Inventory management directly affects customer service, operational efficiency, and profitability. Still, overstocking ties up capital and increases holding costs. If you have too little inventory, sales will suffer as you fail to cover demand. How do you find the perfect balance between too little and too much?
Knowing how to calculate the optimal inventory value will help you find the balance that cuts costs and enhances your demand response.
Understanding inventory optimization
Successful businesses must use capital efficiently, keep costs low, and meet customer demand. Inventory optimization serves all these goals. It is balancing stock to meet customer demand with the least inventory.
It costs money to hold inventory. Costs include warehouse space, insurance, spoilage, and obsolescence. Reducing inventory reduces capital requirements and improves cash flow.
Inventory optimization directly impacts profitability, operational efficiency, and customer satisfaction. By matching inventory levels to demand, SMBs can avoid stock-outs and excess inventories.
Maintaining optimal inventory levels offers these key advantages:
- Cost savings: Businesses cut storage, insurance, and obsolescence costs by reducing stocks. You are less likely to need expensive expedited transport for last-minute orders.
- Improved cash flow: Optimal inventory levels free up cash invested in excess stock. This enables you to reinvest in market expansion or reduce interest-bearing debt.
- Customer satisfaction: Having the right products when customers want them improves the customer experience.
- Operational efficiency: Streamlined inventory processes reduce stock management complexity. The result is faster order fulfillment, fewer errors, and smoother operations.
Let’s explore inventory optimization and its components.
Demand forecasting
Accurate demand forecasting provides a solid foundation for an optimized inventory system. Planners need accurate forecasts to schedule production and order stocks to meet market demand. Improve cash flow management, reduce waste, and improve customer satisfaction with accurate forecasts.
Advanced planning software analyzes historical data and broader market indicators to identify patterns and trends.
Lead time
Lead time is the time between order placement and the moment when inventory is ready for use. According to a recent Netstock analysis, 72% of Small and Medium Businesses reported long and unreliable lead times. Lead time affects inventory levels because businesses must hold more stock to prevent stock-outs while waiting for order replenishment. Shorter lead times enable leaner inventory levels, reducing costs and increasing cash flow.
Use stock reduction strategies to optimize inventories:
- Supplier relationships: Develop reliable supplier relationships to reduce lead times and ensure on-time deliveries. Regularly communicate with suppliers to address potential delays.
- Diversifying suppliers: Several supply sources ensure continuity if a supplier can’t deliver.
- Order timing and frequency: Carefully plan the timing and frequency of orders based on lead time. Proper timing prevents stock-outs and reduces excess inventory.
Safety Stock
Safety stock is the extra inventory you hold to protect against unexpected demand spikes, forecast inaccuracies, or supply chain problems. It is the buffer that enables you to meet demand during uncertain times.
Determining the right amount of safety stock
- Analyze demand variability: Understand demand fluctuations to assess the appropriate safety stock. The greater the variability, the more safety stock you need.
- Consider lead time: The longer the lead time, the higher the safety stock you need to cover potential delays. Adjust safety stock levels based on lead time reliability.
- Balance costs and risks: Higher safety stock reduces the risk of stock-outs, but it also increases holding costs. Strike a balance between risk tolerance and cost to settle on the ideal safety stock.
Inventory turnover ratio
The inventory turnover ratio measures how often a company sells and replaces its inventory in a period, usually a year. It is calculated by dividing the cost of goods sold (COGS) by the average inventory during the same period. A high turnover ratio shows efficient inventory management. A low turnover ratio suggests slow-moving inventory.
Inventory Turnover Calculation
Inventory Turnover Ratio = COGS / Average Inventory
Use the inventory turnover ratio to track turnover. Identify trends and improvement areas. Use the inventory turnover ratio to adjust stock levels and ensure that inventory holding follows demand.
Methods for calculating optimal inventory quantity
Optimal inventory levels will depend on the inventory strategy you use.
Economic Order Quantity (EOQ)
The EOQ is a useful method to determine the optimal order quantity that cuts the total inventory cost. It balances ordering and holding costs, helping you to decide how much inventory to order for the most cost-efficient solution.
EOQ Formula
EOQ = √2 x D x S/H
Where:
- D = Demand rate (units per period)
- S = Ordering cost per order
- H = Holding cost per unit per period
EOQ Calculation Example
- A company sells 10,000 spoons each year.
- The order costs $50 to place
- The holding cost is $2 per spoon mannually
EOQ=√2×10,000×502
=1,000,000/2
=500,000
≈707units
The company should order 707 spoons each time they place an order to reduce total inventory costs. The optimal number of orders per year is 14.
Just-In-Time (JIT) Inventory
Using JIT strategies, inventory is ordered and received as production needs it. JIT offers many benefits, including:
- Cost reductions: Lower inventory holding costs.
