What is Inventory management?

Inventory Management can be defined as a systematic approach to ordering, storing and using a company’s inventory. In business terms, inventory management means the right stock, at the right levels, in the right place, at the right time, and at the right cost and price.

What is inventory management?

If you’re just starting out in a retail or wholesale business, one question may arise in your mind “What is inventory management?” or “What is inventory control?

Effective inventory management and inventory control are the same things. Inventory management refers to the process by which you can track the amount of product you have in your warehouse, store or sitting with other retailers and distributors. This permits you to have the right number of units in the right place, at the right time and for the right price.

When you effectively tracking and managing your physical inventory, you’ll know how many items you have, when you might run low on products and whether you should replenish that item in order to keep selling it.

And as a busy business owner, you should be able to do all of this at a glance. This enables you to make good purchasing decisions quickly and easily. Good inventory control helps to create an efficient supply chain.

What is Inventory management system?

Inventory is always changing. Throughout each day, sales, returns, new receipts, even damage and theft affect your inventory levels. In retail, manufacture, food service and other inventory-intensive sectors, a company’s inputs and finished goods are the essences of its business. A lack of inventory when and where it’s needed can be extremely harmful.

Inventory must be safeguarded, and if it is not sold in time, it may have to be disposed of at clearance price or simply destroyed. Effectively managing inventory becomes harder as your business scale up and the number of inventory you’re handling increases. Therefore, inventory management is essential for businesses of any size.

Knowing when to restore inventory, what amounts to acquire or manufacture, how much price to pay, as well as when to sell and at which price, etc. can become complex decisions. This guide will instruct all you need to know about inventory management systems. We’ll explain the types of systems you can choose from, and which may suit you best.

Small businesses will usually keep track of stock manually and determine the reorder points and quantities using an Excel formula. Larger businesses will use specialized enterprise resource planning (ERP) software. Proper inventory management strategies differ depending on the industry.

Inventory management techniques

Depending on the type of business or product being analyzed, a company will use various inventory management methods. To help, look at the following inventory and warehouse management methods and activities.

1. Just-in-Time Management

Just-in-time (JIT) manufacturing comes from Japan in the 1960s and 1970s. Toyota Motor (TM) contributed the most to its progress. This method allows businesses to save significant amounts of money and cut down waste by keeping only the inventory they need to manufacture and sell products. This method minimises storage and insurance costs, as well as the cost of liquidating or discarding excess inventory.

It’s still considered being a risky strategy for some. It can be great for offsetting the risks related to inventory management to your manufacturer or supplier instead. If demand suddenly spikes, the manufacturer may not source the inventory it needs to satisfy that demand, suffering its reputation with customers and driving business toward competitors. Even the smallest delays can be problematic; if a key input does not arrive at “just in time,” a bottleneck can occur.

2. Cycle counts

The cycle count method involves dividing your inventory into smaller, more focused lists of products that need to be counted. You can divide your products by product category, product vendor, or even warehouse location. But there are 2 certain counts that are the best inventory control technique: high risk and high value.

High-risk counts are the products that have the largest inventory variations, are prone to theft or damaged, or have had the most inventory corrections performed against them because of breakages or returns. This type of count ensures you’re analyzing the reasons there have been so many write-offs, and thus, you’ll understand how to reduce the causes.

High-value counts are a list of products that have the highest cost or potential sales value. As these items are your most cash-intensive, it’s necessary to understand and precisely track them at all times.

3. Materials Requirement Planning

The materials requirement planning (MRP) depends on sales-forecast, which means manufacturers must have accurate sales records to implement accurate planning of inventory requirements and to communicate those requirements with materials suppliers on a timely basis.

For example, a ski manufacturer using an MRP inventory method might ensure that materials such as plastic, fibreglass, wood, and aluminium are in stock according to forecasted orders. Failure to accurately forecast sales and plan inventory purchases results in a manufacturer’s inability to fulfil orders.

4. FIFO

For inventory valuation, there are three common calculations are used:

  • LIFO (last-in, last-out)
  • FIFO (first-in, first-out)
  • AVCO (Average Cost or Weighted Cost).

Choosing the right inventory valuation approach is a necessary step as it can have a considerable impact on your profitability.

Companies use FIFO just like other inventory management systems as they think this is the method that is most practical against what’s going on in your warehouse while ensuring your balance sheet also indicates the actual costs you’ve paid to gain inventory.

5. Economic Order Quantity

The economic order quantity (EOQ) model is used in inventory management by determining the number of items a company should add to its inventory with each batch in order to minimize the total costs of its inventory during continuous consumer demand. The costs of inventory in the method include holding and setup costs.

The EOQ method seeks to assure that the proper amount of inventory is ordered per batch so that the company does not have to make orders too frequently and makes sure that there is no excess of inventory remaining on hand. It considers that there is a trade-off between inventory holding costs and inventory setup costs, and they minimize total inventory costs when both setup costs and holding costs are reduced.

6. Par levels

Par levels are the minimum quantities you want to have in stock for each product. If your inventory counts go below that level, you realize that you require reordering that product.

It is a method of prioritization within your reordering process. Setting your par levels gives you a structure, and it is an excellent way of keeping up with demand.

