There are a variety of inventory management terms, like safety stock and economic order quantity, that businesses need to comprehend to manage inventory successfully.
Understanding these concepts can benefit your business in several ways:
- Effective communication. Everyone in your warehouse can communicate with one another clearly without any confusion.
- Optimizing inventory levels. You can optimize inventory levels by implementing strategies like reorder points and safety stock.
- Cost controls. Grasping terms like economic order quantity can help you reduce holding and ordering costs.
- Better decision-making. You can make strategic and data-driven decisions like when and how much to order.
- Better risk management. Incorporating key concepts like safety stock and lead time into inventory management practices helps you better manage the risks associated with supply chain disruptions and other unforeseen events.
To enhance your proficiency in inventory management, here are 27 must-know terms and definitions to familiarize yourself with.
Common inventory management terms and definitions
1. Inventory
Inventory is goods and materials a business holds for resale or production, including raw goods used in early production, work-in-progress items, and finished goods available for purchase.
2. Stock-keeping unit (SKU)
A SKU is a unique identifier consisting of numbers and letters that retailers and manufacturers use to identify and track a product. They’re usually printed scannable labels found on products and hold data like price and manufacturer information.
3. Finished goods inventory
Finished goods inventory is an inventory management term that typically applies to manufacturers. It refers to all completed products available for sale, whether completed through production or purchased in finished form to resell.
4. Stocktake or inventory count
An inventory count is the process of counting and recording how much inventory a business has on hand. Stocktakes are vital for accurate inventory records, financial reporting, stockout and overstock prevention, and compliance and auditing.
5. Inventory cycle counting
Cycle counting is an ongoing stocktaking process. Unlike a full-scale inventory count, businesses regularly count a small portion of inventory to ensure inventory accuracy and promptly address discrepancies without shutting down operations.
6. Deadstock
Deadstock is stock that hasn’t been sold and is unlikely to be sold because it is either expired, out of season, or obsolete. Businesses will try to manage stock before it becomes deadstock.
7. Backorder
A backorder is an order for a product that is currently out of stock, where the business commits to fulfilling it once the item becomes available again.
8. Warehouse management system (WMS)
A WMS is software used to manage and control the many aspects of warehouse operations, including inventory tracking, data gathering, order processing, and order picking and packing.
9. Stock replenishment
This is the process of restocking products to ensure businesses can meet demand. Companies will typically restock products when a certain inventory level is reached.
10. Reorder point (ROP)
The reorder point is the specific inventory level at which businesses should replenish stock to avoid stockouts. The ROP formula is (Lead Time + Safety Stock + Basic Stock) x Unit Sales Per Day.
11. Stockout
Stockouts occur when a product is no longer available for purchase. They can occur for various reasons, like poor demand forecasting, product delays, a sudden increase in demand, and supply chain disruptions.
They can have negative consequences like lost sales and unhappy customers, so businesses do everything in their power to minimize the impact of these events.
12. Safety stock
Safety stock is the extra inventory kept on hand to mitigate the risk of stockouts caused by supply and demand uncertainties.
While safety stock has the advantage of ensuring sales aren’t interrupted, there is the downside of having more capital tied up in stock, which increases carrying costs and reduces cash flow.
13. Lead time
Lead time has different meanings depending on the context. However, in inventory management, lead time is the time (days) it takes to receive stock in the warehouse after placing an order.
It is crucial for inventory planning and control as it helps companies optimize inventory levels and determine when to order stock to prevent stockouts and overstocking.
14. Consignment inventory
Consignment inventory is a business arrangement where a consignor, like a manufacturer, provides inventory to a consignee, like a retailer, without upfront payment. The consignor retains ownership until the inventory is sold, with the consignee acting as an agent.
15. Cost of goods sold (COGS)
COGS is the direct costs of buying or producing goods a business sells. The formula to calculate COGS is Starting Inventory + Purchases Over a Specific Period − Ending Inventory.
16. Average inventory
This is the average value of a business’s inventory over a specific period, calculated using this formula: (Starting Inventory + Closing Inventory) / 2.
