Buffer Stock

Updated on March 7, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Buffer Stock?

A buffer stock system can be defined as a government scheme used to stabilize prices in a volatile market. In this, stocks are bought and stored during good harvests to disallow costs from falling below the price levels or a target range, and supplies are released during harvests to prevent prices from rising above the price levels or a target range.

Buffer Stock

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Buffer Stock (wallstreetmojo.com)

The buffer stock scheme holds significance at the time of heavy harvests, which makes individuals buy and store commodities during good harvests to disallow costs from falling below the normal price levels. In addition, the supplies are released during harvests, preventing the prices from rising above the price levels.

Key Takeaways

  1. Buffer stock refers to keeping aside a chunk of a particular commodity that is traded in the market to offset price fluctuations when they occur.
  2. Safety stock, on the other hand, is a slightly different concept. Buffer stocks help maintain and control the prices of commodities that go out of hand; however, safety stocks protect producers from suppliers upstream.
  3. The advantages of buffer stocks are that they maintain price stability, minimize food shortages, and prevent sudden drops in prices. 

Buffer Stock Explained

A buffer stock scheme can be comprehended as a government scheme used to stabilize prices in a volatile market. The scheme aims to stabilize the prices, ensure an uninterrupted supply of goods, and prevent farmers and producers from going out of business due to an unexpected fall in prices. Genesis wheat stores, ever-normal granary, EU cap, International Cocoa Organization (ICCO), and 1970 wool floor price scheme in Australia are a few examples of a buffer stock scheme.

Below is the buffer stock diagram. The chart shows that the price of the stocks decreases from P to P2 (at times of good harvests). This is because the stocks will be bought or stored to prevent the falling of the prices of the goods below a target price range, i.e., with this buffer stock mechanism, the price will adjust itself to the normal target price range. On the other hand, if the price of the stocks increases from P to P1 (at times of bad harvests), the stocks will be released to prevent the rising prices of the goods above a target price range.

Buffer-Stock

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Buffer Stock (wallstreetmojo.com)

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Purpose

Though the buffer stock meaning is enough to make clear its purpose, it is important to solely have a look at the objectives to understand why the government creates such options. The buffer stocks schemes are chosen at the times of surplus whereby commodities are bought in bulk to be sold in the event of economic shortages.

The initiative helps the government in many ways, the major ones being the following two:

  • Firstly, it ensures price stability for those goods and commodities, and
  • Secondly, the stocks in reserve help the economy remain protected against economic turmoil, arising because of shortages.

How To Calculate?

Calculating buffer stocks does not involve any specific formula, but there are methods that can be applied to computing these figures.

Let us have a look at the three methods that are widely used to calculate it:

Fixed Buffer Stock

This is the method that does not involve any buffer stock formula. Instead, it follows the values decided by the inventory managers. They take into consideration the daily consumption of products and items over a period and accordingly determine a buffer value. It is a fixed figure, which remains unchanged until there is a notification from the inventory manager.

Time-based Process

As the name suggests, here the buffer stock calculation is done at regular intervals, depending on the actual consumption and demand forecasted. This value prediction may turn out a risky approach as there is a possibility of the brand being left with many unwanted stocks, which may not be usable after a certain point in time.

The General Approach

Last but not least is the general approach, which is the most popular among organizations. Here, the average buffer stock is calculated, which is neither too much nor too less. Instead, it brings out results that help firms have sufficient stocks to deal with potential situations where they might run out of stocks. The general formula that is used to calculate the buffer stock in inventory management is given below:

Buffer Stock = (Maximum Daily Usage*Maximum Lead Time) – (Average Daily Usage*Average Lead Time)

Here,

  • Maximum daily usage mentions the maximum number of units sold in a day,
  • Maximum lead time is the longest time taken by the supplier to ship the stock
  • Average daily usage is the average number of units sold in a day, and
  • Average lead time is the average time the supplier takes to ship and deliver the items.

Examples

Let us consider the following examples to understand the concept better:

#1 – Genesis Wheat Stores

In genesis wheat stores, Joseph stored stock of wheat for at least 7 years of feast, and in this way; it became possible for him to distribute wheat from his stores during the 7 years of famine.

#2 – Ever-Normal Granary

In the first century, China established it to stabilize supply using purchasing grains during good years and distributed the same to regions facing shortages. Henry A. Wallace revived this idea from the history of Chinese culture.

#3 – Eu Cap or Common Agricultural Policy

This policy consisted of minimum prices for multiple foodstuffs, which encouraged oversupply. As a result of this phenomenon, the EU was left with no choice other than to buy the surplus. The surplus was then stored in huge warehouses. However, this scheme turned out to fail since it became highly expensive for the participants to continue purchasing the surplus. Also, there was hardly any shortage. At least, this compelled the EU to implement quotas to limit the excess of supplies and slowly reform common agricultural policy to minimize the overall targeted minimum prices.

Importance

The importance of the buffer stock system is realized during the fixation of procurement targets. Buffer stocks are excess stocks of food items stored in the godowns. This system helps evenly distribute food items to various parts of a country. These food stocks can be used to satisfy the food requirements when there is a fall in production levels due to diseases in crops or extreme weather conditions such as droughts and floods. Moreover, it helps in regulating and controlling prices constantly. With this system, sending food supplies to areas in distress on time gets convenient.

Advantages

Some of the advantages are given below:

  • It helps regulate food supplies and eliminates or minimizes the probabilities of food shortages.
  • This system helps maintain price stability, further encouraging higher agriculture investment.
  • It helps eliminate the probability of a sudden drop in price levels that tend to put farmers out of business and even leads to a rise in unemployment. It allows farmers to maintain their incomes by regulating the price levels.
  • Buffer stock scheme allows the government to earn tremendous profits by purchasing stocks during a glut and selling off those stocks during a shortage.

Disadvantages

Some of the disadvantages are given below:

Buffer Stock Vs Safety Stock

Buffer stock and safety stock are often used interchangeably. However, this often creates confusion. Buffer stock distinguishes it from safety stock because it protects the customer from the producer when there is an abrupt change in the demand for a particular product. On the other hand, the safety stock system protects the producers from probabilities like incapability in their upstream processes and suppliers.t

Frequently Asked Questions (FAQs)

What is the optimum level of buffer stock that should be maintained in a business?

No particular defined level of buffer stock is decided that a business should maintain. The buffer stock level depends on the industry the business is involved in, the volatility of the markets, the nature of the business, management decisions, and many other factors.

Is maintaining buffer stock compulsory for business organizations?

While it is not structurally compulsory for an organization to maintain buffer stock, it is advised and commonly observed among business organizations to maintain it. To protect itself from the dynamic risks of supply chain management, market volatility, etc., it becomes strategic for an organization to maintain buffer stock to mitigate itself against these risks.

Which industry generally sees a trend of maintaining high levels of buffer stock?

The food grains industry has seen high buffer stock maintenance globally. Since food crops are such a vital resource, business organizations and governments need to maintain a buffer stock for food grains to avoid causing a shortage of such a vital resource.

Recommended Articles

This has been a guide to what is Buffer Stock. We explain its examples, how to calculate, vs safety stock, purpose, importance, advantages & disadvantages. You may learn more about financing from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *