What is Inventory Management?

For those looking for a definitive guide on inventory management — this is it. Here, you’ll find everything you need to understand and manage your inventory, from basic terms and formulas to complex control procedures and techniques to achieve the best results.

Inventory Management Definition

Inventory management (aka stock management), which is a part of supply chain management, is the process of managing a company’s inventory and stock. Supply inventory management involves the storage of inventories, overseeing the orders for stock inventory, and controlling the number of items in stock.

Below are a few key inventory management terms.

Stock Inventory Management Terms

Term
Definition
Barcode reader An optical scanner that can read printed barcodes, decode barcode data, and send it to a computer. Almost all barcode scanners have a decoder circuitry that analyzes the barcode’s image data by the sensor and sends the barcode’s contents to the scanner’s output port. 
Bundles or bundling Involves two or more complementary goods or services sold together as a combined package
Cost of goods sold (COGS) The carrying value of goods sold during a certain period that includes the costs of materials and labor used to create the goods
Deadstock Discontinued line of unworn goods like clothing items that are no longer available on the market but still have their original tags
Decoupling inventory A technique that describes saving extra raw materials or work-in-progress for all or some stages of the production process so that low stock or breakdown doesn’t slow or stop operations
Economic order quantity (EOQ) One of the classical production scheduling models used to define the ideal order quantity that minimizes inventory costs such as holding and ordering costs
Holding costs Costs associated with storing unsold inventory
Landed costs The total cost of creating and transporting a product to the end customer
Lead time The time between the initiation and completion of a production process
Order fulfillment The process of fulfilling an order to the customer’s specifications that includes delivery of products as promised at the time of sale
Order management The process of receiving, tracking, and fulfilling customer orders
Purchase order (PO) A legally binding document created by a buyer for a seller that specifies the list of products to purchase
Pipeline inventory All items in transit between different locations of a supply chain
Reorder point A specific level of inventory at which stock needs to be replenished
Safety stock An additional quantity of an item in inventory held to reduce the risk of that item being out of stock
Sales order A document issued by a seller to a customer that specifies the details about products or services ordered by the customer
Stock keeping unit (SKU) A scannable bar code printed on product labels that denotes a distinct type of item for sale with all its distinguishing attributes
Third-party logistics (3PL) The use of third party businesses to distribute, warehouse, and fulfill orders
Variant An SKU used to track inventory with inventory tracking services

What Are the Types of Inventory?

Under different taxonomies, there are from four to ten and even thirteen types of inventory. We’ll look at the main six types. Understanding the difference between those types is crucial for successful inventory management.

Raw Materials

Raw materials are materials that are needed to turn your inventory into a finished product. For example, if you’re making t-shirts, then fabric, threads, dyes, and print designs are the raw materials you need to produce t-shirts. There are two types of raw materials, direct and indirect. Direct raw materials are those that are directly used in the production of a finished product, and indirect raw materials are those that are used indirectly, such as factory costs.

Work-in-Process

Work-in-process, aka work-in-progress or WIP, includes raw materials that are still in production at the end of the accounting period. Work in progress is comprised of the number of raw materials required to finish a product and the cost of additional processing as each unit moves through different manufacturing steps. In a confectionary business, WIP can be all the components required to produce a cake, such as dough bases, tarts, and so forth that are stored and cooled for later use.

MRO Inventory

MRO, which stands for maintenance, repair, and operation inventory, includes all the consumable materials and supplies required for manufacturing that are not a part of finished goods inventory. Good examples of MRO inventory might be personal protective equipment, such as gloves and masks, cleaning supplies, such as disinfectants, or office supplies, like notebooks, pencils, and pens

Finished Goods

Finished goods are goods that have completed the manufacturing process and are ready for sale. For example, in a confectionary business, a finished product is a cake that’s ready but has not yet been distributed or sold to a customer.

Pipeline Inventory

Pipeline inventory is inventory in transit between locations, such as a warehouse and a retail outlet. In some instances, especially in the case of overseas shipments, inventory can remain in the pipeline for days or weeks at a time.

