Effective inventory management is a complex balancing act: having just the right amount of stock, at the right place, at the right time. This balance is crucial across industries, whether it’s a retailer stocking shelves or a manufacturer feeding a production line.
There are different types of inventory, from raw materials to finished goods. And there are different types of inventory management techniques that you can apply. Like LIFO, FIFO, JIT, EOQ, etc.
What is Inventory?
Inventory is a company’s stock of goods and supplies for production or sale. This encompasses finished products, in-progress items, raw resources, and operational supplies.
Inventory matters in business operations. Because, it directly affects a company’s ability to serve customers and its financial health. Inventory is often one of a company’s most valuable assets.
Types of Inventory
Not all inventory is created equal. Businesses categorize their inventory into various types, each serving a different purpose in the supply chain.
1. Raw Materials
Raw materials are the basic inputs used to create a product. These are unprocessed (or minimally processed) goods that a company buys to feed into its production process.
2. Work-in-Progress (WIP)
These types of inventory consist of items that have entered the production process but are not yet completed. These are partially finished goods at various stages of production.
3. Finished goods
Another type of inventory is the finished products or goods ready for sale or distribution. This inventory has finished the production process and is awaiting customers to buy.
4. Maintenance, Repair, and Operations (MRO) Inventory
MRO inventory (Maintenance, Repair, and Operations) includes supplies and materials that aren’t part of the final product. But, these are used to support day-to-day operations and production maintenance.
Examples for Each Type
The four main inventory types have implications across different industries. Depending on the context, businesses face critical issues when they are not maintained properly.
- Raw materials example: A bakery’s raw materials include flour, sugar, yeast, eggs, and milk – the fundamental ingredients to bake bread and pastries. Without these on hand, the bakery can’t produce goods to sell each morning.
- WIP example: In construction, a half-built house is work-in-progress inventory. Lumber has been framed into a structure, wiring and plumbing partially installed, but the house isn’t finished.
- Finished goods example: In retail, a bicycle shop’s finished goods inventory is the set of bicycles, and accessories, assembled and ready for customers to purchase. Every bike sold immediately converts that portion of inventory into revenue.
- MRO example: In a large hotel, the inventory includes not just the items in rooms for guests (toiletries, minibar snacks as finished goods for sale), but also MRO supplies critical to operations. The hotel’s MRO inventory would be things like light bulbs, cleaning chemicals, toilet paper, bed sheets, and HVAC filters. These items don’t get “sold” to guests, but they are consumed in daily operations.
Inventory Management
Inventory management is the process of overseeing and controlling a company’s inventory levels, orders, storage, and distribution. It involves tracking inventory from the moment it’s acquired (or produced) until it’s sold or used, and deciding when and how much to restock. The process helps meet customer service level targets while minimizing the total cost of inventory ownership.
A well-managed inventory system offers multiple benefits like:
- Ensures smooth operations and sales
- Improves financial health
- Reduces risks and waste
However, managing inventory also has some notable challenges:
- Demand variability and forecasting errors
- Inaccurate inventory data
- Balancing costs
- Operational bottlenecks
- Human errors and restrictive policies
Inventory Management Techniques
Over years of practice, businesses and supply chain experts have developed a variety of techniques and strategies to manage inventory efficiently. These techniques help determine when to reorder or produce, how much to keep on hand, and how to prioritize different items.
1. Just-in-Time (JIT)
This strategy and production methodology aims to receive goods (or produce items) exactly when they are needed in the production process or for sale, but not before. It minimizes inventory holding costs by keeping inventory levels extremely low and resupplying only as needed.
2. First-In, First-Out (FIFO)
FIFO is an inventory issuance and accounting method where the oldest inventory items (first in) are the first ones to be used or sold (first out). A company will rotate its stock so that the items that have been in inventory the longest are the next to be dispatched or sold.
