Safety Stock, Reorder Point & Lead Time: How to Calculate With Formulas
Safety stock is the amount of inventory a business needs to have to achieve a certain level of risk mitigation when it comes to stockouts. There are typically two types of inventory: core and seasonal. Core inventory is inventory that remains in-stock all year round. Seasonal inventory consists of products you bring in for a specific period of time.
Safety stock is also called:
- Buffer inventory/stock
- Safety stock inventory/stock
- Buffer inventory/stock
- “Just in case” inventory/stock
The reorder point is calculated using the safety stock metric. It tells a business at what point it is time to place a new order to restock inventory, along with the minimum order and display quantities. This metric accounts for lead time, helping businesses to avoid costly stockouts. We’ll dive into that more later.
The importance of safety stock and reorder point
Stockouts are a costly problem for retail businesses. According to a study conducted by IHL Group, retailers are missing out on $1 trillion in sales every year because of it. Two metrics to consider which help mitigate the risk of stockouts are safety stock and reorder point.
Out-of-stocks happen because of many reasons, including:
- Improper, ineffective or inaccurate inventory and operations management practices
- Spikes in customer demand
- Poor demand forecasting and inventory accounting
- Disruptions in production process
- Changes in lead time from suppliers
- Internal communication challenges
And when stockouts happen, retailers aren’t only missing out on sales. They’re also creating a poor customer experience, and possibly pushing potential lifelong customers to competitors.
Safety stock and reorder point help businesses face these challenges head-on, and maintain a consistent customer experience while also capturing sales — and minimal wasted warehouse space.
Safety stock provides a buffer of inventory for you to dip into when the above circumstances occur, while reorder point provides a buffer of time for you to restock on merchandise. This means fewer rush fees owed to suppliers, less operational chaos, and a more efficient use of warehouse space.
Let’s look at how to calculate these metrics:
How to calculate safety stock
There are two ways to calculate safety stock: one with standard deviation, and one without. First, we’ll look at the more simplified version.
Using the basic safety stock formula
The basic safety stock formula is:
Safety stock = (max daily sales * max lead time in days) – (average daily sales * average lead time in days)
Now, let’s define the variables:
- Daily sales: total $ in sales per day
- Lead time: amount of time it takes from placing an order to receiving product from supplier
Therefore, the maximum is the highest daily sales and/or longest lead time for that time period, while the average is exactly that.
Here’s an example to illustrate the basic safety stock calculation:
Your brand is known for the jeggings on your ecommerce site, even though you sell an array of apparel and accessories. You sell 125 pairs of jeggings every day, on average. Your best day was 300 jeggings units sold.
Because of the renowned jeggings, that’s something you want to make sure you ALWAYS have in stock — but never too much so that you have extra inventory of previous seasons’ styles.
From the time you place an order with your jeggings supplier, it takes 15 days for the product to arrive in your warehouse, on average. There have been times where this has been as quickly as 5 days, and others (like pre-holiday) where it’s taken as long as 30 days.
To get your safety stock, you’d do the following:
Safety stock = (300 * 30) – (125 * 15) = 9000 – 1875 = 7125
Your ideal level of safety stock is 7,125 pairs of jeggings.
Using standard deviation to calculate safety stock
The safety stock formula with standard deviation is more complicated but also more accurate. It accounts for variations in metrics. The formula goes like this:
Safety stock = desired service level * standard deviation of lead time * demand average
Here’s what each of those variables mean:
- Desired service level: A business’s targeted probability that the inventory on hand is enough to meet actual customer demand. To get this number, you’d balance inventory costs against the cost of a stockout.
- Standard deviation of lead time: Recall that lead time is how long it takes from placing an order to receiving product from a supplier. While suppliers may quote a lead time, in reality, this number fluctuates. The standard deviation of lead time accounts for these variations from the norm.
- Demand average: The average quantity of products purchased by customers during a period of time.
Let’s turn back to our jeggings example. You’ve determined your desired service level to be 90%. However, you don’t plug that figure into the equation. Instead, a 90% desired service level would be a 1.28 Z-score, which is what you use in the calculation.
With the standard deviation of lead time to be 16 days and demand average to be 125 units of jeggings per day (recall this metric from earlier), your retail math looks like this:
Safety stock = 1.28 * 16 * 125 = 2560
How to calculate reorder point
You may have heard of ROP inventory in conversations around reorder point. ROP is the acronym for reorder point, and ROP inventory simply refers to the level of inventory at which you’ll reorder to be able to meet demand and optimize inventory control.
The ROP formula takes the safety stock, as well as lead time, to determine what that level is:
Reorder point = lead time demand + safety stock
For that calculation, lead time demand is as follows:
Lead time demand = lead time * average daily sales
You may also be wondering how to calculate lead time. The lead time formula is as follows:
Lead time = sum of number of days from date of order until date merchandise is received in warehouse
Going back to the jeggings, recall that lead time is 15 days, and the average daily usage rate is 125 units. Here’s how the reorder point formula would work:
Lead time demand = 15 * 125 = 1875
Reorder point = 1875 + standard deviation
When you get down to XX units of jeggings, it’s time to place an order to restock.
Many inventory management software options will automatically calculate your reorder point and process purchase orders for you, helping to reduce the risk of stockouts.
If you find your safety stock is too high, here are some ways to reduce it:
- Leverage automation: Automation does not only save time, but they can also keep your data more accurate. As systems are connected and using the same data points, operations management is more streamlined and efficient. For example, if you set your inventory management software to automatically reorder when inventory hits a certain point, you don’t need to wait until someone comes into the office to do it manually.
- Optimize your supply chain: Look for local suppliers, increase collaborations with your existing suppliers, and conduct an audit on your existing supply chain to see where you have the biggest opportunity.
- Reduce lead time: One easy way to reduce safety stock is to work to reduce lead times. Ask your existing suppliers to see if there’s a way to expedite the process, and if not, shop around to see if there’s someone else who can — without sacrificing quality.
- Create steady demand: Keep a close eye on demand spikes and dips — what caused those fluctuations? From there, look at ways to address it. For example, you might consider increasing your marketing and advertising budget during dips. Increase collaboration between marketing and retail ops; make sure they’re each proactively communicating.
- Analyze and optimize: Is your safety stock being put to good use? You’ll never know unless you take a look at it to see how it’s performing. You might find that you can reduce safety stock for particular items or reduce lead time for others, for instance.
Applying the Safety Stock Formula to Your Business
While it’s crucial to find safety stock and apply it to your business, it’s only one inventory metric among many. It gives a snapshot of your business through one perspective. The real value is when you look at your KPIs holistically, identifying trends, issues and even your wins.