What Is Inventory Management?
Inventory management refers to the process of ordering, storing, using, and selling a company's inventory. This includes the management of raw materials, components, and finished products, as well as warehousing and processing of such items. There are different types of inventory management, each with its pros and cons, depending on a company’s needs.
- Inventory management is the entire process of managing inventories from raw materials to finished products.
- Inventory management tries to efficiently streamline inventories to avoid both gluts and shortages.
- Four major inventory management methods include just-in-time management (JIT), materials requirement planning (MRP), economic order quantity (EOQ) , and days sales of inventory (DSI).
- There are pros and cons to each of the methods, reviewed below.
The Benefits of Inventory Management
A company's inventory is one of its most valuable assets. In retail, manufacturing, food services, and other inventory-intensive sectors, a company's inputs and finished products are the core of its business. A shortage of inventory when and where it's needed can be extremely detrimental.
At the same time, inventory can be thought of as a liability (if not in an accounting sense). A large inventory carries the risk of spoilage, theft, damage, or shifts in demand. Inventory must be insured, and if it is not sold in time it may have to be disposed of at clearance prices—or simply destroyed.
For these reasons, inventory management is important for businesses of any size. Knowing when to restock inventory, what amounts to purchase or produce, what price to pay—as well as when to sell and at whatprice—can easily become complex decisions. Small businesses will often keep track of stock manually and determine the reorder points and quantitiesusing spreadsheet (Excel) formulas. Larger businesses will use specialized enterprise resource planning (ERP) software. The largest corporations use highly customized software as a service (SaaS) applications.
Appropriate inventory management strategies vary depending on the industry. An oil depot is able to store large amounts of inventory for extended periods of time, allowing it to wait for demand to pick up. While storing oil is expensive and risky—a fire in the U.K. in 2005 led to millions of pounds in damage and fines—there is no risk that the inventory will spoil or go out of style. For businesses dealing in perishable goods or products for which demand is extremely time-sensitive—2021 calendars or fast-fashion items, for example—sitting on inventoryis not an option, and misjudging the timing or quantities of orders can be costly.
For companies with complex supply chains and manufacturing processes, balancing the risks of inventory gluts and shortages is especially difficult. To achieve these balances, firms have developed several methods for inventory management, including just-in-time (JIT) and materials requirement planning (MRP).
Some companies, such as financial services firms, do not have physical inventory and so must rely on service process management.
Accounting for Inventory
Inventory represents acurrent assetsince a company typically intends to sell its finished goods within a short amount of time, typically a year. Inventory has to be physically counted or measured before it can be put on a balance sheet. Companies typically maintain sophisticated inventory management systems capable of tracking real-time inventory levels.
Inventory is accounted for using one of three methods: first-in-first-out (FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing. An inventory account typically consists of four separate categories:
- Raw materials — represent various materials a company purchases for its production process. These materials must undergo significant work before a company can transform them into a finished good ready for sale.
- Work in process (also known as goods-in-process) — represents raw materials in the process of being transformed into a finished product.
- Finished goods — are completed products readily available for sale to a company's customers.
- Merchandise — represents finished goods a company buys from a supplier for future resale.
Inventory Management Methods
Depending on the type of business or product being analyzed, a company will use various inventory management methods. Some of these management methods include just-in-time (JIT) manufacturing, materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI). There are others, but these are the four most common methods used to analyze inventory.
1. Just-in-Time Management (JIT)
This manufacturing model originated in Japan in the 1960s and 1970s. Toyota Motor (TM) contributed the most to its development. The method allows companies to save significant amounts of money and reduce waste by keepingonly the inventory they need to produce and sell products. This approach reduces storage and insurance costs, as well as the cost of liquidating or discarding excess inventory.
JIT inventory management can be risky. If demand unexpectedly spikes, the manufacturer may not be able to source the inventory it needs to meet that demand, damaging its reputation with customers and driving business toward competitors. Even the smallest delays can be problematic; if a key input does not arrive "just in time," a bottleneck can result.
