Optimal Stocking Level Formula – Definition
The optimal stocking level formula determines the minimum amount of inventory required to meet the regular demand and attain maximum profitability without being out of stock. It is one of the most economical KPIs for businesses, leading to minimal cost. The inventory cost is kept minimum.
Significance of Optimal Stocking Level Formula
Using the optimal stocking level formula, an e-commerce business benefits through the following ways:
- It provides enough working capital to invest in other elements of the business
- There is more space available in the warehouse
- Business owners have more control over their inventory because of lower SKUs
Applications of Optimal Stocking Level Formula
With the optimal stocking level formula, an e-commerce business can:
- Adjust stock levels available in the warehouse
- Reduce the risk of stock-outs. By maintaining optimal stock levels, companies can increase profitability through effective inventory management.
Optimal Stocking Level Formula
Optimal Stock Level =
Optimal Order Quantity + Minimum Stock Level + Safety Stock Level
Where,
Optimal Order Quantity – Effective amount of stock a business should have at a given time.
Minimum Stock Level – Minimum amount of stock that must be kept in the warehouse.
Safety Stock Level – Extra stock in the warehouse to reduce stockout risks.
Understanding with the help of an example
Suppose a pen manufacturing company produces raw materials required to make pens. The firm ABC places orders of 80,000 leads each year. Out of 365 days, the company operates for 250 days.
- To calculate the optimal order quantity:
The company receives 80,000 lead orders in a year. The warehouse storing cost is A0.05, and the cost of each order is A$100. Therefore, the optimal order quantity is approximately 17,888 leads. - To calculate the minimum stock level:
The company receives 80,000 liters of paint for 250 working days. If the lead time of the order is a week (7 days), then the MSL would be 2,240 leads. - Lastly, the safety stock level. Considering the exception with the lead time (say 21 days), the safety stock would be 4,480 liters.
Hence, optimal stock level = 17,888 + 2,240 + 4,480 = 24,608 leads.
Inference
The optimal stocking level formula helps companies determine customer demand, maintain adequate inventory levels, and exercise low holding costs.