Inventory Management
Chapter 1

What is Inventory Management?

Inventory management is the process of ordering, handling, storing, and using a company’s non-capitalised assets – AKA its inventory. For some businesses, this involves raw materials and components, while others may only deal with finished stock items ready for sale.

Either way, inventory management all comes down to balance – having the right amount of stock, in the right place, at the right time. And this guide will help you achieve just that.

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Retail inventory management

Retail is the general term used to describe businesses that sell physical products to consumers. While not exclusive to retail, inventory management tends to play more of a role in this industry than any other.

We’ll therefore be focusing mainly on inventory management from a retail perspective within this guide.

Retail can be split into several areas:

  • Offline. Where a company sells via a brick-and-mortar store or physical location.
  • Online. Where a company sells over the internet via an ecommerce website or marketplace.
  • Multichannel. Where a company sells in multiple different places, usually a combination of online websites and marketplaces.
  • Omnichannel. Where a company provides a unified, integrated experience for customers across all the different online and offline channels it sells on.

Businesses may also choose to trade via wholesale channels. This involves selling inventory (usually in bulk) directly business-to-business (B2B) or taking part in B2B ecommerce.

A company’s inventory will therefore need to be managed in accordance with which of these retail models it operates within.

Inventory management in action

We’ve covered the broad definition of inventory management. But what’s actually involved when it comes to making good inventory management happen?

Bottom line:

You want to keep inventory levels balanced at all times without ever having too much or too little of each product in stock.

This sounds simple, but rarely is. In reality, good inventory management all comes down to understanding:

  1. Types of inventory. So you know what type of inventory is where and can have full visibility over it.
  2. Inventory forecasting. So you know how much stock is needed to satisfy demand over an upcoming time period.
  3. Purchasing inventory. So you know when and how to create purchase orders to re-order new stock.
  4. Inventory storage. So you know how much of each inventory item can be suitably housed, and where to send it.
  5. Inventory analysis. So you can use metrics to make more informed decisions about your inventory as time goes on.
  6. Handling techniques. So you can quickly and efficiently book-in, put away, pick, pack and ship inventory as and when needed at your various locations.
  7. Multichannel tracking. So you have visibility on where exactly your inventory is as well as additions (purchases) and subtractions (sales & shrinkage), to give as close to a live stock figure as possible.
  8. Accounting. So you can properly record your inventory on financial documents.
  9. Inventory tools. So you can automate as much of the inventory management process as possible.

These are the basic ingredients of quality inventory management. And you’ll need to take a systematic approach to them in order to best equip your business for long term growth.

Luckily, we expand on each of these points in depth within the different chapters of this guide.

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The importance of inventory management

A retail business is useless without its inventory. And so while it may not be the most exciting subject, inventory management is vitally important to your business’s longevity.

Good inventory management helps with:

  • Customer experience. Not having enough stock to fulfil orders you’ve already taken payment for can be a real negative.
  • Improving cash flow. Putting cash into too much inventory at once means it’s not available for other things – like payroll or marketing.
  • Avoiding shrinkage. Purchasing too much of the wrong inventory and/or not storing it correctly can lead to it becoming ‘dead’, spoiled, or stolen.
  • Optimising fulfilment. Inventory that’s put away and stored correctly can be picked, packed and shipped off to customers more quickly and easily.

Inventory Management Infographic

Key inventory management terms

Inventory management is a complex subject. And there’s a lot of systems, processes and general pieces that go into the puzzle.

Here’s a glossary of key terms you’re likely to come across:

