Inventory Policy: Everything You Need to Know in 2023

2.5 Minutes

In this article, we will explore what inventory policy is and its significance. We will also share our 9 step process to optimize your inventory management policy. Read on to learn more. 

inventory policy

What is an Inventory Policy?

An inventory policy is a set of guidelines that a company follows to determine when, how much, and what type of inventory should be ordered or produced to meet customer demand while minimizing costs.

Example: For a company that sells smartphones, their inventory policy could specify that they should purchase 500 units of the Galaxy Z model whenever the inventory drops to 100 units and maintain a safety stock of 50 units to cater to unexpected surges in demand.

what is inventory policy

Importance of Inventory Policy

Inventory policy is important for a number of reasons, some of the most common reasons include: 

Cost Management:

An inventory policy helps in effectively reducing and managing associated inventory costs. By optimizing order quantities and reorder points, companies can minimize excess inventory and storage expenses while ensuring products are available to meet customer demand.

Customer Satisfaction:

A well-crafted inventory policy ensures that products are readily available to meet customer demands. This leads to faster order fulfillment, reduces the risk of stockouts, and ensures that customers receive their orders in a timely manner which builds loyalty and a positive brand reputation.

Cash Flow Optimization:

Inventory policies aid in better cash flow management by preventing overstocking or understocking situations. By holding an optimal level of inventory, businesses can allocate resources more efficiently and invest in opportunities for growth instead of tying up capital in excess stock.

Operational Efficiency:

An inventory policy streamlines operations by setting clear guidelines for order placement and inventory management. It allows for systematic monitoring and control of inventory levels, reduces manual errors, and improves the overall effectiveness of the supply chain.

what is an inventory policy

Inventory Management Policies

While there are a number of inventory management policies, here are some of the most common policies:

1. Order Quantity Policy:

The policy defines the number of items in order to optimize order size and minimize costs. It ensures adequate stock levels to meet demand without excessive expenses.

2. Reorder Point Policy:

This policy indicates when to reorder to prevent stockouts or excessive holding costs. It ensures consistent product availability for customers.

3. Safety Stock Policy:

It outlines extra inventory kept as a buffer against demand or supply variations. This policy ensures uninterrupted service and enhances customer satisfaction.

4. Demand Forecasting Policy:

This approach uses predictive techniques for estimating future demand and informing inventory decisions. It prevents overstocking and ensures product availability.

5. ABC Classification Policy:

Inventory is categorized into classes (A, B, C) based on importance. This prioritization ensures resources focus on high-value or fast-moving items.

6. Cycle Counting Policy:

Regular partial inventory counts ensure accuracy and eliminate comprehensive counts. This fosters efficient operations and informed decision-making.

7. Stock Review Policy:

This policy details how often and by which methods stock levels are reviewed. It supports informed replenishment decisions and consistent product availability.

an inventory policy

10 Steps to Create an Inventory Policy

Use our 10 Step process to develop an effective inventory policy. Simply follow the steps below:

Step 1. Define Objectives

Identify the specific needs and objectives that the inventory policy should address, such as reducing holding costs, improving order fulfillment, or increasing turnover rate. Determine the key metrics to track the policy's performance.

Example: The objective is to reduce inventory carrying costs by 15% and improve order fulfillment speed by 25%. Key Performance Indicators include inventory turnover rate and order fulfillment time.

Step 2. Data Collection and Analysis

Gather historical and current data to understand sales trends, demand, and inventory levels. Analyze this data to predict future demand and optimize stock levels.

Example: Data shows that 500 units of "Widget A" are sold monthly, but current stock levels are at 800 units. Analysis reveals an opportunity to reduce excess inventory and optimize reordering processes.

Step 3. Determine Inventory Types and Levels

Identify different categories of inventory and establish optimal stock levels for each. Consider factors like demand variability and lead time in setting these levels.

Example: Raw materials, including 200kg of steel, are classified separately from the 150 finished "Bike Model X" in stock. Safety stock is determined based on historical sales data and supplier lead times.

Step 4. Choose an Inventory Management Method

Select an appropriate inventory management technique to maintain optimal stock levels. This method should align with the business's operational needs and objectives.

Example: ABC analysis is employed, classifying "Gadget Y" as an 'A' item due to its high sales volume. The focus is on maintaining optimal stock levels to avoid stockouts and overstocking.

Step 5. Develop Ordering Policies

Create procedures for ordering inventory, focusing on efficiency and accuracy. Establish relationships with suppliers to ensure timely and cost-effective procurement.

Example: An automated ordering system is set up to purchase 100 units of "Tool Z" when stock levels reach 50 units. Negotiations with suppliers ensure a lead time of just 5 days.

Step 6. Implement Inventory Control System

Introduce a system or software for real-time tracking and managing inventory. Ensure that staff is adequately trained to use this system effectively.

