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Sourcing, sorting, and selling stock—inventory management seems easy, right?
The complexity of inventory management lies in the finer details of managing aspects like restocks, handling inventory valuation, and ensuring accurate demand forecasting.
Inventory management gets a lot more complex as the volume of inventory handled increases.
Recent reports reveal that:
Using inventory management software can protect your business’s profit margins from taking a hit.
We’ll come back to this in a bit.
Given how inventory management is the fundamental building block in enabling businesses to minimize costs and boost profitability—having a solid understanding of inventory management goes a long way in ensuring your business stays ahead of the curve.
We suggest starting with the basics. This post provides a rundown of the most popular inventory terms. We’re breaking down inventory management terminologies and acronyms to help you build your knowledge of inventory management.
Inventory management is a lot more than keeping your stock in check. It is deeply interconnected with supply chain and logistics—where terms like “Batch Picking” and “Lot for Lot” come into the picture.
While these terms might seem too technical, they are all important factors that will help your business find the right balance and efficiency in managing your stock.
We’re explaining these terms and providing a few examples so that the next time you hear these buzzwords, you will understand how they can make inventory management much easier for your business.
We will explore 28 essential inventory management terms frequently mentioned in discussions about ordering, organizing, and distributing stock.
A backorder policy outlines the steps to take when a product is out of stock. It ensures that any units demanded but unavailable immediately are fulfilled later.
In this case, a company might notify customers about the delay and provide an estimated delivery time.
COGS refers to the direct costs of producing or purchasing the goods a company sells, such as raw materials, labor, and manufacturing expenses.
It is crucial for calculating gross profit and setting pricing strategies.
For example, if a furniture company spends $200 on materials and $100 on labor to produce a chair, the COGS is $300. Understanding COGS helps businesses manage production costs and maximize profitability.
Batch picking is an inventory management technique in which similar orders are grouped together, or “batched,” to be picked together. This minimizes the time spent moving around the warehouse.
Let’s say there are three orders containing the same item—a picker would then retrieve all three at once rather than making separate trips.
This method is particularly effective in warehouses where items are frequently picked and can significantly reduce labor costs and increase picking efficiency.
Lead time is the interval between recognizing the need for more stock and its arrival. Shorter lead times enhance a company’s ability to respond to changes in demand.
If a company’s lead time for a product is typically 10 days, reducing it to 5 days can improve responsiveness and reduce the need for large safety stocks.
Companies now use real-time analytics and automation to minimize lead times, thus improving overall supply chain efficiency.
Stock-out management involves strategies to handle situations when inventory is depleted and unable to meet demand.
Effective management includes identifying alternative suppliers, expediting incoming shipments, or suggesting substitute products to customers.
For instance, an online retailer might display similar in-stock items to customers when a product is unavailable.
Companies use various models to predict stockouts, such as the Safety Stock formula.
Safety Stock = Z * √(Lead Time Demand Variance), where ‘Z’ is the desired service level.
Age management monitors how long products have been in inventory to prevent obsolescence or spoilage.
This is especially critical for perishable goods or items with expiration dates. For instance, a grocery store might prioritize selling older stock first to avoid waste, applying the FIFO (First In, First Out) principle.
Companies increasingly use barcode scanning systems and inventory management software to track the age of inventory and automate reordering processes.
Deadstock refers to unsold inventory that no longer has demand, often due to seasonal changes or trends.
Managing deadstock involves markdowns, bundling products, or donating them to free up space for more sellable inventory.
For example, a clothing retailer might offer end-of-season sales to clear deadstock items.
Safety time adds a buffer to lead time to account for supplier delays or other uncertainties.
Consider a company with a lead time of 7 days. To ensure stock is received on time, they might add a safety time of 3 days.
This approach can help avoid stockouts in unpredictable delivery times and, in turn, provide an extra layer of protection against inventory shortages.
Cycle stock is the inventory needed to meet expected demand during the lead time.
Suppose a store expects to sell 100 units over a week (its lead time), which would be its cycle stock. Balancing cycle stock with safety stock is essential for optimizing service levels while controlling costs.
