The Inventory Optimization Guide: Techniques To Manage Stock Better

Key Takeaways

Stockouts Galore: More than 50% of online shoppers in 2022 were unable to complete their purchase due to products being out of stock.

Shopper Showstopper: A significant number of potential sales were lost because of stock unavailability, highlighting the critical need for better inventory management.

Bye-Bye, Buy Button!: The high rate of stockouts demonstrates a major frustration for online shoppers, pushing them towards competitors.

Empty Cart Drama: Companies must find solutions to keep their virtual shelves stocked to avoid losing customers ready to buy.

Stockout Blues: Efficient stock management is crucial for retaining customers and closing sales, as stockouts negatively impact revenue.

More than 50% of online shoppers were unable to complete a purchase in 2022 because products were out of stock.

Stockouts really do cause walkouts. 

But that doesn’t mean you dump a million units into your warehouse. There’s a cost to holding inventory too, and it’s expensive.

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Inventory optimization holds the key to these problems. It’s your golden ticket to potentially saving thousands of dollars in implicit and explicit costs.

In this guide, we explain various inventory optimization techniques to help you find the most cost-effective inventory levels to hold. Let’s dive in.

What is Inventory Optimization?

Inventory optimization is the process of determining the optimum level of inventory based on supply and demand to minimize inventory costs.

If you stock fewer units than you need, you run the risk of losing customers. 

As Benjamin Knight and Dmitry Mitrofanov explain in an HBR article:

Running out of stock is an expensive prospect for any retailer.

Barring a suitable replacement, the retailer misses out on revenue.

Even if there is a replacement, the customer might be frustrated, which could mean less customer loyalty and lower lifetime value.

There are costs to holding excess inventory, too. 

• You need capital to buy inventory, on which you pay the cost of capital. 
• Then there are the costs of storing the inventory—insurance, utilities, and more. 
• There’s also the risk of shrinkage, theft, errors, and damage when you store goods in the warehouse.

To hold optimal inventory, you need an inventory optimization technique that helps you hold minimum inventory without the risk of a stockout.

What Can Inventory Optimization Do For Your Brand?

Here’s how inventory optimization adds value to your brand:

• Improved customer satisfaction. The most critical benefit of optimizing inventory is that it helps you meet customer demands by never running out of stock. Repeatedly losing orders just because you don’t have enough inventory can snowball into significant losses and result in upset clients who might switch to a competitor in the long term.
• Lower carrying cost. The inventory sitting in your warehouse is costing you money. First, there’s an opportunity cost. If you have $100,000 worth of inventory sitting idle, you could’ve invested that money into money market securities and generated, say, a 3% (or $3,000) return. Then there are other costs, like damage to inventory and storage.
• Lower risk of stockouts. Holding optimum inventory helps prevent stockouts. Your safety stock is factored in when we calculate the optimum inventory level. When inventory reaches the safety level, you place another order and receive it before the safety stock runs out.
• Improved profitability and cash flow. Optimizing inventory levels lowers your cost of capital and improves profitability. For inventory-heavy industries, the dollar amount of increase in profitability can be astonishingly high. Also, since you won’t tie excess cash into inventory post-optimization, you’ll have more cash available as working capital.

What Challenges Will You Face on Your Inventory Optimization Journey?

The specific challenges you face when optimizing inventory depend on your industry and the inventory optimization techniques you choose. 

However, here’s a list of the types of challenges you can expect:

• Inaccurate demand forecasting. Forecasting demand is the toughest part of optimizing inventory. You can estimate demand based on trends, seasonality, and economic factors. Your forecast is very likely to be incorrect, but the idea is to get as close as possible.
• Supply chain disruptions. You can reserve a safety stock based on average lead time. But if there’s a war in the country you’re sourcing goods from, you won’t have much of an option. That’s why it’s important to build a resilient supply chain and diversify your suppliers.
• Scalability. As business size, locations, and SKUs grow, optimizing inventory levels can become daunting. Modern AI-powered tools can help address scalability concerns, but you might need to spend a little extra on deploying artificial intelligence (AI) systems and training your team.
• Determining the optimum inventory level. When should you reorder inventory? How much should you order? These questions require analysis, and the answer depends on your demand forecast, lead times, and carrying costs.
• Cost of upgrading legacy systems. You may have to upgrade to more powerful systems to effectively track inventory across multiple locations and automate inventory-related tasks. This upgrade is often expensive, and if you’re not prepared, your budget constraints might compel you to hit pause.