3. Last-In, First-Out (LIFO)
LIFO is essentially the opposite of FIFO. It assumes the most recently acquired inventory is the first to be used or sold. Under LIFO, if you picture a pile of coal being added from the top, you always take from the top of the pile (the newest coal) first.
4. ABC Analysis
This is an inventory categorization technique based on the Pareto principle (80/20 rule). It segments inventory items into three categories: A, B, and C according to their importance. These are usually measured by annual consumption value or sales value.
5. Economic Order Quantity (EOQ)
A classic inventory management formula that calculates the optimal order size that will minimize total inventory costs. Those costs typically include ordering, or setup, costs and holding or carrying costs.
The EOQ formula, derived by Ford W. Harris in 1913, is:
EOQ = √(2DS/H)
Where:
- D = annual demand (units per year),
- S = ordering cost per order (fixed cost to place an order or setup cost for production),
- H = holding cost per unit per year (could be unit cost * carrying rate%).
6. Dropshipping
In dropshipping, a store or seller doesn’t keep goods in stock. Instead, they send customer orders straight to a third-party supplier (like a manufacturer, wholesaler, or other business), who ships the product to the customer. This means that the retailer advertises and sells the product, but the supplier owns and holds on to the stock until it’s sold.
7. Safety Stock Management
Safety stock is the extra inventory a business keeps above anticipated demand to protect against uncertainties. Managing safety stock is about striking the appropriate balance: too little and you run the danger of stockouts; too much and you are locking up more money.
Industry-Specific Examples of Inventory Management
Inventory considerations can look very different from one industry to another. From retail ecommerce to the food industry, all have different inventory management implementations.
1. Retail Industry
Top retailer Walmart pioneered a Vendor-Managed Inventory (VMI) model with its suppliers. In Walmart’s system, suppliers like P&G have real-time access to Walmart’s sales and inventory data and are responsible for replenishing their products in Walmart’s warehouses.
- Business: Walmart, Shwapno, Agora, etc.
- Inventory Types: Finished goods, MRO inventory
- Method Used: FIFO, LIFO
2. Manufacturing Industry
Toyota Motor Corporation – a leading global automobile manufacturer – provides a classic case study in manufacturing inventory management, especially with its Toyota Production System (TPS) which introduced just-in-time and lean principles.
- Business: Cars, Smartphones, Computers, etc.
- Inventory Types: Raw materials, WIP, finished goods
- Method Used: JIT, ABC Analysis
3. eCommerce Industry
Amazon.com Inc., the eCommerce giant, handles inventory at a massive scale across its fulfillment centers. Amazon’s model is part retailer (buying and stocking products to sell) and part marketplace (holding inventory on behalf of third-party sellers via Fulfillment by Amazon).
- Business: Amazon, Ebay, Daraz, etc.
- Inventory Types: Finished goods, MRO
- Method Used: FIFO, LIFO, Safety Stock, Dropshipping
4. Restaurant Industry
Behind the scenes, restaurants carefully manage inventory of ingredients and supplies to deliver consistent food quickly. A prime example is McDonald’s.
- Business: Restaurants, Cafes, Fast Food Chains
- Inventory Types: Raw materials, finished goods, MRO
- Method Used: FIFO, JIT, EOQ
Inventory Management Systems
Having the right system to manage inventory is just as important as using the right techniques. Inventory management systems can range from a pen-and-paper log or spreadsheets (manual) to advanced software solutions integrated with scanning devices and real-time databases (automated).
Manual vs. Automated Systems
| Manual System | Automated System |
|---|---|
| Humans record and track inventory using paper forms or basic software | Software and specialized hardware track inventory with minimal human input |
| Small business staff count stock periodically and update a spreadsheet | Inventory Management Software (IMS), Enterprise Resource Planning (ERP) systems |
| Low-cost, simple | Reduces human error, improves efficiency, ensures accuracy, saves time |
| Labor-intensive, prone to errors, untenable with large inventory volumes | Could be costly |
Features of Modern Inventory Software
Modern inventory management software comes packed with features that enable efficient control. modern inventory software acts as the central nervous system of supply management, ensuring accuracy and providing intelligence.
