Management of inventory levels for manufacturing companies is a balancing act. A large inventory will result in dead stock, which will drive up overhead costs. If you have low inventory levels, you may encounter stockouts, unable to satisfy customer demand. Optimal levels of inventory will lie somewhere between these two options.
The ideal zone for your business is where profitability is at its peak. So, how do you determine the optimal inventory levels for your business? Let's take a look.
What Are Inventory Levels?
Inventory levels are the quantities of raw materials, semi-finished goods, and finished goods that a business maintains across its entire distribution and logistics network, at any given point in time.
Inventory is a critical component of any operation, regardless of size. It is a buffer between supply and demand and helps you avoid stockouts or excess inventory. But many businesses need to learn how much inventory they need to carry to meet customer demand.
This can lead to overstocking and understocking, which can be costly in terms of lost sales and wasted shelf space. For example, if a company carries too much inventory, it will likely tie up working capital and incur storage costs. On the other hand, too little stock may lead to lost sales and customer dissatisfaction.
What Are the Different Types of Inventory Levels?
Inventory levels can be used to determine the amount of inventory that your company should keep in stock. To maintain a healthy balance in business, it is imperative to know the four levels of inventory: minimum, maximum, average, and danger stock levels for your business.
Minimum inventory levels are the base or minimum levels you should maintain per every Stock Keeping Unit (SKU). You risk stocking out and not being able to meet customer demand if you fall below this threshold.
A company needs to maintain minimum inventory levels to avoid running out of stock and missing out on fulfilling customer orders. This can lead to lost sales and customer dissatisfaction. Additionally, not having the necessary items in stock can translate into longer lead times, which can also cause customers to look elsewhere.
For instance, if a company sells a popular item and does not maintain a certain minimum inventory level, it may be unable to meet customer demand, and lose out on potential sales, which will ultimately affect its market reputation.
Maximum inventory levels are the highest amount of inventory a business should have at any given time. These levels are determined by considering sales trends, seasonal variations, and inventory costs. Your brand risks incurring unnecessary overhead costs if your inventory exceeds that threshold.
Therefore, before placing a purchase order (PO), you must calculate your maximum inventory levels.
For example, let's assume that you determine that your maximum inventory level is 100 items for certain reasons. In that case, you should only place POs for 100 items and not more, even if attractive discounts are available on larger orders.
'Danger inventory levels' imply that a company's inventory supply is rapidly running out, so it is prudent to avoid such levels. For instance, when inventory levels for a particular item reach the "danger" level, this indicates that the company should immediately restock that item to avoid a supply shortage.
When the inventory of a business hits danger levels, the business is forced to purchase stock from suppliers who can deliver it within the shortest time frame. Over time, this will increase transportation costs and overall costs of procuring supplies.
An average inventory level is the ideal quantity of stock you should maintain for your business. This way, you have enough inventory to satisfy your customers' demands at any given time. All while minimizing inventory costs, moving cash flow, and increasing profit margins.
For example, if a business typically sells 100 items a month, it should aim to keep an average inventory of 100 items. This will ensure that it has enough stock to meet customer demand but not so much that it ties up too much cash in inventory.
What Are Optimal Inventory Levels?
Optimal inventory levels are the right quantity of stock levels that an organization should have in its warehouses or fulfillment centers at any given time. By managing inventory optimally, you can minimize the risk of losing sales due to out-of-stock items and incurring excess inventory costs.
Overstocking can lead to holding up excess capital, and yet not all the inventory may not be sold at the end of the process. Keeping less stock can also lead to backorders and stockouts, affecting your sales and profits. While determining inventory levels that best suit your business, you should account for the ideal number of stock required, based on your demand across the year.
Why It Is Important to Maintain the Right Inventory Levels?
The cost of inventory is often a significant portion of a company's expenses. At the same time, the value of inventory decreases over time as it becomes less valuable and its value depreciates. Maintaining an optimal level of stock is crucial so that companies can meet customer demand while keeping their costs down.
Optimizing inventory levels helps to build trust and loyalty with customers. It also helps companies to offer discounts to encourage customers to increase their purchases from the business. Moreover, maintaining low holding costs benefits businesses by enabling them to minimize overhead costs associated with storing excess stock and maximize profits.
How to Determine Optimal Inventory Levels?
What factors should the logistics manager consider when determining the optimal stock level? While every firm might have a different method to calculate inventory, they are modeled on the following four elements:
Demand from customers
Accountants and management should work together with logistics managers to analyze demand trends over time, demand forecasts, and seasonal demand.
Good slotting needs to be adequately managed by knowing the turnover for each SKU. Demand may be analyzed with tools such as ABC analysis to organize SKUs.
Type of product
When determining the optimal stock level, it is crucial to consider the company's business sector and product characteristics. Managing inventory for certain products such as medical or food businesses differs significantly from cable and pipe storage. The former requires specific storage systems tailored to the products.
Safety, maximum, and minimum stock levels
The optimal stock level for each SKU can be calculated with these three numeric values. Hence, a company's maximum stock level will be determined by its storage systems, methodologies, and equipment for handling orders.
Warehouse managers must also know the lead times of suppliers. Lead time refers to the difference between when a stock entry order is created in a warehouse and when the supplier delivers the goods to the warehouse.
Best Practices for Maintaining Optimal Inventory Levels
Let's look at some of the best practices that support businesses to achieve optimal inventory levels:
Organize inventory by priority
Certain products require more attention than others due to their high demand. To ensure this, inventory management techniques help by organizing inventory and ranking items from most to least important. There are several levels of hierarchy:
- A- products with a high level of sales that need to be reviewed frequently and reordered regularly.
