Inventory management is the process of orchestrating the flow of goods through a company in a continuous cycle of ordering, storing, producing, selling, and restocking goods. Inventory management is generally performed at two levels: aggregate inventory management and stocking location and item-level inventory management. In determining their, inventory strategy, companies make tradeoffs between minimizing the amount of cash tied up in inventory or holding more inventory to maximize customer service or production efficiency.
Inventory strategy involves inventory management at the item level through policies, such as safety stock (described later), and to inventory controls through polices, such as ABC classification to prioritize replenishment rates, which take item level attributes, such as consumption value, lot sizes and order lead times, into account.
Inventory can be broadly classified into three categories: raw materials/components, work in progress, and finished goods. Manufacturing companies purchase raw materials or components, store them until ready for production, and transform them into finished goods. Nonmanufacturing companies, such as wholesale distributors and retailers, stock finished goods for sale to final consumers.
All companies must strike a balance between inventory levels and demand because inventory consumes a company’s cash and incurs carrying costs. Regardless of the type of business, companies must maintain tight control over inventory to conserve cash while ensuring they have enough stock to meet production schedules or forecasted customer demand and actual orders.
Benefits of inventory management
Inventory management is complex and varies depending on your industry, your function within the company, and the type of item being managed. Deciding how to plan and manage inventory is a collaborative effort full of trade-offs, risks, and rewards.
No two companies are alike. Depending on their business model, companies use a number of different methods to manage inventory. Inventory costs the company money, but it may be necessary to hold more safety stock to maintain superior service levels to avoid stockouts and to maximize operational efficiency. Manufacturers with expensive machine and people operations will sometimes carry excess inventory to avoid shutting down these operations due to a lack of inventory—which would cost the company more money.
Almost all companies maintain safety stock inventory to protect against unexpected changes in supply and demand. In this way, inventory functions as a protection against the unexpected, and as a buffer against production shutdowns. Safety stock represents a balance between service or fill rates (the percentage of customer orders that a company can ship immediately from stock) and the additional cost of ordering and holding more inventory. The consequence of not having enough inventory are stock-outs, which can be detrimental to a business especially if customers have alternatives, such as ecommerce-based businesses where rapid fulfillment is expected. Stock-outs represent lost revenue and can adversely affect customer loyalty.
Manufacturers typically establish inventory controls, such as minimum and maximum stocking levels and reorder points, within their ERP systems. Distributors establish reorder points in a decentralized manner, allowing each distribution center to determine their inventory levels based on local factors or demand-driven methods. Local factors can include SKU-level demand, lead times, or seasonal patterns. Demand-driven methods can include point-of-sale data from their retail customers. Many procurement organizations take pricing discounts into consideration in their purchasing strategy and may buy more supply than required to obtain favorable price points.
Best inventory management software
Inventory management: Financial implications
Inventory management involves making trade-offs between revenue, cost, and risk. Classified on the balance sheet as a current asset, inventory consumes company cash. Careful attention must be paid to the length of the cash conversion cycle—the time between purchasing raw materials (for a manufacturer) or merchandise (wholesaler or retailer) to the final sale of finished products and receipt of payments from customers.
During that time, cash remains tied up, and companies must ensure their inventory is sold in a timely manner (called inventory turns) to return the cash to the business. Slow-moving inventory incurs holding costs, risks, and adversely affects a company’s cash flow. Accordingly, companies require a disciplined process to ensure that the level of inventory investment is in line with the expected level of customer demand.
Inventory management also requires rigorous costing to support both internal management reporting and statutory financial reporting. Inventory costs used in production must comply with absorption costing methods for allocating both direct and indirect labor and overhead to products as they take shape on the production line. And the finished goods, also referred to as merchandise inventory, require allocating any costs associated with preparing it for sale.
These costs can include transportation, labor, and other handling expenditures. An aggregate, the sum of all inventory across the company is used to determine the inventory line item on the balance sheet and the cost of goods sold on the income statement.
What are the types of inventory management systems?
Businesses employ a variety of inventory management systems, depending on their operations, complexities, or needs. Examples of the three primary inventory management systems are manual, periodic, and perpetual. Perpetual systems are the most advanced and accurate inventory management systems, whereas the manual method is the least sophisticated way to oversee inventory operations.