17. Inventory turnover
Inventory turnover measures how often a business’s inventory is sold and used over a specific period, often a year. It’s a good metric for determining how efficiently a company manages inventory. The formula to calculate inventory turnover is Cost of Goods Sold (COGS) / Average Inventory.
18. Inventory costing
Inventory costing is the costing method used to assign costs to stock, including:
- First in, first out (FIFO): The first units added to inventory are sold first. In this costing method, the cost of goods sold (COGS) is calculated by allocating the cost of the oldest products to those sold first.
- Last in, first out (LIFO): Products purchased recently are sold first. With LIFO, the cost of the most recent products is assigned to those sold first.
- Average weighted cost: Average cost per unit calculated by taking the total cost of all items and dividing it by the number of items.
- Actual cost: The true cost to acquire or produce an item, calculated by recording all the costs to manufacture it, like direct costs (e.g., materials and labor) and indirect costs (e.g., overhead and utilities).
19. Landed cost
Landed cost is the total cost of shipping a product, including the original product cost, inland and ocean transportation costs, customs, taxes, duties, insurance, crating, and handling.
20. Carrying cost
Also known as holding cost, carrying cost is the total cost of holding and storing inventory, including transportation, wages, warehousing, security, depreciation, rent, utilities, and taxes.
Holding cost is calculated using this formula: Total Carrying Costs / Total Annual Inventory Value* 100.
21. Just-In-Time (JIT)
JIT is an Inventory management strategy where a company receives inventory from suppliers at the closest possible time to when it’s needed. The main aim is to minimize carrying costs to free up cash flow.
22. Economic order quantity (EOQ)
EOQ is the ideal or optimal order quantity a company should purchase to minimize total inventory. The main goal is to balance holding and order costs. The formula for economic order quantity is 2DSH, where:
- D = unit demand for product.
- S = ordering cost per order.
- H = annual unit holding cost
23. ABC analysis
Also known as ABC classification, ABC analysis is a method for classifying inventory based on their value and importance. This approach assumes that some inventory is more valuable and that companies should devote more resources to valuable stock.
Inventory is typically divided into three categories:
- Category A: High value and importance
- Category B: Moderate value and importance
- Category C: Low value and importance
24. Demand forecasting
Demand forecasting is the process of predicting future demand for items based on market trends, historical data, and other information. The main aim is to help businesses make better decisions around production, inventory, and supply chain management.
25. Days inventory outstanding (DIO)
Also referred to as days sales of inventory (DSI), DIO represents the average number of days a business retains its inventory before selling it. It’s a financial metric used to determine how well a company manages its inventory turnover.
The formula for calculating DIO is Average Inventory / Cost of Goods Sold (COGS) x 365 days.
A lower DIO is preferred as it indicates a faster inventory turnover and implies that a company is selling its inventory quickly. A higher DIO suggests a slower inventory turnover and that the company may be overstocking and have too much capital tied up in stock.
26. Shrinkage
Shrinkage is the loss of inventory that cannot be accounted for. Shrinkage can occur due to various factors, including theft, obsolescence, damage, recording errors, and spoilage.
Because shrinkage impacts a business’s profitability, businesses monitor it closely to identify the root cause and implement measures to control it. These measures include training, technology like a warehouse management system, and security measures like cameras.
27. Gross margin
The gross margin is a financial measure of how much profit a company retains after subtracting the direct costs of producing the goods it sells. It is calculated using this formula: (Revenue – Cost of Goods Sold) / Revenue x 100.
A higher gross margin number is favorable as it indicates that a business is more profitable or retains a larger percentage of the revenue.
The bottom line on inventory management terms
Understanding key inventory management terms is crucial to improving your inventory management. Not only can it help you and your team communicate more clearly, but it also helps you optimize inventory levels, better control costs, improve decisions, and reduce the risks associated with unforeseen events.
So be sure to enhance your proficiency by familiarizing yourself with these 27 common inventory management terms. Simply bookmark this post and refer back to it whenever you need a refresher.