This is where inventory management comes in, giving you complete visibility into the inventory process from start to finish at every level, from material sourcing to warehousing and distribution. This visibility eliminates guesswork and provides valuable data reducing the risks of scarcity or excess inventory at any given point, ultimately helping you meet demands and generate sales.
So, what exactly is an Inventory Management System, and why is it a crucial piece of your business?
To help give you a complete understanding of everything you need to know, this guide will cover:
- What is inventory management?
- The benefits of an inventory management system
- The steps that are involved in managing the inventory management process
- Common inventory management terms, techniques and main formulas
- Essential tips to successfully manage your inventory
What is Inventory Management?
Simply put, inventory out means money in; however, striking a balance to avoid shortages and overstocking can be difficult. Inventory management tracks and controls the entire flow of goods from purchasing raw materials from suppliers, manufacturing, storing, stock on hand, and production through to sales. It's a crucial part of your business that will guarantee the right quantity of goods are available when and where you need them and are delivered to your customers, warehouses, retailers and distributors in a timely manner. This ensures your production processes are not interrupted, meeting customer demands, improving customer satisfaction and increasing sales.
Why is Inventory Management Important?
Inventory is one of the most valuable and largest assets a company can have. It can directly impact your cash flow and mean the difference between profit and loss. As inventory management allows full transparency to monitor the level and flow of goods from the suppliers to the consumers, it prevents having too little or too much stock.
Though inventory is recorded as a 'current asset' on the balance sheet, it consumes company capital. It ties up cash that can otherwise be redirected into other areas for growth or expansion. Only once the inventory is sold, it becomes revenue and return to the business. To do so, high inventory turnover is required meaning goods must be sold quickly during a given period. Low turnover can lead to excess inventory being held longer, increasing the ongoing and maintenance costs of holding that stock and affecting your bottom line. Companies must ensure their inventory strategies align with the sales forecasts and expected level of customer demand.
It is also a requirement by the ATO to carry out a stock take at the end of each income year for tax purposes; therefore, it's essential to keep appropriate records. A stock take involves counting and checking all products and trading stocks in your business to ensure all records are accurate and correct.
What are the benefits of inventory management?
From improving accuracy to lowering expenses, effective inventory management is critical to the success of your business. It can provide numerous benefits to day-to-day warehouse operations, including:
Real-time data on inventory
An effective inventory management system gives you access to up-to-date data, providing a complete picture of your stock level, and preventing the issues of overstocking, understocking or stocking obsolete items. You can record and update every transaction, from new purchases to outgoing sales and order shipments. Knowing the exact level of your inventory also helps to improve the overall speed and efficiency of your service and helps to respond to customer demands. You can access information such as how long the inventory has been stored. Based on this, you can make decisions on whether the item is becoming stagnant or obsolete in the market.
Improved tracking
Barcode scanners, RFID technology and sensors with GPS tracking are must-have features in effective inventory management. As these details are saved and tracked in the system, it reduces errors, speeds up the pick and pack process, and prevents theft or losing items. Tracking is necessary, especially for manufacturers with hundreds or thousands of SKUs and multiple versions of the products. Tracking abilities also give customers peace of mind once purchased, as the items can be tracked from when the order was placed until it was delivered.
Planning & forecasting
Changes in consumer behaviours, trends and market conditions can prevent companies from predicting future demands. If there's a demand, there must be a supply. Having too little of a product that's high in demand can result in the loss of potential and loyal customers. An accurate inventory management mitigates these risks of under and over-stocking, ultimately reducing costs, minimising waste and saving space. Comparing historical inventory and sales data along with season trends, supplier information, delivery, and lead time will help guide procurement decisions.
Improved productivity
An inventory management system can significantly reduce time-consuming labour-intensive activities, meaning employees can concentrate on tasks that matter most. It can improve warehouse operations by reducing the time to process, audit and track the merchandise. Using the RF scanner and access to live information within the system means employees know where to locate the stock and the quantity improving picking and packing processes, ultimately speeding up the order fulfilment process. The sales team can utilise the real-life data of what's in stock, how much is in stock, at what price and the expected lead and delivery time to close a sale.
