Inventory Management: A Complete Guide for Retailers
What is inventory management?
Inventory management simply refers to the handling and controlling of a company's non-capitalized assets. For most retailers, this involves the overseeing and controlling of finished items that are ready to be sold.
The fundamental goal is to keep inventory levels balanced at all times without ever having too much or too little product in stock. So staying on top of ordering, forecasting and storage are key parts of good quality inventory management - something most businesses will use a quality inventory management system for.
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Why is inventory management important?
A retail business is useless without its inventory. Yet holding this inventory ties up a lot of cash and resources. Being able to manage it effectively and efficiently is therefore vitally important to cash flow and a great way to save money.
Save on storage costs
Warehousing costs tend to fluctuate based on how much product is being stored and for how long. The longer an item sits on a shelf without being sold, the more it costs a business.
Good inventory management results in items spending less time sitting in the warehouse before being sold. And this means reduced costs for storing them.
Avoid spoiled or dead stock
It’s not just storage costs where a retailer is potentially losing money from poor inventory management. Perishable items will be entirely wasted should too much be ordered at one time or it isn’t stored sufficiently.
Too much stock that becomes ‘dead’ due to going out of season or style is similarly wasteful. Better managing of inventory helps avoid wasting money on too much spoiled or dead stock.
Improve cash flow
Any inventory is likely to have been paid for upfront. But until this stock is sold, it’s just a hole in the bank balance and a dip in cash flow.
This leaves more money in the bank to spend on growth instead of inventory.
Calculating inventory value
Knowing what items are actually in stock and being stored as inventory in the warehouse is, of course, vital. On top of this, it’s also key to know the value of this inventory.
Inventory value is a legal accounting requirement, but is also a piece of data that gives a crucial insight when making certain business decisions. For example, whether you can afford to purchase new stock.
Some retailers use retail accounting software such as QuickBooks for inventory management, whilst others will outsource to third party accountancy firms.
The figure tends to be a sum total of how much it costs to acquire your inventory, including any freight or transport costs. There are a few basic methods for calculating this.
FIFO works on the model of having the oldest inventory brought into stock being sold first. Calculating cost of goods would therefore align with the following example:
If you sell 100 iPhone cases and brought in the first 75 at a cost of $5 and the next 25 at a cost of $7.50, then cost of goods would be:
- First 75 at $5 = $375
- Second 25 at $7.50 = $187.50
LIFO works by having the newest inventory brought into stock being sold first. See how cost of goods differs when using the same example:
If you sell 100 iPhone cases and brought in the first 75 at a cost of $5 and the next 25 at a cost of $7.50, then cost of goods would be:
- First 75 at $7.50 = $562.50
- Second 25 at $5 = $125
This is where an average unit cost over a specific period of time is used to calculate the cost of inventory.
The Average Cost method is generally used when FIFO or LIFO aren’t able to be used in a retailer’s accounting system. Or if it’s particularly difficult to assign a specific cost to individual items.
FIFO tends to be the most commonly used method. But LIFO can be useful in industries where prices fluctuate a lot or the newest units genuinely are sold first.
It’s worth noting, however, that some regions don’t allow LIFO as a viable method of calculating cost of goods. FIFO is therefore the more popular and generally recommended option.
Inventory management techniques
Now that we’ve established a way of calculating inventory value, let’s start taking a look at what good quality inventory management actually looks like in practice.
There are several key techniques and methods that can be used to manage inventory effectively.
Just in Time (JIT)
The Just in Time method is where a business would maintain a very low level of inventory and order goods in as and when they are needed. This represents a move away from the traditional philosophy of piling stock high to meet any sudden rises in demand.
The severely reduced amount of inventory being held at any one time means a business can save massively on storage costs and decrease waste.
However, it requires finely tuned and accurate forecasting that accounts for seasonal fluctuations in demand. Any mistakes here can result in not being able to fulfil orders and a nosedive in customer satisfaction.
Regular stock review
A stock review is simply a typical analysis of stock against projected future sales. This is particularly useful for any retailer still managing all inventory manually, although it is highly recommended to invest in a specific software.
It’s best to set a predefined period to complete the stock review over. Then compare current stock levels against future projections to determine how much inventory to order.
Obviously, this can save money in the short term if no software or specific system has been purchased. But doing manual stock reviews can be a monumental drain on time and resources while also opening up huge potential for human error.
This enables a retailer to analyze all current on-hand inventory by dividing it into three categories - A, B and C. Which category a particular item falls into is based on inventory value and cost significance.
- A Items: Are of high value with low sales frequency.
- B Items: Are of moderate value with moderate sales frequency.
- C Items: Are of low value with high sales frequency.
ABC Analysis allows a retailer to prioritize how they manage different inventory items. It works well alongside the Just in Time technique as it allows to point focus at items that need more attention.
For example, A items are of high value but stock levels will be kept lower so maintaining a close eye on these is essential. Whereas C items are relatively high in number and so don’t need such tight observation.
While this is a popular method, it’s worth noting that its analysis is based purely on monetary value and doesn’t take any other factors into account.
Dropshipping effectively removes the task of inventory management from a retail business. A customer would place an order and then have it fulfilled straight from the manufacturer or wholesaler.
A premium is usually added on top of bulk buying any stock, but this can be offset by the complete lack of warehouse or storage costs.
Dropshipping can be a great option for startups or smaller businesses. But order processing can prove tricky and the lack of control over customer experience means it’s something to think twice about for high-growth and larger retailers.
Inventory management forecasting
A phenomenal amount of good inventory management comes down to being able to forecast future demand for specific items. And to put it plainly - this is no easy task.
