The complete guide to inventory forecasting
A long story short: Inventory forecasting can help you reduce inventory and increase product availability. The process requires smart software algorithms to succeed. If done right, inventory forecasting also improves your customer satisfaction and saves time on replenishment administration.
Inventory management is both a necessary evil and a huge opportunity at the same time for any retail owner, whether e-commerce or brick and mortar business. Retailers struggle to keep their inventory available. They face a never-ending cycle of deciding what they can afford to order, how much, and when. It is truly a world of compromise, and this might seem to be a retailer’s destiny. But it doesn’t have to be that way. You, and thousands of business owners around the world, are beginning to see the light at the end of the dark inventory management tunnel: inventory forecasting. Inventory forecasting is what all major retailers do, and at the end of the day, it’s what sets the big guys apart from smaller SME businesses.
This guide will take you through the process of inventory forecasting and explain everything step by step. Inventory forecasting is complicated and complex. But following our steps gives any business the possibility to jump in fast and see real results quickly, if they remain dedicated to the goal and consistent in their inventory forecasting strategy.
What you will learn:
- Why inventory forecasting is important for retail owners
- How sales forecasting is directly associated with inventory forecasting
- What product segmentation is and why it’s important for inventory forecasting
- Why inventory forecasting is specific to every point of sales or warehouse
- How inventory forecasting is associated with customer satisfaction
- How to use inventory forecasting for automated replenishment
- Extra point: How to plan price promotions with inventory forecasting
But first, let’s take a look at the basic financials of a retail business. Every business is different, but inventory turnover is a critical indicator for retail businesses generally. To keep things simple, inventory turnover is defined here as how fast you sell the goods in your inventory, measured in days.
The table below shows the numbers we have gathered over the years and represent a typical retail business in the given field. As you can see, the money you spend on inventory is substantial and represents the biggest opportunity for optimization.
|Type of Goods||Median inventory turnover (days)||Off peak inventory value as a % of annual revenue||Peak season inventory value as a % of annual revenue|
|Niche slow-moving goods||95||20||24|
As we all know, inventory is a never-ending story. You sell some goods, then the next day you take that money and order more goods from your suppliers. A big chunk of cash is constantly in the flow. Inventory forecasting is about reducing this chunk of cash to a minimum, without compromising on-shelf availability of your goods. And when you look at your business expenses and compare ways to optimize, everything else pales in comparison. Inventory replenishment gives you the opportunity to optimize up to 40% of your costs, far beyond any other optimization opportunity of a retail business. Consider this table:
|Retail business expense||Opportunity for optimization|
Why inventory forecasting is important for retail owners
How sales forecasting is directly associated with inventory forecasting
Inventory forecasting is directly dependent on sales forecasting. It makes sense, doesn’t it? You create sales forecasts. From those sales forecasts, you know how much inventory you need to keep on hand to satisfy demand. The more accurate your sales forecasting is, the smaller your inventory can be. So here is a step by step guide on how to do inventory forecasting, with further steps to complete the order process:
- Create a sales forecast so you know how much you’ll sell in the future (in days, weeks, months).
- Check your inventory to see how much you have in stock and how much more you need to order to satisfy future sales demand (if appropriate).
- Create a replenishment list based on points 1 and 2.
- Apply restraints to your list such as lead times (the time it takes goods to reach your inventory after you place an order to your supplier) and minimal order quantities (minimal amount of goods your supplier allows you to order). Adjust your list based on these restraints.
- Place your orders.
- Repeat every single day!
Simple, right? No, it’s not simple.
Just taking into account lead times and minimal order quantities can leave you going in circles. Sales forecasting in and of itself is as complicated as forecasting the weather, when done right. In addition, you need your forecasting to be unbiased to achieve high accuracy, so you have to remember all the details from your complex operation. This is madness, though, and you know it. When you outsource the job to a software solution like Inventoro, it considers billions of combinations before it produces the most accurate results possible, the optimum order to meet anticipated demand. This cannot be done on paper, or in your head, or with an Excel spreadsheet.
Consider the numbers:
|Inventory size managed by human insight and experience||no optimization|
|Inventory size managed by an Excel spreadsheet||8% optimization potential|
|Inventory size managed using an algorithmic forecast||30% optimization potential|
When you stop trying to do what automated technology should be doing for you, and let Inventoro do its thing, you win in so many ways. You have more accurate sales forecasts, so you hold less inventory and free up cash. You let the software do it, so you don’t have to, saving time and frustration. Remember when you did your own taxes? Remember that pain and frustration? Letting a professional take control, outsourcing that unpleasant business, was a critical moment in the development of your company. You relinquished control to a tax advisor, someone who could do the job much better than you could. It is now time to put your faith in 21st century technology, in a more sophisticated, more accurate, data driven solution.
