Everything You Need to Know About Inventory Management

everything you need to know about inventory management

Inventory encompasses everything from boxes of straws in the back office of a small diner to an enormous warehouse full of product parts for a large retailer. In either case, inventory includes all of the goods purchased from a supplier that a company plans to eventually sell.

Carrying and managing inventory has many associated costs that affect a company's bottom line and productivity. Proper inventory management is essential to maintain a competitive edge and minimize waste. Read ahead to learn everything to know about inventory management.

What is Inventory Management?

Inventory management is a systemized approach to ordering, storing, and selling both raw materials and finished products.

It is the process of tracking and organizing products in the duration that the business owns them. Profit is generated when inventory is sold to customers.

The most important features of inventory management include-

  • Picking and Packing - Directs workers to the correct warehouse to pick up items and pack them
  • Shipping - The invoices, packing sheets, and other aspects involved in shipping inventory
  • Managing Warehouse Locations - Placing items in the correct warehouse to minimize waste
  • Receiving Orders - Manages incoming orders to direct them to the proper fulfillment center
  • Tracking Inventory - A real-time total of the inventory status of each product
  • Reporting Tools - Generates inventory data to gain insights that can improve decision-making processes
  • Barcode Tracking - Manages barcode input data and coordinates with shipping and accounting systems

Why is Inventory Management Important?

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Because inventory is an asset that is documented on a balance sheet for tax purposes, managing inventory properly is critical to reducing expenses.

Organizations must physically count their in-house goods to calculate the number stock on-hand, or they have to utilize a software system that can reliably document all inventory-related data.

Not only is tracking inventory a good business practice, but it is also required to comply with SEC rules and the Sarbanes-Oxley Act for public enterprises. As part of an effort to meet these standards, businesses must understand and have records of all of their supply chain processes.

Businesses that lose track of inventory are losing money. Not comprehending how much product is on-hand may cause overordering, underordering, and inefficient workflow processes.

It's also essential to manage inventory to predict future sales and profits. Businesses that have an efficient ordering process use their historical sales and inventory data to estimate how much to buy in the future and how much will sell.

There are a lot of associated costs with carrying inventory that affect profits, especially for small businesses. In the U.S., manufacturers, retailers, and wholesalers have 1.9 trillion in inventory costs. Experts assert that 90% of a company's inventory is stored, whereas only 10% is in route to be sold. Proper inventory management can help to alleviate many of these carrying costs.

An effective inventory management system also improves customer satisfaction because there is a certainty of what is available to sell and what isn't.

The company will know exactly when the next set of supplies are coming and won't have to worry that a customer will need a product that isn't at the store. The company will be prepared and know which products are low on stock. They can then adjust their sales and marketing strategies accordingly.

What is an Inventory Management System?

From a traditional paper ledger to spreadsheets, there is a large variety of tactics and technologies used by small and large businesses to manage inventory. However, an inventory management system is usually a type of software that counts and tracks products and raw materials.

Quality management systems track all of the stock while providing intelligence that identifies which products sell better than others. They also usually include a notification system that alerts management when stock is low.

With the rise of e-commerce and globalism, inventory management has overseen new obstacles that require high-tech solutions. An effective management system can meet these challenges by ensuring that products are at the correct place at the correct time.

Types of Inventory Management Systems

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The most common types of inventory management solutions include-

1. Full Inventory vs. Cycle Counting
A full inventory count is usually performed annually and in accordance with a financial audit. When the business is closed, an inventory team will count all of the items in the warehouse. Because all of the inventory is counted at one time, this process is timely and extensive.

Cycle counting is utilized to count a segment of inventory on a frequent basis. For example, a retailer may count one set of products on a Wednesday, another set of items on Thursday, and so on.

If the warehouse is larger, the items with greater value can be counted more frequently than others. Smaller, regular inventory counts help businesses have a more comprehensive view of their stock.

There's always a potential for human error in either inventory or cycle counting. Unreliable inventory data causes difficulties for the entire business, so it's best to utilize a software system that is more accurate in its counting process.

2. Manual Inventory Count
A manual inventory system is updated and controlled without the use of a technical system. Counters may use a ledger to perform a manual count or they might use a spreadsheet.

Small businesses sometimes find a manual approach to be more efficient because they don't have as much stock to concern themselves with.

A manual count can be conducted internally or the owner can hire an outside vendor to complete it for him/her. Small businesses usually close one or two days per year to perform a manual inventory check.

Each step of this process has the potential for human error. Workers might count items in the warehouse incorrectly or data may be improperly inputted. Unfortunately, one miscounted piece of stock can affect several other parts of the manual count. In many cases, businesses have had to redo their entire inventory count because of one small mistake that was made.

Finally, manual-based data doesn't always translate into useful information that gives a comprehensive view of inventory, supply, and customer demand.

3. Barcode System
This system utilizes a reader to scan a barcode that is attached to each product or package. Workers can wear a barcode reader, allowing the process to speed up dramatically.

An advantage of the barcode system is that the count is done in real-time because the input data is immediately uploaded into a database. If there an item has already been scanned, the worker will receive an alert.

Because there is less potential for human error, management is more confident in making decisions to purchase and sell more/less inventory.

4. Radio Frequency Identification Tags
An RFID utilizes radio waves to read and capture data stored in a tag attached to a product.
There are two types of RFIDs- active and passive.

Active systems employ tag scanners that are located throughout the storage facility. Real-time updates of stock counts and their location are given to the vendor or an in-house inventory counter.

A passive system can only be read when someone turns the scanner on. Both types of processes automatically document the inventory in a database when a tag is read. Passive systems simply require the worker to manually turn the reader on himself.