Manual inventory system: This method of managing inventory depends on the physical counting of items and recording the details on paper or in a spreadsheet. This process is widely used by small businesses that have not moved to inventory management software solutions.
Periodic inventory system: This is an inventory management system where the inventory count is performed at the end of an accounting period rather than after every sale and purchase. It’s a relatively simple system that’s better suited for smaller businesses with fewer goods.
Perpetual inventory system: The system is the most sophisticated, leveraging automated software solutions to deliver real-time insights. As soon as any stock enters a facility, is moved, sold, used, or discarded, the inventory system will update balances immediately aided by scans from hand held devices that scan item barcodes or RFID tags.
Radio-frequency identification (RFID) system and inventory management systems
RFID is a technology tracking system that supports inventory management systems. RFID systems use specialized tags attached to every item to track its whereabouts. RFID simplifies inventory management by scanning newly arrived shipments into the system or outbound shipments using mobile scanners. RFID tags can be active, continually broadcasting a signal, or passive, requiring physical readers to track items. RFID tags are the best for providing real-time data and insights on where inventory at all times.
Inventory management vs. cycle counting
Cycle counting is a method of checks and balances to confirm that physical inventory counts match a company’s inventory records. The periodic counting of individual items throughout the year ensures the accuracy of inventory quantities and values.
Having an accurate system of tracking on-hand inventory quantities is essential for managing supply and demand, maintaining high customer service levels, and planning production.
Instead of leveraging inventory management systems, you can perform cycle counting to take complete physical inventories. Or businesses can use both techniques side-by-side to verify inventory quantities and values. Inventory management supports serialized cycle counting.
Inventory management examples—industry use cases
While inventory management is common across most industries, there are particular industries with unique requirements that warrant specialized systems. Notable examples are food service (restaurants) and retail.
Retail inventory management
Today, retailers must offer very flexible customer buying options for goods that are offered through different channels. Intense competition from large ecommerce vendors and demanding customers have forced retailers to operate a mixed business model, combining brick-and-mortar stores and online buying experiences, referred to as omnichannel retail.
Omnichannel provides buyers with flexible options, such as order in store, ship to home, buy online, return in store, or ship from a distributor to a store for pickup. The goal is delivering an excellent end-to-end customer experience which could mean the difference between success and going out of business.
In order provide the best customer experience through omnichannel, retailers need to have real-time visibility into their stock on hand to ensure that the customer shopping experience results in orders. Stockouts not only prevent specific orders from being filled, but frustrated customers are also very likely to look for similar items on a competitor’s store or website. Loyalty is fleeting and brand switching is common. Lost customers may never return affecting potential future sales.
As a result, retailers need to manage inventory very carefully to finesse the fine line between having enough inventory to fill the highest percentage of their customer orders and not having too much which strains their cash flow and risks having left over stock at the end of a buying season that cannot be sold. Retail inventory management software (combined with order management systems) allow retailers to swiftly react to changes in buying behavior and adjust their channel strategies and inventory levels.
Restaurant inventory management
Managing restaurant inventory is unique in that it must provide real-time ingredients monitoring because many are fresh, have short shelf lives and carefully tracked through to consumption. The system must also carefully monitor stock levels, trigger restocking orders, record new inventory receipts, and help manage menu costs.
Managing fresh ingredients has inherent challenges by helping managers to closely monitor their shelf lives to prevent spoilage. At best, spoilage results in wasted money, while worst case, it can cause food poisoning and trigger actions from health authorities.
Inventory management software can help restaurants manage their unique challenges. By automatically connecting sales with inventory levels, restaurants can have a complete view of orders, consumption, insight into ingredients stocks, avoid spoilage and manage their margins. Inventory management software also reduces time spent on administrative tasks by sending alerts to managers about potential shelf life expirations, automate reordering when items exceed their spoilage dates or fall below set replenishment levels.
