FAQ - How does a manufacturing company know how much safety stock to hold?
Safety stock is needed where uncertainty exists whether the uncertainty is in supply or demand. Uncertainty of supply is generally more controllable and, being further down in the supply chain, it is easier to recover from minor problems. Safety stock to cover uncertainty of supply should therefore be kept to a minimum and the cause of the uncertainty tackled.
Uncertainty of demand is generally less controllable. The stock you need to carry depends on whether the product is engineered to order, made to order or shipped from stock.
For make to order and engineer to order companies, what to stock and how much is essentially a commercial decision based on your customer's required lead time compared to your cumulative lead time (for definition see jargon buster), combined with the accuracy of your forecast (see below). For engineer to order companies, design time has to be included. Balanced against the commercial requirement to hold stock is the financial requirement to carry as little stock as possible. If your cumulative lead time is inside the lead time required by your customer, the only reason to stock is to make in larger batches than your customers need or to smooth out peaks of demand. You can reduce the need to carry any stock by applying the world class manufacturing techniques to reduce lead times and batch sizes (see the world class manufacturing checklist).
For companies that would like to be able to ship from stock, you have to carry some safety stock. How much stock you carry in this case depends on your ability to forecast. With a perfect forecast, you make just what you need, when you need it. Every company has to forecast. If there is no formal forecast, purchasing people forecast what to buy, planners forecast what they need to get made, manufacturing people forecast capacity requirements, accountants forecast cash flow, salesmen have targets and so on. Without a formal forecasting process integrated into the planning system, all these forecasts will be different so inventory will be out of balance and you can only ship to the lowest forecast for each product. The solution is to have one agreed forecast that everyone works to, preferably produced by sales/marketing.
Once you have an agreed forecast, the safety stock level for items you want to deliver from stock is determined by the accuracy of the forecast compared to replenishment time. There have been attempts at a mathematical formula for stock levels but in practice you fix a stock level that balances the commercial risk of running out of stock against the cost of holding stock and try to reduce your lead times and batch sizes and improve your forecast accuracy faster than pressure from your customers (and finance)!