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12 Proven Inventory Optimization Techniques To Boost Efficiency

There are various inventory optimization techniques. Some of them apply only to a few industries, while others are more general. 

Let’s look at these techniques so you can pick one for your inventory optimization strategy.

1. Forecast your demand

Demand forecasting is the most plain-vanilla inventory optimization technique. All the other techniques we list in this guide start with forecasting demand.

To forecast demand, you look at historical sales data, current market trends, overall economic conditions, and any industry-specific parameters like commodity prices.

A demand forecast is an estimate, and you’ll almost always get it wrong. 

However, factoring in the effects of the parameters we mentioned helps you get closer to the actual number.

2. Prioritize with ABC analysis

Remember the Pareto principle from back in school? It said: Roughly 80% of outcomes come from 20% of causes.

If you have multiple inventory items, take a quick peek at your inventory. You’ll notice that roughly 20% of inventory items account for 80% of the sales revenue.

ABC analysis uses this principle and states that you can divide your inventory items into three categories:

• A items: These are high-value items that represent roughly 20% of units in your inventory and 80% of your sales. These items have a high impact on profitability, so it’s critical to control them, accurately forecast their demand, and frequently review inventory levels.
• B items: B items are moderately valued items that make up roughly 30% of your inventory units and 15% of sales. These items require a balanced approach—monitor them regularly and ensure there are no stockouts, but not as intensively as you’d monitor A items.
• C items: These items account for the largest portion of your inventory in terms of quantity (roughly 50%) but only about 5% of sales. These items have a lower impact on financial performance, so it makes sense to monitor them less rigorously.

The composition, both in terms of units and value, may differ significantly based on your inventory portfolio.

However, the principles of ABC analysis give us a valuable framework to understand which items to prioritize so we can optimize our efforts and use capital more efficiently.

3. Economic order quantity (EOQ)

Economic order quantity helps you determine an optimal order quantity based on three factors:

• Demand
• Ordering costs
• Carrying costs

You plug these numbers into the following formula, and you get the total quantity (in units) of inventory you should place an order for:

D is the total annual demand, K is the order cost per purchase order, and C is the annual carrying cost per unit.

The annual demand is estimated based on historical sales data and other factors like economic conditions and customer preferences. 

Order costs include costs related to a purchase order, like shipping and handling.

Carrying costs are one of the most expensive categories, ranging between 25% and 40% of a company’s average inventory investment. 

Inventory carrying costs include costs such as:

• Cost of capital: Cost of capital includes the interest on working capital tied into inventory, if it’s financed through debt. If you borrow $100,000 at 5% to finance inventory, the cost of capital would be $5,000.
• Storage costs: These include costs related to owning and operating your warehouse, such as utilities and interest on leases.
• Other costs: Your inventory could get damaged while stored in the warehouse, the item might go out of style, and goods may shrink or be stolen. There are various risks to stored inventory, and you need to quantify them. Use your experience and estimate the amount of goods you could end up losing to these risks.

4. Implement just-in-time (JIT) inventory management

Toyota implemented JIT as part of the broader Toyota Production System (TPS) to achieve key objectives like enhancing efficiency, minimizing waste, and improving overall quality.

JIT is a “pull” system where goods are received in a production process only when they’re needed.

Materials, parts, and goods are supplied from the previous process or an external vendor directly to the process whenever they're supposed to be used, eliminating all carrying costs you incur when holding inventory.

JIT has helped Toyota build a resilient production system, but there are various inherent risks to using JIT.

For example, supply chain disruptions and unplanned downtime can result in delivery delays and halt your production.

That’s exactly why Toyota doesn’t take a more strategic approach to implementing JIT. As was beautifully described in an HBR article:

Toyota takes a strategic approach to inventory planning. 

Operationally, this stands on three legs: strategically sized inventories in the right locations to act as a buffer to meet changing demands, safety stock that factors in the risk of disruption, and a nuanced view of lead times. 

