What is Inventory Management? A Primer for Small Businesses
Inventory management is the systematic process of tracking the flow of goods. Learn the essentials of proper inventory procedures in this guide.
Managing the volume of inventory efficiently is about securing the right stock in the right quantities. It supervises the moving of a company's non-capitalized assets - sourcing, handling, and, ultimately, points of sale.
As many as 43% of small businesses rank this task as their biggest struggle and for good reason- the processes behind it are complex and require a solid strategy to maintain accuracy.
If a business fails to handle their stock successfully, it can lead to critical issues such as loss of profits due to missed opportunities. In fact, over 70% of shoppers would rather acquire an item from a competitor rather than wait for the item to be restocked.
Maintaining a reliable inventory strategy through the use of inventory management software is vital to business success as it greatly impacts customer experience and cash flow.
A Brief History of Inventory Management
Back in the day, managing inventory used to be entirely manual, with salesmen relying mostly on instinct to manage their stock. Today, this practice has evolved into a state of near-perfection with advances in technology. And yet, as many as 43% of businesses still do not track their stock in any way or choose to use laborious manual processes; so establishing a solid inventory tracking strategy is a simple way to stay ahead of competitors.
Inventory management dates back to 50 thousand years ago when sticks were ingeniously used to tally stock. Even before the Industrial Revolution, traders had to keep track of their stock manually. The evolution of managing inventory was slow and ponderous but a significant breakthrough was made in the 19th century when Herman Hollerith invented the punch-card tabulating machine. This marked a new era as it allowed for semi-automated data processing.
In the 20th century, a new method for tracking stock was invented - the barcode - which quickly became the standardized tracking process across the world. The next step was computerized systems in the 90s, which were mostly unavailable to smaller businesses due to their high cost.
Today, 50% of retailers use RFID tags and complex data modeling to maintain exceptionally reliable inventories. The systems and technologies behind inventory management are constantly evolving and the future is bound to make this process even more intuitive, accurate, and convenient.
How Inventory Management Can Save You Money
Inventory management is a cornerstone of any successful business. Without a clear and actionable strategy in place, businesses can expect to encounter regular issues regarding customer service and sales.
A successful management approach leads to-
- Lower storage costs - by having the optimal amount of stock, businesses can cut costs on storage space.
- Customer satisfaction - the ability to provide for customers' needs at any moment can improve customer retention and satisfaction rates.
- Less depreciation - storing goods for an extended period of time, or not storing them correctly, may lead to spoilage and excess waste.
- Optimizing cash flow - by cutting costs on unnecessary storage and unsold inventory, a business can use the excess capital for other purposes.
- Better planning - by adequately managing its inventory supply, a business can easily keep track of what needs to be replenished.
- Reduced spoilage - implementing proper storage techniques of perishable items and avoiding overstocking can significantly reduce inventory spoilage.
The food industry has particularly strict guidelines and regulations that have significant impacts on provisioning. Striking the balance between having enough food to supply to customers while avoiding excess stock buildup is a complex dilemma as either extreme could result in significant losses for the business. This is a universal challenge many other industries face as well.
Inventory Management Types
Inventory types can be classified into four categories- (1) raw materials, (2) works-in-process (WIP), (3) finished goods, and (4) maintenance, repair, and operations (MRO) goods.
1. Raw materials
Raw materials are used to manufacture finished goods or their respective components. Companies can directly produce or extract raw materials or purchase them from an external supplier. To give a basic example, wooden planks are a type of raw material needed to make a wardrobe.
WIPs are all of the materials or parts that are unfinished and moving through production. Until these items have been inspected or controlled for quality, they cannot be put up for sale. For instance, this could include wood that has been stripped and painted but not yet assembled into a wardrobe.
3. Finished goods
These are products that have been completed and are ready for sale to the customer. Following the previous examples, this would be the finished wardrobe.
4. MRO goods
This consists of items that are required for the finished product to operate. For instance, bolts and screws as spare parts in case the wardrobe needs to be repaired.
Businesses that manufacture and sell goods will have to manage most of these inventory types, especially if they grow and tackle new markets.
Inventory Management Terms
To fully understand inventory management, it's essential to become familiar with the many terms and acronyms which are integral to it. Understanding these definitions will make it much easier to communicate with others in the supply chain and simplify the processes.
- 3PL - Third-Party Logistics is the business's use of a third-party for warehousing, shipping, fulfillment, or any other inventory process.
