Inventory Management Basics: How Much to Order, and When

Inventory is cash on a shelf

Holding stock costs money every month it sits: storage space, insurance, items damaged, stolen or lost, and products that go out of date or out of fashion before they sell. Then there's the cash itself. Money tied up in inventory can't pay down a loan or fund marketing, and that opportunity cost is real even though no one sends you a bill for it.

Operators usually estimate the total as a percentage of the inventory's value per year. Once every piece is counted, it's almost always higher than they first guessed.

The two costs you're balancing

Ordering has costs of its own: shipping, receiving, inspecting, paperwork, and time. Order in big batches and you pay those costs rarely, but you hold a lot of stock on average. Order small batches and your shelves stay lean, but you're placing orders constantly.

One cost falls as order size rises, and the other climbs. Somewhere in between, their total is lowest.

Economic order quantity

The classic formula for that sweet spot is the economic order quantity: the square root of (2 × annual demand × cost per order ÷ yearly holding cost per unit).

A shop sells 12,000 units of a product a year. Each order costs $50 to place and receive, and holding one unit for a year costs $2. The formula gives the square root of 600,000, or about 775 units, which works out to 15 or 16 orders a year.

At that quantity the yearly ordering cost and the yearly holding cost come out equal, about $775 each. Better still, the answer is forgiving. Ordering 600 or 950 at a time costs only 2 or 3% more in total, so rounding to a case size or a supplier's minimum costs very little.

The formula assumes steady demand, a fixed delivery time and a single price. When a supplier offers a discount for larger orders, the cheapest quantity can jump to the discount threshold, and it's worth checking the total cost at each price break.

When to reorder

The reorder point is the stock level that triggers the next order. It covers the demand you expect while waiting for the delivery, plus a buffer.

The shop sells about 33 units a day, and orders take 10 days to arrive, so it needs 330 units to get through the wait. Add the buffer covered in the next section, 42 units, and the reorder point is 372. When stock falls to 372, the order goes out.

The waiting period, or lead time, matters as much as the sales rate. A supplier who takes three weeks instead of ten days roughly doubles the stock you need on hand when you reorder.

Safety stock is the price of a promise

Sales don't arrive at a steady 33 a day. Some days bring 20, some bring 45. Safety stock is the extra kept on hand for the busier stretches, and its size depends on how often you're willing to run out.

If daily sales vary with a standard deviation of 8 units over a 10-day lead time, covering 95% of order cycles without running out takes about 42 units of safety stock. Raising that to 99% takes about 59. Getting to 99.9% takes about 78.

Each extra point of reliability costs more stock than the last. Pick the level per product: a key item that sends customers to a competitor when it's missing deserves a high one. An item that customers will happily wait a few days for doesn't. Running out has costs too, and the best level is where the two meet.

Turnover, and which items to watch

Inventory turnover is the cost of goods sold in a year divided by the average value of stock on hand. Turnover of 6 means the shelf empties and refills about every two months. Falling turnover means stock is piling up relative to sales, often before anyone notices in the sales figures.

In most businesses a small share of the products carries most of the value. Count those items often, forecast them carefully and review their order quantities regularly. The long tail of slow, cheap items can be managed with simple rules and checked less often.

Key takeaways

• Holding inventory costs storage, insurance, loss, obsolescence and the use of the cash, usually more than owners first estimate.
• Economic order quantity balances ordering costs against holding costs, and the total cost barely changes near the optimum.
• Reorder point = expected demand during lead time + safety stock.
• Each extra point of in-stock reliability needs more safety stock than the last, so set the level product by product.

Frequently asked questions

How much inventory should a small business keep?

Enough to cover expected demand until the next delivery arrives, plus safety stock sized to how reliably you need to have each item. The right amount differs by product, and turnover compared with your own history shows whether it's drifting too high.

What is a good inventory turnover ratio?

It depends on the business. A grocer turns perishable stock over far more often than a furniture store. Compare turnover with your own past and with similar businesses, and look into any product line where it's falling.

Does EOQ still matter with modern inventory software?

The software usually runs the same logic, with better demand estimates. Understanding the trade-off between ordering and holding costs helps you check its suggestions and decide when a bulk discount is really worth taking.