What it means
Every unit sitting in a warehouse costs money in capital, storage, insurance, handling and the risk of obsolescence. That total is usually expressed as an annual holding cost per unit, and in many businesses it runs to 20% or more of the item's value each year.
Against that sits the cost of ordering and the cost of stockouts. Ordering more often means more administration, freight and set up cost, while ordering too little means lost sales, expedited shipping and unhappy customers.
The classical answer is the economic order quantity, which finds the order size where total ordering cost and total holding cost are equal and their sum is at its lowest. It assumes steady demand and fixed costs, which rarely hold perfectly, but it gives a useful starting point.
Real operations add two more ideas. Safety stock is a buffer held against demand or lead time varying, and the reorder point is the stock level that triggers a new order, calculated from usage during the lead time plus that buffer.
Most businesses also apply ABC analysis, sorting items by value so effort goes where it counts. A small minority of lines usually accounts for the large majority of stock value, and those items justify tight control while low value items can be managed with simple rules.
In practice
Real-world examples
Example 1
A bakery supplier switches from weekly to daily deliveries of fresh ingredients. Ordering costs rise, but waste falls by $60,000 a year because far less stock reaches its use by date unsold.
Example 2
An electronics retailer applies ABC analysis and finds that 300 of its 5,000 lines account for two thirds of stock value. It moves those lines to weekly review and leaves the rest on a simple minimum and maximum rule.
Example 3
A machinery manufacturer raises safety stock on a single imported casting after a shipping delay halts its line for nine days. The extra holding cost of $18,000 a year is accepted against a production stoppage that cost $240,000.
Think of it
Inventory management is like stocking your home fridge. If you buy too much food, it spoils before you can eat it and wastes your grocery money. If you buy too little, you have nothing for dinner and must make an emergency trip to the shops.
Formula
Calculation
Economic order quantity = the square root of (2 x annual demand x cost per order / annual holding cost per unit)
Reorder point = (daily usage x lead time in days) + safety stock
A distributor sells 25,000 units a year of a component. Each purchase order costs $100 to raise and receive, and holding one unit for a year costs $20 in capital, storage and insurance.
The economic order quantity is the square root of (2 x 25,000 x $100 / $20) = the square root of $5,000,000 / $20 = the square root of 250,000 = 500 units. At that size the business places 25,000 / 500 = 50 orders a year costing 50 x $100 = $5,000, and holds an average of 250 units costing 250 x $20 = $5,000, for a total of $10,000. The two costs matching confirms the optimum.
Compare that with the old habit of ordering 2,500 units at a time. That means 10 orders a year at $1,000 of ordering cost, but average inventory of 1,250 units costing 1,250 x $20 = $25,000, a total of $26,000 and $16,000 worse. For the reorder point, with 250 working days a year usage is 25,000 / 250 = 100 units a day, so a six day lead time plus 200 units of safety stock gives (100 x 6) + 200 = 800 units.Case study
Seen in the real world
The following is an illustrative and fictional example. Pinegrove Hardware, an invented chain of eleven trade counters, carried average inventory of $2,400,000 against cost of goods sold of $9,600,000, giving stock turnover of 9,600,000 / 2,400,000 = 4.0 times a year. Despite holding that much, it was still failing to supply 9% of customer requests on the day.
The invented operations team ran an ABC analysis and found that 8% of lines drove around 70% of stock value. They put those lines on weekly review with calculated reorder points, moved slow lines to a central branch with next day transfer, and cleared discontinued items at whatever price they could get.
Average inventory fell to $1,600,000, lifting turnover to $9,600,000 / $1,600,000 = 6.0 times and releasing $800,000 of cash, while availability improved from 91% to 96%. The counterintuitive result, less stock and better service, came from holding the right items rather than simply fewer of them.
Watch out
Common mistakes
- Cutting inventory across the board by a fixed percentage, which removes fast moving stock the business needs alongside the slow stock it does not.
- Ignoring the holding cost of capital, which makes stock look free to keep and encourages over ordering to secure volume discounts.
- Setting safety stock by feel rather than from actual demand and lead time variability, which usually means far too much on stable lines and too little on volatile ones.
Questions
People also ask
What is a good level of safety stock?
Enough to cover the normal variation in demand and lead time for that specific item, which means high value stable items need much less buffer than volatile or long lead time ones.
Does just in time always beat holding buffer stock?
No, because just in time lowers holding cost but raises exposure to supply disruption, and the right balance depends on the cost of a stoppage.
How often should stock be counted?
Most businesses now use rolling cycle counts, checking high value items monthly and low value items once or twice a year, rather than relying on a single annual count.