3 Key Elements of Inventory Optimization- Checklist for Businesses

There is a fine line that businesses must walk to balance their supply and demand. When companies stray too far from this optimal inventory volume, they can experience increased stock expenses and stockouts.

Practicing inventory optimization requires organizations to take an in-depth look into sales and demand trends to determine how much stock is necessary to keep in storage. By maintaining minimum stock levels, companies can efficiently fulfill orders while minimizing inventory expenses.

What is Inventory Optimization?

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Inventory optimization involves managing stock levels to meet performance targets and demand while minimizing inventory costs. In other words, it is the minimization of stock levels to reduce inventory-related expenses, freeing up capital for other operations.

To achieve inventory optimization, businesses need to have a clear insight into their supply and demand ratio. This requires accurate forecasts to prepare inventory for fluctuating demand. Inaccurate sales predictions can result in-

  • Stockouts
  • Excessive storage costs
  • Backorders
  • Lost sales
  • Supply chain disruptions
  • Unsatisfied customers
  • Decreased customer loyalty and advocacy
  • Decreased income

Therefore, businesses should analyze their supply chain needs to determine how to maintain low stock levels without under or overstocking. Management should consider the lead time, shipping rate, daily usage, and economic order quantity (EOQ) of each product line. This enables inventory managers to calculate optimal stock quantities and accurate reorder points.

With the supply chain undergoing a complete digital transformation over the years, many businesses are able to source cost-efficient products worldwide. However, this globalization and boom in technology have made it challenging for some companies to anticipate demand trends.

By achieving inventory optimization, businesses can gauge and capitalize on fluctuating customer demand, gaining a powerful competitive edge over companies with poor forecasting skills.

3 Elements of Inventory Optimization

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Optimizing inventory requires a business to know precisely when and how much product to order to fulfill customer requests without increasing stock maintenance costs. Reorder points often vary due to slow and peak seasons, requiring extensive knowledge of sales trends to accurately predict future demand.

In order to achieve inventory optimization, companies need to understand the three primary elements-

1. Demand Forecasting

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Every product has a unique life cycle, making it challenging for large companies to manually track each item's demand patterns. While there are multiple ways to predict demand, forecasting software aggregates historical and real-time sales data to detect trends and make projections. It also continuously updates its algorithm with incoming data from transactions to improve accuracy.

A forecasting solution monitors when each item is purchased, order quantities, and peak seasons to determine how a business can optimize their stock levels. For example, if the software notices a particular item's demand significantly decreases in the fall, it will alert management to cease reorders. This can save companies storage costs and the risk of products going obsolete.

Forecasting also informs marketers when to launch different campaigns. For example, product lines that are only popular during the summer should not be promoted during the winter.

2. Inventory Policy

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Next, businesses need to set their inventory policy, meaning they must determine each product line's optimal stock level. Many companies use the ABC analysis method, also known as the Pareto Rule, where management categorizes inventory into A, B, and C groups based on their usage.

Group A consists of the items with the highest turnover rates and is typically the smallest category. Group B contains products with average consumption levels, falling between group A and C. Finally, group C holds goods with the slowest turnover rates that contribute the least to the bottom line.

By categorizing inventory using the ABC method, businesses can determine which products should be stored on-hand and which can be ordered on demand. Then, management must calculate how much safety stock to keep in case of unexpected demand increases, supply chain disruptions, and vendor complications.

However, retaining the correct amount of stock is only useful if products are stored appropriately. Warehouses should also be organized to streamline order fulfillment, restocks, unloading, and shipping. For businesses with multiple warehouses, management should also assign employees to distribute inventory based on each location's demand trends.

3. Stock Replenishment

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Once companies determine the optimal stock levels for each product, they must calculate reorder points to actively maintain a healthy inventory count. A reorder point (ROP) is the quantity that triggers stock replenishment. In other words, it is the minimum amount of stock a business can hold before placing another order.

Management also needs to determine order sizes to avoid over and understocking products. To optimize stock replenishment, businesses need to focus on-

  • Supplier Reliability
The amount of time it takes a supplier to fulfill an order significantly impacts stock availability. If a vendor has prolonged lead times, companies must plan reorders in advance, making operations dependent on purchase orders.

Businesses must also have a clear idea of their vendor's production cycles and operating hours. This is especially important for companies that have foreign suppliers. For example, manufacturers overseas may close for a national holiday that the United States does not recognize. These instances can delay lead times, stalling sequential processes, such as order fulfillment.

  • Goods in Transit
It is not enough to have an accurate count of on-hand inventory when replenishing stock, companies must also account for what goods are in transit. Otherwise, management can accidentally double inventory orders, driving storage, and stock expenses.