Improved customer service
Customer satisfaction is a key factor in driving your business's success. In a highly competitive industry with a saturated market, it's essential to identify high-turnover items to ensure product availability at all times to meet demands to avoid losing customers. Issues such as late deliveries and out-of-stock are all frustrating experiences that can prevent new customers from returning and affect the retention rate of existing customers. These are missed opportunities leading to lost sales and revenue; if it continues to occur, it can damage your brand reputation.
What are the steps involved in the inventory management process?
Depending on the size of your business and the industry you are in the flow of goods from the purchase of raw materials to delivery to the end users will vary. A defined inventory management process is essential for better cost control and will significantly impact your supply chain management.
Generally speaking, the process will follow similar steps below.
- Purchase of materials: The initial purchase of the raw materials to turn into products or the finished products to sell is the start of the flow of inventory. Conducting thorough research on the vendors to source material from and knowing the right quantity to order is fundamental.
- Delivery of materials to the warehouse: All raw materials for manufacturing, finished goods for distribution or indirect materials required for daily operations are delivered to the dedicated area of the warehouse.
- Review of delivered goods: It's essential to review the delivered goods to ensure the quantity matches the purchase orders and the quality is to that of your standards. Once reviewed, the goods will be sorted and stored in appropriate areas of the warehouse. At this stage, most companies may assign SKUs and barcodes for easy tracking.
- Production: Manufacturing of your finished products from the purchased materials. This step does not apply to businesses such as wholesalers/retailers.
- Monitoring of available inventory: Having an accurate figure on the available inventory in the warehouse minimises issues of obsolete stocks, stockouts, and missing orders and prevents theft and fraud.
- Placement of orders: Orders can be placed by internal and external sources of the company. Internal departments such as sales can place the order on behalf of the end customers.
- Goods are taken from stock: Once the order has been approved, the goods are sent out for delivery by appropriate methods. It's recommended to track orders up to the fulfilment stage continuously.
- Updating and restocking of inventory: Inventory levels must be updated to ensure stocks are not entirely depleted and are replaced promptly once they reach below the minimum level determined by the company.
What are the common inventory management terms?
There are many moving parts and stakeholders involved in inventory management. For a better understanding, let's get familiar with some basic terminology and formulas.
AIDC: Automatic Identification and Data Collection:
Barcodes, RFID tags and QR codes are all different methods of AIDC. They are used to automatically identify and track products within your inventory management.
ABC Analysis:
Based on the Pareto Principle stating, 20% of a business's activities create 80% of the output and profit. Therefore, that 20% should be the central focus to drive more success. When applied to inventory management, it's determining the most and least popular or important items based on demand, cost and risk factors and categorising them into different classes. Based on the sales volume of the items, they can be classed as Class A, Class B and Class C.
Batch Tracking:
Grouping inventory items with similar production characteristics in a batch as they make their way through production and distribution channels. Example characteristics include expiration and manufacturing dates, location, source and the type of materials used. Batch tracking is highly beneficial in the case of product recalls potentially due to hazardous or defective items.
BOM: Bill of materials:
Comprehensive list of all materials, parts, quantity, descriptions, costs and detailed steps to produce an item. BOM ensures the organisation has sourced the right materials in the right quantity before production, minimising the risks of delays while remaining within budget.
COGS: Cost of goods sold:
Also known as 'cost of sales', it refers to the direct costs of producing the goods in each stage of the inventory management process. COGS is a requirement for tax purposes as it's considered an expense.
Consignment:
The supplier retains ownership of the products until they are sold, eliminating the need for business owners/retailers to bulk purchase the products upfront.
Demand planning:
Forecasting or predicting customer demand for a particular product to reduce the risk of capital loss that comes with overstocking or understocking of inventory.
DIO: Days inventory outstanding:
The average number of days the inventory is held before being sold to the end user. This clearly shows how quickly a company can turn inventory into cash, the cost of holding and the reasons for the delay in selling the product.
EOQ: Economic Order Quantity:
EOQ is the optimal level of inventory to purchase to meet customer demand. Having the perfect amount of stock on hand reduces storage, order and holding costs while eliminating unnecessary expenses.