5. Warehouse Robots
Robots use machine learning to scan labels without attached barcodes. Warehouse robots have better sensors and response capability than other forms of inventory counting systems.

They also integrate with warehouse management software to upload all data quickly and accurately. Employing a robot can dramatically reduce labor costs as they automatically perform inventory counts without needing human supervision.

The Benefits of Inventory Management

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Using a software system to manage inventory provides many benefits, including-

1. Less Potential for Human Error
Profits are lost and time is wasted if a count has to be redone because someone made a mistake.
Many software systems involve barcode scanning that eliminates the need to manually enter information. By performing a correct count the first time, companies can dramatically reduce their warehouse costs and increase profits.

2. Adaptable to Changing Situations
Because there are always busy and slow seasons, inventory management will never be exactly the same throughout the year.

Businesses that perform manual counts have to rely on their workers to adapt to a busier season, perform accurate counts, and not make any mistakes.

For some, this can be a nearly impossible task. An optimized inventory software system is able to handle increases in stock because they don't require breaks, time-off, or inventory management training.

3. Increase in Worker Morale
Companies benefit by utilizing an inventory management software system because workers are no longer required to perform as many dangerous or mundane tasks.

There isn't a need for a vendor to climb on top of a stack of boxes to count items on a top shelf, nor does anyone have to spend hours counting particles of clothes. An inventory software system can complete many of these projects automatically.

The software can also integrate with mobile phones, allowing managers to perform updates at any location. This will help to improve employee morale and free up resources to complete other important tasks.

4. Improves Customer Satisfaction
A software system can increase the delivery of inventory while decreasing the potential for human error. Businesses will have a better ability to know which items to order from suppliers, when to order them, and how much to order.

As a result, customers will be pleased that they can rely on the company for excellent service and quick response times. A quality inventory management system can be a piece of a larger puzzle that provides a competitive edge.

How to Manage Inventory

Different companies will employ various inventory management strategies. Even smaller businesses have to count their inventory to remain competitive in their industries.

Regardless of the size or scope of the business, the best practices for inventory management include-

ABC Method
This is an inventory categorization analysis tactic that divides stock into 3 categories- A items, B items, and C items. Category A is the highest level of control and accurate record-keeping, and C is the least.

Typically, the products that generate the most amount of revenue are placed in Category A because there's a greater importance to properly manage this stock as it generates more profit. Further sales and inventory analysis can determine when to move a product to a different category.

Two-Bin Method
In the two-bin method, products are stored in two areas or bins, depending on how large the item is.

When a bin becomes empty, new products are moved into it. When the inventory from the second bin is gone, the company can order new supplies.

Fixed Order Quantity
This is a control system where the maximum and minimum inventory levels are set in stone.

When the stock reaches a fixed minimum number, the company can order a fixed number of new items. This prevents the company from over-ordering and not running out of inventory.

Fixed Period Ordering
For this inventory process, products are ordered according to a certain amount of time, such as every month or few weeks.

This system is optimal for small businesses that don't have the resources to implement an advanced inventory management system.

Vendor Managed Inventory
This system allows the supplier to manage inventory rather than putting the responsibility on the business. The vendor will re-order depending on the number of sales, or at a set time of the month.

Grocery and health-care chains tend to use a supplier management inventory system as it streamlines the entire process.

Inventory Management Formulas

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Those who are new to inventory management will come across some unfamiliar terminology and formulas. It's essential to understand these formulas to properly manage inventory. These include-

1. Economic Order Quantity
This is the number of items a company should purchase from a supplier to help minimize carrying costs and save time. Here's some terminology to understand before calculating an EOQ-

D = Order costs
K = Quantity sold per year
H = Carrying costs

EOQ = The Square Root of (2 x D x K / H)

2. Days Inventory Outstanding
This refers to the number of days it takes for stock to turn into sales. A lower DIO is preferred because it implies there is higher customer demand. Here is the equation to calculate the DIO-

DIO = (Cost of Average Inventory / Cost of Goods Sold) x 365

3. Re-order Point Formula
This formula lets businesses know when more stock should be ordered. To perform this calculation, take the following steps-

  • Calculate the lead time demand in days
  • Determine the safety stock in days
  • Add these two together
RPF = Lead Time Demand + Safety Stock

4. Safety Stock Formula
The company should have enough stock on hand to fulfill orders but not so much that it increases carrying costs. This formula helps businesses know how much stock to have on-hand before re-ordering.
Take the following steps-

  • Multiply the maximum number of products used in a day by the maximum lead time in days
  • Multiply the average use per day by the average lead time in days
  • Find the difference between the two to determine how much inventory to have on-hand before re-ordering
SSF = (Max Daily Usage x Max Lead Time in Days) (Avg. Daily Usage X Avg. Lead Time in Days)


Here are the key takeaways to remember about inventory management-

  • Understand the meaning of inventory management Inventory management includes the ordering, storing, and management of products. Elements include picking and packing, barcoding, shipping, and more.
  • Effective Inventory management is important. Stock management saves money, time, and helps businesses comply with federal and state laws and regulations.
  • Businesses use different systems that include full inventory, cycle inventory, manual inventory count, barcode system, radio frequency identification tags, and warehouse robots.
  • Proper inventory management is beneficial Benefits of inventory management include less potential for human error, adaptability, an increase in customer satisfaction, and an improvement in worker morale.
  • There are different methods to manage inventory Pick between the ABC method, the two-bin method, the fixed order quality method, the fixed period ordering process, and vendor managed inventory to manage inventory.
  • Know the important formulas helps understand how to calculate EOQ, DIO, RPF, and SSF will save money and streamline the ordering process.