bottleneck operation interfere with the bottleneck. This can require a substantial safety stock if there are ongoing problems with the upstream production process.
A company may elect to reduce or eliminate safety stock levels in cases where there is little customer demand, customers are indifferent if deliveries are delayed, or where it is too expensive to maintain an adequate safety stock level. For example, if an adequate safety stock level is considered to be $100,000 in order to maintain a 99% fulfillment rate, versus just $10,000 to maintain a 95% fulfillment rate, management may choose the lower inventory investment.
Safety stock can also be reduced when there are similar items in stock, toward which the customer service staff can direct customers.
Having too much safety stock may result in many holding costs, such as the costs of obsolescence, inventory storage, interest expense, and spoilage.
It is possible to fine-tune the level of safety stock needed, based on a statistical analysis of historical demand records and future demand estimates. However, this can be an expensive and time-consuming approach, so it is more common to set a fixed safety stock level, and review the adequacy of this level from time to time. Pareto analysis can be employed to revise safety stock levels on a more frequent basis for only the most heavily-used inventory items.
In short, it can be quite difficult to optimize the precise level of safety stock at which a company's customers are least unhappy, while also minimizing the investment in inventory.
Safety stock is also known as reserve inventory or buffer stock.