Just-In-Time Inventory (JIT):
This method keeps stock levels as low as possible by ordering products only on an as-needed basis. While this approach significantly cuts costs, the main drawback is the risk of stockouts, and accurate demand planning is needed to ensure new products are received in time.
Lead Time:
Refers to the period between an order being placed to when that order is actually received.
Obsolete Inventory:
Refers to any products at the end of their product life cycle. These are products that have not been sold or are not expected to be sold in the future. Obsolete inventories can result in significant losses for the company.
Seasonality:
A change in customer demand that can occur at any given point in the year. Understanding seasonality can help produce a more accurate demand planning for your business.
What are the main formulas for inventory management in the warehouse?
Inventory management is an integral aspect of any operation. For effective management, all logistics managers must regularly calculate key performance indicators allowing them to adjust and improve their stock levels and eliminate cost overruns.
Safety Stock
Also known as buffer stock, the additional inventory kept on hand that is above the required amount to cover unforeseen events such as a change in lead time or demand surge. It requires extra production and storage costs; however, it is essential to retain existing customers and avoid interruptions in business operations.
Safety stock = (Maximum daily usage × Maximum lead time in days) – (Average daily usage × Average lead time in days)
Where:
- Maximum daily usage/sale is the highest number of units sold in one day.
- Maximum lead time is the longest number of days it takes for the supplier to deliver the products from the date of order placement.
- Average daily usage is the average number of units sold in one day.
- Average lead time is the average time it takes the supplier to deliver the inventory.
Reorder Point
To identify the ideal time to reorder stock to replenish the depleting stock level to ensure the availability of goods for sale.
Reorder point = (Average daily usage x Average lead time in days) + Safety stock
Where:
- Average daily usage is the average number of finished products sold or raw materials used per day.
- Average lead time is the average time it takes the supplier to deliver the inventory.
- Safety stock is (Maximum daily usage × Maximum lead time in days) – (Average daily usage × Average lead time in days).
Economic Order Quantity
Also known as the Wilson formula, it determines the right amount of inventory stock to purchase at a given time. The EOQ formula can also be used to determine how many orders need to be made annually to satisfy demand.
EOQ = √(2DK/H)
Where:
- K is how much ordering purchase costs (per order), including shipping and handling costs.
- D is the annual demand quantity of materials your business needs over a year.
- H is the cost of storing/holding a particular item per year.
Days of Inventory Outstanding
Refers to the number of days it takes for a stock to turn into sales. A lower DIO is preferred as it means revenue is generated quicker. However, the DIO varies depending on the industry, market, product sold, and business models.
DIO = (Average inventory/COGS) × Days in period
Where:
- Average inventory is (Beginning inventory value + Ending inventory value) / 2
- COGS is your cost of goods sold
- Days in period is the number of days in the timeframe you want to measure, whether weekly, quarterly or annually.
Stockout Cost
Implications from stockout can significantly impact your business, from financial losses to poor customer satisfaction. Stockouts can occur for several reasons, such as a surge in demand, supplier delays, inefficient stock replenishment, production delays, logistic issues etc.
Stockout cost = (D x A x P) + C
Where:
- D refers to the number of days out of stock
- A is the average units sold per day
- P is the price of the stockout item
- C refers to the cost of consequence.
Note: Cost of consequence only applies to businesses that require raw materials to produce the finished products.
Maximum Stock Level
The highest capacity or the exact number of goods a business can store on its premises.
Maximum Stock Level = Re-order point + Re-order quantity – (Minimum usage × Minimum lead time)
What is demand planning?
Demand planning predicts the number of goods anticipated to sell so businesses can plan effectively to maintain sufficient inventory levels to satisfy that demand. It requires a variety of data sources, such as historical sales, customer trends, and seasonality data aiding organisations in making informed decisions about production, inventory management and resource allocation. The main aim of demand planning is to reduce the risk of excess or shortage of inventory if supply chain disruptions are to occur.
