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Inventory management: a beginner’s guide

Updated 26 July 2022 • 14 min read

An inventory management system is crucial for success as it provides a business with detailed insight into the financial health of their enterprise and helps keep proper stock levels to serve customers better.

Below we discuss inventory management, how it can best serve your business, and why you should consider investing in an intelligent stock management system.

What is inventory management?

Inventory management is the process of purchasing, storing, using, selling and tracking a company’s inventory.

It follows the movement of goods — from raw material to sale — with the goal of ensuring a company has the right amount of inventory on hand at the right time in the right locations to meet customer demand, lower holding costs and minimise waste.

What are the different types of inventory?

These are the various types of inventory:

Finished goods

Finished goods are the items you have created, assembled, or packaged that are ready to sell to the customer.

Raw materials

A company uses raw materials to create or finish products to sell. Examples of raw materials include oil to make soap, wood to make furniture, or paper to make books.

Work-in-progress

Work-in-progress (WIP) inventory consists of unfinished goods and raw materials moving through the manufacturing process.

Maintenance, repair and operating

Maintenance, repair and operating (MRO) inventory refers to the items used to manufacture goods — for example, machines and tools.

Safety stock

Safety stock is additional inventory kept by a business to manage unexpected events. For example, when supplier shortages occur or you experience a surge in customer demand, safety stock may enable you to fulfil orders.

Cycle inventory

A business might order cycle stock in phases to help them get the right level of inventory at the lowest storage price.

Decoupling

Decoupling refers to the additional items, or WIP, kept on hand to prevent production line hold-ups.

For example, inventory used by one stage of a manufacturing line might slow down other parts of the process. However, decoupling is when stock is kept separate, so this doesn't occur.

Dead stock

Inventory that doesn't sell is typically called dead stock. Because dead stock takes up valuable storage space, businesses may prefer to donate it to a charitable organisation.

Inventory management vs. inventory control

Inventory management might sound like inventory control, but they are not the same.

Inventory management encompasses your supply chain, fulfilment, manufacturing, and sales. Without an inventory management system, it won't be easy to manage inventory, manage suppliers, production lines, and more.

Inventory control refers to how a business manages the stock currently in storage. Inventory control means knowing exactly how much inventory you have available at any given time, where it's kept, and whether or not it's in sellable condition.

Inventory control also refers to how the stock is maintained and how a business works to minimise the time spent managing inventory.

Why is inventory management important?

Inventory management is critical to the success of a business because it helps you serve customers and grow your revenue.

Managing your stock efficiently is essential for a few reasons. If a business orders more raw materials than they need to make products, they will spend more money on stock than necessary, and lose money by holding excess inventory in storage.

Alternatively, if an inventory manager doesn't order enough raw materials, there won't be enough products to meet demand.

Core inventory management terms

When managing your inventory, you'll need to know the following terms:

Backflush

Backflush is an approach used in just-in-time (JIT) inventory management, where costing is delayed until the products are complete. Backflushing can be helpful in scenarios when a production process is short.

Bundling and kitting

This sales technique bundles or groups certain products together to encourage sales of a new item. For example, a computer company may bundle a PC with a monitor or software, or a soda company may bundle 3 types of soda in a package to introduce a new flavour.

Consignment

To consign means keeping inventory with a third party but maintaining ownership of the goods.

Cost of goods sold (COGS)

The cost of producing goods sold from your inventory is also known as the cost of goods sold, or COGS. The COGS includes additional charges as well, like packaging and delivery costs.

Cycle count

Cycle count is used for auditing purposes and may also be used for taxation compliance. In a cycle count, a smaller portion — or a sample — of the entire inventory is counted to calculate the whole stock level.

Days of inventory on hand

Days of inventory on hand refers to how long products are held in inventory before they're sold and indicates how well inventory is managed.

Dead stock

Dead stock is stock that is not being sold or turned over and is therefore “dead weight,” taking up space that might be utilised for more lucrative items.

Demand forecasting

Demand forecasting estimates a product's future demand. The process helps sales teams set targets. Demand forecasting can also help create budgets and pricing strategies.

Holding costs

Holding costs refer to the storage of unsold inventory. Holding costs would include insurance, storage space, and labour to manage inventories.

Lead time

The lead time on a product refers to a supplier's total time to fulfil the required order after the purchase order has been received. The lead time can also indicate the time between the placement of an order and when the goods are received.

Order fulfilment

Order fulfilment refers to the time between a product purchase and the customer’s receipt of that product.