Stocktake policies dictate how and when physical inventory counts are conducted to ensure accurate records. These could be periodic (annually or quarterly) or perpetual, where inventory is counted continuously over the year.
A DTC business might do a full inventory count after closing for a public holiday to ensure no discrepancies.
Accurate stocktake policies are crucial for maintaining inventory accuracy and preventing losses due to theft, damage, or misplacement.
Some suppliers set a minimum order quantity (MOQ) that businesses must meet.
If an order is below this minimum, companies may need to adjust their order sizes or find ways to combine orders, which impacts inventory levels and holding costs.
Suppose a supplier has an MOQ of 1,000 units, but the company only needs 700. It must decide whether to meet the MOQ—potentially increasing holding costs—or look for another supplier.
An SKU is a unique identifier for each distinct product in inventory. SKUs help businesses track inventory, manage stock levels, and analyze sales trends.
For example, a retail store might assign different SKUs to each type and color of T-shirt. Effective SKU management allows businesses to monitor which products sell well and which do not, aiding in restocking decisions and marketing strategies.
Inventory forecasting predicts future needs based on historical data, trends, and service-level goals.
Modern tools utilize machine learning for more accurate predictions, incorporating factors like seasonality and market changes.
Accurate inventory forecasting helps companies maintain optimal stock levels, reduce carrying costs, and improve service levels by aligning supply with demand.
A loss policy treats any unmet demand as lost sales. This approach is often adopted in high-demand environments where backorders may not be feasible, ensuring that the impact of stockouts is clearly understood.
A business may adopt a loss policy where stockouts result in lost sales because backorders can disrupt the flow of new collections.
The ROP is the inventory level at which a new order should be placed to avoid a stockout.
It is determined by the lead time demand plus safety stock.
For example, if a store sells 10 units of a product daily and has a lead time of 5 days, the ROP would be 50 units (10 units/day x 5 days).
Adding safety stock based on demand variability ensures a buffer against unexpected spikes in demand or supply delays.
Landed cost is the total cost of a product from the supplier to its final destination, including purchase price, shipping, customs, and other fees.
Calculating the landed cost helps businesses determine the true cost of a product and set prices accordingly.
For instance, importing electronics might include the purchase price and taxes, insurance, and freight costs.
Carrying cost refers to the total cost of holding inventory over a period, including storage, insurance, taxes, and obsolescence.
High carrying costs can take away a large share of your profit margins.
Take the case of a company with $100,000 worth of inventory—a carrying cost rate of 20% would incur $20,000 in carrying costs annually. Reducing carrying costs involves optimizing order quantities, improving turnover rates, and managing slow-moving stock.
JIT is an inventory strategy where stock is replenished exactly when needed, minimizing holding costs.
For instance, a car manufacturer may use JIT to receive parts only as they are required in the assembly line, reducing storage space and costs. However, JIT requires a reliable supply chain and careful planning to avoid disruptions.
As this Twitter user pointed out, many business owners struggle with managing a high volume of outdated stock. To address this, SKUs should be regularly reviewed and categorized to eliminate obsolete items and focus on maintaining inventory levels that align with current supply chain realities.
DIO is a metric that calculates the total number of days a company holds inventory before selling it. A lower DIO indicates efficient inventory management.
For example, if a company’s cost of goods sold is $1,000,000 and the average inventory is $200,000, the DIO would be 73 days (DIO = (Average Inventory / COGS) x 365).
EOQ determines the optimal order size that minimizes the total inventory costs, including ordering and holding costs.
The EOQ formula is EOQ = √(2DS/H), where ‘D’ is the annual demand, ‘S’ is the ordering cost per order, and ‘H’ is the holding cost per unit per year.
For instance, a company with an annual demand of 10,000 units, an ordering cost of $50 per order, and a holding cost of $5 per unit would have an EOQ of 447 units.
ABC analysis is a technique used by businesses for inventory categorization. It splits up the items into three categories based on their importance:
In a supermarket, luxury goods like high-end cheeses would be ‘A’ items, mid-range products like household cleaners ‘B,’ and everyday essentials like bread ‘C.’
