Inventory Optimization | 4 mins read

3 Core Components of Inventory Optimization

3 core components of inventory optimization
Hanh Truong

By Hanh Truong

Inventory optimization can make a positive impact on a business's profitability and longevity by maximizing sales and revenue. With effective strategies, organizations will be able to monitor their inventory and maintain the right level of stock to meet consumer demands.

Practicing inventory optimization will also improve efficiency, as business owners can reduce warehouse-related costs, make informed replenishment decisions, and achieve customer satisfaction.

What is Inventory Optimization?

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Inventory optimization is the practice of managing inventory to meet forecasted service levels while minimizing spending.

In order for businesses to be profitable, inventory must be kept at an optimal level. For example, high levels of inventory may lead to overstocking and excess waste. While customer demands may be met with these products, unsold items will take up warehouse space and incur carrying costs. Additionally, many stock items may expire or become obsolete if they are kept in inventory for too long.

On the other hand, while it may be cost-efficient to have lower levels of inventory, this may cause stock-outs to occur quicker which will lead to loss of potential sales and higher expenses to expedite new purchase orders.

To determine the most opportune inventory level, supply chain managers will generally consider lead times and shipping costs, as well as analyze the historical sales volume of products. These metrics will help organizations calculate which items they need to replenish, the quantity necessary, and when they should be ordered.

Many retailers will implement POS (point-of-sale) software systems that have inventory management features to further minimize their risk of losing sales and customers to stockouts. These solutions not only streamline transactions but will also simplify the process of tracking inventory, as well as alert authorized users about potential stock-outs, and automate reorders.

By optimizing inventory in this way, businesses will curtail delays in their supply chain management and meet their customers' expectations.

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3 Components of Inventory Optimization

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There are 3 key elements of inventory optimization that will help business owners gain insight into how they can properly replenish stock to meet demand without overspending. These components are-

1. Demand Forecasting

To forecast future customer demand, management teams will usually analyze historical sales trends from the past quarter or year. This will provide visibility into which products or services were popular and what types of items customers tend to buy.

Since new products may not have historical data, it is recommended that managers consistently examine the item's life cycle. For example, a new children's toy may experience positive growth in sales trends during its first month in the market and become stable for a quarter.

By closely assessing the product life cycle, businesses can quickly detect any decreases in sales and appropriately adjust their inventory.

Seasonality is also important to monitor with demand planning because it will indicate predictable fluctuations in sales throughout the year. These insights will allow business owners to make informed decisions about order quantities and prepare their inventory beforehand.

2. Inventory Policy

An inventory policy outlines what items to stock and how many quantities of each unit should be kept on hand. To determine this, businesses most commonly use ABC analysis. The ABC analysis model classifies products into 3 statuses based on their financial performance-

  • A Category - These are the most important inventory items because they sell well and have high-profit margins.
  • B Category - These are goods that have moderate profit margins.
  • C Category - These items have a steady demand from customers but contribute less to a business's bottom line, compared to A and B products.

Categorizing items with this model will help managers determine which products they need to prioritize and the optimal inventory level for each item.

Maintaining safety stock is also crucial to an inventory policy, as it will mitigate instances of shortages. Safety stock levels can be calculated with the following formula-

  • (Maximum Daily Usage x Maximum Lead Time) - (Average Daily Usage x Average Lead Time) = Safety Stock

For example, a steakhouse sells an average of 15 filets a day and it usually takes 3 days to get the filets shipped from their kitchen in New York to Chicago. However, on good days, sales will go up to 25 filets a day but due to weather changes, lead time can take up to 5 days.

  • The calculations for this case would be- (25 x 5) - (15 x 3) = 80

Therefore, the steakhouse would need to carry approximately 80 filets as safety stock.

Lastly, if a business has multiple warehouse facilities for inventory, executives should use the latest POS inventory software to streamline multi-location management. This will enable managers to monitor their inventory across all sites and make purchase orders from one central location.

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3. Replenishment

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Stock replenishment is the process of reordering more inventory items to meet consumer demand. To optimize inventory replenishment, businesses should consider-

  • Reliability of Suppliers
A supplier's lead time, which is the amount of time between when an order was placed and when it arrives, is key to how quickly stock can be replenished. Their hours of operation and production cycles can also affect how fast customers' orders can be fulfilled.
Businesses should be knowledgeable about their supplier's lead times and processes to make orders accordingly. They should also employ suppliers who are reliable and are be able to complete orders promptly to minimize any delays.

  • Monitor Moving Inventory
Before business owners replenish inventory, they should monitor the goods they may have in transit from their suppliers to their warehouses. This will ensure that they are not making double purchases and reduce inventory spending.

The best practices of inventory optimization take stock management to another level, enabling businesses to boost their profitability by making informed buying decisions and meeting customer demands.

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