Inventory management software
Modern, cloud-based inventory management systems provide comprehensive materials management capabilities that effectively manage the flow of goods across your company and its global supply network. In conjunction with warehouse management systems, they provide accurate and timely visibility into inventory levels, restocking plans and order fill rates, all effect customer satisfaction. Combined with supply chain planning systems, they take the guesswork out of inventory management by matching demand with supply through optimizing stocking levels, increasing order fill rates, ensuring on-schedule production runs, and improving working capital utilization.
Inventory management and supply chain management
Inventory management is a critical component of supply chain management in that a supply chain’s reason for being is the movement of goods, either delivering raw materials and subcomponents to manufacturers or fulfilling orders for finished goods to consumers. Both help companies reduce costs, improve cash flow, and increase profit margins.
Inventory visibility
A key benefit of modern cloud inventory management solutions is their ability to provide real-time visibility into inventory across multiple nodes of the supply chain, such as production facilities, suppliers, goods in transit, and distribution centers. This gives decision-makers the insights they need to maintain customer satisfaction. This is particularly critical for companies with extended supply networks, variable demand and intense competition.
A real-time view of stocking levels and their location helps them better manage production schedules and customer order processing. For example, if a delivery is held up due to transportation problems, managers can cover the temporary shortfall by shifting stock from one distribution center to another where higher demand levels warrant having more inventory.
Combined with supply chain planning software, having real-time data on order volumes helps planners determine how much of a particular item they need, where it should be located, and how frequently they need to restock in order to meet actual and forecasted demand and production levels.
Integrated supply chain planning
Complex supply chains challenge companies to align supply with demand and determine inventory levels with greater precision. Sophisticated demand planning solutions can help utilizing sophisticated algorithms that incorporate multiple scenarios including item and location combinations as well as inventory policies to generate the optimal demand plan. What-if scenarios play a vital role in ensuring planned inventory levels will be sufficient to meet customer demand, avoid stock-outs, and ensure resiliency.
Managing suppliers to optimize inventory management
Choosing the right suppliers is the responsibility of the Procurement organization. Suppliers can have a significant impact on inventory. For example, achieving just-in-time availability depends on having reliable, qualified suppliers that can meet specific delivery timelines. If they miss scheduled shipping dates, production and customer orders may be delayed, resulting in decreased customer satisfaction.
The net requirements plan incorporated through supply planning into the demand plan must be able to support the complexity of global supply chains to determine raw materials and component inventory requirements for production. Finally, planning systems help determine inventory policies for setting safety stock levels (excess inventory used as a buffer against supply and demand uncertainty) basically taking the guesswork out of inventory decisions and their potential negative impact on cash flow.
Integrated business planning combines statistical forecasts with actual demand signals to provide up to date forecasts and inventory levels that meet your desired or target customer service levels. It helps you manage uncertainty in demand and supplier lead times. Replenishment orders are generated whenever an inventory position falls below a minimum threshold. These orders incorporate estimated lead times to ensure adequate stocking levels. Based on the specified inventory policy, the replenishment order may be a fixed order quantity or computed quantity, calculated as a difference between the maximum threshold and inventory position, and can be adjusted for minimum order quantities.
Cloud inventory management—Where are you in your journey?
If you’re ready to learn more about modern inventory management, a good place to start is by asking yourself the following questions:
- Are we optimizing our inventory by aligning it with demand and supply planning?
- Are we using the right inventory policies to minimize inventory cost and maximize customer service?
- Is fragmentation of inventory hindering our ability to execute?
- How are we managing our safety stocks?
- How much of our working capital is tied up in inventory?
- How can we improve our inventory turns?
- How is inventory availability supporting our customer satisfaction goals?
Many companies are still using spreadsheets or inflexible legacy systems for some or all aspects of inventory management. While that approach might seem adequate, older technologies can lead to suboptimal business outcomes. To compete in a today’s complex supply chains and respond adequately to inevitable disruptions, you need modern cloud solutions that share information in real time to achieve better alignment between planning, production and an integrated view of your inventory.
Cloud-based integrated supply chain management (SCM) suites help companies develop synergies across their planning and inventory management, as well as other crucial supply chain functions, such as procurement, manufacturing, logistics, and order management. The result: greater efficiency, customer service, and higher profit margins.
Where are you in your journey to integrated inventory management? How can we help?
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