Inventory management refers to the process of ordering, storing, and using a company’s inventory. These include the management of raw materials, components, and finished products, as well as warehousing and processing such items.
For companies with complex supply chains and manufacturing processes, balancing the risks of inventory gluts and shortages is especially difficult. To achieve these balances, firms have developed two major methods for inventory management: just-in-time and materials requirement planning: just-in-time (JIT) and materials requirement planning (MRP).
Some firms like financial services firms do not have physical inventory and so must rely on service process management.
How Inventory Management Works
A company’s inventory is one of its most valuable assets. In retail, manufacturing, food service, and other inventory-intensive sectors, a company’s inputs and finished products are the core of its business. A shortage of inventory when and where it’s needed can be extremely detrimental.
At the same time, inventory can be thought of as a liability (if not in an accounting sense). A large inventory carries the risk of spoilage, theft, damage, or shifts in demand. Inventory must be insured, and if it is not sold in time it may have to be disposed of at clearance prices—or simply destroyed.
For these reasons, inventory management is important for businesses of any size. Knowing when to restock certain items, what amounts to purchase or produce, what price to pay—as well as when to sell and at what price—can easily become complex decisions. Small businesses will often keep track of stock manually and determine the reorder points and quantities using Excel formulas. Larger businesses will use specialized enterprise resource planning (ERP) software. The largest corporations use highly customized software as a service (SaaS) applications.
Appropriate inventory management strategies vary depending on the industry. An oil depot is able to store large amounts of inventory for extended periods of time, allowing it to wait for demand to pick up. While storing oil is expensive and risky—a fire in the UK in 2005 led to millions of pounds in damage and fines—there is no risk that the inventory will spoil or go out of style. For businesses dealing in perishable goods or products for which demand is extremely time-sensitive—2019 calendars or fast-fashion items, for example—sitting on inventory is not an option, and misjudging the timing or quantities of orders can be costly.
KEY TAKE AWAYS
- Inventory management refers to the process of ordering, storing, and using a company’s inventory. These include the management of raw materials, components, and finished products as well as warehousing and processing such items.
- For companies with complex supply chains and manufacturing processes, balancing the risks of inventory gluts and shortages is especially difficult.
- To achieve these balances, firms have developed two major methods for inventory management: just-in-time and materials requirement planning: just-in-time (JIT) and materials requirement planning (MRP).
Inventory Management Methods
Depending on the type of business or product being analyzed, a company will use various inventory management methods. Some of these management methods include just-in-time (JIT) manufacturing, materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).
Just-in-time (JIT) manufacturing originated in Japan in the 1960s and 1970s; Toyota Motor Corp. (TM) contributed the most to its development. The method allows companies to save significant amounts of money and reduce waste by keeping only the inventory they need to produce and sell products. This approach reduces storage and insurance costs, as well as the cost of liquidating or discarding excess inventory.
JIT inventory management can be risky. If demand unexpectedly spikes, the manufacturer may not be able to source the inventory it needs to meet that demand, damaging its reputation with customers and driving business toward competitors. Even the smallest delays can be problematic; if a key input does not arrive “just in time,” a bottleneck can result.
Materials Requirement Planning
The materials requirement planning (MRP) inventory management method is sales-forecast dependent, meaning that manufacturers must have accurate sales records to enable accurate planning of inventory needs and to communicate those needs with materials suppliers in a timely manner. For example, a ski manufacturer using an MRP inventory system might ensure that materials such as plastic, fiberglass, wood, and aluminum are in stock based on forecasted orders. Inability to accurately forecast sales and plan inventory acquisitions results in a manufacturer’s inability to fulfill orders.
Economic Order Quantity
The economic order quantity (EOQ) model is used in inventory management by calculating the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory while assuming constant consumer demand. The costs of inventory in the model include holding and setup costs.
The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand. It assumes that there is a trade-off between inventory holding costs and inventory setup costs, and total inventory costs are minimized when both setup costs and holding costs are minimized.
Days Sales of Inventory
Days sales of inventory (DSI) is a financial ratio that indicates the average time in days that a company takes to turn its inventory, including goods that are a work in progress, into sales.
DSI is also known as the average age of inventory, days inventory outstanding (DIO), days in inventory (DII), days sales in inventory or days inventory and is interpreted in multiple ways. Indicating the liquidity of the inventory, the figure represents how many days a company’s current stock of inventory will last. Generally, a lower DSI is preferred as it indicates a shorter duration to clear off the inventory, though the average DSI varies from one industry to another.
Qualitative Analysis of Inventory
There are other methods used to analyze a company’s inventory. If a company frequently switches its method of inventory accounting without reasonable justification, it is likely its management is trying to paint a brighter picture of its business than what is true. The SEC requires public companies to disclose LIFO reserve that can make inventories under LIFO costing comparable to FIFO costing.
Importance of inventory management
For any goods-based businesses, the value of inventory cannot be overstated, which is why inventory management benefits your operational efficiency and longevity.
From SMBs to companies already using enterprise resource planning (ERP), without a smart approach, you’ll face an army of challenges, including blown-out costs, loss of profits, poor customer service, and even outright failure.
From a product perspective, the importance of inventory management lies in understanding what stock you have on hand, where it is in your warehouse(s), and how it’s coming in and out.
Clear visibility helps you:
- Reduce costs
- Optimize fulfillment
- Provide better customer service
- Prevent loss from theft, spoilage, and returns
In a broader context, inventory management also provides insights into your financial standing, customer behaviors and preferences, product and business opportunities, future trends, and more.