Vendor Managed Inventory

Vendor-managed inventory is an inventory management practice where a supplier of goods is responsible for optimizing the inventory held by a distributor. One of the most notable examples of vendor-managed inventory can be seen in the relationship between Walmart and its suppliers: Walmart’s suppliers are held responsible for taking care of their own inventory at Walmart’s warehouse.

Decoupling Inventory

Decoupling inventory is inventory stock that has been set aside as a backup against potential issues in the production pipeline. An example of decoupling inventory might be the extra microchip units in the manufacturing of video game consoles as they are the most important components that can significantly affect the production process in case something goes sideways.

Why Is Inventory Management Important?

One shall not underestimate the importance of stock inventory management both for small and large businesses. For once, it allows you to avoid deadstock and spoilage, as well as optimize storage, production, and fulfillment. Below, we’ll look at the number of things good inventory management can do.

Inventory Management Techniques

Since stock inventory management is complex, business owners and managerial executives have been turning to inventory ratios and formulas for generations to help them run things smoothly: stay organized, improve performance, target business goals, and forecast revenue and expenditure.

By adopting ratios, you can analyze critical performance benchmarks and discover revenue opportunities. The basic inventory management formulas, such as inventory turnover, cost of goods sold, or day’s sale average, are easy to implement yet extremely helpful in accessing performance and business efficiency. We’ll talk about some of those critical and more complex ratios below.

Economic Order Quantity (EOQ) Formula

Purchasing the right amount of inventory stock is only the beginning. It’s always important to keep the carrying costs in mind, which are attached to all the products you buy. The larger the inventory, the more expensive is its storage and the bigger the risk of it going out of date Good news is there is an equation to keep your tab on those things — the Economic Order Quantity (EOQ) formula.
EOQ = √2DK/H
EOQ = √2DK/H, where

D = Fixed cost per year
K = Demand in units per year
H = Carrying cost per unit per year

EOQ is a formula that helps calculate how many units your business should be adding to its inventory in order to reduce the total costs of stock inventory management. To calculate EOQ, you’ll need the following variables: demand rate, setup costs, and holding costs.

There are a number of EOQ calculators you can find online to help you figure it out.

Days Inventory Outstanding (DIO) Formula

Days Inventory Outstanding is the liquidity metric that estimates an average number of days you hold your inventory before the sale. The formula shows how quickly you can turn your inventory into cash, which is a good indicator of your company’s operational and financial efficiency.
Days Inventory Outstanding = (Average inventory / Cost of goods sold) x Days in the period, where
Days Inventory Outstanding = (Average inventory / Cost of goods sold) x Days in the period, where

Average inventory = (Beginning inventory + Ending inventory) / 2
Cost of goods sold = Starting inventory + Purchases - Ending inventory
Days in period = the number of days in the period (week/month/quarter/year)

If you’re just starting out your business, you’d value your starting inventory at zero. If your business is established, the value of your starting inventory would be the same as the value of your ending inventory in the previous year. There are three established ways to value inventory, such as FIFO, LIFO, and Average Cost. FIFO, which means first in, first out, assumes the company sells the oldest products first, whereas LIFO, last in, first out, assumes the opposite. The Average Cost is based on the average price of all goods currently in stock. Regardless of the chosen method, the important thing is consistency.

Reorder Point (RP) Formula

The next formula calculates the right time to place your order for the inventory restocking. While EOQ answers the question of “What is an inventory level you want to maintain?”, it doesn’t tell you how to actually do it. Ideally, you want your restock shipment to arrive when your previous batch is about to sell out. If it comes too early, you might face all kinds of storage and handling issues. And if it comes late, you’re in danger of running out of stock. So, you want to make sure you always have enough products, which is where determining your reorder point gets important.

In order to do it right, you would need to know the time it takes for:
• Picking and handling of your items
• Packing
• Shipping (lead time)
Reorder Point (RP) = (Lead time x Average daily usage) + Safety stock
Reorder Point (RP) = (Lead time x Average daily usage) + Safety stock

The basic formula for the reorder point is the average daily usage rate for an inventory item multiplied by the lead time in days to replenish it plus the safety stock as a backup.

