Inventory management has developed its own set of key words and key phrases. We find that practitioners are not always sure about the meanings of these words, which can impede effective business communication, particularly when implementing inventory optimization and forecasting software.  Sometimes two companies (supplier and customer, supply chain software vendor and customer, etc.) use the same word but apply different meanings to it.  This post aims to clarify some basic definitions.

Backorder Policy
A prescription of what to do when there is a stockout. Under a backorder policy, any units demanded but not provided immediately are provided later, when available.

Cycle Stock
The portion of inventory that is expected to cover the lead time demand. In an inventory control system, the reorder point is comprised of the cycle stock and the safety stock. The more safety stock, the lower the risk of stocking out.

Economic Order Quantity (EOQ)
A classic but not always useful estimate of the “best” order quantity.  The EOQ takes account of three factors: the average level of demand, the cost of holding inventory, and the cost of making a replenishment order. SmartForecasts provides alternative order quantity recommendations based on additional factors: the long-run stability of the system (i.e., you have to order at least enough to keep your head above water) and any supplier-imposed order minimums and multiples.

Fill Rate
An item availability metric that measures the fraction of items demanded that are supplied immediate from stock on hand. Expressed as a percentage: A 90% fill rate means that 90% of the units demanded, on average, are immediately available. Fill rate differs from service level in that it takes account of how large a stockout is, not just how often a stockout happens. Accordingly, fill rate and service level can be very different numbers. What’s the difference between fill rate and service level?

Inventory Forecasting
An inventory management process that predicts future inventory levels, costs, and service level performance. 

Inventory Optimization
An inventory management process that yields an inventory with the lowest possible cost and maximum possible service.   Inventory Forecasting methods that employ traditional rule of thumb policy or service level targeting are not sufficient to optimize inventory since the choice of service level is arbitrary and will not yield the maximum overall service for the lowest total cost.

Lead Time
Lead time is the interval between inventory realizing that you need more stock, i.e., detecting that inventory has dropped to or below the reorder point or min, and its arrival back in stock. The lead time might be composed of several intervals: the time to sense the problem, the time to request purchasing to get more, the time until purchasing actually cuts a purchase order, the time for the vendor to deliver, and then the time to restock. The shorter the lead time, the more lean and agile your operation. You can use SmartForecasts to do “what if” analysis, examining the gains to be made from reducing lead times.

Lead Time Demand
Lead time demand is a random quantity totaling all the demands that arrive during the lead time. SmartForecasts’ key analytical computation is estimation of the probability distribution of lead time demand. From this flow assessments of service level, fill rate, and reorder point (min).

Lot for Lot Policy
Otherwise known as “sell one, buy one.” Represents a replenishment policy driven by a reorder point or min and a replenishment quantity that is equal to what was consumed. The replenishment frequency parallels the demand frequency as an order is placed to replenish each time inventory is consumed.

Loss Policy
A prescription of what to do when there is a stockout. Under a loss policy, any units demanded but not provided immediately are considered lost: either the customer gets those units elsewhere or just doesn’t get them at all.

 Make/Procure to Order
An item is produced or ordered from a supplier when ordered by the customer.   Inventory is not automatically replenished with Make to Order items.

The level of inventory which, when reached or breached, triggers replenishment. Identical to the reorder point R. The Min is comprised of the cycle stock (expected lead time demand) and safety stock (to protect against demand and supply variability).

The “order-up-to” level in min/max systems. The actual order quantity is random in the min/max system: How much is ordered depends on the current gap between available inventory and the max.

Min/Max Policy
Represents a replenishment policy driven by the Min and the Max.   When supply breaches the Min, an order is placed up to the Max.   With Min/Max policy, the order quantity will vary depending on the gap between supply and max

Order Quantity
A fixed number of units to order when the reorder point has been reached or breached

Order Quantity Minimum
Order quantities are often negotiated with suppliers rather than simply calculated from an item’s demand history. Some suppliers require that any order be at least of a certain size. If you would like to order 7 but your supplier has an order quantity minimum of 10, you are stuck ordering 10.

Order Quantity Multiple
As with order quantities, order multiples are often imposed by suppliers, who may insist that order quantities be an even multiple of some basic unit. For instance, if a supplier only provides six packs, you cannot order either 5 or 7 units; instead, you must order 6 or 12 

Order Up to Policy
Represents a replenishment policy driven by the Order Up to Level and a fixed replenishment frequency.   For example, every two weeks (the replenishment frequency)

Q,R or R,Q Policy
Represents a replenishment policy driven by the reorder point (R) and the reorder quantity (Q). With a Q,R policy, the replenishment quantity is always the same.

Reorder Point
The level of inventory which, when reached or breached, triggers replenishment. Also the same as the min in min/max systems. Example: If reorder point is 7, any inventory level  from 7 on down will trigger a replenishment order.  The Reorder Point or ROP is comprised of the the cycle stock and safety stock.

Rule of Thumb
A way to determine inventory requirements based on an easy-to-understand rule such as “order 10 days’ worth of supply every time inventory falls to 5 days of supply.”

Safety Stock
The amount of inventory added to the average lead time demand to accommodate random increases in demand, thereby minimizing the risk of stockouts, with their attendant lost sales or backorders. The safety stock is strongly influenced by the volatility of demand. In an inventory system, a replenishment order is triggered when the supply of inventory is forecasted to hit the safety stock level. The order is placed at the Reorder Point.

Safety Time
The amount of days added to the lead time to accommodate for increases in supplier lead time.   By increasing safety time, orders will be triggered sooner thereby minimizing the risk of stockouts.

Service Level
An item availability metric that measures the ability to avoid stocking out during a replenishment lead time. Expressed as a percentage: A 90% service level implies a 10% chance of stockout.  What’s the difference between fill rate and service level?  In inventory forecasting, safety stock and reorder point levels can be planned with a user defined service level target.