Effective demand planning guarantees to improve profit and customer satisfaction and reduce cost as businesses are aware of the right amount of inventory to stock at the right time. Excess inventory ties-up capital, the cost of storing and managing and the added risk of the inventory becoming obsolete. Alternatively, shortages can lead to stockouts, loss of sales and delays in the customer purchase process leading to dissatisfied customers.
Additionally, demand planning helps the organisation to develop better pricing strategies. With insights into future customer demand patterns and the costs associated with holding inventory, businesses can adjust their current pricing to remain competitive and reflect the product value.
How is inventory management different from other processes?
There are overwhelmingly many processes involved with running a business. The endless list of acronyms of processes, systems and practices is challenging to keep up, so it's entirely normal to confuse some of these practices.
People sometimes confuse inventory management with related practices, such as:
Inventory Control
While they sound similar, the two practices have different focus areas. Inventory control is one key part of the inventory management process. Also referred to as stock control and is the daily activity of managing stock you currently have in the warehouse. It's knowing details such as the quantity, location and condition of the stock, ensuring that supplies are stored efficiently, keeping costs down and minimising the time spent counting and controlling inventory. Inventory control begins once the ordered materials are received at the warehouse, followed by the process of storing, transferring, tracking, and deploying orders to fulfil customer orders and manage returns. The three most common inventory control methods include:
- FIFO (First In, First Out) - oldest inventory is used or sold first.
- LIFO (Last In, First Out) - the last or newest items received in inventory are used or sold first to fulfil customer orders.
- FEFO (First Expiring, First Out) - focused on the product expiration date, and the item with the earliest expiration date is used or sold first to avoid the product becoming obsolete.
Warehouse Management
Warehouse management and inventory management complement each other. While there are similar functions, both disciplines support the flow of goods from the supplier to the end consumer. While both facets focus on meeting customer satisfaction, warehouse management focuses more on the detail of every movement within the warehouse. Warehouse management provides full visibility of the warehouse. It presents detailed information, such as the precise location of stock, how items are stored, what processes are to be used for different items, what actions warehouse staff have taken and when ultimately keeping those involved accountable to prevent loss, damage or theft. In contrast, inventory management provides a high-level view of all available inventory while presenting information to calculate sales trends, profit margin and costs involved with storing. Inventory management allows for demand planning, and based on that information, businesses can determine reorder points and stock levels to avoid over or under-stocking products.
Supply Chain Management
Inventory management is an essential component in running the supply chain as it oversees the flow of gооds from mаnufасturers to warehouses and to the points of sale. However, the supply chain encompasses the management of external third-party supply relationships and the movement of stock in and out of the company. While inventory management focuses on trends and orders, supply chains focus on multiple aspects, from demand planning, procurement, production, quality check, and warehouse to customer service.
What is multi-location inventory management?
Referring to businesses that manage more than one facility across multiple locations. Businesses may operate several facilities for reasons such as expanding storage capacity, faster shipment of products to the end users by being closer to shipping facility, or stock occasional overstock with buffer warehouses. The success of running several facilities depends on effective communication between teams, consistent inventory standards or operating procedures must be enforced, and a centralised inventory management system to synchronise information across all locations.
How to choose an inventory management system?
There are abundant inventory management system options on the market but choosing the right system to implement will solely depend on your business needs.
Factors to consider:
Understand your business needs:
The first step is to understand the challenges that your business is facing. Identifying your business challenges aids in determining the utmost important features and functionality you need to look for in the new inventory management system.
Ask yourself:
- Are you frequently overstocking or understocking?
- Are you able to determine the stock level?
- Do you have visibility across all warehouse locations?
- Are you lacking full data insights preventing you from forecasting customer demands?
Availability of integrations:
Whether you are a B2B or B2C company, multi-channel management is a crucial factor to consider when choosing to implement the right system. Having an integrated system means having access to accurate real-life data from multiple areas of your business and provides transparency between the teams. Consider if the inventory software will integrate with your existing business software eliminating manual data entry and reducing error, data loss and delays experienced from transferring data between the systems.
Support:
It's essential to choose a vendor that provides training and assistance during and after the implementation stage to fully onboard employees and reduce adoption barriers.
