What Is Safety Stock?

by Carmelo Montalbano; Updated September 26, 2017
What Is Safety Stock?

Safety stock is the amount of overproduction held by a company to cover scheduled deliveries, delays in receiving new stock for production, delays in producing new production and any other situation that would otherwise make it appear that the company was not able to produce product according to a regular production schedule.

The amount of safety stock is a function of technology available to create product, relationship with suppliers and employees and the ability to properly forecast demand.

How is a Supply Stock Determined?

Supply stock is determined by first examining what the optimum policy is for producing product, how that policy will be engineered and what statistical measure of failure the company willing to absorb. Each of these measures is determined below. The essential point is that supply policy finds its roots in the "just in time" product delivery cycle. "Just in time" cycles attempt to lower interest expense by keeping less inventory, using technology to lower wage expense and using quality control to maintain product superiority. The net effect is to employ a production schedule equal to corporate forecasts of product need and no more.

What is the Optimum Policy for Producing Product?

Optimum supply stock begins with the issue of sales forecasts--the absolute minimum level of inventory that a company is willing to keep idle and in storage above its sales. Company reputation and cost of holding inventory are key issues. If product depends on basic materials subject to varying and seasonal prices, then the company must also decide how the most cost-efficient purchase of these assets must take place. Policy requires constant adherence to worker and technological cost structure as well.

How Supply Stock Policy Will Be Engineered?

Supply stock must clearly enunciate the costs of production and how they vary with the normal ebb and flow and seasonality of orders. In addition, especially with new technology products, management must decide whether the product will be obsolete in a few years. The next step is to optimize the costs of production with the expected output. Management scheduling of employee time to operate machinery for the production may have to be adjusted. Supplier costs can be optimized with bulk orders delivered over time, greater competition of contracts and reformulation or substitution of raw materials.

The Cost of the Supply Chain and the Cost of the Supply Stock

The collection of specific cost inputs is absolutely necessary to understanding the relationship between the costs of production. It is also important in deciding how crucial and expensive any particular delay in the supply chain affects other costs. For example, a delay in receiving ore may idle workers in a smelting plant. Once these costs are determined, it is possible to statistically estimate how much risk the company must be willing to take to maintain a supply stock adequate to the policy determination discussed in step 2.

Supply Stock is Determined by Statistical Testing

There are standard statistical tests particular to a company's production schedule that will determine supply stock needs. The process begins with the company philosophy detailed in step 1. If a company decides it is willing to absorb production shortfalls 2 percent or 20 percent of the time, it will solve for the supply stock necessary to cover shortfalls by solving for the statistical probability of such an event occurring.

This is done by using a normal distribution of statistical possibilities and finding how much excess production must be directed to supply stock and avoid the forecasted shortfall that will eventually occur. These forecasts of sales and statistical processes must be reviewed regularly as well as the cost structure it implies.

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About the Author

After an 18-year career on Wall Street as a trader of municipal and mortgage backed securities, Carmelo Montalbano developed a very large desktop trading application that managed more than 30 institutional portfolios. Technology and small business acquisitions continue to be his primary interest.

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