- Increased efficiency: Streamlines operations by reducing excess inventory and focusing on production efficiency.
- Improved cash flow: There is less capital invested in inventory. This free cash is for other business activities.
Yet, JIT is not without its challenges. These include:
- Supply chain dependency: JIT relies on a stable and efficient supply chain. Any disruption can lead to stock-outs and delay production.
- Demand fluctuations: Sudden demand changes are difficult to manage with low inventory.
- High coordination: Requires precise supplier coordination to ensure timely delivery.
ABC Analysis
ABC Analysis is a classification system used to separate inventory into three manageable categories:
- A-items: High-value items
- B-items: Moderate-value items
- C-items: Low-value items
The ABC analysis is based on the Pareto Principle that attributes 80% of system improvements to 20% of the effort. The ABC analysis separates 20% of the inventory items accounting for 80% of the value. Use it to focus inventory management efforts with more work on A-items.
Steps to perform ABC analysis
- Calculate the Annual Usage Value: Multiply annual demand by the unit cost for each inventory item.
- Rank the Items: Sort the items in descending order based on their annual usage.
- Categorize the Items: Classify the top 70-80% of the total value as A-items, the next 15-25% as B-items, and the remaining 5-10% as C-items.
Focus tight inventory control on A items, ordering more frequently and ensuring accurate forecasts. B-items require moderate control, order C-items in bulk with less frequent reviews.
Effective use of the ABC analysis delivers the following benefits:
- Resource allocation: Allocate resources more effectively by focusing on the A-items.
- Improved inventory management: Identify where stricter controls and forecasting will deliver improved results.
- Cost efficiency: Avoid overstocking on high-value items and save on holding costs.
Did you know: Netstock automatically classifies your inventory?
Enabling you to focus on the 20% of SKUs that make up 80% of sales.
Tools and software for inventory optimization
Demand and supply planning solutions automate complex calculations, provide real-time data, and enhance decision-making. These modern tools help businesses efficiently manage stock by forecasting demand, streamlining ordering, and reducing stock-outs and overstocking, all while offering accurate insights to maintain optimal inventory levels and respond quickly to market changes
Netstock is a proven leader in offering best-in-breed demand forecasting, inventory management, and order planning solutions. With real-time data monitoring and integrated systems, ensure that your data is accurate and current. With Netstock’s functionality, you’ll improve inventory performance by cutting excess stock, reducing the risk of stock-outs, and optimizing order quantities.
Use the single-view dashboard to see how your inventory is performing. You’ll be able to easily access key metrics, like stock levels, order status, and supplier performance.
See Netstock in Action
Additional tips and best practices
Implement these best practices to optimize your inventory.
Regular audits
Regular inventory audits help maintain accurate stock records, identify discrepancies, and ensure that your inventory processes function effectively. Audits can detect issues like shrinkage, misplacement, and data entry errors that could cause stock-outs or excess inventory. Accurate stock levels lay the groundwork for accurate forecasting and order planning.
Steps for an effective audit
- Prepare in advance: Schedule audits and provide the necessary resources.
- Count inventory: Physically count all stock items and compare the results with inventory records.
- Reconcile discrepancies: Investigate discrepancies and identify the root causes.
- Update records: Adjust your inventory records to reflect accurate stock levels and document changes.
- Review audit results: Analyze the audit results to identify trends and recurring issues. Take corrective actions.
Supplier relationships
Strong supplier relationships enable a reliable supply chain and reduced lead times. With better supplier relationships, you can secure more favorable terms, reliable deliveries, and better communication.
Tips for maintaining good supplier relationships
- Maintain open and consistent communication: Ensure that expectations are clear and that issues are promptly addressed.
- Negotiate Fair Terms: Work with suppliers to negotiate terms that benefit both parties.
- Honor Commitments: Ensure that your business fulfills its commitments. Pay invoices on time and honor lead times.
- Provide Feedback: Offer suppliers constructive performance feedback. Work together to improve processes and service levels.
Continuous improvement
Continuous improvement drives effective inventory management that can adapt to changing market conditions.
How to implement continuous improvement practices
- Monitor KPIs: Use these KPIs to identify areas for improvement.
- Include feedback: Ask your team, suppliers, and customers to identify issues and improvement opportunities.
- Stay informed: Keep up with industry trends, technological advancements, and best practices.
- Implement small changes: Continuously test and implement small process challenges. Monitor the impact and adjust as needed.
- Regular training: Provide your team with ongoing training.
Well-managed inventory drives long-term success
Inventory management is an essential business function, providing a continuous product stream to fulfill demand. Effective inventory managers can reduce costs and improve cash flow while meeting customer demand.
Harness the power of real-time accuracy and streamlined, effective inventory processes. Take control of your inventory and stay competitive in a rapidly changing market.