Reorder point

A reorder point is a set level of stock that indicates a need to purchase more from the supplier. Any stock left after hitting the reorder point is considered safety stock to manage unexpected events like demand surge or supplier shortage.

Stock keeping unit (SKU)

For easy identification, a stock keeping unit, or SKU, (pronounced "skew") is assigned to each product. A SKU code is typically 6 to 9 digits long to distinguish one product from another. In addition, certain digits may indicate various characteristics of products like colours or sizes.

Inventory management process

Various aspects go into inventory management, and knowing the specifics can help with your stock management and inventory planning.

1. Forecast demand

Forecasting demand is the first step in inventory management. Demand forecasting is the process of making an educated guess regarding the future demand for your products.

Estimating the driving factors, quantity, quality, pricing, and more can be challenging, and there are several ways to calculate these figures.

2. Place purchase orders

Part of why inventory management is essential is because it helps you predict your needs before they become urgent.

Supply and demand can vary greatly depending on the circumstances. Having a system in place can help you know when to place purchase orders.

3. Produce products

Producing more products than you can sell will result in tied-up capital, draining your business of valuable funds.

On the other hand, producing too few products can lead to shortages and lost sales opportunities. Inventory management provides detailed insight regarding how much product you'll need and when.

4. Stock inventory

After you produce or purchase your products, you'll need to stock your inventory in a way that's efficient and easy to track.

Whether it's storing raw materials to craft finished products or storing completed products, holding stock in a way that considers the needs of your goods is critical.

5. Sell inventory

Next is selling your inventory and moving your product into customers' hands. Inventory management helps you move products efficiently by providing insight into the number of items available and helps you quickly locate products within a warehouse.

6. Report on sales

Keeping track of your inventory and sales is critical for your business's success. Data and reports can help identify weak spots in your business and opportunities for growth.

Common inventory management techniques

You can approach inventory management differently depending on your needs. We’ve listed out the most used types of management techniques employed by businesses below.

ABC analysis

ABC inventory management stems from the Pareto principle. The Pareto principle states that 20% of a business's activities create 80% of the output and profit. Therefore, most energy should focus on the activities that drive the greatest performance.

Economic order quantity (EOQ)

EOQ — also known as optimum lot size — refers to the ideal order quantity at any given time. Ordering the perfect amount of stock results in lower storage and ordering costs.

FIFO and LIFO

First in, first out (FIFO) refers to the principle of selling the oldest stock first to check stock isn’t sitting for a prolonged period or expiring. Last in, first out (LIFO) focuses on a different principle, being that the most recently-purchased stock is the most expensive, and therefore needs to be sold first to recuperate the cost.

Just-in-time (JIT) inventory management

Companies use just-in-time inventory management to keep their stock levels as low as possible. The JIT approach helps keep costs down and cashflow high; however, as with any approach, there can be drawbacks, like stockouts.

Minimum order quantity

Minimum order quantity is similar to JIT inventory management in that it also helps keep costs low. This approach relies on minimum order quantities from suppliers to save money.

Periodic inventory management

Instead of keeping track of inventory continuously, periodic inventory management is the method of only monitoring stock levels at the start and end of accounting periods.

Perpetual inventory management

Perpetual inventory management is when a company continuously tracks inventory as it makes its way through the supply chain; stock levels are automatically updated when items are received and sold.

Safety stock inventory

The safety stock inventory method is the process of re-ordering each time your safety stock level is reached. Safety stock is stock you keep beyond your expected sales in case of unforeseen events like a demand surge.

Vendor-managed inventory

Vendor-managed inventory is when a supplier or vendor of a product assumes responsibility for inventory and shipping.

Inventory management formulas

Various formulas can be used for different needs. Here are a few types and how they can help a business get ahead.

Economic Order Quantity (EOQ) formula

Your EOQ is the optimal level of stock you should order to minimise your ordering and holding costs. The EOQ can save a business a considerable amount of money.

Days Inventory Outstanding (DIO) formula

Days Inventory Outstanding (DIO) refers to the days for stock to turn into sales. Generally, a lower DIO is ideal as this generates revenue quicker. However, keep in mind that different industries, products, and business models will have various average DIOs.

Calculate your DIO using the following formula:

Reorder point formula

It's challenging to know when to re-order more stock. However, there are calculations to help.

Figuring your estimated reorder point can be done following these steps:

Safety stock formula

Safety stock is essential to account for unforeseen circumstances and acts as a buffer when you sell out of stock. Keeping enough safety stock is important to meet demand, but you don't want to keep too much, straining your cashflow.