Another point to keep in mind: Holding a bigger inventory doesn’t necessarily mean higher product availability. Keeping more of what you sell the most of is smart; you avoid stockouts. Keeping more of what you don’t sell much of just ties up your money in unsold inventory. Therefore, it is useful to remember that a bigger inventory, in the wrong places, is no guarantee you will avoid stockouts (the moment when a customer wants to buy a product but you cannot satisfy that demand because you’ve run out of the product they want.)
What product segmentation is and why it’s important for inventory forecasting
Now that you understand the basics of inventory forecasting, we’d like to introduce a key factor for creating your replenishment order list for every day, focus. Obviously, you don’t sell just one item. You sell hundreds of SKUs, even thousands. And inventory forecasting needs to be done on every single item, independently. Not only that, it needs to be warehouse-specific as well (more on that later in this text). To understand which of your items need “special care” and which can be left alone, you need to do product segmentation. This is the process where you put all your items in one long list, starting with your best sellers at the top, all the way down to the products that almost never sell at all. Then you make two lines on the list. You have just segmented your products into:
Winners – Items that represent 80% of your sales
(usually not more than 20% of your inventory, these are your best-selling items)
Chasers – Items that show sales but not in high frequency or volume
(the majority of your items, they make your shop big and popular)
Losers – stuff that doesn’t sell at all or very little
(this is your dead stock or toxic inventory)
This simple division shows you what you need to concentrate on in inventory forecasting. The Winners are your cash cows. You want to have these available at all times, which means you set a high service level for this group. Service level reflects the availability of your goods. For Winners it should approach 99.9%.
Chasers are somewhat important, but the cost of near 100% availability of these goods would no longer benefit your bottom line. You can set the service level for these to 95%, knowing that maybe you will not always satisfy demand, but that’s okay. It won’t happen often, you can hope.
And then there are the Losers. Don’t even consider these in your inventory forecasting efforts. You need to get rid of this stuff. Delist these products from your offer, stop selling them altogether. You’re just losing money on them. The longer they sit in your stock, the longer your money is tied up in them, the longer you can’t use that money for more profitable purposes.
Keeping this type of focus is vital for you to get inventory forecasting right. It clearly defines what items are key to your business and what items you should stop selling.
When we spoke about replenishment and inventory forecasting, we emphasized the point that based on our forecasts, you can optimise your purchase orders. That’s the goal of the whole process. Product segmentation adds the concept of service level to the equation. You can simply decide that you’ll run out of some of your items from time to time. It’s cheaper and worth the risk. But you have to know which items can face this risk and which ones need to stay available under all circumstances.
Why inventory forecasting is specific to every point of sale or warehouse
Inventory forecasting is done on every single item independently, on all your SKUs. SKU stands for the stock-keeping unit, and that means that every item in any warehouse is a single SKU. Move that item to a different location (another warehouse), and that SKU will be different. Let’s say you sell t-shirts, and you have one model in five sizes. You do your business both online and offline, so you have both an e-shop and a high street boutique. That means you keep your items in two locations. So you should consider that a single t-shirt in five sizes and two locations actually represents 10 SKUs.
Each location (point of sales) has a different sales forecast, so you need to do inventory forecasting for each point of sale independently. Consider this example:
Your sales forecast tells you that your business will sell 100 t-shirts next month. But you sell your goods online as well as in your brick and mortar shop downtown. So you might think: “OK, I’m going to keep half of those shirts in my e-shop warehouse and leave the other half in the shop downtown.”
But sales don’t happen as intuitively as you think they should. You run the sales forecast for each of your locations independently, only to find that 83 t-shirts are forecast to be sold online and only 17 in your downtown store! So, if you stick to your original plan, you’ll end up with 33 T-shirts in overstock in the brick and mortar shop and face 33 stockouts online. That’s why locations are so vital for inventory forecasting. You have to forecast your sales to the smallest possible inventory detail to get your inventory forecasting right.
When you get this detailed in your forecasts, you realize that you need to do this calculation for every SKU. If you have thousands of them, you have no chance of getting it right off the top of your head. You might challenge the software on one single item, because you know all too well how t-shirts sell. You’re the t-shirt expert, right? But try to do it with all your items, and we’ll be here ‘till next Wednesday. SKU by SKU. Location by location. It’s simply beyond the capabilities of one human mind. How can one person know, much less remember, all the details? Don’t be hard on yourself. You’re just one human being. Trust data. Trust a data-driven software solution like Inventoro. Then you’re ready to do inventory forecasting the way it should be done, the way the biggest retail organizations on the planet have been doing it for years.
