12.3.

4 Safety stock A retailer or manufacturer may want to reduce the chance of running out of a
particular inventory item by holding safety stock, which is a quantity of the item that is held to reduce
the chance of the item being out of stock, regardless of the inventory held because of EOQ. It may be
worthwhile for an organization to hold safety stock in the following situations: • Stockout costs are high,
such as rush delivery costs or high opportunity costs from lost manufacturing time. • Demand for the
product is uncertain, so it is difficult to determine how many units will be required in each period. •
Supply is uncertain, such as issues with the lead time of the supplier or shortage of source materials.
There is a cost to holding safety stock, as it results in additional carrying costs, above those considered at
the EOQ. The average inventory will now be calculated as EOQ / 2 + safety stock. It is important to
include the safety stock when determining carrying costs. Consider Berger Inc., which had an EOQ of 269
mattresses and carrying costs of $50 per mattress. Management would like to implement a safety stock
of 30 mattresses, as there is an additional cost of $200 for rush deliveries from the manufacturer when
Berger is out of stock. Based on this level of safety stock, there are additional annual carrying costs of
$1,500 per year (30 mattresses × $50 annual carrying cost per mattress), but Berger has determined
these additional costs are worth it compared to the impacts of having no inventory, such as lost sales
and frustrated customers. Berger would still order 269 mattresses in each subsequent order, but will
always have 30 mattresses in stock so that it never runs out. Also note the impact on the cost per unit.
The ordering costs will remain unchanged but the carrying costs will increase: Total relevant costs = total
ordering costs + total carrying costs Order costs (15,000 demand / 269 EOQ = 56 orders (rounded up) ×
$120 cost per order) $ 6,720 Carrying costs {[(EOQ of 269 / 2 for average inventory) + 30] × $50 cost per
unit of inventory} 8,225 Total relevant costs $14,945 On a per-unit basis: Order costs ($120 per order /
269 units per order) $0.45 (rounded up) Carrying costs related to safety stock ($1,500 per year / 15,000
units) $0.10 Carrying costs $50.00 Total per-unit costs are $50.55, or $0.10 more per unit with the safety
stock. Management Accounting Chapter 12: Strategic Supply Chain Management — In-Depth 428 12.3d
Let’s look at an example To continue the Fence Co. example from above, the company recently ran out of
oak posts for several days, which affected its delivery times to customers. For this reason, Fence is
instituting a safety stock of 20 oak posts. The previous reorder point was 280, and with this safety stock,
the reorder point becomes 300 units (280 previous reorder point + 20 safety stock). When Fence has 300
oak posts in inventory, it must place an order.