Your warehouse and store shelves are stocked with products. But are they products your customers actually want? Is it filled with last year’s models while your bestsellers run dry? How soon do you need to reorder before you lose sales? These are not questions you want to answer with a guess.

Successful businesses routinely analyze inventory to determine purchase orders, lease warehouse space, and boost profit margins. Here are some common inventory analysis methods retail businesses use to optimize stock levels and maximize profitability.

What is inventory analysis?

Inventory analysis examines and evaluates your inventory to ensure there is enough—but not too much—stock on hand to meet customer demand. The goal is minimizing carrying costs without overordering, while also avoiding stockouts that cost you sales. It’s one of the core inventory management processes that businesses use to improve their inventory performance.

Analyzing inventory data means studying key metrics like average inventory levels, inventory turnover rate, supplier turnaround times, and safety stock levels among others. This data helps inventory managers make informed decisions about purchasing, production, and sales.

Types of inventory

An analysis of inventory will collect data on several categories of inventory items. They include:

• Raw materials. These are the basic goods or components that a company uses to manufacture a final product. For example, fabric and thread are a garment maker’s raw materials.

• Work-in-process (WIP). WIP, also known as work-in-progress, refers to goods that are in the process of being manufactured but are not yet completed. An example would be a half-sewn blouse on an assembly line.

• Finished goods. These are final products that are ready for sale to customers. For a clothing retailer, completed shirts, pants, and dresses on the rack are finished goods.

• Cycle stock. This refers to the regular amount of inventory a company expects to sell during a specific period, replenished in cycles.

• Safety stock. Safety stock is extra inventory kept as a buffer against unexpected spikes in demand or delays in new supply. Anything extra that isn’t cycle stock or safety stock is considered excess inventory.

Maintenance, repair, and operating (MRO) supplies. MRO inventory refers to items used to support production and business operations, but are not part of the final product. Examples include office supplies, lightbulbs, and spare machine parts.

Goals of inventory analysis

Here are some common goals of inventory analysis:

1. Improve cash flow and profitability. By holding only the necessary amount of inventory, a business frees up capital that would otherwise be tied up in stock. This improves cash flow and increases profitability by reducing storage costs.

2. Optimize inventory levels. The main goal is to find the sweet spot between having too much and too little inventory. This inventory control approach prevents both excess stock and insufficient inventory—a particular concern with popular items.

3. Safety stock. Safety stock is extra inventory kept as a buffer against unexpected spikes in demand or delays in new supply. Anything extra that isn’t cycle stock or safety stock is considered excess inventory.

4. Minimize costs. Inventory analysis helps you generate cost savings by reducing holding costs (e.g., storage, insurance, obsolete inventory, spoilage), ordering costs (e.g., transportation, handling), and stockout costs (e.g., lost sales, customer frustration). Upon identifying inefficiencies in your inventory costs, you can make improvements that free up cash for other purposes. 

5. Anticipate demand. “The more you know about your demand, the less uncertain you are about demand,” McGill University management professor Javad Nasiry explains in a blog post. “That means you can manage your inventory better and reduce inventory levels in your warehouses, because keeping inventory is costly.”

6. Purchase planning. Understanding your inventory levels and needs helps you optimize purchases from suppliers. “Depending on the purchasing volume, vendors may offer allowances for scenarios such as prompt payment, which further drive down inventory costs,” Nilesh Mehta, founder of Bridge Investment System Consulting, notes in a blog post.

7. Enhance customer satisfaction. A well-managed inventory system ensures that popular products are always in stock, which leads to fewer back orders, faster fulfillment, and improved customer service.

8. Support informed decision-making. Inventory analysis touches many corners of your business, from supply chain management to marketing. It provides the data needed to make better decisions about purchasing, production schedules, sales promotions, and pricing strategies.

Inventory analysis strategies

1. ABC analysis
2. VED analysis(GMROI)
3. HML analysis (DIO)
4. SDE analysis
5. Material requirements planning (MRP)
6. Economic order quantity (EOQ)
7. Fast, slow, and non-moving
8. Custom par levels

Different businesses need different approaches to inventory analysis. Your choice depends on goals like reducing holding costs, maintaining proper safety stock levels, and improving cash flow. Here are eight well-established methods of inventory analysis—some of which are used in concert with one another:

1. ABC analysis

ABC inventory analysis is widely used in retail, wholesale, and manufacturing because it helps companies focus on their high volume items, while scaling back on goods with low sales volume. When companies conduct ABC inventory analyses, they divide inventory into three categories based on their value to the company. “A” items are high-value and are monitored more closely, “B” items are of medium value and require moderate control, and “C” items are low-value and are managed with a less strict approach.

The ABC analysis method is based on the Pareto Principle (also called the 80/20 rule), which suggests that roughly 20% of your items account for 80% of your total value. In this case, the 20% applies to “A” items. Because they’re theoretically generating 80% of your business’s value, these items require frequent monitoring, accurate inventory forecasting, and higher security in your stores and warehouses.

