Effective inventory management is essential for any business, ensuring that products are available when needed while keeping costs low and operations efficient. Whether you’re managing a small retail shop or a large wholesale operation, mastering the basics of inventory management can help you optimize stock levels, reduce waste, and increase profitability.
In this article, we’ll explore the core concepts, various types of inventory, and key strategies that will help you maintain a well-balanced, efficient inventory system.
What is Inventory?
Put simply, inventory is the quantity materials or “stuff” in storage. Within the context of this article, it refers to all forms of material intended for sale kept by an organization.
Inventory is a big part of a company’s assets, but it can also be a liability that ties up an organization’s working capital. Having too little inventory can be as costly as having too much.
The key to a successful business lies in figuring out the optimum way to manage your supply chain.
What is “Inventory Management”?
The core concept behind inventory management is to ensure you have the right amount of inventory, in the right place, at the right time, at the right cost.
Keeping track of your stock-on-hand helps to optimize your inventory to satisfy customer demand in the market for products and services, without exposing the company to unnecessary costs and risks.
It seems that the simplest approach to always have enough inventory on hand is just to carry an excessive amount of inventory.
Yet keeping excessive inventory on hand for indefinite sales will drain the resources of a business — especially since inventory makes up the largest percentage of costs for many retail and wholesale businesses.
Types of Inventory
Different classes of inventory need to be managed differently to match your business objectives. On a basic level, we have:
- Work in Progress (WIP): Items which are in the process of conversion into the finished product.
- Finished Goods: Items which are ready for purchase and consumption.
- Maintenance, Repair & Operating Items (MRO): Miscellaneous items which are not directly part of the production chain, such as tools and office supplies.
- Raw Materials: Materials which can be converted into components or products, such as gold which is used for jewelry.
From a functional perspective, we have:
- Current-Demand Stock: This is the inventory for immediate use that is computed based on the current expected demand.
- Transit Inventory: This is inventory en route from one place to another. Also known as pipeline stock.
- Anticipation Stock: Limited capacity to produce the inventory during peak seasons results in the need to acquire inventory earlier in “anticipation” of demand.
- Safety Stock: Also called buffer stock, this is the extra inventory that’s carried to serve as a cushion for uncertainties in supply and demand.
Purpose of Holding Inventory
Understanding the different reasons for holding inventory helps you to manage your supply chain.
- Unreliability of Supply: Holding inventory protects you from unreliable suppliers, or when an item is scarce and without the guarantee of a steady supply of stock.
- Fluctuation in Demand: As demand levels are never an absolute certainty, holding extra inventory can enable organizations to meet unexpected surges in demand.
- Quantity Discounts: Many suppliers offer discounts based on certain quantity breaks because large orders tend to reduce total processing and shipping costs thanks to economies of scale.
Inventory Costs
Maintaining inventory is expensive, so factoring in inventory costs will help in deciding the order quantity.
1. Ordering Costs: Includes all costs involved with placing an order and procurement. It also includes associated labor costs, for example: clerical and processing.
2. Holding Costs: The cost of storage for physical inventory. This includes facilities, insurance, tax and handling, etc.
3. Shortage Costs: Incurred when there’s a stock shortage. This reflects the loss of sale and the corresponding loss in revenue/profit. Also includes the possibility of losing goodwill when customers leave because they can’t wait for the next batch of stock to arrive.
Inventory Valuation
Inventory valuation is to determine an organization’s profit, and an understanding of the financial importance of inventory is key to measuring its impact on cash flow.
First-In, First-Out (FIFO): FIFO assumes that the first goods purchased are the first to be used or sold, regardless of the actual timing of their use or sale. This method is closely tied to the actual physical flow of goods in the inventory.
Last-In, First-Out (LIFO): LIFO assumes that the most recently purchased/acquired goods are the first to be used or sold, regardless of the actual timing of their use or sale. This method best matches current costs with current revenues.
Average Cost Method: This inventory valuation identifies the value of the inventory and cost of goods sold, by calculating an average unit cost for all goods available for sale during a given period. This method treats all inventory in the same way, thereby leveling out price fluctuations.
Specific Cost Method: This method requires tracking the actual cost of each unit of merchandise from beginning to end—best suited for an environment without much inventory to track. This complicated method usually requires the use of a sophisticated tracking system.
The impact on the bottom line and the taxes that an organization must pay is closely tied to the inventory valuation method that’s used. This is best shown with the example below:
| ITEM | DATE PURCHASED | COST | RETAIL |
| Small White Shirt | 1 January | $1 | $5 |
| Small White Shirt | 2 January | $2 | $5 |
| Small White Shirt | 3 January | $3 | $5 |
First-In, First-Out (FIFO):
We assume that the first item bought is also the first item that’s sold.
Revenue: $5
Cost of Goods Sold (COGS): $1
Gross Profit: $4
LIFO Valuation:
We assume that the last item bought is also the first item that’s sold.
Revenue: $5
Cost of Goods Sold (COGS): $3
Gross Profit: $2
Average Cost Valuation:
To calculate the average cost:
$1 + $2 + $3 = $6
$6 / 3 = $2
Revenue: $5
Cost of Goods Sold (COGS): $2
Gross Profit: $3
Based on the examples, we can safely conclude that:
FIFO valuation: gives, in this particular example, a high gross profit = higher taxation.
LIFO valuation: gives, in this particular example, a low gross profit = reflects a poor COGS.
Average Cost valuation: gives a balanced valuation.
Setting Up an Inventory Management System
Inventory management is more than just implementing a process. It also allows you to set up a standard system through which you can manage and streamline your inventory and business efficiency.
If inventory management is the process of knowing what stock is on hand, it’s important that we base our purchasing on anticipated demands to make better procurement decisions.
