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Additionally, Inventory planning is crucial for businesses because a successful plan allows them to meet customer demand while remaining profitable. Poor inventory planning can lead to problems, such as excess or insufficient inventory, which can result in lost sales or higher carrying costs. On the other hand, effective inventory planning can help businesses to reduce costs, improve customer satisfaction, and increase profitability.
In the previous blog, we learned what inventory planning is, why it is important, and some of the most common challenges to resolve while developing an inventory plan. Let’s look at the key elements you need to consider when building an inventory plan.
4 Pillars of an Inventory Plan
Since an inventory plan forms the foundation of crucial inventory management processes, it is important to understand the main elements that usually shape the plan. We cover four basic pillars of an inventory plan here, but they may differ depending on the specific requirements of your business.
1. Inventory replenishment
Inventory replenishment is often interpreted as inventory planning, but both relate to something different. As a subpart of inventory planning, this is the process of ordering and purchasing new stock to maintain suitable inventory levels. Inventory planning is a long-term consideration of how to reach inventory objectives, while short-term operational concerns focus on the immediate needs. Making sure that you consider both strategies can put your business in an advantageous position for success.
An important component of inventory planning is selecting a suitable replenishment strategy and model. Each of these is discussed below:
a. Inventory replenishment strategies
An inventory replenishment strategy helps you determine how and when to restock your inventory. Mostly, businesses choose one of the following replenishment strategies depending on their requirements.
- Continuous or perpetual inventory system that allows you to continuously monitor your inventory levels and place orders when it reaches a minimum amount. The threshold level can be determined using a replenishment model.
- Periodic inventory system that allows you to keep your inventory up to date with a periodic system that counts and forecasts demand. This streamlined process will enable you to replenish stock at the end of each week, month, or quarter.
b. Models of Inventory repair
Inventory repairing models provide the key to efficient inventory management through sophisticated mathematical formulae that maximize warehouse stocking levels, enable cost-effective ordering frequencies, and ensure a steady supply chain. Some of the most common inventory replenishment models are mentioned below:
A. Economic Order Quantity (EOQ)
The EOQ model helps you to calculate the most optimal amount of inventory to order while minimizing costs associated with ordering and storage. The formula used to calculate the amount is:
EOQ = Square root of (2*Order costs*Demand rate) / Holding costs
B. Safety stock
Many retailers and manufacturers keep safety stock that can be used in case of a supply chain issue or another emergency. The amount of safety stock can be calculated as:
Safety stock = (Max daily demand * max lead time) – (average daily demand * average lead time)
C. Reorder point
To ensure that you are always well-stocked, the reorder point model can provide invaluable insight into when it is optimal to place orders. This helps you avoid costly stockouts and unexpected deliveries while keeping pace with demand. The formula calculates the minimum inventory level at which you should place your next order with the supplier. It takes inventory lead time into consideration to ensure that you have enough stock until the next batch arrives at your store or warehouse.
Reorder point = (Average daily demand* Average lead time in days) + Safety stock
D. Day sales inventory (DSI)
The DSI model helps you to calculate the average time your current stock will last. A low DSI value is more favorable since it shows more demand leading to higher profits and less holding costs, while a high DSI value might relate to the difficulty in clearing stock or making sales. DSI can be calculated as:
DSI = (Average inventory / Cost of goods sold) * 365 days
2. Demand forecasting
Inventory forecasting (also known as demand forecasting) is another important aspect of inventory planning. Demand forecasting is the process of predicting future customer demand for a product during a specific period. Depending on the stability of a market and demand variation, a forecast can be modeled in two ways: deterministically or probabilistically.
- Deterministic demand forecasting outputs a single demand value and is tied to the assumption that future demand is stable and predictable based on historical data and trends.
- Probabilistic demand forecasting generates a range of possible solutions and assumes uncertainty and unpredictability of future demand.
There are different ways to estimate future demand. Additionally, at a high level, depending on data availability, these methods can be classified as:
a. Qualitative demand forecasting
These methods predict demand based on expert opinions, market analysis, and consumer surveys. When a business is just getting started, leveraging current available data may be difficult. That’s why building budgets from the ground up can provide an insightful foundation for success. For example, Delphi method, focus groups, market research, etc.
b. Quantitative demand forecasting
These methods predict demand with statistical algorithms or by training machine learning models on past data. This is used when a business has years of historical data. Statistical demand forecasting methods include time-series analysis, exponential smoothing, or moving averages, while machine learning techniques involve supervised and unsupervised learning such as clustering, neural networks (example: ChatGPT), and hidden Markov model.