2. Materials Requirement Planning (MRP)
Thisinventory management method is sales-forecast dependent,meaning that manufacturers must have accurate sales records to enable accurate planning of inventory needs and to communicate those needs with materials suppliers in a timely manner. For example, a ski manufacturer using an MRP inventory system might ensure that materials such as plastic, fiberglass, wood, and aluminum are in stock based on forecasted orders. Inability to accurately forecast sales and plan inventory acquisitions results in a manufacturer's inability to fulfill orders.
3. Economic Order Quantity (EOQ)
This model is used in inventory management by calculating the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory while assuming constant consumer demand. The costs of inventory in the model includeholdingand setup costs.
The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand. It assumes that there is a trade-off between inventory holding costs and inventory setup costs, and total inventory costs are minimized when both setup costs and holding costs are minimized.
4. Days Sales of Inventory (DSI)
This financial ratio indicates the average time in days that a company takes to turn its inventory, including goods that are a work in progress, into sales. DSI is also known asthe average age of inventory, days inventory outstanding (DIO), days in inventory (DII), days salesininventory or days inventory and is interpreted in multiple ways.
Indicating the liquidity of the inventory, the figure represents how many days a company’s current stock of inventory will last. Generally, a lower DSI is preferred as it indicates a shorter duration to clear off the inventory, though the average DSI varies from one industry to another.
Inventory Management Red Flags
If a company frequently switches its method of inventory accounting without reasonable justification, it is likely its management is trying to paint a brighter picture of its business than what is true. The SEC requires public companies to discloseLIFO reservethat can make inventories under LIFO costing comparable to FIFO costing.
Frequent inventory write-offs can indicate a company's issues with selling its finished goods or inventory obsolescence. This can also raise red flags with a company's ability to stay competitive and manufacture products that appeal to consumers going forward.
What Are the Four Main Types of Inventory Management?
The four types of inventory management are just-in-time management (JIT), materials requirement planning (MRP), economic order quantity (EOQ) , and days sales of inventory (DSI). Each inventory management style works better for different businesses, and there are pros and cons to each type.
How Did Tim Cook Use Inventory Management at Apple?
Tim Cook is known as an inventory genius. “Inventory is like dairy products,” Cook is quoted saying. “No one wants to buy spoiled milk.” For this reason, inventory management can save a company millions.
What Is an Example of Inventory Management?
Let's look at an example of a just-in-time (JIT) inventory system. With this method, a company receives goods as close as possible to when they are actually needed. So, if a car manufacturer needs to install airbags into a car, it receives airbags as those cars come onto the assembly line instead of having a stock on supply at all times.
The Bottom Line
Inventory management is a crucial part of business operations. Proper inventory management depends on the type of business and what type of product it sells. There may not be one perfect type of inventory management, because there are pros and cons to each. But taking advantage of the most fitting type of inventory management style can go a long way.
Four popular inventory control methods include ABC analysis; Last In, First Out (LIFO) and First In, First Out (FIFO); batch tracking; and safety stock.What are the methods techniques in inventory management? ›
- ABC Analysis: This method works by identifying the most and least popular types of stock.
- Batch Tracking: ...
- Bulk Shipments: ...
- Consignment: ...
- Cross-Docking: ...
- Demand Forecasting: ...
- Dropshipping: ...
- Economic Order Quantity (EOQ):
Four popular inventory control methods include ABC analysis; Last In, First Out (LIFO) and First In, First Out (FIFO); batch tracking; and safety stock.What are the 3 major inventory management techniques? ›
In this article we'll dive into the three most common inventory management strategies that most manufacturers operate by: the pull strategy, the push strategy, and the just in time (JIT) strategy.What are the most important inventory management techniques? ›
The three most popular inventory management techniques are the push technique, the pull technique, and the just-in-time technique. These strategies offer businesses different pathways to meeting customer demand.What is the most common method of inventory management? ›
FIFO is one of the most common Inventory management techniques used in manufacturing. This system helps ensure that the oldest products are used first and reduces the chance of spoilage or obsolescence.What are the ABC techniques of inventory control? ›
ABC analysis is an inventory management technique that determines the value of inventory items based on their importance to the business. ABC ranks items on demand, cost and risk data, and inventory mangers group items into classes based on those criteria.What are the 4 basic types of inventory models? ›
There are four main types of inventory: raw materials/components, WIP, finished goods and MRO.What are 5 stages of inventory management process? ›
- Receive and inspect products. The first step in the inventory management process includes receiving your order from the supplier. ...
