How to Calculate Safety Inventory

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The safety level of inventory is a specific dollar amount a company has at all times to meet consumer demand. Numerous methods exist to calculate this stock level. Variances such as inventory cost, inventory type, demand and the company’s facilities all factor into these equations. Fortunately, a few basic formulas exist for companies to use. Accountants often use these to provide management with basic information on inventory safety levels. Two different calculations are necessary to determine inventory safety level.

Inventory Turnover

Review the previous annual financial statements. Write down the annual cost of sales from the income statement and total inventory on hand from the balance sheet.

Compute the average inventory level by dividing the total inventory on hand by 12. For example, a company with \$240 million in inventory has an average monthly balance of \$20 million.

Divide the annual cost of sales by the average monthly inventory. A company with \$180 million in total cost of sales with \$20 million average monthly inventory has an inventory turnover of nine, respectively. This means the business sell through its entire inventory nine times a year.

Days Supply of Inventory

Divide the total annual cost of sales by 360. This provides the company with total daily inventory costs. The previous example company has average daily inventory costs of \$500,000.

Compute the days of supply by dividing the average inventory by the daily inventory cost. The example company has 40 days of inventory supply as its safety level.

Maintain inventory levels at 40 days for each period throughout the year. Accountants can recalculate these formulas to ensure the company meets its inventory goals.

Tips & Warnings

• Accountants use 360 to provide a round figure for daily calculations.

References

• "Intermediate Accounting"; David Spiceland, et al.; 2007
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