Definition of Safety Stock
Safety stock is an additional quantity of an item held by a company in inventory in order to reduce the risk that the item will be out of stock. Safety stock acts as a buffer in case the sales of an item are greater than planned and/or the company's supplier is unable to deliver additional units at the expected time. If the company is a manufacturer, a safety stock of materials could minimize the risk of production being disrupted.
Of course there are additional holding or carry costs associated with safety stock. However, the holding costs could be less than the cost of not filing a customer's order on time or having to stop its production line.
Example of Safety Stock
Assume that a company uses the economic order quantity (EOQ) model to determine the amount of product or materials it orders. Since the model requires an assumption (estimate) of annual demand, there is a risk that demand will be greater than the estimate used. Let's say that the company's EOQ is 1,000 units. As a precaution, the company may decide to always have an additional 100 units on hand as its safety stock. If demand is not constant, the company could increase the quantity of its safety stock during its peak sales periods and then reduce the quantity during periods of low sales.