Average inventoryThe average inventory on-hand over a given time period, calculated by adding Ending Inventory (EI) to Beginning Inventory (BI) and dividing by two.
Average inventory costAn inventory valuation method that bases its figure on the average cost of items throughout an accounting period.
Back order (BO)An order for a product that is currently out of stock, and so cannot yet be fulfilled for the customer.
Barcode scannerA device used to digitally identify items via a unique barcode, then perform inventory and fulfilment tasks like booking-in, picking, counts, etc.
Beginning Inventory (BI)The value of any unsold, on-hand inventory at the start of an accounting period.
BundlesA group of individual products in an inventory that are brought together to sell as one under a single SKU.
Carrying costsThe total costs associated with holding and storing inventory in a warehouse or facility until it is sold on to the customer.
Cost of goods sold (COGS)Direct costs of purchasing and/or producing any goods sold, including everything that went into it – materials, labour, tools used, etc. Does NOT include indirect costs – like distribution, advertising, sales force costs, etc.
Dead stockInventory that remains unsold for a long enough period of time for it to be deemed outdated and virtually unsellable.
Ending Inventory (EI)The value of any unsold, on-hand inventory at the end of an accounting period.
First-in-first-out (FIFO)An inventory valuation method that assumes stock that was purchased first, is also the first to be sold.
Inventory countAlso known as a stock take, this is the systematic process of taking a physical count of inventory in order to verify accuracy.
Inventory shrinkageAn accounting term to indicate inventory items that have been stolen, damaged beyond saleable repair or otherwise lost between the point of purchase and point of sale.
Inventory valuationThe process of giving unsold inventory a monetary value in order to show as a company asset in financial records.
Inventory variantThe variations of a single product that a company may hold in its inventory. For example, stocking a t-shirt in various colours and sizes.
Inventory visibilityThe ability of a person or business to see exactly where its inventory is and how it is being used.
Last-in-first-out (LIFO)An inventory valuation method that assumes the most recent products added to your inventory are the ones to be sold first.
Lead timeThe time it takes for a supplier to deliver new stock to the desired location once a purchase order has been issued.
MultichannelA retail model that sells in multiple different places, usually online via a combination of websites and marketplaces.
OmnichannelA retail model that goes beyond multichannel to integrate all of a company’s online and offline sales channels into one, unified customer experience.
Order fulfilmentThe process of getting a customer’s sales order from your warehouse or distribution centre to it being in their possession.
Order managementThe systematic order management process behind organising, managing and fulfilling all the sales orders coming into a business. From receiving orders and processing payment, right through to picking, packing, shipping, handling returns and communicating with customers.
OversellingTaking online orders for a product that turns out to be out of stock (usually through poor inventory management). Preventing overselling is key to providing a high-quality experience for online customers.
Pipeline inventoryAny inventory that has not yet reached its final destination of a company’s warehouse shelves, but is currently ‘en route’ somewhere within their supply chain – e.g. currently being manufactured, or being shipped by the supplier.
Purchase order (PO)A commercial document created by a business to its supplier, detailing quantities, items and agreed prices for new products to add to on-hand inventory.
Sales order (SO)A document created when a customer makes a purchase, detailing which products are to be received and how much has been paid or is owed.
Stock keeping unit (SKU)A unique alphanumeric code applied to each variant in a company’s inventory, helping to easily identify and organise a product catalogue.
Supply chainThe complete flow a product or commodity takes from origin to consumer – including raw materials, to finished goods, wholesalers, warehouses and final destination. A retailer might only be directly responsible for certain chunks of this supply chain, but should still be aware of it in its entirety for the products they sell.
Third-party logistics (3PL)Refers to the use of an external third party to handle warehousing, inventory, fulfilment and/or customer service on behalf of a retail company.

Key inventory management formulas

It’s not just common terminology you need to know when it comes to inventory management. There are some specific formulas to take note of too.

We’ll be going into greater depth with how and when to use these formulas later on in this guide. But here’s a quick run through to use as a reference point:

1) Inventory turnover

Inventory turnover measures the number of times a company has sold and replaced inventory over a given time period:

Inventory turnover = COGS / Average inventory

This gives an insight into the overall efficiency of a company and its inventory management processes. The higher the inventory turnover rate, the more efficient a business is at getting through its inventory.

2) Sell through rate

Sell through rate takes the amount of inventory a retailer receives, and compares it against what is actually sold over a given period. It’s usually expressed as a percentage:

Sell through rate = (No. of Sales / Stock On-Hand) x 100

This helps analyse if your investment in a particular product is working out well. Low sell through rates indicate you either overbought or priced too high, while high sell through rates indicate you may have under bought or priced too low.

It’s a great way to make decisions on future purchase quantities for a product or from a particular supplier.

3) Days of inventory outstanding (DIO)

Days of inventory outstanding (DIO) measures the typical number of days it takes for inventory to turn into sales.

DIO = (Ave Inventory Cost / COGS) x 365

It’s hard to draw insights from just one calculation. But you should look into typical industry standards, and also keep track of whether you are trending up or down as time goes on.

4) Safety stock

Safety stock is the backup stock needed to meet unexpected supply problems and/or sudden changes in demand.

Safety stock = (Max Daily Sales Volume x Max Lead Time in Days) - (Ave Daily Daily Sales Volume x Ave Lead Time in Days)

Bear in mind that you want to have enough safety stock to meet demand. But not so much that increased carrying costs puts a strain on cash flow.

5) Reorder point

The reorder point helps determine when to order new inventory. It is a specific point in time that acts as a trigger to re-order as soon as stock has diminished to that certain level.

Reorder point = (Lead Time in Days x Ave Daily Sales Volume) + Safety Stock

It’s important to consider the lead time for new stock to be delivered when setting reorder points. Enough stock should be leftover to keep up with demand before the newly purchased inventory becomes available for sale.

6) Economic order quantity (EOQ)

EOQ is a formula that helps calculate exactly how much inventory to order. It takes into account a company’s typical demand, ordering costs and carrying costs to provide the most economical figure possible:

EOQ = √ 2 x (Demand x Ordering Costs) / Carrying Cost per Unit

This is obviously quite a complicated formula to use. But we cover this in greater depth in Chapter 4: Purchasing Inventory.

This initial guide covers all the basics of inventory management. But there’s much more that goes into it that we’ll explore in the coming chapters, starting next with the different types of inventory you need to be aware of.

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More inventory management chapters

    1. What is Inventory Management?
    1. Types of Inventory
    1. Inventory Forecasting
    1. Buying & Purchasing Inventory
    1. Inventory Storage
    1. Inventory Analysis
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Chapter 1

What is Inventory Management?

Chapter 2

Types of Inventory