There are almost as many ways to manage inventory as there are types of inventories. But with a number of management techniques to choose from, how can your small business know which one will work for them?
As inventory plays a significant role in the success of a company, the management of this department must be immense and comprehensive. As a small business owner, you might want to learn a few of the inventory management techniques out there, to help you deal with your stock control.
Common Inventory Management Methods
There are various strategies that businesses might employ for their inventory control and management that focus on the associated costs, production and order times, stock life, and quantities associated with their inventory. Such management techniques include:
- Just-in-Time Management
- Materials Requirement Planning
- Economic Order Quantity
- Day Sales Inventory
- ABC Analysis
The just in time inventory management method is about decreasing wastage, cutting costs, and increasing efficiency by ordering goods only when needed. Just in time, or JIT management, focuses on the selling of its inventory stock only as the customer requires it. Also known as lean production manufacturing, this method revolves around cutting non-essential costs while freeing up cash flow for the business by only ordering the minimum inventory requirement.
With so much of the market shifting to online retail and inventories, many businesses find JIT inventory management an effective method as it provides them with the ability to sell products to customers before actually buying them. Once the customers have bought the items, the retailer will purchase the items from a third party and have them ship directly to the customer.
Benefits of JIT
There are a few things to note with the just in time inventory method. Lowering inventory carrying costs means less wastage and increased efficiency. None of the inventory goods are purchased or manufactured without the business first knowing there are customer demands to fill.
However, inventory levels are always low, so the company won’t be in possession of safety stock. This makes the likelihood of a stock-out higher compared to other stock control methods that insist on using larger inventories.
Materials Requirement Planning
Materials requirement planning, or MRP, is an inventory control system that covers the production and manufacturing process of goods sold by a company. This method plans for inventory needs in advance, with the goods being produced beforehand to meet the expected demand of the market.
Generally, when undertaking the materials requirement planning, businesses should ask themselves these three questions and take the appropriate steps to answer them:
- What is needed? Take stock of the materials on hand.
- How much is needed? Identify additional stock required.
- When is it needed by? Schedule the production or purchase of said materials.
Bill of Materials
When dealing with materials requirement planning, you will need to collect information from the bill of materials or BOM. Essentially, the BOM is a long list of all raw materials and components required to produce or manufacture the inventory goods.
The BOM illustrates the relationship between the required manufacturing materials and the finished goods, breaking down the finished product by material and categorizing the different parts.
Lead time is another aspect of MRP that should be factored into the product planning. The lead time refers to the time it takes between ordering material and receiving it. A proper MRP system should take into account the material lead time (the time it takes to order and deliver materials), factory or production lead time (the time it takes to produce and ship a product), and customer lead time (the time between the customer ordering the product and receiving it) when product planning.
Benefits of MRP
One of the most significant benefits of using inventory management strategies like MRP is the improvement in production efficiency and productivity for the companies. Businesses must consider the cost of labour, materials needed in the supply chain, and the current and future demand from customers before undertaking the production process and creating or purchasing what they need. Such precautionary planning means fewer mistakes and less wastage of materials and manpower.
Economic Order Quantity
Economic Order Quantity, or EOQ, is about ordering the ideal quantity of inventory with the lowest associated overhead costs, such as order costs, shortage costs, and holding costs to a business. The EOQ method is mainly used as an inventory management technique that seeks to balance out inventory holding costs with inventory set-up costs.
With the order quantities in mind, businesses will seek to order the exact amount of inventory they need for each batch to cover the market demand without causing excess inventory that must be stored. The main objective is to minimize costs and meet demands with the precise inventory quantity.
To calculate the EOQ, you will need to collect specific information from your company, mainly the setup costs (all costs connected to ordering inventory), demand rate (the amount of inventory the business sells each year), and holding costs of a product (costs connected to the storing and handling of excess inventory). The formula is as follows,
EOQ = Square root of ( 2 x Demand rate x Setup costs + Holding costs)
This formula and the EOQ is an essential cash flow tool, especially when dealing with inventory expenses. When employed well, this strategy allows a company to minimize inventory buying and storing costs while acquiring and selling the optimum quantity of goods to fulfill customer demand.
Day Sales Inventory
Day sales of inventory, or DSI, refers to the average time it takes for a business to sell off all of its stock, including all goods still in the production phase. Basically, DSI is a measurement used to determine how long a company’s current stock will last them.