- Sort and stock products. ...
- Accept customer order. ...
- Fulfil, package and ship order. ...
- Reorder new stock.
- Fine-tune your forecasting. ...
- Use the FIFO approach (first in, first out). ...
- Identify low-turn stock. ...
- Audit your stock. ...
- Use cloud-based inventory management software. ...
- Track your stock levels at all times. ...
- Reduce equipment repair times.
What is an XYZ analysis? An XYZ analysis divides items into three categories. X items have the lowest demand variability. Y items have a moderate amount of demand variability, usually because of a known factor. Z items have the highest demand variability and are therefore the hardest to forecast.What is JIT technique? ›
JIT techniques work to level production, spreading production evenly over time to foster a smooth flow between processes. Varying the mix of products produced on a single line, sometimes referred to as "shish-kebab production", provides an effective means for producing the desired production mix in a smooth manner.What is the concept of inventory management? ›
Inventory management, a critical element of the supply chain, is the tracking of inventory from manufacturers to warehouses and from these facilities to a point of sale. The goal of inventory management is to have the right products in the right place at the right time.What are the two main inventory control models? ›
Types of Inventory Control Systems
The two main systems are periodic and perpetual tracking systems.
The three types of inventory include raw materials, work-in-progress, and finished goods.What is ABC model of inventory? ›
ABC analysis is a method in which inventory is divided into three categories, i.e. A, B, and C in descending value. The items in the A category have the highest value, B category items are of lower value than A, and C category items have the lowest value. Inventory control and management are critical for a business.What is the first rule of inventory management? ›
Rules of Inventory #1: Have Enough Inventory to Service Demand. In the past, when inventory ran out, companies would simply issue a backorder while they purchased or manufactured more items. Customers would simply wait for the item to be in stock again.What is Lean 5S in inventory management? ›
This method includes the five steps of Sort, Set in Order, Shine, Standardize, and Sustain. Generally speaking, the steps of 5S involve going through items in a workspace, removing what's unnecessary, organizing items, cleaning, performing maintenance, and making sure these things become habits.What are the five 5 methods of inventory evaluation? ›
The five most commonly used inventory valuation methods are FIFO (First In, First Out), LIFO (Last In, First Out), FEFO (First Expired, First Out), Weighted Average, and Specific Identification.What are the 4 components of inventory? ›
The four types of inventory are raw materials, work-in-progress (WIP), finished goods, and maintenance, repair, and overhaul (MRO) inventory.
Specifications or bill of material (materials and parts required to make the product) Inventory availability (what is in stock) Purchase orders outstanding (what is on order, also called expected receipts) Lead times (how long it takes to get various components)What are the three most common inventory control models? ›
Three of the most popular inventory control models are Economic Order Quantity (EOQ), Inventory Production Quantity, and ABC Analysis. Each inventory model has a different approach to help you know how much inventory you should have in stock.What are the five inventory tools? ›
To summarize, five powerful inventory tools to utilize in inventory management software include: reorder alerts, reports, dashboards, barcoding and mobile, and system integration. Inventory management software also has many other dynamic features and tools to help with inventory control and management.What are the basics of inventory model? ›
Inventory models deal with the time at which orders for certain goods are to be placed, and the quantity of the order. The research problem concerns ways of optimizing these decisions, taking into account the cost of obtaining the goods, the cost of holding a unit in inventory, and the cost of shortages.What are the two types of inventory models? ›
Two types of inventory are periodic and perpetual inventory. Both are accounting methods that businesses use to track the number of products they have available.