- Bundles - groups of products that are sold together as a single product.
- COSG - the cost of sold goods is the cost associated with the production and storage of goods.
- Cross-docking - the practice of moving products directly to the shipping area without storing them first.
- Deadstock - products that have never been sold to, or used by a customer. These products have usually become outdated and are unlikely to ever be sold.
- Decoupling inventory - also known as safety stock, this is a crucial part of the inventory that is set aside in case of a complete halt in production, rendering some parts unavailable.
- EOQ - Economic Order Quantity is the number of new products businesses should order after having taken into account the demand and storage costs.
- Carrying costs - also known as order costs', these are the costs of storing inventory before it is sold.
- Landed costs - expenses associated with transporting and buying stock, including shipping, warehousing, import fees, duties, and taxes.
- Pipeline inventory - products in the company's supply chain that have not yet reached their final destinations.
- Reorder point - the low level of inventory at which stock should be replenished.
- Sales order - a document sent to customers that confirms a purchase has been made before the order is fulfilled.
- SKU - a Stock Keeping Unit is a unique tracking code assigned to each inventory item that tracks their color, size, style, and any other relevant attributes.
- Variant - a unique version of the product, usually related to characteristics such as size or color.
Inventory Management Methods
There are four most commonly used inventory management methods- (1) Just-in-Time (JIT), (2) Material Requirements Planning (MRP), (3)Economic Order Quantity (EOQ), and (4) Days Sales of Inventory (DSI).
All of these methods are aimed at reducing costs and delivery time while maintaining the excellent product quality that exceeds customer expectations.
JIT is a method of inventory management that isn't related to sales forecasting. With this method, businesses order only the amount of materials needed for the production process. This keeps costs for works-in-progress and storage to a minimum. However, if the demand unexpectedly rises, manufacturers may experience issues keeping up.
2. Material Requirements Planning
MRP focuses on forecasting sales and developing plans for inventory needs based on previous purchases. Therefore, this method requires accurate historical data and strong analysis.
3. Economic Order Quantity
EOQ is a company's ideal order quantity. By assuming constant demand from consumers, companies calculate the necessary number of units while minimizing inventory costs. The optimal solution is when both the inventory holding and inventory setup costs are minimized.
When expressed as a formula, the economic order quantity is as follows-
EOQ = (2DS / H)
Where D stands for demand, the number of products needed to fulfill demand, S stands for setup cost, and H stands for holding fee, otherwise known as storage cost associated with each product.
4. Days Sales of Inventory
DSI is the number of days that a company needs to sell its inventory. It is usually calculated as the average value of the inventory and sold goods in a given time. This financial ratio is used to determine how long, on average, a company's stock lasts. DSI allows companies to estimate when inventory has to be replenished.
To calculate the DSI, the following formula can be used-
DSI = (Ending Inventory / Cost of Sales) x (# of Days in the Period)
Different methods are used across different businesses and industries. Organizations should determine which method is most suitable for their business to most effectively manage inventory and limit risks such as inaccuracies in data.
Inventory Management Software
Inventory management has evolved significantly with technology that enables real-time, automated processes. Today, tools such as software allow businesses to track inventory levels, orders, payments, and deliveries - the entire product journey. This also gives insight into every aspect of a business's requirements and eliminates the need for laborious manual work.
Several key features to look for in any inventory management software are-
- Inventory optimization - the system should provide insights and recommendations for helping maintain the optimal amount of each product.
- Report generation - the system should produce sales reports on each product, allowing the business to manage inventory more successfully and optimize pricing.
- Real-time tracking - the system should provide a feature to track your inventory across multiple storage units and sales points.
- Cloud-based - the system should provide a regularly-updated backup on the cloud that cannot be lost or overwritten.
- Demand forecasting - most importantly, the software should be able to forecast future inventory needs. This works by analyzing past data to determine future demand while incorporating other external factors such as economic conditions and weather changes.
Businesses should regularly investigate their specific needs and find ways to optimize their
inventory management processes. With a quarter of all retailers now investing in new technologies to improve their performances, now is the time to act and come out ahead of the competition.
Inventory management software is a tool that can transform any company's performance, often with low extra costs and virtually zero effort required. With the right strategy, and the right systems in place to execute it, businesses can use inventory management software to lower costs, increase efficiency, and enhance their reputation.
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