Safety Stock (SS) Formula

Safety stock is an additional quantity of a product in a warehouse that serves as insurance against demand fluctuations and prevents out-of-stock situations. There are different methods to calculate safety stock, such as fixed safety stock, time-based calculation, Heizer’s and Greasley’s methods. But the general formula looks as follows:
Safety stock = (Maximum daily use x Maximum lead time) – (Average daily use x Average lead time)
Safety stock = (Maximum daily use x Maximum lead time) – (Average daily use x Average lead time), where

Maximum daily use = maximum number of units sold in a single day
Maximum lead time = the longest time it has taken the supplier to deliver the stock
Average daily use = the average number of units sold in a day
Average lead time = average time taken by the supplier to deliver the stock

Bulk Shipments

The bulk shipping method is based on the premise that it’s almost always cheaper to ship and procure items in bulk. While the thesis holds true, there’s an obvious downside to the method in terms of extra money spent on warehousing the inventory. To offset the potential negative effects related to warehousing expenses, you need to make sure that the money saved from purchasing products in bulk compensates for the increase in warehousing costs.

ABC Inventory Management

ABC inventory management is based on putting products into categories in order of importance, with A being the most valuable category and C the least. One of the advantages of categorizing inventory in such a way is that it helps to forecast demand based on products’ popularity over time and manage resources more effectively. However, the ABC method could ignore products that are just starting to trend and place them erroneously into the lower categories.

Just in Time (JIT)

Just In Time is a smart stock inventory management technique that aims to lower the volume of holding inventory. JIT helps save on holding costs by ordering inventory a few days before it’s needed for distribution or sale. It’s a rather risky approach to managing inventory and requires a highly agile business that can handle a shorter production style.

First In, First Out (FIFO)

First In, First Out, aka FIFO, is a valuation method that is based on the assumption that the oldest products are sold first. Companies that trade in perishable products typically follow the FIFO method for obvious reasons. For tax purposes, FIFO assumes that assets with the oldest costs are included in the income statement’s cost of goods sold (COGS) which can be roughly calculated as follows: Goods Available for Sale (which equals to the sum of Beginning Inventory and Purchases) - Ending Inventory.

Last In, First Out (LIFO)

Last in, first out, aka LIFO, is an inventory valuation method that is based on the assumption that the products bought or produced last are sold first. Typically, on the balance sheet, LIFO will produce a larger cost of goods sold (COGS) and a lower closing inventory (in normal times of rising prices), and FIFO will produce lower COGS and higher closing inventory. FIFO is used as a default valuation method for tax purposes and is generally more recommended. Some countries prohibit LIFO valuation altogether.

Consignment

In wholesaling, consignment is the process of handling inventory over to a retailer but retaining ownership of products until they are sold, at which point the retailer purchases the consumed products. Selling on consignment involves a high degree of uncertainty from the retailer’s point of view and a high degree of confidence on the part of the wholesaler. For retailers, however, consignment offers the benefit of a wider product range without capital investment, while for wholesalers, the transfer of products can also mean a transfer of other responsibilities, such as marketing.

Dropshipping and Cross-Docking

In a dropshipping agreement, one party directly transfers customer order and shipping details to the manufacturer who handles the fulfillment on that party’s behalf. Similarly, in cross-docking, incoming semi-trailer trucks (or railroad cars) unload goods onto outbound trucks (cars, etc.), which means that the transfer of goods happens without the need for warehousing. In some circumstances, however, an unloading party might need some storage space to sort products while unloading, but even then, the warehousing costs are minimal.

Inventory Kitting

Inventory kitting is the process of bundling multiple individual products with different SKUs into one single product with one SKU. The are several benefits to inventory kitting, including the increase of an average order, reduction in return rates, and improvement in shipping efficiency. Kitting has become especially popular with the rise in online stores and marketplaces that successfully employ the technique to sell related products as a bundle. One of the notable examples of kitting is subscription boxes that are used to combine complementary products from different or a single manufacturer and ship them on a weekly or monthly basis.