Inventory management types
Typically, inventory types can be grouped into four categories: (1) raw materials, (2) works-in-process, (3) finished goods, and (4) maintenance, repair, and operations (MRO) goods.
- 1. Raw materials are any items used to manufacture components or finished products. These can be items produced directly by your business or purchased from a supplier. For example, a candle-making business could purchase raw materials such as wax, wicks, and decorative ribbons.
- Works-in-progress inventory refers to unfinished items moving through production but not yet ready for sale. In the case of a candle-making business, work-in-progress inventory might be candles that are drying and unpackaged.
- Finished goods are products that have completed the production process and are ready to be sold: the candles themselves.
- Maintenance, repair, and operations (MRO) goods are items used to support and facilitate the production of finished goods. These items are usually consumed as a result of the production process but aren’t a direct part of the finished product. For instance, disposable molds used to manufacture candles would be considered MRO inventory.
As you’ll see below, there are other terms such as “decoupling inventory” and “pipeline inventory” used to describe types of stock-based on its theoretical purpose and use. Nonetheless, physical inventory almost always falls into one of the four categories above.
Inventory management program
Inventory management terms
Physical devices used to check-in and check-out stock items at in-house fulfillment centers and third-party warehouses.
Groups of products that are sold as a single product: selling a camera, lens, and bag as one SKU.
Cost of goods sold (COGS)
Direct costs associated with production along with the costs of storing those goods.
Items that have never been sold to or used by a customer (typically because it’s outdated in some way).
Also known as safety stock or decoupling stock; refers to inventory that’s set aside as a safety net to mitigate the risk of a complete halt in production if one or more components are unavailable.
Economic order quantity (EOQ)
EOQ refers to how much you should reorder, taking into account demand and your inventory holding costs.
Also known as carrying costs; the costs your business incurs to store and hold stock in a warehouse until it’s sold to the customer.
These are the costs of shipping, storing, import fees, duties, taxes and other expenses associated with transporting and buying inventory.
The time it takes a supplier to deliver goods after an order is placed along with the timeframe for a business’ reordering needs.
The complete lifecycle of an order from the point of sale to pick-and-pack to shipping to customer delivery.
Backend or “back office” mechanisms that govern receiving orders, processing payments, as well as fulfillment, tracking and communicating with customers.
Purchase order (PO)
Commercial document (B2B) between a supplier and a buyer that outlines types, quantities, and agreed prices for products or services.
Any inventory that is in the “pipeline” of a business’ supply chain — e.g., in production or shipping — but hasn’t yet reached its final destination.
Set inventory quotas that determine when reordering should occur, taking into account current and future demand as well as lead time(s).
Also known as buffer stock; inventory held in a reserve to guard against shortages.
The transactional document sent to customers after a purchase is made but before an order is fulfilled.
Stock keeping unit (SKU)
Unique tracking code (alphanumeric) assigned to each of your products, indicating style, size, color, and other attributes.
Third-party logistics (3PL)
Third-party logistics refers to the use of an external provider to handle part or all of your warehousing, fulfillment, shipping, or any other inventory-related operation. Fourth-party logistics (4PL) takes this a step further by managing resources, technology, infrastructure, and full-scale supply chain solutions for businesses.
Unique version of a product, such as a specific color or size.
Inventory management formulas
If you’re new to inventory, you’ll probably come across a lot of formulas that might seem confusing at first. However, with a little bit of homework, these formulas can be very useful for keeping stock levels optimized.
Here’s an overview of some of the most common inventory formulas…
- Economic order quantity (EOQ) formula
- Days inventory outstanding (DIO) formula
- Reorder point formula
- Safety stock formula
1. Economic order quantity (EOQ) formula
Your EOQ is the optimum number of products you should purchase to minimize the total cost of ordering or holding stock. Figuring out your EOQ can potentially save you a significant amount of money.
EOQ = √(2DK / H), or the square root of (2 x D x K / H)
D = Setup costs (per order, generally includes shipping and handling)
K = Demand rate (quantity sold per year)
H = Holding costs (per year, per unit)
Looks complicated, doesn’t it?
The good news is that we’ve made working out your EOQ easy.Download EOQ Calculator
Download EOQ Calculator
2. Days inventory outstanding (DIO) formula
Days inventory outstanding (DIO), also known as days sales of inventory (DSI), refers to the number of days it takes for inventory to turn into sales. The average inventory days outstanding varies from industry to industry, but generally a lower DIO is preferred.
Determining whether your DIO is high or low depends on the average for your industry, your business model, the types of products you sell, etc.
3. Reorder point formula
The reorder point formula answers the age-old question: When is the right time to order more stock?
Calculating your reorder point takes three steps:
- Determine your lead time demand in days
- Calculate your safety stock in days
- Sum your lead time demand and your safety stock
To make this practical, we’ve designed a tool that will let you know exactly when it’s time to place an order for a new shipment of products.
Know exactly when it’s time to place an order for a new shipment of products.Download ROP Calculator
Download ROP Calculator
4. Safety stock formula
As we touched upon earlier, safety stock acts as an emergency buffer you can break out when it looks like you’re on the verge of selling out. You want to have enough safety stock to meet demand, but not so much that increased carrying costs end up straining your finances.
While this sounds like common sense, the trick is to decide on how much safety stock to carry:
- Multiply your maximum daily usage by your maximum lead time in days
- Multiply your average daily usage by your average lead time in days
- Calculate the difference between the two to determine your safety stock