3. Driving factors to consider in inventory plan
Although advanced demand forecasting and replenishment models consider the impact of crucial drivers on an inventory plan, there are several essential considerations that must be considered before finalizing the plan. These include:
- Budget: Forecasting accurate inventory levels is half the game. Having the necessary budget for effective plan execution and resource utilization is just as important. Inaccurate budget allocation can lead to undesirable outcomes irrespective of plan efficiency.
- Product type: Different product characteristics must be considered while planning your inventory, such as its shelf life, category, price, expiration date, and holding cost.
- Lead time: This is the duration between placing an order and receiving the inventory from your supplier. Inventory plans must consider the lead times of different product categories so that you can place orders on time and have enough stock to sell until the next batch arrives.
- Seasonality: Seasons and trends do have an impact on product demand. Your plan should account for these seasonal changes, for example, stocking up on winter clothes as the season arrives and clearing summer stock.
- Promotions: Marketing campaigns, discounts, and promotional offers directly influence product demand. They might boost sales and require you to have additional stock on hand.
- Suppliers and vendors: Different parameters must be considered when it comes to choosing suppliers, such as their locations, price ranges, and the possibility of product shortages during high season demand.
- Economic factors: Economic downturns, declining retail stock prices, and rising interest rates can impact your inventory plan as well.
4. KPI analysis in inventory plan
An inventory plan’s success is measured by the progress of its KPIs, which provide vital feedback to track and maintain performance. Furthermore, this is necessary as it allows you to adjust and make improvements wherever needed. There are metrics that retailers and manufacturers calculate to measure the success of their inventory plan, and the most common ones include:
a. Inventory turnover rate
This metric shows how quickly you are selling your inventory. A higher turnover rate shows quick sales while a lower turnover rate shows slower sales and excessive inventory. It is calculated as:
Inventory turnover rate = Cost of goods sold / Average inventory
b. Order fill rate
The order fill rate shows how often you manage to fulfill customer orders from your inventory. A higher fill rate suggests that you can keep up with customer demand, while a lower fill rate means that you are unable to fulfill customer demand on time.
Order fill rate = (Total orders shipped / Total orders placed) *100
c. Stockout rate
The stockout rate shows how often you fail to fulfill customer orders because of out-of-stock situations. It is calculated as:
Stockout rate = Products out-of-stock / Total number of products available
d. Gross margin return on inventory (GMROI)
GMROI metric shows how much profit your company generates for every dollar spent on inventory. A higher GMROI means that your inventory is generating more money than you initially spent on purchasing it. It is calculated as:
GMROI = (Gross margin / Average inventory) * 100
e. Inventory carrying costs
You should continuously track inventory carrying costs. This can help you to optimize your expenditure by making small plan adjustments. Hence it can be calculated as:
Inventory carrying cost = (Inventory holding amount / Inventory value) * 100
You can calculate inventory holding cost by aggregating different costs, such as capital, service cost, storage, risk charges, etc.
To summarize, the pillars of an inventory plan support and guide the development and implementation of an inventory management strategy. With a solid plan in place, businesses can accurately forecast demand, set appropriate inventory levels, manage lead times, and minimize carrying costs.
1. Effective inventory planning is crucial for businesses as it enables them to meet customer demand while remaining profitable.
2. Inventory planning consists of four key pillars:
- Inventory Replenishment
- Demand Forecasting
- Driving Factors
- KPI Analysis
3. Businesses should select strategies that align with their specific requirements, considering factors like demand variability and operational needs.
4. Businesses can use either qualitative or quantitative demand forecasting methods based on data availability and market stability.
5. Before finalizing an inventory plan, consider various drivers, including budget, product characteristics, lead time, seasonality, promotions, suppliers, and economic factors. These factors can significantly impact your inventory management strategy.
6. Key performance indicators (KPIs) provide vital feedback and allow you to make adjustments and improvements as needed to optimize inventory management.
1. What is the difference between inventory planning and inventory replenishment?
Inventory planning is a long-term consideration of how to achieve inventory objectives, while inventory replenishment is the short-term process of ordering and purchasing new stock to maintain suitable inventory levels.
2. What are some common inventory replenishment strategies and models?
Common replenishment strategies include continuous/perpetual inventory systems and periodic inventory systems. Common replenishment models include Economic Order Quantity (EOQ), safety stock, reorder point, and Day Sales Inventory (DSI).
3. What are some important KPIs to track in inventory planning?
Key performance indicators (KPIs) in inventory planning include inventory turnover rate, order fill rate, stockout rate, gross margin return on inventory (GMROI), and inventory carrying costs. These metrics help assess the efficiency and effectiveness of inventory management.