- B- products of moderate value requiring monthly reorders.
- C- minimally reorderable low-value products.
Establish points for reordering
Reorder points are determined by how frequently you sell a product and how long it takes to restock it. By setting reorder points, you ensure that you never run out of stock.
The best way to do this is to assess customer demand and lead times. It is helpful to have inventory management software that alerts your team to begin refilling.
Invest in an inventory management program
Inventory management software allows SKUs, orders, and inventory to be synced in real time. It also simplifies the process of centralized inventory management, fulfillment centers, and sales channels.
By using inventory management software, you can automate time-consuming and human-prone tasks regarding inventory. You can set automatic reorder levels to avoid running out of stock in times of high customer demand.
Audit inventory regularly
To ensure maximum accuracy, you must perform inventory audits even with an effective inventory management system. The good news is that with modern inventory software, you can also automate this process. With this software, spot checks, cycle counts, and complete annual checks can be carried out.
Bundle and kit products
By kitting, separate products are bundled together and sold as a single unit, which increases the average order value. Additionally, this is a cost-effective way to keep shipping costs down and deadstock at a minimum.
In this step, you define a bundle size, select bundle products, and track bundles to ensure you have enough items for each variant.
The use of hedge inventories
Inventory hedging is a method of avoiding adverse effects from strikes or interruptions of supplies. In hedging, risks, and potential costs involve speculation and forecasts of events that may not occur. It may, however, benefit organizations when adverse conditions arise.
Being able to respond quickly
Consumer demands and needs can be effectively balanced with a quick response. When data generated at checkouts are promptly available to suppliers, they can manage inventory and reduce lead times by developing more accurate forecasts. It enables suppliers to coordinate shipments to meet the demands of their customers.
A quick response strategy has usually proven useful for businesses with high turnover and low-profit margins. The benefits of this strategy are:
- Stores can have lower inventory levels.
- It is possible to track all goods.
- By matching deliveries with sales, suppliers reduce waste.
How to Calculate Minimum and Maximum Inventory Levels?
Identifying your minimum and maximum stock levels is the first step in calculating your optimal inventory levels. The following information will help you:
1. Reorder point - when your inventory needs replenishment to avoid a stockout situation.
2. An economical or optimal order quantity - how much inventory quantity can be purchased economically at one time.
3. The minimum consumption - is the least amount of demand expected over a given period.
4. The normal consumption rate - estimated demand for that period based on your historical sales.
5. Minimum order lead time - waiting time for your replenishment once your order has been placed.
6. Normal delivery time - when you expect your replenishment to arrive at your warehouse once the order is placed.
Your inventory levels can be calculated effectively once you have these numbers.
Minimum Inventory Level Formula
The minimum inventory level formula is defined as follows:
Minimum inventory level = reorder point - (normal consumption x normal delivery time).
Let's take t-shirts as an example. Typically, your normal delivery time is 3 weeks for reorder points of 15,000 t-shirts. Each week, 600 units of these shirts are consumed.
Minimum inventory level = 15,000 shirts - (600 shirts per week x 3 weeks) = 13,200
You would need 13,200 shirts as a minimum inventory level in this example.
Maximum Inventory Level Formula
Use the following formula to determine the maximum inventory level:
Maximum inventory levels = reorder point + reorder quantity - [minimum consumption x minimum lead time].
In this example, you reorder around 20,000 shirts, but your reorder point is still capped at 15,000. Your minimum lead time hovers around 3 weeks, and you consume 500 shirts per week.
Maximum inventory levels = 15,000 shirts + 20,000 shirts - (500 shirts x 3 weeks) = 33,500
In this example, the maximum inventory level is 33,200 shirts.
Calculating Optimal Inventory Levels
The optimal stock level is between your minimum and maximum levels. To maintain optimal inventory levels, you need to calculate this number.
You must do more than just plug numbers into a formula and get optimal levels. You need to consider your real-time inventory data and the growth assumptions you use to forecast future demand.
As these factors constantly change, it can be challenging to calculate your exact optimal stock level. Some businesses use spreadsheets to calculate this number, but this method is unreliable and time-consuming.
Instead, an inventory management software or operations optimization tool is the better option. It helps to automate inventory processing, improves stock control, and enhances order fulfillment.
Keeping your inventory in check with TranZact
Keeping your inventory levels in check is challenging for businesses. With many data points to keep in mind, it becomes difficult for them to maintain spreadsheets and build upon hours of calculation for every data point. This holds them back from expanding their offerings and scaling effectively. This is where TranZact comes in.
TranZact goes beyond an ordinary ERP and is a crucial software solution for your business. It helps you keep your inventory in check and monitors your end-to-end inventory and sales cycle. This tool is a must-have for companies looking to automate their business and reduce their costs effectively in no time.
By integrating with Google Sheets, Tally, and other solutions, you can effectively integrate TranZact with your existing tools while leveraging the power of a robust platform to optimize your business further.
FAQs on Inventory Levels
1. How to forecast inventory levels?
Inventory forecasting is a method of predicting the amount and timing of inventory a business needs to meet future demand. It's a process that helps you decide how much inventory to purchase or make and how much to store to meet customer demand at the lowest cost.
2. What is the minimum inventory level?
A business' minimum inventory level is the lowest quantity of stock on hand. This is based on the demand for their products and how quickly they can replenish their stock if needed.
3. What is the maximum inventory level?
The maximum inventory level is the highest amount of inventory that should be stored in your warehouse. Several factors, including time, determine what it takes to replenish stock, how often you sell items, and how long customers buy items.