Safety stock is the stock held by a company in excess of its requirement for the lead time. Companies hold safety stock to guard against stock-out.
Safety stock is calculated using the following formula:
|Safety Stock = (Maximum Daily Usage − Average Daily Usage) × Lead Time|
Lead time is the time which supplier takes in ordering the items
ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external supplier. DEL Ltd. takes 10 days in manufacturing and delivering an order. ABC's requires 10,000 units of rims. Its ordering cost is $1,000 per order and its carrying costs are $3 per unit per year. The maximum usage per day could be 50 per day. Calculate economic order quantity, reorder level and safety stock.
EOQ = SQRT (2 × Annual Demand × Ordering Cost Per Unit / Carrying Cost Per Unit)
Maximum daily usage is 50 units and average daily usage is 27.4 (10,000 annual demand ÷ 365 days).
Safety Stock = (50-27.4) × 10 = 226 units.
Reorder Level = Safety Stock + Average Daily Usage × Lead Time
Reorder Level = 226 units + 27.4 units × 10 = 500 units.
Written by Obaidullah Jan, ACA, CFA