- Real-time tracking: The system updates stock counts immediately as transactions happen. This real-time visibility means both customers and staff know what’s in stock now.
- Barcode/QR code scanning: Modern systems integrate with barcode scanners or even smartphone apps that scan QR codes. This greatly speeds up receiving, picking, and auditing.
- Integration with other systems: Inventory software often integrates with accounting systems, sales channels, and supplier systems. Integration with accounting means that inventory values and cost of goods sold are updated in financial records, and purchasing can flow through to accounts payable seamlessly.
- Analytics and reporting: Good software provides dashboards and reports on key metrics like inventory turnover, aging inventory, stockout incidents, valuation reports, etc.
Cloud-Based vs. On-Premise Systems
Cloud-Based systems are hosted by the software provider and accessed via the internet. Examples include many Software-as-a-Service (SaaS) offerings like Zoho Inventory, TradeGecko (QuickBooks Commerce), or Oracle NetSuite.
On the other hand, on-premise systems are installed locally on the company’s own servers or computers. Examples might be older ERP or inventory modules that a company installs in-house.
Importance of Accurate Inventory Tracking
When inventory records are accurate, a business runs smoothly. You can fulfill customer orders reliably because you know exactly what’s in stock. This leads to higher customer satisfaction and trust.
Benefits of Accuracy
- Accurate Inventory Management
- Facilitates smooth business operations
- Enables reliable customer order fulfillment
- Increases customer satisfaction and trust
- Avoids last-minute surprises and emergency expediting
- Simplifies replenishment
- Optimizes purchase plans and production schedules
Consequences of Poor Tracking
- Inaccurate inventory tracking can lead to stockouts and lost sales.
- System misrepresentations can result in missed revenue and potential customer loss.
- Overstock and higher carrying costs can occur due to the system’s overestimation of inventory.
- Auto-reorders can double up inventory, causing unnecessary double-ups.
- Inaccuracies can cause production delays, such as a lack of sufficient raw material for production.
Role in Decision-Making and Customer Satisfaction
Inventory data is a critical input for many decisions, from day-to-day operational ones like “when do we reorder item X?” to strategic ones like “should we discontinue this product line?” If the data is wrong, decisions will be flawed.
Inventory Metrics & KPIs to Track
To effectively manage inventory, companies rely on key performance indicators (KPIs) and metrics that quantify how well inventory is being utilized and controlled.
- Inventory Turnover Ratio:
This ratio measures how many times inventory is sold or “turned over” during a period (usually a year). It’s calculated as:
Inventory Turnover = Cost of Goods Sold (COGS)Average Inventory
- Days Sales of Inventory (DSI):
Also known as Days Inventory Outstanding (DIO) or simply Inventory Days, this metric converts the turnover ratio into an average number of days an item stays in inventory before being sold.
DSI = (Average Inventory/COGS)×365
- Stockout Rate:
This measures how often inventory stockouts occur. It can be defined in a few ways depending on business: e.g. the percentage of SKUs that had at least one stockout in a given period, or the percentage of total order lines not fulfilled immediately due to no stock.
Stockout Rate = (Total number of item requests/Number of times an item was out-of-stock when requested) ×100%.
- Carrying Cost of Inventory:
This is the percentage cost of holding inventory over a period (usually a year). It includes all the expenses related to storing and maintaining inventory: warehousing (rent, utilities), insurance, taxes on inventory, depreciation or spoilage, and the cost of capital (opportunity cost of money tied in stock).
- Lead Time (Supply Lead Time):
In an inventory context, lead time is how long it takes to replenish stock once an order is placed. For manufactured items, it could be production lead time; for retailers, it’s supplier lead time including shipping.
- Backorder Rate:
This is closely related to stockout rate, but specifically measures the proportion of orders (or order lines) that could not be filled from stock at the time of ordering.
