There is a whole process to performing good inventory forecasting, cash requirement planning, and general management of the entire cash conversion cycle of an inventory reliant business. Below are some general things to consider when defining a single step of that process. That would be the safety stock.
- ABC analysis: Conduct an ABC analysis to classify inventory items based on their value and demand variability. High-value items with low demand variability may require a lower safety stock level than low-value items with high demand variability.
- Historical demand variability: Analyze historical demand data to identify the variability in demand over time. Based on this analysis, you can calculate a safety stock level that accounts for unexpected demand fluctuations. This typically is a result of seasonality, so what you can do is look at historical sales each month and then forecast the expected amount of sales in the same month for the next year based on a percentage of that same month last year. For example, if sales were higher in September and October, but lower in November then you want to be sure of the reason why and plan accordingly for how much stock you will need during that time and an appropriate buffer.
- Service level requirements: Determine the service level requirements for your business. The service level is the percentage of orders that can be fulfilled from stock without backorders or stockouts. Based on this requirement, you can calculate the safety stock level that will help you achieve the desired service level.
- Lead time variability: Analyze historical lead time data to identify the variability in lead times from your suppliers. Based on this analysis, you can calculate a safety stock level that accounts for unexpected delays in receiving inventory.
- Simulation modeling: Use simulation modeling to simulate different demand and supply scenarios and determine the safety stock level that will provide the desired service level while minimizing inventory carrying costs.
- Collaborative planning with suppliers: Collaborate with your suppliers to develop a safety stock plan that takes into account their lead times, order minimums, and other factors that can impact inventory availability.
Look, these things are never going to be a perfect science. All you can do is try and use all available data that is relevant and try to plan reasonably. Don't expect perfection, but try to make things run as smooth as possible.
Article found in Accounting and Finance.