How inventory forecasting is associated with customer satisfaction
In this guide we pay a lot of attention to numbers and cash, because your bottom line is the most important thing in your business. But do you know what is equally or even more important? Your customers. The simple logic is that the more satisfied your customers are, the higher chance they will return to spend more time and money in your shop or store.
You can boost your PPC campaigns to the max. You can go to extremes and deeply discount goods to attract buyers to your business, making every Friday Black. Both tactics are likely to have a positive sales effect, especially combined. But they’re both expensive. The more you use them, the less money you will actually make.
What you really want is your customers coming back for free, and you can see this most easily with e-shops. Those that generate the most direct traffic are the ones that dominate the market. You need to become the first choice for your customers. Then you can charge more and put less into your marketing. That’s the moment your business can really take off.
Here is a list of factors which affect customer satisfaction in a typical e-shop. Pay careful attention to which ones are associated with inventory forecasting:
|Number of items on sale||associated|
|Availability of products||associated|
|Customer support||not associated|
|Accessibility and UX||not associated|
That’s two factors associated out of the five listed. How are these two factors associated? First, let’s look at “Number of items on sale”. Customers don’t like to visit five sites, whether online or brick and mortar, to make a purchase. It takes too much time (e-commerce), or it increases transportation costs (in-person shopping). Customers like to buy their goods all in one place. Our data shows that the number of items on sale in an average e-shop has risen by 40% in the last two years, with the Covid pandemic accelerating this growth even as you read these lines.
So an e-shop selling 10 items will never be as popular as an e-shop with 10,000 items. Scale is important for success. But the more you offer, the more complicated it gets to keep everything in stock. That’s where inventory forecasting plays a vital role. With a large amount of items, it becomes impossible to manage inventory by intuition.
Product availability is critical. Customers want to have their goods immediately when they buy them. We now see e-shops offering same day delivery, which is what sets them apart from their two week delivery competition. When people want stuff, they want it now. That’s why you always need to have the items you sell the most in stock. Inventory forecasting is the best way to make that happen.
Inventory forecasting doesn’t only lead to savings. In the long run it has a spiral effect on customer satisfaction, which leads to more frequent sales and cheaper customer retention. Inventory forecasting creates a powerful feedback mechanism that builds customer loyalty to your business over time, because demand for goods sold the most is always satisfied.
How to use inventory forecasting for automated replenishment
The process is as follows. You start with sales forecasting, then do product segmentation, taking into account minimum order quantities and lead times. This leads you to your perfect replenishment list, which tells you exactly how much you should order from which supplier and when.
You could stop there. You could use that list and place those orders manually. But why would you? Let the automated technology work instead of you. All you need to do is to approve the list and let the machines place the orders for you.
Obviously, each supplier has a different order format. Some need an email, some need you to enter their B2B portal and place your orders there. The formats are different, we’ve seen them all. What’s vital is that they repeat. You don’t change suppliers every month, hopefully. So you can customize your automation to fit your suppliers’ needs. The way to do that is to have the software create a purchase order list, usually in a table of some sort.
Zapier takes your table, reads the lines, and turns them into specific order formats based on your suppliers’ criteria. It creates an email for one, a digitally signed purchase order for another. Whatever you want. When that is done, the system automatically sends each individual order to your supplier. The best news: What we just wrote in a couple of paragraphs happens in less than a second.
Zapier and Integromat usually offer a free plan for smaller jobs, and most of our clients easily fit into this. So it’s only a matter of setting up the system once and you’re good to go.
At the end of the day (and that end is likely to be earlier using automated technology), automated replenishment together with inventory forecasting can save you a substantial amount of time compared to manual replenishment, offering another crucial side benefit.
By now, with the basics of inventory forecasting, you should have the key facts to decide if automated inventory forecasting is right for you. If you wish to start, our software will get you set up immediately. All you need to do is connect your inventory data via an API or .csv. Be sure to watch this video first if you want a better understanding of the key functions of our inventory forecasting system. But before you go, an extra point (to go with the touchdown you’re about to score when you start automated inventory forecasting).
Extra point: How to plan price promotions with inventory forecasting
Inventory forecasting is a very useful tool when it comes to promotion planning. From what we know through years of experience working with our clients, everybody is eager to offer discounts, but rarely do businesses actually apply any mathematics to the process before they do so.
When planning promotions, businesses need to concentrate on these questions:
- How much of a discount should I offer to maximize profits?
- How long should the discount run?
- Do I have enough inventory to satisfy the higher demand caused by this discount?
- What will the cannibalization effect be on other non-discounted goods?
- How will my sales decrease when I end the price promotion?
All of these questions are directly associated with inventory forecasting. Especially the last two questions are the ones which actually influence the profitability of your price promotion on your business as a whole. When it comes to price promotions, not all that glitters is gold. In order to understand the whole effect of price promotions, inventory forecasting should be used.