Summary: In this blog post, you’ll learn about inventory management. Topics include what is inventory management, why it’s important in 2020, inventory management amid the covid-19 pandemic, inventory accounting, inventory management techniques and best practices.
What exactly is inventory management?
By definition, inventory management, or inventory control, is the processes of purchasing, storing, and using a company’s inventory. This ranges from the raw materials used to produce inventory to the finished products that enter and exit a warehouse. In short, inventory management is knowing what you have and where you have it at any given time. Smaller companies often manage their inventory manually using Excel spreadsheets while larger ones will use enterprise resource planning (ERP) software.
What is the importance of inventory management?
Inventory management is the backbone of the supply chain and without it, companies risk making costly and frequent mistakes such as overstock, out of stock, miscounts, mis shipments, et cetera. These errors occur most frequently with manually managed inventory while automation removes some of the human error from the processes.
The true costs of poor inventory management
While manual management methods may work for simple companies, they can be a liability to fast-growing ones. Miscounts and overstock or out-of-stock have very real costs associated with them. Retailers often have over 80 percent of their working capital in their stock, making overstock a liquidity problem as a company can’t get their cash back until excess the stock is sold, often at reduced margins. On the other hand, out-of-stock of raw materials delays production while a shortage of finished goods results in lost sales from dissatisfied customers. Annually, retailers lose nearly $2 trillion as a direct result of overstocks and out-of-stocks.
These problems are also costly in terms of error correction. Mis-shipments mean a company has to pay to send the correct shipment while also paying for the return of the incorrect one. In the case of miscounts, lost or damaged goods need to be replaced all while a company pays for the doubled pick time. Further, in order to retain customers, companies have to scramble to correct these errors before customer loyalty takes a hit and future profits diminish.
Inventory management during COVID-19
The coronavirus pandemic which took the world by storm has had unforeseen consequences in every aspect of life. Many companies are having to ask themselves how they can adapt to the current climate in their industry (and out of it). For inventory management, this means adjusting future forecasts to take the effect of the virus into account.
Forecasting in uncertain times
Forecasting relies on past sales to predict future demand, but what happens when your demand suddenly changes? With no end of the pandemic in sight, it is safe to assume that coronavirus conditions will continue indefinitely. As such, when making new forecasts, use data from the beginning of the outbreak (in the U.S., this means approximately since March 2020) to determine future demand. Whether demand has gone up or down, setting realistic expectations for future sales will help businesses to avoid the costly problems of overstock or out-of-stock.
Changes in supply chain
One of the most prominent problems with manufacturing during the pandemic has been the disruption of supply chains. Disruptions can result from government restrictions, surges in demand, or business closures. Either way, any business that purchases merchandise or produces their own finished goods may need to switch suppliers in order to meet the forecasted demand, or, at a minimum, know where to get materials or finished goods if the supply chain gets disrupted.
In short, inventory management is important because it saves time and money by avoiding mistakes in inventory and supply chain that have the potential to become costly liabilities to a business. During these uncertain times, which have seen drastic changes in markets and demand, it is especially crucial that companies are on top of their inventory and are able to respond quickly and effectively to sudden changes. With proper software and management tools, businesses can minimize their losses while fulfilling requirements and keeping customers happy even amid the pandemic climate.
How inventory management works
Inventory management is the term used to describe the many operations that all work together to accomplish the larger goal of inventory control. The primary tasks involved are knowing when to restock, what amounts to purchase, when to sell and at what price.
Your (management) mileage may vary
While these are the basics of inventory management for any company, the exact practices vary widely based on the industry and the product involved. A fast fashion company has to sell all of the season’s inventory within a very limited time or risk having to sell the overstock at a steeply discounted price. On the other hand, an auto parts manufacturer can keep their stock on hand longer as the demand for their product does not diminish so quickly outside of the season during which it was produced. Similarly, a beverage manufacturer has different inventory needs as either of the above examples since their product must be stored at a certain temperature and be sold before the sell by date.
On a balance sheet, inventory is a current asset since the company will sell the finished product in the near future, depending on the type of product. However, this does require that companies keep careful counts of their current inventory to ensure that there are no errors in their accounting. Typically, companies use either first-in-first-out (FIFO) costing, last-in-first-out (LIFO) costing, or weighted-average costing to account for their inventory.