Implement Six Sigma

Six Sigma is one of those buzz words from the 90s that has lingered on. The term describes a quality management improvement process typical to a large manufacturing plant. What the process aims to do in manufacturing is to keep product variation and defects at a minimum level. In a broader sense, Six Sigma is based on the idea of continuous and incremental improvement to the overall efficiency and quality over time. Product inventory management plays two critical roles in Six Sigma: firstly, it’s the management of raw materials and work in progress, and secondly, it’s the inventory control of finished goods. Similar to JIT, in Six Sigma, you hold on to only the right amount of stock to keep production schedules going thus reducing carrying stocks and optimizing production flow. For finished goods, Six Sigma aims to identify and eliminate the root problem of excess inventory to optimize production and reduce carrying costs accordingly.

Set Par Levels

Par levels, usually employed by the restaurant businesses, describe the minimum amount of a product a business should have on hand to meet that product’s demand until any additional inventory is delivered. Although par levels bear some similarity to the safety stock, they are not exactly that. To end up at a par level figure, you need to take the amount of inventory used each week, add safety stock to the figure, and divide the sum by the number of deliveries each week, like so:
Par level formula
Par level = (Inventory used in a week + safety stock) / Number of deliveries a week

For example, if your restaurant business uses 20 pounds of tomato each week (with the safety stock being 3 pounds), and the delivery comes in twice a week, then your par level should be calculated as follows: (20+3)/2 = 11.5 pounds. This means that as soon as your level of tomatoes drops to 11.5 pounds, you need to reorder.

Manage Relationships

Relationship management affects every single party in a supply chain so it’s important to invest time and money into building long-lasting trusting relationships with suppliers, distributors, and customers. Trust building might be an ongoing process, but the benefits far outweigh the costs. It’s also important to pay attention to measuring and evaluating suppliers’ performance and spot any detractions from established agreements early on to prevent circumstances where product inventory management suffers.

Contingency Planning

To prevent contingencies from happening, you need to follow good inventory management practices, such as those outlined below.

  • Rely on a few people (as opposed to a single individual) to manage restocking by dividing replenishment responsibilities among several employees.
  • Use accounting and inventory management software to document all inventory procedures with comings and goings and use analytical tools to forecast future demand.
  • Keep all vendor information with contracts, contacts, and specific leverage terms (such as conditions to get a discount) in one place to be readily available for people responsible for supplier relationship and product inventory management.


    However, following good practices might not be enough in times of crisis. You need to have a solid contingency plan (or several plans). To arrive at such a plan, you need to determine the nature of potential contingencies first, which might include the following crises:

  • An unexpected spike in demand for a particular product;
  • Cash flow problems;
  • Lack of space in a warehouse;
  • Shipment delays;
  • Discontinuation of a product that was promised to a customer, and so on.


    By identifying potential contingencies, you can create a backup plan to mitigate potential negative effects in case those contingencies end up happening. Contingencies are very good examples where a good relationship with suppliers can potentially save the day: suppliers might be more willing to accept the products that don’t sell very well, sell items on credit in case of cash flow problems, or help you determine the time when some of the needed items could be back in stock. However good your relationships might be, it’s always worth considering alternative suppliers who you could turn to if others don’t deliver on their promises.

Backordering

Backordering is an inventory practice where a company takes orders and payments on items that are currently out of stock. Even though it might be a sensible strategy for single out-of-stock items, when there are tens of thousands of orders like that, backordering can quickly turn into a mess. Enabling pre-orders increases sales, but it can also increase customer dissatisfaction and result in longer fulfillment times and broken promises. Finding and maintaining a balance in backordering is of utmost importance, otherwise, you risk losing customers and money.

Accurate Forecasting

Inventory forecasting, aka demand planning, is the practice of using past data and known upcoming events to predict future demand and inventory levels. Accurate forecasting ensures that your business has enough products to fulfill customer demand and does not over/underspend on inventory. There are several efficient forecasting methods with the weighted moving average being one of the most accurate. However, demand forecasting goes beyond simple estimates and needs to account for complex patterns over time in sales history and economic trends, among others.