There are a multitude of variables that can affect demand and it’s impossible to know for certain exactly what’s round the corner.
Thankfully though, there are some ideas to consider to help predict as closely as possible.
Set forecasting boundaries
It’s essential to set certain boundaries when forecasting in order to give the most reliable and accurate outcome:
- Forecast period. This is the specific amount of time into the future that a forecast will be attempting to predict.
- Trend in demand. The increase or decrease in demand over a certain period of time. Trends over the short, medium and long term past should be considered in order to make future projections easier.
- Base demand. This is simply the exact current demand for a product at the specific point a forecast is due to start from.
Know reorder points
Setting a clear reorder point for each item allows retailers to know exactly when to order new stock. It is a specific point that acts as a trigger as soon as stock has diminished to that certain level.
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 new inventory is available.
Economic Order Quantity (EOQ)
After deciphering the exact point new orders need to be placed, it’s time to consider how much stock to actually order. This is where the Economic Order Quantity (EOQ) formula takes prime position.
EOQ is a calculation that helps work out the ideal quantity of inventory to order for a specific product while minimizing carrying costs. The three variables involved are:
- Demand. The number of units sold over a given time period, usually a year.
- Relevant ordering cost. Total ordering cost per purchase order. This includes all staff, transportation and any other costs associated with making each purchase order.
- Relevant carrying cost. Assume the item is in stock for the entire time period in question and decipher the carrying cost per unit.
Then put these into the following formula:
For example, a business sells 2,400 office chairs a year (200 a month) with ordering costs of each purchase order being $100. If the carrying cost per unit is worked out at $5, then the formula turns into this:
Economic Order Quantity = square root of ((2 x 2,400) x $100) ÷ $5)
Economic Order Quantity = square root of 96,000
Economic Order Quantity = 310
So in this particular example, we’ve determined that the perfect order quantity for this specific item is 310 units.
Key inventory management metrics
Some key metrics and equations have already been mentioned in this guide. But there are several more that are involved and need to be paid close attention to when it comes to high quality inventory management.
Inventory turnover gives an indication of how quickly stock is sold and shipped once it has been received into a warehouse. The faster stock is moved, the less it costs to store it and the more profit can be made on each sale.
Keeping track of this enables greater insight into the popularity of certain items to help gauge future buying practices.
Use the following formula to calculate inventory turnover:
Safety stock is the backup stock needed to meet unexpected occurrences and sudden changes in demand.
For example, an unexpected heat wave could see retailers selling barbecue equipment experience a sudden rush in demand. The stock needs to be there to meet this, but they also don’t want to keep too much on hand at any one time.
This is where the following formula can be useful to ensure a healthy balance:
As mentioned earlier, reorder points are vital in order to know exactly when to order new stock for a specific item.
In essence, an item’s reorder point needs to be as soon as its safety stock levels are hit. But the lead time between ordering and receiving the order needs to be taken into account.
Use the following formula for a simple way to calculate specific reorder points:
Keeping an eye on backorder rate is an excellent way of analyzing forecasting success.
A high backorder rate means a lot of orders are coming in for items that aren’t in stock. Of course, sudden unexpected rises in demand can account for this. But if backorder rate is consistently high then it’s likely a result of poor planning and forecasting.
Work out backorder rate with the following formula:
Carrying cost of inventory
The carrying cost of inventory is basically the cost a business pays for holding goods in stock over a given time period. This can include storage costs, insurance, depreciation, staff costs, taxes and any other expenses relating to holding inventory.
Businesses use this data to determine the amount of profit that can be made on current inventory. It’s also useful to help determine how much inventory to keep on hand.
This is then usually expressed as a percentage of the mean inventory value over the same time period:
Choosing inventory management software
Paying close attention to the above techniques and metrics is a great start. But a growing retail business should be aiming to remove potential for human error as much as possible.
This means taking advantage of a specific inventory management system or piece of software to support manual efforts.
What is inventory management software?
An Inventory Management System effectively does all the heavy lifting for a business when it comes to managing their inventory.
A computerised system is put into place that tracks orders and items through that business’ entire supply chain. This allows the business to see the various parts of its operations in one place and manage everything effectively without relying on manual, paper or spreadsheet processes.
Features of good quality software
Different sized and types of business will have different needs. But good quality software will be able to manage a retailer’s operations throughout their entire supply chain.
Here are a few aspects good quality software should cover:
- Receiving orders. Process customer orders from all sales channels and bring them together to manage in a single place.
- Managing inventory. Take in information across any number of warehouses and locations and update this across sales channels in real-time.
- Warehouse support. Provide barcode systems as well as item location and picking support for warehouse operations.
- Shipping integration. Capability to ship online orders directly in the software and integrate with inventory levels automatically.
- Report key metrics. Easy access to detailed performance analytics that give key insights on making inventory and overall business decisions going forward.
- Innovation driven. Retail is changing at a rapid pace and so it’s good to get on board with software that is going to evolve and change with the industry.
Finding the right software
The above features are foundational pillars to consider with any inventory management system. But each business’ requirements can be slightly different.
It’s worth making a note of any and all specific required features and then narrowing software options down to only those that provide what’s on the list. For example, something like integrated barcode scanners may be an optimal feature for businesses with large warehouses.
It’s always best to test drive the options first. Depending on the size of an operation and level of software, it’s a good idea to either complete a free trial or setup a tailored product demonstration with the company.
Combining a computerized system with the information in this guide should enable any business to master their inventory management.
To see if Veeqo is the right solution to do this and help optimize operations for you, book a product demonstration today.