How do we track and monitor this information? The most important questions are as follows:
1. What item should be ordered?
2. How much of each item should be ordered?
3. When should we order more of an item?
4. Which items are selling well? What’s not doing well?
5. Are we holding too much stock?
6. What is the Return On Investment (ROI) on my stock?
Given the complexity of this task, the solution is surprisingly direct. By leveraging an inventory system, all these questions can be answered without much hassle.
The minimum requirement for a system is that it helps you keep track of when and how much to order.
Fixed-Time Period System (Periodic)
The inventory levels are checked periodically, and the quantity of stock ordered can vary.
A target inventory level is maintained in the system and inventory is checked in intervals (for instance every week or every two weeks). Orders are then placed to restore inventory levels to the target quantity set.
Advantages:
- Because orders are made in bulk, organizations can take advantage of quantity discounts.
- Less administrative process since orders are made in one sweep.
Disadvantages:
- Since inventory level is not checked on a regular basis, a sudden urge of demand can lead to a stockout.
- Gaps in stock movement leads to lesser visibility and accuracy.
Fixed-Order Quantity System (Perpetual)
The quantity of stock ordered with this system is constant or fixed.
An order is placed when the inventory level drops to a level that marks the reorder point. With this system, the inventory is checked on a continual basis and the current level of inventory is assumed to be known.
Advantages:
- Provides a real time view of inventory level.
- Provides greater system responsiveness.
Disadvantages:
- It requires plenty of administrative processes when orders need to be made and received.
- Difficulty in obtaining quantity discounts leads to high ordering costs due to the random nature of reordering.
The difference between these two systems lies in the timing and quantity of orders placed. Under the perpetual system, inventory levels are checked continually and orders may be sporadic. Under the periodic system, inventory levels are checked, and orders are made based on the specified time interval. Ultimately, your choice will depend on the overall objectives of your business.
Introduction to Economic Order Quantity (EOQ)
The economic order quantity equation helps to decide the best order quantity that minimizes inventory holding costs and ordering costs.
The formula is pretty straightforward:
EOQ = square root of: (2SD) / H
Where:
- D represents the demand for the product in units.
- S represents the ordering cost per order.
- H represents the holding cost per unit per year
Check out our Guide to Understanding Economic Order Quantity (EOQ) to learn more.
Reorder Point (ROP)
While Economic Order Quantity (EOQ) helps determine how much to order, the Reorder Point (ROP) tells you when to place an order. To calculate the ROP, you need to know the lead time, which is the amount of time it takes for the supplier to restock your inventory.
This would ensure that there is enough stock to cater to demand during this period.
Safety Stock (SS)
In a perfect world, we can assume that demand and lead times are always constant. In reality, however, these variables can fluctuate quite dramatically. The purpose of safety stock is to lessen the risk of these uncertainties.
This is done by ordering buffer stock on top of the value defined in the ROP.
The ABCs of Inventory Classification
Identifying your bestsellers and prioritizing importance based on high impact and value will help prevent the waste of precious resources (especially time).
We can use the ABC classification in order of priority—items in group A are the top-sellers you want to keep the closest eye on, group B’s items are of relative importance, and group C is of the least importance.
Based on Pareto’s 80/20 law, a small percentage of items in the inventory can account for a large percentage of value.
The value of an item is decided through sales and profits. ABC classification can be assessed by:
- Annual sales.
- Percentage of sales for each item.
- Ranking and classification from highest to lowest.
After setting up these classifications, we can assign different management strategies for each tier to match their importance.
Get more bang for your buck when you focus more on the fast-moving items that have a greater impact on the business.
Inventory Performance Metrics
Given the importance of inventory management on the financial and operational value in any organization, it’s important to regularly measure and evaluate processes.
These can range from accuracy of records, efficiency of storage methods, units available, and dollar value tied to inventory. There are, however, two standard metrics to measure the efficiency of your inventory management and the financial health of your organization.
Inventory to Sales Ratio:This measures the inventory quantity relative to the number of fulfilled sales orders. The aim is to keep the inventory to sales ratio low, which indicates productive use and minimized cost of carry.
Inventory Turnover:This measures how quickly the inventory is cycling through your business. A higher turnover value is a general indicator of success, but be careful if it’s too high. An extremely high turnover could also be an indicator of pricing that’s too low, or inefficient inventory forecasting.
Wrapping Up
Mastering the fundamentals of inventory management is crucial for driving sales success and optimizing business operations. Effective inventory management balances supply and demand, minimizes costs, and maximizes resources. By understanding inventory types and their purposes, businesses can better handle market fluctuations, reduce costs, and boost profitability. Implementing the right inventory management system, such as Fixed-Time Period or Fixed-Order Quantity Systems, along with tools like Economic Order Quantity (EOQ) and Reorder Points (ROP), ensures that products are available when needed. Regularly assessing inventory metrics, like turnover rates and inventory-to-sales ratios, provides valuable insights into organizational efficiency and financial health, helping businesses refine their strategies for sustained success.
About Qoblex
Since 2016, Qoblex has been the trusted online platform for small and medium-sized enterprises (SMEs), offering tailored solutions to simplify the operational challenges of growing businesses. Specifically designed for B2B wholesalers, distributors, and eCommerce ventures, our software empowers users to streamline operations from production to fulfillment, allowing them to concentrate on business growth. Qoblex efficiently manages inventory and order data across multiple sales channels includingShopifyandWooCommerce, integrates with popular accounting systems such asXeroandQuickBooks, warehouses, and fulfillment systems, and boasts a robustB2B eCommerce platform. With a diverse global team, Qoblex serves a customer base in over 40 countries, making it a reliable partner for businesses worldwide.
