Inventory is working capital sitting on a shelf. Too little and you stock out, lose sales, and damage customer trust. Too much and your cash is frozen in product that may or may not sell. This guide covers the formulas, the reorder discipline, and the policies that keep both working capital and customer experience in balance.
The Core Metrics
| Metric | Formula | Healthy range |
|---|---|---|
| Inventory Turnover | COGS ÷ Average Inventory | 4-12 (industry dependent) |
| Days Inventory Outstanding (DIO) | 365 ÷ Turnover | 30-90 days |
| Gross Margin Return on Investment (GMROI) | Gross Margin $ ÷ Average Inventory Cost | >200% target |
| Stockout Rate | Out-of-stock SKUs ÷ Total SKUs | <2% on A items |
| Dead Stock % | Inventory with no movement in 90+ days ÷ Total | <5% |
Reorder Discipline
The reorder point (ROP) is the simple formula every inventory-carrying business should automate:
ROP = (Daily Demand × Lead Time in Days) + Safety StockSet ROP per SKU. When on-hand quantity drops to the ROP, place an order. Modern inventory tools automate this — and the discipline matters more than the tool. Even a spreadsheet with weekly reorder review will outperform "we noticed we were out."
ABC Analysis
Pareto's principle applies hard to inventory. Roughly 20% of SKUs drive 80% of revenue. Categorise:
- A items — top revenue producers. Tight forecasts, weekly counts, generous safety stock, multiple suppliers if possible.
- B items — mid-tier. Monthly review, normal reorder rules.
- C items — long tail. Quarterly review, lean stock, accept higher stockout risk in exchange for capital efficiency.
Costing Methods
- FIFO (First-In, First-Out): oldest cost flows to COGS first. Matches physical reality for most businesses.
- LIFO (Last-In, First-Out): newest cost to COGS. US tax method only; banned under IFRS.
- Weighted Average: blended cost per unit. Simpler bookkeeping; less precise during volatile pricing.
- Specific Identification: each unit tracked individually. Required for high-value items (vehicles, jewellery, art).
The Hidden Costs of Excess Inventory
- Capital cost — your money tied up at your borrowing rate (often 8-15% annualised).
- Storage cost — warehouse space, racking, climate control.
- Obsolescence — fashion, tech, perishable, seasonal stock loses value over time.
- Insurance — most policies premium-rate on inventory value.
- Shrinkage — theft, damage, miscounts. Industry average ~1.5% of inventory annually.
Holding cost for typical small businesses is 20-30% of inventory value per year. A $50,000 excess inventory position costs $10,000-$15,000 annually in pure carrying cost — money that could fund growth.
Try It Yourself
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