Determination of the Safety Stock
The demand for inventory is likely to fluctuate from time to time. In particular, at certain points of time the demand may exceed the anticipated level. In other words, a discrepancy between the assumed (anticipated/expected) and the actual usage rate of inventory is likely to occur in practice. Similarly, the receipt of inventory from the suppliers may be delayed beyond the expected lead time. The delay may arise from strikes, floods, transportation and other bottlenecks, and so on. Thus, a firm would come across situations in which the actual usage of inventory in higher than the anticipated level and/or the delivery of the inventory from the suppliers is delayed.
The effect of increased usage and/or slower delivery would be a shortage of inventory. That is, the firm would face a stock-out situation. Thus, in turn, as explained in detail below, would disrupt the production schedule and alienate the customers. the firm would, therefore, be well advised to keep a sufficient safety margin by having additional inventory to guard again stock-out situations. Such stocks are caned safety stocks. This would act as a buffer or cushion against a possible shortage of inventory caused either by increased usage or delayed delivery of inventory. The safety stock may, then, be defined as the minimum additional inventory to serve as a safety margin or buffer or cushion to meet an unanticipated increase in usage resulting from an unusually high demand and or an uncontrollable late receipt of incoming inventory.
They safety stock involves two types of costs : (i) stock out, and (ii) carrying costs. The job of the financial manager is to determine the appropriate level of safety stock on the basis of a trade-off between these two types of conflicting costs.
The term stock-out costs refers to the cost associated with the shortage (stock-out) of inventory. It is, in fact, an opportunity cost in the sense that due to the shortage of inventory the firm would be deprived of certain benefits. The denial of those benefits which would otherwise be available to the firm is the stock out costs. The first, and the most obvious, of these costs is the loss of profits which the firm could have earned from increased sales if there was no shortage earned from increased sales if there was no shortage of inventory. Another category of stock-out costs is the damage for the relationship with the customers owing to shortage of inventory. the firm would not be able to meet the customer’s requirements and the later may turn to the firm’s competitors. It should, of course, be clearly understood that this type of cost cannot be easily and precisely quantified. Last, the shortage of inventory may disrupt the production schedule of the firm. the production process would grind to a halt involving idle time.
The carrying costs are the costs associated with the maintenance of inventory. Since the firm is required to maintain additional inventory, in excess of the normal usage, additional carrying costs are involved. The stock-out and the carrying costs are counterbalancing. The larger the safety stock. the larger the safety stock-out costs are likely to rise; on the other hand, an attempt to minimize the stock-out costs implies increased carrying costs. The object of the financial managers should be to have the lowest total cost (i.e., carrying cost plus stock-out-cost). The safety stock with the minimum carrying and stock-out costs is the economic (appropriate) level which financial managers should aim at. In brief, the appropriate level of safety stock is determined by the trade-off between the stock-out and the carrying costs.