The 4 types of inventory
In accounting, company’s inventory will fall into one of the following four categories:
Raw materials are what a company uses to produce its goods. A company can either purchase and process the raw materials itself or outsource that work to a manufacturer.
As the name implies, works-in-progress are the raw materials in the process of becoming finished products. They include the cost of the raw materials as well as other costs such as packaging, labor, and shipping.
This type of inventory is a good that finished with production and is ready to be sold to customers
Many people confuse merchandise with finished goods as they are both finished products that are available to consumers. However, merchandise differs in that it was purchased as a finished good from a different company than the one that intends to sell it.
Inventory management techniques and best practices
Though inventory management is a highly customizable system of practices, certain measures should be taken to minimize human error and reduce the chances of costly mistakes. Below is a list of procedures that will help any business, regardless of size or industry, to streamline their inventory control and improve efficiency.
Set par levels
Par levels are the minimum quantity of a product that you have in stock. If a product quantity falls below the par level, it’s time to buy more. This measure helps to ensure that a company is never out of stock of any particular item and can meet customer demand in a timely manner. These levels should not be set arbitrarily, however. Forecasting can help you to determine the minimum amount of product that you should have on hand at all times. This number may fluctuate by season so attention should be given to future conditions. Par levels should also be set according to the quantities of raw materials it takes to produce a finished good. These numbers should not get too high above the minimum, though, as doing so can unnecessarily tie up capital that would be better spent elsewhere.
Establishing reorder points
Closely related to par levels, an order point is the time when you replenish your stock, but unlike par levels, reorder points have to take into account shipping times and potential delays. When doing so, it is in good practice to order “safety stock”, a level of extra stock that is maintained to mitigate the risk of disruptions in the supply chain. Determining reorder points manually can be tedious, but inventory management software can automate this process to help make your inventory restocking more efficient.
If inventory control is a system of maintaining enough inventory to supply a demand, then it follows that accurate forecasting of future demand is a crucial part of successful inventory management. Forecasting uses historical data of production, sales, and demand planning to infer the necessary inventory level at a certain future time. Countless variables need to be taken into account, including market trends, market growth, seasonality, consumer surveys, and more. Though the process can be time consuming, an accurate estimate of future inventory needs can help avoid the problems associated with overstock and out-of-stock and can help ensure timely fulfillment.
Use ABC analysis
ABC analysis, or activity-based costing, is a practice that helps to determine the value of your stock based on what percentage of your revenue it generates. This helps a business to prioritize certain types of stock based on how profitable it is.
|Category||Percentage of |
|Inventory value based|
A stock is your most valuable inventory and should take priority when it comes to setting par levels and given extra consideration in forecasting. C stock, on the other hand, is slow-moving stock that should be sold, likely at a discount, to free up cash and warehouse space that can be used for A and B stock.
Economic order quantity (EOQ)
Economic order quantity is the number of units that a company should purchase in a single order to minimize inventory costs while ensuring sufficient supply. The model also helps to minimize the number of orders a company needs to make in order to maintain stock levels, thereby cutting down on shipping costs from additional inventory orders. The formula works on the assumption that demand, ordering, and holding costs remain constant, so this model will need to be adjusted as circumstances change.
Just-in-time is a risky stock strategy that entails maintaining the absolute minimum inventory requirements to meet demand before there’s a stock shortage. This method requires very accurate forecasting because businesses that rely on JIT risk not being able to meet demand should it spike suddenly which has the potential to drive customers away and toward competitors. That said, the benefits of JIT can’t be denied as it reduces the amount of inventory a company keeps on hand which lowers storage and insurance costs while also eliminating excess stock that would otherwise need to be liquidated later on. This method isn’t for every company so special consideration should be given to the accuracy of forecasting models as well as the costs of failing to meet demand.
Managing your inventory effectively, even in 2020
Good inventory management, the process of purchasing, storing, and using inventory, allows businesses to minimize risks and cut down on costs while meeting customer demand. Through various methods and strategies, companies can ensure that they are able to operate efficiently even during the unusual market conditions of 2020 (and likely beyond). By using best practices, good inventory accounting, and proper inventory management techniques, businesses set themselves up for maximum profitability and give themselves the best chance to thrive even in a changing market.