Inventory Best Practices

The best practices, in inventory or elsewhere, are achieved through continuous improvement in operational efficiency and a collective mindset that embraces technology as a friend rather than a fiend. To guide you in developing your own best practices, below are a few suggestions for where to start or what to look for:

  1. Adopt product inventory management software that can effectively leverage large amounts of data and create a single source of truth and learning for all employees.
  2. Maximize inventory turnover, which can dramatically increase profitability by helping you determine the right reordering points, thereby reducing carrying costs, deadstock, and spoilage.
  3. Employ analytic and forecasting tools for accurate demand forecasting especially if you used to manually trawl through historical data to get an adequate picture of future growth.
  4. Invest in process automation and integrate inventory management software with other tools, including ecommerce.
  5. Follow established accounting disciplines, such as FIFO or LIFO, track and audit inventory consistently, decouple inventory for additional safety.
  6. Invest in good relationship management with suppliers but keep a list of alternative partners handy in case of emergency.
  7. Have a contingency plan ready.

Inventory Management Software for Retailers

Many small businesses rely on excel spreadsheets for their product inventory management, but once your business starts growing, those become extremely limiting. To save yourself the trouble of dealing with all sorts of stock-related issues, look for a cloud-based inventory management system that tracks inventory movement across all your sales channels in real-time.

One of the main advantages of switching to supply inventory management software is the automation of the whole process — you won’t have to worry about overselling by accident or missing reorder points. It will also help reduce the likelihood of human error. Plus, it will save you a significant amount of time that you could allocate to growing your business.
A few notable examples of reliable inventory management software include Orderhive, inFlow, Upserve, Lightspeed Retail, Megaventory, Zoho Inventory, TradeGecko, Odoo, Stitch, Fishbowl, and Contalog.

FAQs

What Are the Objectives of Inventory Management?

  • Ensure there’s readily available inventory and safety stock for unforeseen circumstances
  • Ensure there’s a systematic record of inventory to prevent any confusion like double ordering or ordering of wrong amounts
  • Ensure that costs are minimized without affecting customer satisfaction
  • Ensure that the overall production runs smoothly or at the best possible pace

Why Is Inventory Management in the Supply Chain Important?

Stock inventory management is all about maintaining a perfect balance — meeting customer demand without overstocking. Hence, the goal of inventory management in the supply chain is ensuring there are enough products in the right place at the right place, which is of crucial importance for the efficient operation of all parties within a supply chain.

How Can Inventory Management Be Improved?

Supply inventory management requires businesses to efficiently and accurately track inventory, evaluate inventory and supplier performance, and ensure inventory quality over time. To improve stock inventory management, businesses need to implement inventory software and integrate it with internal and third party systems, consistently track and audit inventory stocks, and use analytic and forecasting tools to better predict the future.

How Does Inventory Management Affect the Working Capital?

The net working capital is the difference between a company’s current assets (cash, accounts receivable, inventory) and its current liabilities (accounts payable, taxes, wages, interest). Excess working capital in holding inventory can delay cash conversion and increase the risk of inventory going obsolete.

What Are Inventory Management Policies?

Product inventory management policies determine the procedures that the company needs to follow to manage the movement of its inventory under control.

What Are the Types of Inventory Management Systems?

There are two main types of inventory management systems (or methodologies), which are periodic and perpetual. Periodic inventory systems make use of physical counting on a periodic basis, while perpetual systems deliver real-time data.

What Is Service Level in Inventory Management?

Service level inventory represents a trade-off between the cost of inventory and stockouts

How Does ERP Help in Inventory Management?

ERP enables companies to control everything from logistics to finance from a single system thus reducing errors and improving overall business efficiency.

What Is Poor Inventory Management?

Poor inventory management is having too little or too much inventory in stock, which means that the business doesn’t have accurate information on how much inventory it has and can lead to mistakes in ordering from suppliers or selling stock-out items to customers. 
 

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Marina Vorontsova
Technical author and eCommerce advocate