December 30, 2022
Swathi v prabhu

Inventory management formulas

Sound financial health is an important parameter to ensure smooth and better working in an organization. The flow of inventory in and out of the organization concerning raw materials and finished goods is an important indicator reflecting the financial health of an organization.

Inventory management should be an essential condition in every organization big or small. Easy access to materials makes finished products faster, which in turn leads to better and more efficient sales.

There are multiple formulas for calculating key inventory management parameters in a warehouse. They include a calculation for safety stock, product re-order points, the economic cost of stock-outs, and the facility’s level of service.

Let us understand a bit more about inventory management formulas

Main formulas for inventory management in a warehouse

Proper management of inventory in a facility generates better productivity in logistics operations and eliminates cost overruns. The main formulas for measuring success in inventory control are as follows:

1. Lead time:

Also known as cycle time in logistics, lead time is an indicator that measures the time elapsed from the moment the warehouse issues a purchase order to a supplier until the goods are received.

Lead time= delivery date - order date

If a company issues an order for raw materials on the 15th of each month and receives stock regularly on the 23rd, the lead time would be: 23 - 15 = 8-day lead time.

2. Safety stock:

Safety stock refers to the amount of reserve inventory stored in a facility. Having a safety stock is essential to deal with unforeseen situations such as the spike in demand for the product, expected changes in turnover, and supplier delays.

Safety stock = (maximum lead time - average lead time) × average product demand

For example, a production center requires 200 units of a product to fulfill existing production orders. If the average lead time is 5 days and the maximum time the supplier takes to deliver the goods is 8 days,                    

The safety stock would be: (8 - 5) × 200 = 600 units of safety stock

3. Stock out:

Stock out refers to a situation where the warehouse receives a customer order but there are not enough products to meet the request.

Stock out = quantity of stock not supplied × unit cost of storage

4. Reorder point

The reorder point is a formula applied in a warehouse to identify the ideal time for the company to place an order with suppliers to ensure smooth work or production flow and optimize storage space.

Reorder point = safety stock + (average consumption x lead time) 

5. Maximum stock level

Maximum stock level is the exact number of goods storage can save without running out of storage costs.

Maximum stock level = (Reorder point + replenishment quantity) - (minimum demand × lead time) 

To calculate the maximum stock level, let’s take the example of the company above, which has a reorder point of 5,000 units and a lead time of 4 days. If the replenishment quantity for each order is 8,000 units, and the minimum demand is

1,000 units, the maximum stock level would be: (5,000 + 8,000) - (1,000 × 4) = 13,000 - 4,000 = 9,000 units as the maximum stock level in the warehouse                                                                                                        

This indicator reflects the maximum level of stock a facility can store to provide customers with logistics service at the lowest possible cost. 

6. Economic order quantity

Economic order quantity is a logistic concept that determines when to place an order with the supplier and in what quantity. It is calculated by the EOQ formula, also known Wilson formula

Q = optimal order quantity

K = cost of placing each order

D = annual demand quantity of the raw material/product

G = cost of storing the raw material in the warehouse

7. Stock turnover ratio

The stock turnover ratio denotes the number of times inventory is sold over a specific period, typically a year. In other words, this parameter measures the number of times that stored products complete the entire business cycle, i.e., they’re sold, leave the warehouse, and payment is collected.

Stock turnover rate = value of SKUs sold / average stock value


1. What Are the Objectives of Inventory Management?

One objective of inventory management is to keep enough stock to satisfy customers. Another is to invest as little as possible in stock while still earning the most profit.


2. Why Is Inventory Management Important in the Supply Chain?

Inventory management is vital in the supply chain because a company must balance customer demand with storage space and cash limitations. Inventory management provides visibility into the supply chain (procurement, production, fulfillment, etc.) so managers can coordinate lead times for deliveries with production timetables.


3.What Are Inventory Management Policies?

Inventory management policies are plans for how to use inventory to make customers happy and reduce costs. Policies outline such things as the stock management method the company uses.


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