Managing a supply chain is not easy, although the job description is seemingly straightforward: Ensure that the right products are available at the right location at the right time. Sounds easy, right? That's because you haven't considered the factors that constantly get in the way — factors such as inaccurate forecasts, transportation delays, and inclement weather.
Of all the factors that can impact available stock levels, forecast accuracy is the most decisive factor in predicting if you'll be able to satisfy demand. Think about it: If we could somehow forecast with 100% accuracy, we'd be able to carry only the inventory we plan to sell, with maybe a little extra to cover for unexpected mishaps.
Bad news-forecasting is inherently challenging, and it will never be perfect. Even with all the AI and big data technology you invest, your forecasts will not be 100% accurate. That's where safety stock comes in. It acts as a buffer between what you planned and what the real world sends your way. It increases the chances that you'll meet your customer service levels consistently.
How can you make sure your most important customers always get the key items they need? By holding safety stock!
How do you overcome the variability in your supply chain so that you can meet a targeted customer service level? You guessed it, safety stock to the rescue!
Holding Safety Stock: Costs vs. Benefits
You might be thinking: "Is my company holding the proper amount of safety stock? How can I be sure?" We all know companies that are holding extraordinary quantities of safety stock to meet demanding customer service level targets. And while piling on buffer stock will in fact improve service levels, there's a problem with this approach: safety stock is costly.
The cost of holding safety stock varies from one organization to the next, but most academic studies estimate inventory carrying costs at anywhere from 20-40% or more of the cost of the stocked merchandise. This is not a one-time investment, but rather, an annual and recurring cost.
How can the cost of carrying inventory be so high? You've got to deal with the costs of warehouse space, people, insurance, shrinkage, and obsolescence — not to mention the cost of money, which for most businesses remains much higher than the puny rates we're currently earning on our savings accounts.
The higher the customer service level you're shooting for, the more inventory you'll need to carry, and the more costs you'll incur. If you had unlimited budget to devote to safety stock, you could achieve perfect customer service — but at what cost? Think about it: for every $1 million in excess inventory you're carrying, it's costing your business $200,000 - $400,000 per year. With most businesses holding tens or even hundreds of millions of dollars of excess inventory, the costs are staggering — as is the opportunity.
So safety stock is a necessary, but potentially very expensive, evil. What we all need to do is make sure we hold the correct amount. Of course, the "correct amount" is not the same for all items and all customers. Read the next blog post about Understanding Your Safety Stock Calculations