By accurately forecasting product demand, you will require less inventory on hand, receive more sales from fewer stock-out items, and benefit from a more efficient replenishment cycle.
Inventory forecasting helps planners predict future inventory levels and make decisions based on data.
However, forecasting formulas are only relevant for products that are selling for at least eight months per year. Items selling less than 8 out of 12 months can’t provide enough accurate data to be reliable. The error rates get too high, and the results become unpredictable.
The key is to have just enough stock to cover supply and demand fluctuations, but not so much that you are tying up cash needlessly and taking up valuable warehouse space.
Once your inventory demand forecasts are in place, it is time to start buying into it. The steps below will give you a walk-through of the replenishment cycle in a time-phased inventory system for items with a forecast.
Calculate your reorder point.
- The reorder point is the quantity at which you place a new order or the lowest acceptable amount of inventory.
Reorder point = lead time demand + safety stock
Calculate your lead time.
- Lead time is how long it takes from the time you place an order until the inventory arrives at your warehouse. Many suppliers provide an estimated lead time, but using your own historical data based on actual performance is a good idea.
Lead Time Demand = lead time x average daily sales
Calculate your review cycle.
- The review cycle is the number of days you are looking ahead to buy. If you buy weekly, the review cycle is seven days. This number is typically driven by the number of days it takes to get an order that qualifies for free freight from the supplier.
Review Cycle Usage = review cycle x average daily sales
Calculate your safety stock.
- Safety stock is the extra stock you have on hand to minimize stockouts or fluctuations in demand.
Safety stock days = usage per day X number of days needed to meet service level goal
Calculate a line point.
- A line point, or “quantity to buy back to,” works similarly to the Max in a Min/Max, with a little more sophistication.
Line Point = lead time demand + review cycle usage + safety stock
These formulas comprise a comprehensive approach to replenishing inventory, but a practical example is Bob’s Motors.
Bob runs an automotive shop and specializes in truck motors. He sells an average of 3 motors per day and buys from the supplier every two weeks. It takes him 30 days to receive a new order from the manufacturer.
Bob’s lead time demand is 30 x 3 = 90 and the review cycle usage is 14 x 3 = 42
Bob wants to have a customer service level of about 95%. Using statistical analysis, we convert the 95% service level to a multiple of 1.37. We will add .37 x the review cycle usage as the safety stock.
42 x .37 = 16.
Another more conservative approach would be to use monthly demand instead of review cycle usage. This method will cause you to carry more inventory, but it may make more sense in your case. The reorder point is 90 + 16 = 106
The line point or the quantity you need to get back up to is: 90 + 16 + 42 = 148
The quantity to buy is simply the difference between the net inventory and line point: 148 – 106 = 42. If net inventory has dropped to 91, the buy quantity would be 148 – 91 = 57
Therefore, when Bob has 106 or fewer motors available and/or on existing open purchase orders, he needs to reorder.
That calculation might look like the following:
119 on hand – 56 committed to sales orders + 20 on existing purchase orders = 83 net available….time to order.
Quantity to Order = Line Point (148) – Net Available (83) = 65
There is no crystal ball to forecast inventory demand. Even with all the data at your fingertips, things can still change. But, if you are prepared for likely scenarios and ready to pivot quickly due to unforeseen circumstances, you will be in an excellent position to maintain proper inventory levels and positive cash flow with an effective replenishment cycle.