Inventory is one of the key accounting terms in a financial statement. It is defined as the goods or services that your business deals in. It might consist of raw materials, finished goods, or a bulk product that is divided into smaller parts and sold individually. Inventory might also consist of intangible goods such as software and mobile applications.
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The importance of Inventory Management helps firms efficiently control supply and demand. Without a successful inventory management system, businesses can risk wrong shipments, shortage of goods, excess inventory, spoilage, delay in fulfilling customer orders, and so on.
In contrast to an enterprise resource planning (ERP) system, inventory management software focuses on a single supply chain process. It can integrate with other system solutions, including point of sale (POS) software, shipping, and sales channel management. This helps companies build a personalized integration stack that can meet their daily needs.
Let us now understand a few selective inventory control techniques.
What Are Some of the Inventory Management Techniques?
Inventory management refers to the process of tracking your inventory or stock level and the movement of goods. It includes delivering raw materials to manufacturers, fulfilling orders for finished goods, and so on. It is one of the fundamental building blocks of a supply chain as it helps businesses minimize costs, optimize cash flow, and increase profitability.
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Economic Order Quantity
Economic order quantity, or EOQ, is a term that is critical to the inventory management process of any enterprise. It refers to the optimum product quantity that a company should have in order to keep buying, holding, and other related costs at a minimum. EOQ assumes that a trade-off exists between inventory holding costs and inventory setup costs and that the total inventory costs are minimized when the holding and setup costs are reduced.
The formula for calculating EOQ is as follows:
√(2*S*D)/H
Where,
- S= setup costs
- D= demand rate or the quantity sold per year
- H= holding costs per year per unit
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Minimum Order Quantity
Minimum order quantity, or MOQ, is the smallest number of goods that a retail business must purchase in order to keep inventory costs low. Typically, inventory items that are costly to produce have a low MOQ compared to low-cost goods that are cheaper and easier to make.
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ABC Analysis
In ABC analysis management technique, you need to calculate the value of the inventory items on the basis of their importance to the business. This inventory technique divides the goods into three different categories based on their impact on the overall inventory cost.
The products are categorized as follows:
- Category A: They are the most valuable product of your business and contribute the maximum to the profits
- Category B: Products in these categories lie between the most and the least valuable products. They don’t have a major but not minimal impact on your company’s profitability.
- Category C: These products are usually low in value, and although they are important for calculating profits, they don’t matter much individually.
The formula for performing an ABC inventory analysis is
(Number of products sold in a year)*(Cost per product)=Annual usage value per product
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Just-In-Time Inventory Management
Just-in-time (JIT) inventory management refers to an inventory technique in which companies buy goods on an as-when-needed basis. This prevents them from ordering too much inventory and reducing the risk of perishable goods or ordering fewer products and risking stockouts.
JIT is an effective inventory control system that aims to eliminate waste and ensure that the goods arrive as they are required for production or for meeting customer demand but not sooner.
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Safety Stock Inventory
Safety stock inventory, also known as ‘buffer stock’ or ‘backup inventory,’ is the surplus inventory that companies order and keep in addition to their typical cycle stock. This is done to prevent a stock-out situation and to meet any unexpected fluctuations in demand.
Safety stock is also kept by businesses to overcome problems such as potential supplier delays, inaccurate demand forecasting, and other uncertainties.
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FIFO And LIFO
FIFO and LIFO are the two methods of inventory management in which businesses calculate inventory at the beginning and at the end of a financial year.
FIFO, or first-in, first-out, is an inventory management technique that values goods on the assumption that the first products that the business purchases or manufactures will also be sold first.
Here’s how to calculate FIFO:
Ending Inventory Value = Remaining Units x Per Unit Value
LIFO, or last-in, first-out, is an inventory management technique that calculates the value of goods based on the assumption that the products which are bought last are sold first.
The formula for computing LIFO is
Ending Inventory Value = Remaining Units x Price of New Units
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Reorder Point Formula
In the reorder point formula, you find out the minimum stock requirement a business should have before they decide to reorder their goods again. A reorder point is bigger than a safety stock amount to factor in the lead time.
The formula for calculating the reorder point is
Average Daily Unit Sales x Delivery Lead Time + Safety Stock
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Batch Tracking
Another way to manage inventory includes batch tracking, wherein companies can group and monitor similar goods to track inventory expiration or trace expired, defective, or spoiled goods back to their original batch. The characteristics used for grouping similar items together include manufacturing date, location, expiration date, supply chain sources, and any specific parts or raw materials used.
Batch tracking is an effective inventory management system as it helps improve inventory accuracy, faster tracking of specific product batches or items even after they are sold, and makes inventory calculation, including FIFO and LIFO easier.
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Consignment Inventory
In consignment inventory, the consignor agrees to supply the consignee with their goods and the consignee does not have to pay for the inventory costs upfront. The consignor who offers the products still has their ownership, while the consignee pays for them only upon sale.
Consignment inventory is a supply chain management benefit in which the consignor or the vendor retains the ownership of the goods till they have been sold. Since the retailer does not actually purchase any stock until it has been sold, unsold products can be returned back to the supplier.