ABC analysis helps prioritize inventory management efforts, ensuring that ‘A’ items receive the most attention to prevent stockouts.
Shrinkage refers to inventory loss due to theft, damage, administrative errors, or supplier fraud.
It affects a company’s bottom line and requires regular audits to identify and mitigate the causes.
For example, a retail store might implement better security measures and staff training to reduce shrinkage rates.
A WMS is software that optimizes warehouse operations, from receiving and storing goods to picking and shipping orders.
A WMS improves inventory accuracy and reduces labor costs. For DTC companies, it helps streamline order fulfillment, ensuring faster and more accurate deliveries. The system provides real-time data, enabling better decision-making and inventory control.
Gross margin represents the difference between sales revenue and the cost of goods sold, expressed as a percentage of sales.
It indicates how well a company manages its production and purchasing costs relative to sales.
For example, if a company sells a product for $100 and its COGS is $60, the gross margin is 40%. A higher gross margin suggests efficient cost management and better profitability.
The lot-for-lot method involves ordering or producing the exact quantity needed for production or sales.
This approach reduces carrying costs and aligns closely with customer demand.
Consider a bakery that orders just enough flour and ingredients to meet the daily orders. This method prevents the wastage of perishable items, and it is particularly useful in environments with fluctuating demand.
This replenishment policy revolves around reorder point (R) and reorder quantity (Q).
A QR policy orders a fixed quantity (Q) whenever inventory reaches the reorder point (R), ensuring consistency in inventory levels and order sizes.
If a retailer has a reorder point of 50 units and a reorder quantity of 100 units, they will order 100 units each time stock drops to 50. This policy helps balance inventory levels and minimize stockouts.
Unlike the QR policy, where the order quantity is fixed, an RQ policy allows the quantity ordered to vary depending on demand or inventory fluctuations. This allows for more flexibility in replenishment based on real-time needs.
Inventory turnover measures how often a company sells and replaces its inventory over a certain period.
It is calculated using the formula COGS / Average Inventory.
A high turnover rate indicates efficient inventory management and strong sales, while a low rate may signal overstocking or weak demand.
For example, a retailer with a turnover rate of 8 might sell and restock its inventory 8 times a year, which indicates efficient inventory use.
Finally, ending inventory is the term used for the value of the goods available for sale at the end of an accounting period.
It is calculated using the formula: Beginning Inventory + Purchases - COGS.
Properly calculating ending inventory is crucial for accurate financial reporting and tax purposes. If a company starts with $10,000 in inventory, purchases $5,000 more, and has a COGS of $7,000, the ending inventory would be $8,000.
Going through the exhaustive list of inventory management seems overwhelming. It doesn’t have to be.
We built GoodDay to ensure you never struggle with managing your stock. Whether tracking your inventory, managing vendors, or taking control of your inventory valuation—do all that and more with GoodDay’s unified, reliable retail operating system.
Schedule a demo to explore GoodDay’s powerful suite of inventory management capabilities.
Understanding the inventory terms listed above will help you better understand how to stay in control of your stock.
Establishing definite processes in ordering and tracking inventory and using an advanced inventory management tool like GoodDay will help you reduce excess and obsolete inventory and optimize logistics and fulfillment costs.
The 80/20 rule is based on the Pareto Principle. According to this rule, 80% of results are due to 20% of efforts. Applying this to inventory management implies that businesses earn 80% of their profits from 20% of their stock.
You must group items based on their type or category to organize inventory. This will help you streamline storage and retrieval.
Moreover, techniques like ABC analysis can help you prioritize high-value or fast-moving items for better management. Leveraging an inventory management system that offers solutions like real-time tracking and automated reordering is a big plus point.
Streamline your scattered spreadsheets and disconnected software into one powerful retail OS.
Streamline your scattered spreadsheets and disconnected software into one powerful retail OS. GoodDayOS™ seamlessly integrates within your Shopify admin, right where your team operates.