It has been pointed out that the company learned a great deal from the Tōhoku earthquake and tsunami of 2011, after which it identified parts vulnerable to disruption and, as a result, were candidates to be stockpiled.

5. Automate with AI-powered inventory management software

Inventory management software can automate almost the entire inventory management process, provided you choose the right software. 

A basic inventory automation system can:

• Place orders when the inventory level hits the reorder point
• Select the best supplier based on price, lead time, and other factors
• Track inventory in real-time
• Generate shipping labels for orders
• Build automated inventory reports that provide insights into performance and a summary of metrics like turnover rates and aging inventory

Inventory management tools have existed for a while, but most are now evolving into AI-powered inventory management platforms.

To say AI is about to revolutionize every part of business, including inventory optimization, is an understatement.

Nearly 40% of retail directors stated in a 2023 survey that they use AI, computer vision, and machine vision for selected operations and departments.

35% of respondents said they have already scaled up this type of technology, and 15% said that they’ll implement these technologies within the next 12 months.

AI inventory optimization examples

Technologies like AI and machine learning augment the capabilities of basic inventory optimization software in various ways.

Here are some examples:

• Improved forecasting ability. AI algorithms bake in various factors, including sales data, market trends, and seasonality, as well as external factors like economic conditions and weather patterns to predict demand. It automatically adjusts the forecast based on real-time data to ensure your forecasts are always derived using up-to-date data.
• Dynamic reorder points. An AI system can automatically adjust the reorder point based on real-time data like demand, lead times, and current inventory levels. If you’re about to enter a few months of slowdown because of seasonality, the AI algorithm automatically lowers the reorder point and minimizes the cost of holding inventory.
• Identify your best suppliers. The AI algorithm can monitor supplier performance metrics like lead times and order accuracy to help you identify the best suppliers.
• Strategic decision-making. AI inventory optimization solutions don’t just generate analytics reports. They offer valuable insights into customer behavior, sales trends, and inventory performance to help you make data-driven decisions.

While AI inventory systems come with an upfront investment, the long-term payoff can be excellent if you implement and use the system well.

10 top inventory management solutions to choose

We did some leg work for you and found the top inventory management systems on the market based on inventory management features and capabilities. Check them out:

1. 1. SkuVault — Best for its detailed restocking recommendations
2. 2. Cin7 Core — Best for manufacturers and product sellers
3. 3. Linnworks — Best for multichannel management automation
4. 4. MRPeasy — Best for manufacturers
5. 5. Helcim — Best for small business inventory + POS in one
6. 6. Zoho Inventory — Best for small businesses
7. 7. Acumatica — Best for modern UI
8. 8. Sage X3 — Best enterprise resource tracking (ERP) package
9. 9. Cin7 Omni — Best for advanced multichannel order management
10. 10. ShipBob — Best end-to-end inventory & fulfillment

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6. Leverage 3PL services

Partnering with 3PL services gives you access to their technology and infrastructure, which includes functionalities that can help optimize inventory. 

Capabilities vary among 3PL service providers, but here’s a general overview of what you can expect:

• Advanced technology and analytics. Many 3PL providers offer advanced warehouse management systems (WMS) with features like inventory tracking and analytics. These tools enable you to track KPIs and visualize inventory data, helping you make smarter decisions.
• Efficient warehousing and distribution. 3PL services manage large warehouses at strategic locations. This reduces your carrying costs and allows you to deliver orders faster.
• Demand forecasting and planning. 3PL service providers often work closely with clients to accurately forecast demand and manage inventory levels. Given their expertise in working with a diverse range of clients and possibly other clients in your industry, their input can be a great asset.
• Multichannel support. 3PL providers can help you manage inventory across various sales channels, such as ecommerce, retail, and wholesale. Keeping your inventories in sync across sales channels helps prevent overstocking—you can just move items across channels if you have excess on any one channel.