Example: An inventory management software is implemented to track the 300 "Electro Widgets" in real-time. Staff receives training on utilizing the software to monitor and manage inventory levels efficiently.

Step 7. Monitor and Optimize

Regularly review key metrics to assess the inventory policy's performance. Make necessary adjustments to enhance efficiency and cost-effectiveness.

Example: After reviewing KPIs, it's noted that the carrying costs for "Gadget Y" have decreased by 10%. Further analysis and optimizations aim to reach the 15% reduction target.

Step 8. Risk Management

Identify potential risks associated with inventory management and develop plans to mitigate them. Consider supply chain disruptions, demand fluctuations, and other uncertainties.

Example: A contingency plan is developed to source "Material Q" from an alternative supplier in case of disruptions. This ensures continuous production of "Product R," to maintain a stock level of at least 200 units.

Step 9. Documentation and Compliance

Document all processes, responsibilities, and protocols associated with the inventory policy. Ensure alignment with legal and regulatory requirements.

Example: The inventory policy for handling and storing 500 units of "Chemical S" is documented with detailed safety and compliance protocols. Regular audits ensure adherence to legal requirements and safety standards.

Step 10. Review and Improvement

Periodically evaluate the inventory policy and make improvements based on data, feedback, and emerging trends. Focus on continuous enhancement of efficiency and effectiveness.

Example: Annual reviews of the policy indicate a consistent surplus of "Item T." Adjustments are made to the ordering process, reducing orders from 400 units to 300 units to align with actual sales data.

inventory policies


TechGadgets Inc. is a gadget retailer that aims to create an effective inventory policy to streamline its operations and reduce holding costs. Here’s how the company implemented our simple 10 step process:

Step 1. Define Objectives

TechGadgets Inc. sets a goal to decrease inventory holding costs by 20% and enhance order fulfillment speed by 30%. With a current excess inventory of 25% and an order fulfillment time of 5 days, they aim to optimize stock to demand and reduce order processing time to 3.5 days. Improvements are tracked with KPIs like inventory turnover rate and order fulfillment time.

Step 2. Data Collection and Analysis

TechGadgets Inc. gathers data and finds that they sell 200 units of "SmartPhone X" monthly but hold a stock of 300 units. They analyze this data to identify patterns and optimize inventory levels to ensure they are not overstocking or understocking particular items.  This improves cash flow and storage utilization.

Step 3. Determine Inventory Types and Levels

The company classifies inventory into categories and determines that "Wireless EarBuds Y" should have a safety stock of 50 units considering its demand variability and supplier lead times. They have 200 units of raw materials and 150 units of finished goods which aligns stock levels with sales forecasts to avoid excess or shortage.

Step 4. Choose an Inventory Management Method

TechGadgets adopts the ABC analysis and classifies "SmartWatch Z" as a Category A item due to its high sales volume and value. They ensure optimal stock levels to avoid overstocking costs and stockouts to enhance customer satisfaction and financial performance.

Step 5. Develop Ordering Policies

The company establishes a procedure where an order for 100 units of "VR Headset Q" is automatically placed when stock levels reach 20 units. By fostering strong relationships with suppliers, they’ve ensured a reduced lead time of 4 days and negotiated bulk purchase discounts.

Step 6. Implement Inventory Control System

TechGadgets implements an inventory management software to track the 500 "PowerBanks P" in real-time and provides training to staff for efficient utilization. This ensures accurate and real-time data is always available for informed decision-making and effective inventory control.

Step 7. Monitor and Optimize

After a quarterly review, TechGadgets notes a 15% decrease in carrying costs for "Wireless EarBuds Y." The company then aims to further optimize the inventory policy using data-driven insights to reach the 20% cost reduction target without compromising service quality.

Step 8. Risk Management

TechGadgets identifies a risk of supply chain disruption due to geopolitical issues affecting the supply of "SmartWatch Z." They develop a contingency plan to source from an alternative supplier to ensure that a minimum stock level of 100 units is maintained to meet customer demand.

Step 9. Documentation and Compliance

All processes and protocols for managing the inventory of 250 units of "Laptop L" are documented to ensure adherence to legal and safety standards. The company conducts regular audits to ensure ongoing compliance and adapts the policy to any changes in legislation or industry standards.

Step 10. Review and Improvement

During an annual review, TechGadgets realizes a consistent overstocking of "Tablet T," and adjusts the reordering process from 200 units to 150 units per order. This is in line with actual sales data and demand forecasts. This iterative review and improvement process ensures the inventory policy remains effective and efficient to adapt to changing business needs and market dynamics.

We hope that you now have a better understanding of what inventory policy is and how to create your own policies.

Turn your spreadsheet into software