Safety Stocks: Beware of Formulas

A formula you find in a book or learn in school is always tempting. It is a "standard." If

you follow it, others are less likely to challenge your results. These results, however, may
be worthless unless you take a few precautions. Following are a few guidelines:
1. Don't use a formula you know nothing
about. Its validity depends on assumptions
may or may not be satisfied. You don't need
know how to prove the formula, but you
need to know its range of applicability.
2. Examine your data. Don't just assume they
meet the requirements. Examine their
summary stats, check for the presence of
outliers, generate histograms, scatter plots,
time series, etc.
3. Don't make up missing data. If you are
missing the data you need to estimate a
parameter, find what you can infer about the
situation from other parameters, by other
methods. Do not plug in arbitrary values.
4. Make your Excel formulas less prone to error
using named ranges rather than cell
coordinates. If a formula is even slightly
complicated, referring to variables by names
"mean" or "sigma" makes formulas easier to
proof-read than with names like "AJ" or "AK."

that
to

by

like
Michel Baudin
Fascinated with the art of making
things, Michel is on a mission to
improve it. Trained in engineering and
applied math, he got his feet wet in
production in the early 1980s, and
later apprenticed under master
Japanese consultant Kei Abe for eight
years, starting his own group in 1996.
He has been consulting since 1987,
teaching courses and writing
technical books. He intends to keep
working with like-minded partners in
the Takt Times Group and
contributing improvements in the
management and technology of
manufacturing as a consultant,
trainer, and writer.

1. The safety stock formula for the reorder point

method
Safety stock is a case in point. The literature gives you a formula that is supposed to allow you to set
up reorder point loops with just the minimum amount of safety needed to prevent shortages under certain
conditions of variability in both your consumption rate and your replenishment lead time. It is a beautiful
application of 19th century mathematics but I have never seen it successfully used in manufacturing.
Let us look more closely at what it is so you can judge whether you would want to rely on it. Figure 1 shows
you a model of the stock over time when you use the Reorder Point method and both consumption and
replenishment lead time vary according to a normal distribution. The amount in stock when the reorder
point is crossed should be just sufficient to cover your needs until the replenishment arrives. But since
both replenishment lead time and demand vary, you need some safety stock to protect against shortages.
If your demand is the sum of small
quantities from a large number of
agents, such as sugar purchases
by retail customers in a
supermarket, then the demand
model makes sense. In a
manufacturing context, there are
many situations in which it
doesn't. If you produce in batches,
then the demand for a component
item will be lumpy: it will be either
the quantity required for a batch
or nothing. If you use heijunka, it
will be so close to constant that
you don't need to worry about its
variations.

Figure 1. The reorder point inventory model

What about replenishment lead times? If in-plant transportation is by forklifts dispatched like taxis,
replenishment lead times cannot be consistent. On the other hand, if it takes the form of periodic milk
runs, then replenishment lead times are fixed at the milk run period or small multiples of it. With external
suppliers, the replenishment lead times are much longer, and cannot be controlled as tightly as within the
plant, and a safety stock is usually needed.
Let us assume that all the conditions shown in Figure 1 are met. Then there is a formula for calculating
safety stock that you can find on Wikipedia or in David Simchi-Levy's Designing and Managing the Supply
Chain (pp. 53-54). Remember that it is only valid for the Reorder Point method and that it is based on
standard deviations of demand and lead time that are not accessible for future operations and rarely easy
to estimate on past operations. The formula is as follows:

Where:
S is the safety stock you need.
C is a coefficient set to guarantee that the probability of a stockout is small enough. You can think

of it a number of standard deviations above the mean item demand needed to protect you against
shortages. In terms of Excel built-in functions, C is given by:
C = NORMSINV(Service level)
Service level
C
90.0%
1.28
95.0%
1.64
99.0%
2.33
99.9%
3.09
The other factor, under the radical sign, is the corresponding standard deviation.

L and L are the mean and standard deviations of the lead time.
D and D are the mean and standard deviation of the demand per unit time, so that the demand for
a period of length T has a mean of D xT and a standard deviation of Dx T

2. Case study: Misapplication of the safety stock

formula
This formula is occasionally discussed in
Manufacturing or Supply Chain Management
discussion groups, but I have only ever seen one
attempt to use it, and it was a failure. It was for the
supply of components to a factory, and 14 monthly
values were available for demand, but only an
average for lead times.
The first problem was the distribution of the demand,
for which 14 monthly values were available. This is
too few for a histogram, but you could plot their
cumulative distribution and compare it with that of a
normal distribution with the same mean and standard
deviation, as in Figure 2. You can tell visually that the
Figure 2. Actual versus normal cumulative
actual distribution is much more concentrated in the
distribution
center than the normal model, which is anything but
an obvious fit. Ignoring such objections, the analyst proceeded to generate a spreadsheet.
The second problem is that he entered the formula incorrectly, which was not easy to see, because of the
way it was written in Excel. The formula in the spreadsheet was as follows:

C*SQRT((AJ4*AL4^2)+(AI4^2*AM4^2))

then, looking at the spreadsheet columns, you found that they were used as follows:

AJ for Standard Deviation of Daily Demand, and

AL for Average Replenishment time.

And therefore the first term under the square root sign was DxL2 instead of LxD2.
The third problem was that the formula requires estimates of standard deviations for both consumption
and replenishment lead times, but no data was available on the latter. To make the formula produce
numbers, the standard deviations of replenishment lead times was arbitrarily assumed to be 20% of the
average.
For all of these reasons, the calculated safety stock values made no sense, but nobody noticed. They
caused no shortage, and the "scientific" formula proved that they were the minimum prudent level to
maintain.