Determine your safety stock levels using the following steps:

Benefits of inventory management

When you properly manage inventory, you can help your business grow in many ways. Below are a few of the benefits.

Cut costs

Purchasing inventory, managing your storage, paying for insurance, and paying employees costs money. Properly managing inventory can help reduce these costs.

Improve cashflow

By optimising the inventory level you keep on hand, you can free up more capital to spend on other necessities.

Avoid stockouts and excess inventory

Carrying excess inventory is costly, but so are stockouts. Better inventory management can help you avoid both of these scenarios.

Negotiate better terms with suppliers

With detailed insight into your inventory, you can better negotiate with suppliers.

For example, knowing you sell a lot of one item during a certain time of the year could help you strike a deal with your supplier to get better prices.

Improve customer experience

When customers know they can count on you to always have stock and offer the best prices, they're more likely to return and stay loyal.

Increase profitability

By understanding your inventory, demand, and turnover, you can increase your business's profitability and growth.

Top challenges for inventory management

Below are some of the most common challenges in inventory management.

Manual error-prone management processes

Keeping track of stock manually when your business is small may be simple. Still, as you grow your business, an automated inventory management system is critical to navigating larger inventory needs.

Collecting accurate stock details

Manually counting inventory once a year is inefficient when you need to know how much stock you have at any given time. Inventory management software with automation features can help you avoid this issue.

Overstocking and understocking inventory

Overstocking can drain your financial resources, and understocking can result in lost customers and sales. Inventory management can help you keep the right levels of inventory for better results.

Adapting to changing consumer demands

Evolving demand and industry trends can feel overwhelming without tools to predict your needs.

Keeping too much inventory of one product could result in obsolete and useless stock. Inventory management technology can help you keep better tabs on your needs.

Poor order management

Knowing when to order stock and how much to order is a common challenge. However, with an inventory management process, seasonal and historical order data can help you accurately anticipate customer demands and order accordingly.

Lack of product visibility

Without software to identify where or how much inventory you have, you will likely have limited knowledge of your inventory. Furthermore, locating stock in your facility using manual processes can be inefficient.

Inventory management best practices

Multiple strategies can help you maintain your inventory successfully. Here we present some of the best practices used by businesses around the world.

Categorise inventory using ABC analysis

ABC analysis is a method of organising your inventory into a hierarchy of most- to least-crucial items.

“A” items are the higher selling, top priority items, “B” items are valuable but medium priority items, and “C” items are lower priority.

Understand your reorder point

Employing a reorder point formula that works with your business needs is essential to know when to order more stock.

Keeping enough stock prevents unexpected stockouts due to market spikes. Furthermore, a formula can help you keep less stock on hand when necessary during seasonal slumps.

Carry safety stock inventory

Keeping extra inventory on hand protects against variable market conditions, evolving customer demand, and changing lead times.

By neglecting to keep safety stock available, you could lose out on revenue, customers, and market share, but keeping it prevents stockouts and protects against forecasting mistakes.

Track inventory by batch and expiry date

Keeping tabs on your inventory batches and expiry dates can protect against any obsolete or expired stock. Unsellable products only drain your financial resources, and neglecting to maintain records on these can ruin your enterprise.

Optimise inventory turnover rates

Calculating your inventory turnover rate can help you better understand market demands.

By understanding the needs around your products, you can identify steps to take to better stock your inventory. To optimise turnover rates, you might experiment with pricing, forecasting customer demand, or liquidating obsolete stock.

Track inventory management KPIs

Tracking inventory key performance indicators (KPIs) can help reduce guesswork by providing clear goals to hit each day, week, quarter, or year.

Reduce dead stock counts

Dead stock can drain resources, so reducing it will be ideal in optimising operations. By tracking your inventory, you can lower your lead times, eliminate obsolete stock, and improve forecasting accuracy through real-time data tracking.

Use inventory management software

Manually calculating inventory needs can be a drain on resources and even increase the risk of mistakes. Using intelligent inventory management software can save you time, money, and energy by automating procedures.

Improve your inventory management with MYOB

Manual inventory management can drain your resources and increase costs. With MYOB, you can understand what's selling and what's not, avoid running out of hot-ticket items, and oversee your inventory from the warehouse or the road.

By accurately tracking your inventory through MYOB's inventory management software, you can identify your best sellers and optimise reorder points. MYOB's intelligent inventory management software gives you a better way to manage all inventory operations. Start a 30-day FREE trial today!

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