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Perpetual Inventory Management
Perpetual inventory system refers to an accounting method that consists of counting inventory as soon as the business receives the consignment. This basic inventory management system helps deliver real-time insights into your stock levels. Although typically calculated using pen and paper or Excel spreadsheets, a perpetual inventory system records inventory changes in real time using computerized point-of-sale systems.
Today, a perpetual need for an inventory management system provides immediate reporting of the changes in inventory and an accurate calculation of the inventory at hand.
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Dropshipping
Dropshipping is an inventory management technique in which the supplier ships or delivers the product directly to the customer. It is also referred to as an order fulfillment method of inventory management – where when a customer purchases a product, instead of picking the good from your own inventory, the product is delivered to the consumer directly by the third party. Typically, the store does not own or store any physical inventory of its own.
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Lean Manufacturing
Lean manufacturing is a broad set of management practices that can be applied to any business practice. It is a production process based on the ideology of minimizing waste within a manufacturing unit while maximizing productivity at the same time. It ensures improved business efficiency by removing any waste and non-value-adding activities from your business operations.
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Six Sigma
Six Sigma is one of the most popular inventory management processes that provide companies with the necessary tools to improve the performance of their business and reduce unsold or excess inventory. It typically uses statistics and data analysis to detect any errors, extra costs, or defects. In the process, six sigma aims to improve counting cycle times and reduce any manufacturing defects.
What Is the Process of Inventory Management?
The inventory management process involves tracking and controlling the stock as it moves from the suppliers to the warehouse to your customers. The five stages of the inventory management process include purchasing stock, producing or manufacturing it, holding the stock, selling the finished products, and reporting them on your financial statements.
Let us understand each of these five steps better.
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Purchasing Stock
The first step in the inventory management process is purchasing stock. This includes buying raw materials that can be used for manufacturing other products or buying goods that do not require any assembling or production to be sold.
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Manufacturing the Goods
The second stage in the inventory management process is manufacturing or production. Not all businesses are involved in manufacturing. For instance, a firm that deals in finished goods does not hold any physical inventory of its own, or sells wholesale products, and will not require any manufacturing or production.
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Holding the Stock
Holding stock indicates storing your inventory before it is manufactured or until the finished goods are sold to the final consumer. However, this does not apply to firms that do not have any inventory of their own and rely on third-party sellers to ship goods to their customers.
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Selling
Once your goods have been manufactured and packed, they are ready to be sold to the final customer. This process is known as sales and involves delivering your products into your customers’ hands and charging payment for the same.
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Reporting
Reporting is the final stage of the inventory management process. Once you have sold the goods, it is time to report them on your financial statements. The inventory sold is recorded as ‘cost of goods sold’ in the profit and loss or income statement. On the other hand, some companies use the FIFO method while others use the LIFO method to compute inventory, which is recorded as an asset in the balance sheet.
How Does Inventory Management Work?
At the basic level, various inventory management techniques work by tracking products, components, and different ingredients across suppliers, stock available on hand, goods produced, and sales. This ensures that the stock is used in the most efficient and effective way possible.
Further, inventory management provides forecasts and insights in real-time to better understand the number of products sold, inventory unsold, and projected sales in a particular period. This helps companies plan better to produce and help to manage inventory in a better way.
Let us take an example to understand how the process of inventory management works. John decides to set up a business manufacturing and selling wooden desks. Each chair he manufactures requires four different sizes of wood. John contacts his supplier and buys eight planks of each size of wood he requires. The planks purchases are now all included in John’s business inventory.
As John turns the raw materials into desks, he proceeds to sell them. John’s inventory levels will now undergo a change. He will not only need to track the number of desks sold but also the amount of raw material he has at any point in time, how many desks he can produce, how fast he can produce, the number of desks he can sell, and so on.
This helps John forecast sales for a given period and determine the raw materials accordingly he will require.
The Use of Inventory Management Software
Today, all these details can easily be stored in inventory management software that keeps track of all your stock, purchase orders, bulk shipment, supplier truck, etc. Based on historical sales data and customer demand, you can even do demand forecasting with the help of an advanced analytics solution.
It helps you identify how much inventory you need for a certain period of time so that you can meet demand in a timely manner.
Wrapping Up
Inventory control methods, or inventory management control techniques, help businesses better track their inventory, its movement, and the volume of goods sold or unsold. Companies use several inventory management techniques depending upon their size, industry, and requirement. However, certain inventory techniques are used by almost all enterprises to track their stock levels.
Frequently Asked Questions
When measuring the success of your inventory control processes, it is important to track certain numbers. These metrics include stockouts, unsold goods, inventory turnover ratio, dead stock, and order cycle time. Once you have implemented new inventory management techniques, you can then compare data and KPIs from before and after.
Inventory management strategies include monitoring demand closely to avoid stockouts or excess stocks, auditing your inventory stock regularly, tracking product expiration dates, and investing in an inventory management system.
Inventory management policies refer to a standardized set of guidelines that provide a framework for an organization to make informed decisions about buying inventory. It typically relies on an understanding of your company’s supply chain management capabilities to support consumer demand.
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