What is Inventory Management?

Intro to Inventory Management

Many entrepreneurs wing it when their businesses first get running. They hustle to meet order demands and keep customers happy – often without a formal order fulfillment and inventory management system behind them.

While this can work at a small scale, once those orders start ramping up, most entrepreneurs find that they need something a little more structured. This is where inventory management comes in.

So if you’re finding that you need a better way to fulfill orders for your happy customers, then read on.

What is inventory management?

Put simply, inventory management refers to how a company stores, processes and uses its inventory. It’s a fairly broad concept – one that includes the management of raw materials, product components and finished products. It also covers warehousing and processing goods during the various stages of production.

Inventory management may include some or all of the following elements:

• Naming inventory items (using “Stock Keeping Units”, or “SKUs”)
• Naming and tracking locations where your goods are sold – sometimes down to the shelf level
• Tracking the movement of inventory between locations
• The process of ordering and purchasing products from your suppliers
• Reviewing the contents of your inventory.

Why is inventory management important?

Along with its people and processes, a company’s inventory is one of its most valuable assets. In many sectors (including manufacturing, restaurants/food service, retail and others) a company’s inputs and finished products form the foundation of its business. An inventory shortage of just one ingredient for a final product can mean that production must stop. This can be very damaging to a company – both financially and in terms of its reputation. Inventory is also important because:

Inventory carries risks

Having a large inventory carries the risk of spoiling/rotting (if perishable). It’s also at risk of theft, damage, or simply shifts in consumer demand.

Inventory may need to be insured

At major companies, inventory is often insured.

Inventory may lose value if unsold

If inventory is not sold in time it may have to be gotten rid of at drastically reduced sale prices, or simply destroyed.

For these reasons, inventory management is of key importance – for businesses of every size, small and large.

But knowing when to restock certain items, what amounts to buy, what price to pay, as well as when to sell and at what price, can easily become tricky and complicated decisions.

Many smaller businesses and startups choose to keep track of their inventory manually. From there, they determine when to reorder goods using their own judgement, or based on simple Excel formulas.

But businesses of all size can benefit from a more integrated approach to inventory management.

The inventory management formula

The total cost of a company’s inventory is calculated as the sum of the:

• Purchase costs
• Ordering costs
• And holding costs.

Written as a formula, TC = PC + OC + HC

Here, TC is the Total Cost; PC is Purchase Cost; OC is Ordering Cost; and HC is Holding Cost.

Inventory management methods

The size of a company – as well as the industry in which it operates – will determine the inventory management methods it uses.

Some major inventory management methods include:

• Just-in-time (JIT) management
• Materials requirement planning (MRP)
• Economic order quantity (EOQ)
• and days sales of inventory (DSI)

Just-in-Time Management (JIT)

Just-in-time management is about keeping only what you need. In other words, companies that use the JIT system keep only the inventory they need to produce and sell products, with nothing extra. It’s an approach that keeps storage and insurance costs to a minimum. It also reduces the cost of liquidating or discarding excess inventory.

However, JIT inventory management can be risky. If consumer demand suddenly increases, a company may not be able to source the inventory it needs to meet that demand. Small delays can also cause trouble, and lead to bottlenecks in production.

Materials Requirement Planning (MRP)

Unlike JIT, materials Requirement Planning is about looking far ahead, using forecasts to anticipate likely demand. In this way, MRP is what is known as “sales-forecast dependent”.

This means that accurate sales forecasts need to be drawn up ahead of time, and are used in order to inform suppliers of a business’s likely upcoming needs in a timely manner.

Economic Order Quantity (EOQ)

If MRP is about being as accurate as possible about forecasting upcoming orders, Economic Order Quantity (EOQ) is about keeping the costs of inventory as low as possible.

This model of inventory management is approached by calculating the number of units a company should add to its inventory with each batch of goods it produces – in order to keep the total costs of its inventory as low as possible (and assuming constant consumer demand). It also seeks to keep the frequency with which it submits orders to its suppliers to a reasonable level.

Days Sales of Inventory (DSI)

Days of Sales inventory is about estimating the average time, in days, that a company takes to turn its inventory, including goods that are a work in progress, into sales.

In many ways, DSI indicates the liquidity of the inventory – namely, how many days a company’s current stock of inventory will last. On balance, a lower DSI is preferred as it means a shorter period to sell all inventory, though the average DSI varies from one industry to another.

Given the complexities of inventory management, many companies use what is called an order management system.

What Is an Order Management System (OMS)?

In order to manage the often complex demands of inventory management, many businesses turn to an order management system or OMS.

In essence, an OMS is any tool or platform that helps a company to track sales, orders, inventory and fulfillment. Order management systems use analytics capabilities as well as in-built formulas to help companies manage their inventory intelligently.

Order management system metrics

Order management systems help companies manage their inventories by automatically calculating multiple metrics related to the goods a company produces. These metrics may include:

Maximum Stock Level

This is the level of stock beyond which a company shouldn’t buy any more goods. For perishable goods, this number is particularly important.

Minimum Stock Level

This is the absolute minimum number of products a company needs in order to fulfill demand and is related to the rate at which a particular product sells, as well as how long it takes to produce that product.

Reorder Level

This is the stock level at which a company needs to issue a reorder request – in order to keep above the minimum stock level.

Average Monthly Inventory

This is an estimate of how much inventory a company keeps on hand in a month. It is calculated as follows:

Average Monthly Inventory = (Inventory at month beginning + Inventory at month ending) /2

Inventory Turnover Ratio

This is a measure of how many times a company has completely replaced its existing stock.

Inventory management for entrepreneurs

When you’re just getting started in business, manually tracking your inventory may work well. However, as your business begins to scale, you’re likely to need a more comprehensive way of keeping track of your inventory.

That’s where a great inventory management system – such as QuickBooks – can help. Read more about how to choose an inventory management system for your small business.

Track your inventory easily and quickly, with just the touch of a button. Because when your inventory needs are taken care of, it’s easier to focus on running your business.