Maintaining ideal inventory levels is a function companies need to plan for as early as possible. The amount of inventory on hand affects everything from overhead and storage costs to the ability to fulfill customer orders and generate profits.
While it’s important to have sufficient inventory to meet market demand, excess inventory can leave a company with low cash flow and many unsold products.
Determining optimal inventory levels — and finding the most efficient way to maintain them — is a primary factor in a company’s success.
What are inventory levels?
Inventory levels are the amount of goods a company currently holds that are ready to be sold and shipped to the customer. This can refer to the total goods across a company’s entire distribution network or goods within an individual warehouse location.
Optimal inventory levels are the quantity of on-hand products that ensure a company can fulfill customer demand without tying up too much capital or ending up unsold.
Why having optimal inventory levels are essential
Inventory is a significant part of any business that sells physical products to customers. Not only is inventory the primary source of revenue and expenses, but it’s also central to all other areas of operations, including supply chain management, sales, and customer service.
Improves cash flow
Optimizing inventory levels helps maximize profits while still keeping carrying costs under control. Holding too much inventory requires more space and manpower to facilitate and may prove challenging to sell within the projected time.
On the other hand, too little inventory can lead to lost sales and additional expenses for rushed restock orders. With the ideal number of products on hand, a business can operate more efficiently, only spending what it needs and generating more profit.
Leads to better supplier relationships
A better understanding of ideal inventory levels leads to increased lead times and accuracy when placing orders with suppliers. A company can draw from real data, such as sales forecasts, average stock turnover, and order lead time to determine exactly how many products to order for a given time.
By having a firm grasp of current stock levels and how much to reorder, a company can effectively build its supplier relationships and supply chain strategy.
Increases sales and customer satisfaction
Maintaining the right amount of inventory allows a company to operate more effectively and capably meet customer demand. As a result, employees and storage locations are not overloaded with unnecessary products or are unable to increase sales due to lack of inventory. As a result, a company can quickly increase its sales cycles, fill rates, and customer satisfaction.
How to know what your optimal inventory levels are
A company’s optimal inventory level depends on several constantly changing factors: on-hand inventory, order lead times, historical and projected customer demand, and more.
While the exact number depends on the particular industry and market, there are a few key factors to look at when determining the best inventory levels:
Customer demand forecast: The best way to forecast customer demand (also called demand forecasting or sales forecasting) is looking at historical data. By drawing from past sales and seasonality, it’s easier to establish a baseline and estimate upcoming sales and target inventory levels.
Inventory turnover: Some SKUs and product categories will sell faster than others. Inventory turnover rates are a good indication of the ideal quantity a company should carry for each product.
Another consideration when it comes to types of inventory is specialized storage requirements. For example, large or temperature-sensitive products may not be feasible to carry in greater quantities, even if they’re popular products. In this case, it’s advisable to keep a lower inventory level and negotiate smaller but more frequent supplier deliveries.
Production lead time: Knowing the lead time required by every supplier or manufacturer determines a company’s restocking schedule and the inventory levels to keep on hand.
Production entails several steps, from processing raw materials to assembling the finished goods, and can take anywhere from several days to a few months for delivery. Factoring in order lead times and average inventory turnover gives companies an idea of how much inventory they should maintain throughout a sales period.
Safety stock levels:Safety stock is extra inventory a company holds to buffer against any unexpected changes in supply or demand. The exact quantity is up to the company, but any amount of safety stock is highly recommended to mitigate risk and ensure continued operations. Regardless of the exact amount, safety stock should be factored into a company’s optimal inventory level.
What is the minimum inventory level?
The minimum inventory level is the lowest quantity of products a company should have in stock before expecting to operate at a loss. If inventory falls below the minimum level, it could lead to stockouts, unhappy customers, and a loss in profit.
Minimum stock levels are calculated using the same factors as optimum inventory levels, including customer demand, inventory turnover, and production lead times. Below is the formula to calculate minimum inventory levels:
Minimum inventory level = Reorder level – (Average usage per day/week × Average lead time)
For example, say a retailer’s reorder level is 5,000 units, its average usage or turnover is 500 units a week, and the average lead time is four weeks. This results in a minimum inventory level of 3,000 units. Alternatively, you can you the reorder point formula as well to calculate when you should reorder new inventory.
What is the maximum inventory level?
The maximum inventory level refers to the highest quantity of products a company can carry before exceeding its optimum operational capacity. Set limitations typically dictate maximum levels, such as warehouse space, market demand, or available working capital.
Once the maximum level is reached, companies start to tie up resources in products that may not meet the expected profit. Any inventory beyond the maximum recommended level can cause a strain on resources and end up as an overstock.
The formula to calculate maximum inventory levels is below:
Maximum inventory level = Reorder level + Reorder quantity - (Minimum usage per day/week x Minimum lead time)
Take a distributor with a reorder level of 30,000 units and a reorder quantity of 25,000 units. Its minimum usage or turnover is 5,000 per week and its minimum lead time for orders is five weeks. In this example, the company’s maximum inventory level would be 30,000 units.
Best practices for having optimal inventory levels
Determining and keeping optimal inventory levels is a continuous process that greatly impacts all business areas. While inventory management strategies differ for every company, a few best practices are proven to optimize inventory levels.
Perform routine inventory audits
Before calculating inventory levels, conduct an inventory audit to ensure all warehouse operations are in order. All the products in a warehouse should be accounted for and aligned with financial accounts. During an inventory audit, it can be beneficial to group products into separate classifications to help organize optimal inventory levels later.
Although audits take some time, especially for organizations with multiple product lines and warehouses, they can reveal improvement opportunities that should be addressed before managing inventory levels.
Calculate and set reorder point
After setting the optimal inventory level, the next step is calculating a reorder point and implementing a system that automatically starts the reorder process. Reorder points (or reorder levels) are the inventory levels at which a company needs to place an order with its supplier or manufacturer. This process ensures enough inventory stock to fulfill sales and doesn’t fall below the minimum inventory level.
Establish clear guidelines with suppliers
In addition to optimal inventory levels, a company needs suitable suppliers for an efficient supply chain. All inventory details, such as minimum order quantities, lead times, and any non-working holidays observed by the supplier should be established.
Supplier relationships play a significant part in a company’s operations, their product quality and cost should also be periodically assessed to optimize operations.
Implement an inventory management system
Even companies that deal with smaller inventory amounts need to keep track of multiple SKUs and perform several routine steps. An inventory management system can take care of many of these functions, including tracking product data in real-time, calculating inventory costs and returns, and determining the ideal reorder levels.
By automating these labor-intensive calculations, inventory software eliminates human error and allows teams to allocate their time to more valuable tasks.
How QuickBooks helps your optimize inventory levels
Optimizing inventory levels is much easier when using a management system that performs product tracking at every stage. QuickBooks Enterprise starts by tracking inventory levels, locations, and sales in real-time and brings everything together in one place.
Companies can easily see what’s in stock, what’s on order, and which products need to be restocked. Our inventory solution even allows you to set automated order rules and generate purchase orders with one click.
Thanks to all the collected data and reports, you can be sure you’re maintaining optimal inventory levels to bring in the most profit.
Final thoughts
Companies that keep a close watch on their inventory levels automatically position themselves at a significant advantage. Inventory optimization ensures resources are being efficiently utilized and products are only ordered when they can bring in the most profit.
By optimizing inventory levels and using inventory management software to streamline the entire process, companies can gain more control over their operations and maximize their potential earnings.