Backorder Rate = (Number of orders (or line items) backordered/Total orders (or line items) received) ×100%.
Proven Methods to Improve Inventory Management
Improving inventory management is a continuous process. Several proven methods and best practices are used by businesses to tighten their inventory control and optimize performance:
- Regular Audits and Cycle Counting: Instead of doing a full physical inventory once a year, top companies count a subset of inventory on a rotating schedule (daily or weekly) so that every item is verified periodically.
- Integrating Inventory with Accounting and Sales Systems: Here, whenever a sale occurs (whether through a POS system in-store or an online order) the inventory is immediately updated, and similarly, whenever inventory is received or adjusted, the financial records are updated.
- Forecasting and Demand Planning: Using better forecasting methods (trend analysis, seasonality, machine learning, collaborative forecasting with customers) allows companies to get closer to the true demand, so they can stock accordingly.
- Automating Processes: This ranges from automated reordering (letting your system generate purchase orders when stock hits reorder point) to using RFID or IoT sensors for real-time tracking (common in large warehouses or for high-value inventory).
Common Inventory Mistakes to Avoid
There are some frequent pitfalls in inventory management. Being aware of these common mistakes can help a business proactively avoid them.
- Overstocking / Understocking: Overstocking involves maintaining significantly more goods than required “just in case.” This ties up money and raises carrying expenses. Conversely, understocking, carrying too little, results in regular stockouts and backorders, lost sales, and frenzied emergency orders.
- Lack of Categorization: Not categorizing or organizing inventory effectively leads to confusion, inefficiency, and mistakes.
- Ignoring Obsolete Inventory: Obsolete inventory refers to items that are unsellable or no longer in demand. A classic mistake is letting this deadstock just sit indefinitely.
- Not Using Proper Tools: Relying on inadequate tools is a frequent mistake, especially for small businesses. Trying to manage a large number of SKUs via spreadsheets or pen-and-paper can quickly lead to errors and an inability to keep up.
Inventory Management Tools and Software
Some top tools for inventory management include Financfy, NetSuite, QuickBooks, Zoho Inventory, TradeGecko, etc.
Comparison Table of Inventory Management Tools and Software
Modern inventory management is greatly aided by specialized software tools. There are many options on the market, each with different strengths.
| Parameters | Financfy | NetSuite | QuickBooks | Zoho Inventory | TradeGecko (QuickBooks Commerce) |
|---|---|---|---|---|---|
| Real-time Stock Tracking | Yes | Yes | Yes | Yes | Yes |
| Multi-Warehouse Management | Yes | Yes | Yes (Desktop Enterprise) | Yes | Yes |
| Cloud-based Access | Yes | Yes | Yes | Yes | Yes |
| Integration with Accounting Systems | Yes | Yes | Yes | Yes | Yes |
| Barcode/QR Code | Yes | Yes | Yes (Desktop Enterprise) | Yes | Yes |
| Automated Reordering | Yes | Yes | Yes | Yes | Yes |
How to Choose the Right Tool for Your Business
Small or large businesses need to know the factors that determine the right tool:
- Assess business size, budget, and specific needs.
- Small businesses or startups need tools like QuickBooks or Financfy for ease of use and integration.
- Retail or e-commerce companies need features like multi-channel inventory syncing, barcode support, and shipping integrations.
- Manufacturers need support for bills of materials or production scheduling.
- Scalability is important for growth.
- Consider the team’s capability – advanced systems require more training and IT support.
Conclusion
Mastering inventory management requires ongoing improvement. By understanding the different types of inventory and their roles, applying the right techniques and metrics, leveraging suitable software, and avoiding classic mistakes, businesses can turn inventory from a necessary cost into a strategic advantage.
With accurate data and smart planning, inventory becomes a facilitator of growth, ensuring that whatever the business sells or uses, it’s available at the right time in the right quantity. A strong grip on inventory is integral to healthy finances, efficient operations, and happy customers.