Find our top 10 3PL picks from our big roundup:

1. 1. ShipBob — Best for fast global fulfillment
2. 2. J.B. Hunt Transport Services — Best for scaling shipping processes
3. 3. CEVA Logistics — Best end-to-end freight management
4. 4. Ryder Supply Chain Solutions — Best for reverse logistics
5. 5. XPO Logistics — Best coast-to-coast network
6. 6. Expeditors International — Best for shipping high-value products
7. 7. UPS Supply Chain Solutions — Best for managing supply chains
8. 8. DHL Supply Chain — Best for international deliveries
9. 9. FedEx Supply Chain — Best for large businesses
10. 10. DB Schenker — Best for real-time GPS tracking

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7. Monitor key performance indicators (KPIs)

Monitoring KPIs isn’t exactly an optimization technique, but it’s an excellent way to gauge the effectiveness of the technique you’re using.

This means KPI monitoring is a great complementary method to apply with any other optimization technique you use. 

The metrics you should be tracking

The KPIs you monitor depend on your goals. Here are some important inventory optimization KPIs:

• Inventory turnover ratio. Inventory turnover measures the number of times inventory is sold or replaced over a specific period—a month, quarter, or year. Low turnover indicates overstocking or slow-moving inventory and vice versa. There are no benchmarks because every business is unique, but 5 to 10 is a good range for retail businesses. 

Here’s the formula to calculate inventory turnover:

Where average inventory is calculated as:

• Day sales of inventory (DSI). DSI is the average number of days it takes to sell the entire inventory. A high DSI indicates that inventory has been sitting in your warehouse for too long, which could lead to higher capital and holding costs. 

The formula to calculate DSI is:

• Backorder rate. The backorder rate is the percentage of orders that couldn’t be fulfilled because there wasn’t sufficient inventory. High backorder rates are a result of poor demand forecasts or inventory management. 

Here’s how you can calculate the backorder rate:

• Gross margin return on investment (GMROI). The GMROI measures the profitability of inventory for a retail business. It tells you the amount of profit you generate per dollar invested in inventory purchases. 

Here’s the formula:

Where the average inventory cost is calculated as:

Final Thoughts

The specific method you use to optimize inventory depends on your industry and business goals.

If you own a retail shoe business, it’s best to go with simpler methods like EOQ. If you also sell those shoes online, you might consider using a 3PL service.

On the other hand, if you’re a manufacturer with a large product portfolio, ABC or JIT could be great options.

However, almost everyone can benefit by implementing an inventory management system. 

It centralizes inventory data needed to make smarter, data-driven decisions and makes implementing an inventory optimization technique easier.

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Inventory Optimization FAQs

Now that we have the basics covered, let’s quickly go over some common questions related to inventory optimization.

How does inventory optimization impact cost reduction and customer satisfaction?

Optimizing inventory directly impacts inventory-related costs.

When you hold an optimum level of inventory, you incur fewer storage costs and holding costs, like the cost of capital and utilities in your warehouse.

Also, the dollar value of risk to your inventory reduces when you hold fewer units—risk includes the risk of damage, theft, and shrinkage.

Customer satisfaction is a byproduct of inventory optimization.

When you’re able to minimize the backorder rate and deliver orders on time through optimization, you’ll notice an increase in retention rate and, over time, build a more loyal customer base.

What are the key components of an effective inventory optimization strategy?

These are the three key drivers of successful inventory optimization:

• Accurate demand forecasting. The forecasted demand forms the basis of any optimization technique. It’s impossible to forecast demand accurately down to the last unit, but using advanced techniques like predictive modeling, regression analysis, Monte Carlo simulations, and Bayesian forecasting can help you get closer to the actual number.
• A resilient supply chain. Extraordinary circumstances will cause disruption. You can’t stop natural disasters and wars, and that’s why you need a resilient supply chain. Diversify your suppliers across regions, build collaborative relationships with suppliers, maintain adequate safety stock, and develop a crisis response plan. Adverse events will still occur, but you’ll be better prepared to deal with them.
• Employee buy-in. There’s little to gain from pushing employees out of their comfort zone when going on an optimization drive. Instead, seek their input on how they think inventory should be optimized and which systems should be used.

How can a small business improve inventory accuracy?

The best way is to start with the basics. The first order of business should be to gain complete visibility of inventory data using an inventory management system.

Once you have all the information, start by establishing a safety stock so you always have enough inventory to meet service levels. And then figure out the strategy that will work best for your business.