2. VED analysis

VED stands for vital, essential, and desirable (VED). A VED analysis classifies inventory based on how critical it is to business operations. As with the ABC method, the VED approach divides your inventory into three categories. Vital items must always be in stock, essential items must be managed carefully and stocked in anticipation of need to avoid work stoppages, and desirable items should be ordered based on demand.

Health care, aerospace, and critical infrastructure sectors use VED to prevent supply disruptions, while also making it possible to order certain items as needed—especially when suppliers can offer a speedy lead time.

3. HML analysis

An HML analysis measures inventory based on its per-unit cost: high, medium, and low (HML). This approach helps you control high-cost inventory items because their loss or spoilage would have a significant financial impact. Low-cost items are treated with less concern, and medium-cost items fall in the middle of the spectrum.

HML is popular in industries with capital-intensive equipment or high-value components, such as aerospace and heavy manufacturing. In these industries, there is a vast gap between costly goods like manufacturing equipment and inexpensive items like printer paper.

4. SDE analysis

This approach classifies inventory based on its procurement difficulty: scarce, difficult, and easy. Scarce items (e.g., rare components in an electronic device) are carefully monitored with high safety stock levels, while easy-to-obtain items can be ordered as needed. Difficult items (such as pricey but available GPU chips in computer servers) fall somewhere in the middle of the spectrum.

SDE analyses are popular in industries that rely on imported goods, specialized parts, or materials with a limited number of suppliers.

5. Material requirements planning (MRP)

Material requirements planning (MRP) is a production planning and inventory control system used to manage manufacturing processes. It’s valuable for companies engaged in all types of manufacturing and production. These businesses leverage MRP to ensure that materials are always available for production and products are always ready for delivery to customers.

An MRP system considers production schedules, bills of materials, and inventory levels to forecast demand and place orders.

6. Economic order quantity (EOQ)

Businesses use economic order quantity (EOQ) to determine an optimal order size that minimizes the total cost of ordering and reduces carrying costs tied to holding inventory. It’s a widely used supply chain management practice in the retail, wholesale, and manufacturing industries.

“The cost of inventory using the EOQ model involves a tradeoff between holding costs and order costs,” says Alvaro Jirón, owner of mattress maker La Repa De Sueños. “It helps a small business find the optimal order quantity to minimize the sum of both costs.”

7. Fast, slow, and non-moving

This straightforward method for optimizing inventory levels works by classifying inventory based on its sales velocity or turnover rate. The categories—fast, slow, and non-moving—help a business identify which items are bestsellers and which are dead stock. Fast-moving items should be reordered frequently, while slow-moving and non-moving items should be marked for clearance sales or liquidation. It’s commonly used in ecommerce as well as brick-and-mortar retail.

8. Custom par levels

Par level analysis sets a minimum reorder point—or “par level”—for each item. When an item’s stock drops to that predetermined level, it triggers an order to bring it back up to “par.” It’s often used in restaurants, bars, and small businesses that need to maintain consistent stock of a limited number of items.

Metrics and KPIs for inventory analysis

• Inventory turnover rate
• Gross margin return on investment (GMROI)
• Days inventory outstanding (DIO)
• Inventory write-offs
• Stockout rate
• Back order rate
• Available to sell (ATS)

Gather data tied to these metrics and key performance indicators (KPIs) to measure your inventory performance:

Inventory turnover rate

Inventory turnover rates, also called >inventory turnover ratios, show how fast inventory moves through your warehouses and stores before customers make purchases. Inventory turnover ratio measures the number of times inventory is sold and replaced during a given accounting period. It’s calculated by dividing the >cost of goods sold (COGS) by average inventory (determined by adding inventory value at the beginning and end of a period and dividing by two).

Gross margin return on investment (GMROI)

The GMROI metric evaluates the profitability of every dollar you invest in inventory. Calculate this financial data point by dividing your href=”/blog/gross-margin” target=”_blank”>gross margin (the percentage of revenue left after subtracting COGS) by your average inventory cost.

Days inventory outstanding (DIO)

The days inventory outstanding (DIO) metric measures how many days your company holds its inventory before selling it. A low DIO—meaning inventory is sold quickly—typically indicates effective supply chain management, strategic marketing, and competitive pricing.

Inventory write-offs

An inventory write-off occurs when you determine you can no longer sell some of your inventory at intended prices because of obsolescence, damage, theft, or spoilage. You do this by reducing the value of your current assets on the balance sheet. Because the loss flows through to your income statement, it reduces your business’s net income.

Stockout rate

A stockout happens when you run out of a product that a customer wishes to purchase from your business. A stockout can mean lost sales and lower customer satisfaction. You can optimize your inventory management processes by tracking how often your company experiences stockouts.

Back order rate

Your back order rate shows how often you lack products that you need to re-order. Back orders are different from out-of-stock items because the term “out of stock” can imply that an item has been discontinued.

Available to sell (ATS)

ATS refers to the number of units of a product that you have available for sale. This helps you estimate how many sales orders you can accommodate at any given point—and the sales revenue that comes along with it.