7. Days Sales of Inventory

Days sales of inventory (DSI) is a financial ratio that shows the average time in days that a company needs to turn their inventory, including products that are a work in progress, into selling.

DSI is also known for the average age of inventory of your business, days inventory outstanding (DIO), days in inventory (DII), days sales in inventory or days inventory and is explained in different ways. Showing the liquidity of the inventory, the DSI figure shows how many days a company’s present stock of inventory will last. A lower DSI is preferred, as it shows a shorter duration to clear away the inventory. The average DSI differs from one industry to another.

8. Safety stock

You want to eliminate the risk of overselling because of peaks in supply and demand; you hold extra inventory in your warehouse is called safety stock.

Safety stock = 1.65 × Square Root of Lead Demand

But you’ll need to calculate the optimal level of safety stock for your warehouse; sufficient that you don’t oversell on fast-moving inventory, but not so much that you’re tying up too much cash in your warehouse.

9. Qualitative Analysis of Inventory

If a company regularly switches its method of inventory accounting without legitimate justification, it is possible its management is trying to paint a brighter picture of its business than what is true. The SEC requires public enterprises to disclose LIFO reserves that can make inventories under LIFO costing can be compared to FIFO costing.

Regular inventory write-offs can show a company’s issues with selling its products or inventory obsolescence. This can also be a negative sign of a company’s ability to stay competitive and manufacture products that appeal to consumers in the future.

10. Key Performance Indicators (KPIs) analysis

You can analyze Key Performance Indicators (KPIs) to help in improving the workflows around your inventory management planning. They’re also helpful for preventing differences in the warehouse. Here’s what you need to monitor:

  • Gross Margin that influences your pricing and discounting procedures.
  • Inventory Turnover Rate influences how much working capital you’ll have for operating expenses.
  • Sell-Thru Rate allows you to see the particular products and product lines have spikes or dips in sales, and why; to help in your demand planning and restocking processes.
  • Units Per Transaction benefits with both your demand planning and upselling strategies.
  • The rate of Return enables you to analyse which products have a higher rate of return than others, and why, let you know how to improve your pick, pack, ship process or product packaging.
  • Perfect Order Rate ensures you whether your pick, pack, ship process requires improving or not.
  • Lead Time is an important parameter in demand planning, showing you how much time takes for your suppliers to deliver items to you once you’ve been ordered.

How to improve inventory management

1. Focus on your needs

A warehouse full of inventory can be a tough task to manage. The only way of managing it all easier is to single out the items that are the most important and focus on them. It’s highly rare that every item in your warehouse will have the exact demand from customers. Hold the top-selling items in stock, and you’ll have made an impressive start at keeping your customers satisfied.

2. Engage with suppliers

In any stock-based business, it is necessary to manage long-term supplier relationships. Establishing positive relationships with your business’ key suppliers is important to secure reliable supply, unlock competitive pricing and understand emerging trends that may affect your business.

3. Develop an inventory management system

How your business manages order quantities, replenishment cycle times, safety stock, forecasts, seasonality and more is important. Tweak each operation according to your specific business; keeping track of what works and what doesn’t. Making an impressive improvement in one area can be better than a few minor improvements across the board.

4. Utilise the real-time data

Information is a very powerful tool, but it’s must be correct and up to date. Real-time data and analytics; from layered inventory tracking right through to forecasting data, automatic ordering and individualised safety stock can make a real impact on your business. For the most correct data, consider using perpetual inventory management software, as it is the best way to ensure the information you require is always at your fingertips.

5. Go mobile

Mobile technology has revolutionised the inventory management process. Barcode scanning, for example, makes receipting and tracking goods far faster — and helps get rid of unneeded errors. Sales apps, meanwhile, empower salespeople with inventory data on the road. You no longer need to be restrained to a computer in your warehouse. You can track important business operations from home, on holiday, or wherever you are.

What are inventory costs?

Having knowledge about your inventory costs helps you in smarter decision-making. There are three universal categories of inventory costs: 

  1. ordering costs,
  2. carrying costs, and 
  3. shortage costs.

1. Inventory ordering costs

This is the expense gained in creating and processing orders for a supplier. You’d use this to determine the Economic Order Quality (EOQ) of your inventory. Examples of ordering costs are:

  • Cost to make a purchase requisition or purchase order
  • Cost of the workforce required to inspect receipted goods
  • Cost to process the supplier invoice associated to an order
  • Cost to prepare and release a payment to the supplier

2. Inventory carrying costs

Inventory carrying costs is the expenditures related to storing unsold products. This comprises the tangible cost such as storage, handling, as well as intangible costs such as depreciation, the cost of downturn and obsolescence and opportunity costs. Carrying costs will consist of 20% to 30% of a business’s total inventory costs.

3. Inventory shortage costs

Inventory shortage costs, also known as stock-out costs, this is the amount that results from an out-of-stock situation. This can include measurable costs such as the cost of expedited shipping, purchasing last minute from another supplier, or loss of the margin on incomplete sales. These also include costs that are tough to evaluate such as loss of customer faith or loss of customers, idle employees and loss of goodwill.

Sukanta Maiti

I am a Mechanical Engineer by profession, Blogger, and Youtuber by passion. I have been in the engineering field since 2014. I am passionate about sharing all my knowledge about engineering, management, and economics to my readers.

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