DSI lets a business know how long its cash will be tied up in the inventory. Typically, businesses aim for a lower DSI, which illustrates a shorter time needed to sell out their stock for a higher turnover rate, meaning more profits. A large DSI number could illustrate a company is having a harder time selling off excess inventory, or maybe they are retaining inventory for an upcoming sale or busy season.
The reason for a higher day sales of inventory numbers varies by company. Depending on the context of the industry and inventory type, the DSI metric will differ.
Day sales inventory can be calculated using this formula.
Day Sales Inventory = (Average Inventory / Cost of Goods Sold) x 365 Days
Benefits of DSI
The DSI offers a snapshot of the company’s inventory system management for a day. This metric is beneficial to know as it shows businesses how effectively its managing, and turning over, its inventory compared to its competitors.
ABC analysis is an inventory categorization technique whereby a business will classify their inventory based on the value of the goods, placing them in A, B, or C categories. This analysis works for inventory management as it identifies the business’s most important products that can be prioritized over the less valuable stock goods.
When classifying goods into categories, this analysis uses the Pareto Principle, or 80/20 rule, whereby 80% of the value to the business is held within 20% of the goods.
If your business chooses to use this inventory technique, consider splitting your goods into:
- Category A: Includes the highest valued goods, but the smallest category
- Category B: Includes the slightly lower valued goods, but a higher quantity of products
- Category C: Includes the lowest valued goods with the largest quantity of products
Benefits of ABC
These categories offer businesses a quick and simple way to prioritize their workload and focus greater inventory control on the more important goods. However, the categories do not change even when variables come into play, so it could be considered oversimplified a metric in some instances. Overall, the ABC analysis provides a clear view, and control, over the inventory for improved efficiency and fewer chances for a stock-out.
Further Inventory Management Strategies
Included below are two further strategies that can be used in tandem with the inventory management techniques listed above.
Reorder point formula
When it comes to inventory, the reorder point, or ROP refers to the point in time when a company’s stock reaches a specific level that triggers a reorder of that product. Therefore it is the minimum amount of inventory items a business will have in stock before needing to reorder further goods. To determine this point, there is the ROP formula,
ROP = demand during lead time + safety stock
The obtain the ROP, you will first need to calculate the demand during lead time. Lead time refers to the time it takes between ordering goods, and receiving those goods. To determine demand during lead time, businesses can multiple the lead time of a product (in days), by the average number of units sold in a day, or,
Demand during lead time = lead time x average daily units sold
The safety stock is the inventory goods sitting in reserve in case of an emergency, or an increase in market demand. To find the figure that represents the safety stock for a given product, you will need to multiply the maximum daily demand by the maximum lead time, then subtract that number from the average daily orders multiplied by the average lead time, or,
Safety stock level = (maximum daily orders x maximum lead time) – (average daily orders x average lead time)
Once the demand during lead time and the safety stock levels have been calculated, you can plug those numbers into the reorder point formula to determine a product’s trigger point.
Demand forecasting is the reporting and projection of future market demand. Companies will use this forecasting as a type of predictive analytics that will help them determine the optimal inventory supply that will cover future customer demand for specific products. A business should collect past data on their product sales as well as deploy market research to help determine these figures to help with its inventory management system.
What To Do With Excess Inventory
Taking these various methods of effective inventory management into consideration, there are a number of ways businesses can deal with their excess inventory. Even though some techniques insist on keeping stock low, sometimes over-ordering or low demand causes a company to have higher quantities of a specific good.
It is best not to just throw away the extra inventory, as you paid money for those goods and you want to get some of the cost back. Therefore, you could consider discounting the items for a sale or getting your employees to upsell the product. You can also check with your supplier to see if they will take returns, or even donate them to charity.
Take Control of Your Inventory with QuickBooks
With these inventory management techniques in mind, your business can begin to utilize these tools to decrease inventory costs and increase sales. Whichever inventory management method you choose to follow for your small business, QuickBooks Online can help you streamline the inventory management processes with tracking and reporting features.
This quality inventory management software even connects with other inventory management apps to help you gain insight into your inventory and get your costs under control. You can also cover your inventory accounting needs with this cloud-based software. Improve your cash flow and try it free today!