Ask yourself:
- What type of support is being offered by your chosen vendors?
- Do they have an implementation strategy?
- Are they willing to provide training for staff?
- How intuitive is the system to use?
These factors can serve as a guide when shortlisting suitable vendors for your business.
Tips for managing your inventory
Ever-fluctuating markets, customer demand and supply chain disruptions are some factors contributing to the challenge of effective inventory management. To remain competitive and overcome these challenges:
Understand different types of inventories:
There are many different types of inventories, and the type you deal with will depend on the goods you make and sell.
Raw materials:
These are the inventory you use to make your finished products. Not all businesses must purchase raw materials, as production is not part of their business model. Wholesalers and retail businesses are examples of businesses not needing to purchase raw materials, but rather the requirement is to purchase, and store finished products.
Work-in-progress:
Also referred to as unfinished goods. These unfinished goods are assembled/combined to create the finished goods. For example, many components are needed in assembling a car passing through multiple workstations - airbags, brakes, engines, steering wheels etc. The goods involved in the assembly line cannot be sold individually and are stored and managed within the warehouse.
Maintenance, repair and operating goods (MRO):
These indirect goods aren't utilised in making the final products but are essential to ensure your warehouse operates smoothly and effectively. For example, if there's a machinery failure and the spare parts needed are unavailable, the entire manufacturing process can come to a stop causing costly delays. MRO includes supplies for production machinery (e.g. machine oil, light bulbs, motors, gears), safety equipment, cleaning, office and lab supplies.
Finished goods:
Also referred to as for-sale goods. These items are sold either directly to the consumers or to another business.
Manage vendor and supplier relationships:
It's critical to establish a strong relationship with your suppliers. The more trust you've established, the more likely you will gain preferential treatment, such as competitive pricing and faster service. Communication is vital; therefore, keep your vendors in the loop of your decision-making and notify them as soon as possible if you anticipate needing higher inventory.
Practice the 80/20 inventory rule:
As a general rule, most businesses find that 80% of their profits result from 20% of their stocks. Therefore, the inventories that contribute to this 20% should be prioritised and monitored to ensure an optimal level of stock at all times.
Be consistent in how you receive stock:
It's important to establish and enforce a standard procedure and protocol for processing incoming stock for all employees to follow. Once the stocks are received, it's essential to verify and accurately count the number of pallets/boxes and check against the purchase order to ensure the numbers are aligned. A standard procedure will reduce discrepancies between the numbers in your system and what you have on hand.
Order restocks yourself:
Some vendors may provide reorder services. While it's a good idea, it's recommended that you oversee the reorder process yourself. The priority of a vendor is to move their items out of their warehouse as quickly as possible. However, you as a business are only to stock the most profitable items. Therefore, it's essential to take the time to evaluate and check the inventory you need. By handling the reorder process yourself, you also have better insights into tracking customer demand and forecasting future sales. Alternatively, you can set up automatic reorder points within your inventory management software.
Understand Economic Order Quantity (EOQ):
EOQ is the ideal amount of inventory that must be purchased to meet customer demand at a given time. EOQ is the balance between having too much stock or not enough. Having the right amount of inventory can reduce storage and handling costs while maximising your profit.
Plan for the unexpected:
Create a contingency plan in case the unforeseen is to occur. Utilising your inventory management software, you can analyse historical sales data and forecast future demand.
Audit your inventory:
Having insights into your inventory level is critical. The purpose of the audit is to ensure that the available inventory on-hand matches that of the data shown in the software. Together with physical counts, deep dive into key performance metrics such as inventory turnover and costs and compare them to the historical trends.
Use your data to start demand planning:
Predicting possible future customer trends will reduce the risk of overstocking and understocking a product. You can use data such as current inventory levels, historical sales, purchase orders, and manufacture lead time for accurate planning. Predicting possible future trends reduces the risk of not meeting optimal stock level, reduces costs, optimises storage space and guarantees customer satisfaction.
Invest in software to manage your inventory:
Investing in an inventory management system is a necessity to remain competitive in the market. When choosing the right system, look for functionalities such as real-time demand planning, advanced data analytics and real-time reporting.
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