Table of Contents
- How do we define inventory management?
- Why is inventory management important?
- What are the 4 inventory types?
- What are the 3 methods for accounting for inventory?
- What are the 2 inventory systems for tracking cost?
- What's the best inventory management metric?
- What is an inventory management system?
- What is the best inventory management software?
How do we define inventory management?
In its simplest terms, inventory management is the practice of keeping track of the products you sell and their cost. It includes the tools used to track the number of products in your inventory and the method you use to track the cost of goods sold (COGS). Inventory management requires a regular physical count (or stock take) to ensure that the information you have about your stock quantities and inventory value match the reality.Back to top
Why is inventory management important?
Inventory management accomplishes two things. First, it leads to a better experience for your customers by letting you get the right product to the right customer in the right amount at the right time. Secondly, it leads to increased efficiency in your business operations.
Benefits of Inventory Management
If selling products is the core of your business, inventory management is the best way to keep your core in shape. Inventory management makes for healthy efficient operations, sets the stage for building a stronger brand, and fortifies you with an optimal financial position. With inventory management, you’ll be able to:
- Reduce stockouts
- Prevent double-selling
- Deter shrinkage
- Know when to replenish
- Track your profitability
- Understand your costs
- Gain customer insight
- Fulfill quickly, accurately
What are the 4 inventory types?
What counts as inventory depends on the business. Generally speaking, most companies will be concerned with 4 types of inventory: raw materials, work-in-progress, finished goods and buffer.
Raw materials are the ingredients or components used to make a finished product. A brewer, for example, will grain, yeast, and hops, the ingredients they will use in the fermentation process to produce a volume of beer.
Work-in-progress represents the inventory that is in production and not ready for sale. For example, a volume of beer still in the fermentation process.
Finished goods are the products in your inventory that are ready to be sold to your customers. This is the inventory type common to all companies that sell products.
Buffer inventory, or buffer stock, is an amount of stock you hold as insurance against stockouts.
What are the 3 methods for accounting for inventory?
Selling requires buying and storing finished goods or the raw materials you use to make finished goods. It costs money to buy, make and hold that inventory until your finished goods are sold.
These costs (the cost of goods sold, or COGS) are what join inventory management and accounting at the hip. To account for COGS, you have a choice of three methods: FIFO, LIFO or Weighted
- FIFO: First-in, First-Out
This method assumes that the goods that first enter your inventory are also the first to leave. It may not literally be the first good in, but it assumes it is. Thus, FIFO removes the oldest COGS from your inventory account as you sell your finished goods.
- LIFO: Last-in First-Out
This method assumes that the last goods that enter your inventory will be the first to leave. It is considered a controversial method applied to products that experience high cost-inflation. This is because LIFO removes the newest (and presumably the highest) COGS from the inventory account as the finished goods are sold.
- Weighted Average
Under this method, COGS is derived by dividing the cost of all products available for sale by the number of products available for sale.
What are the 2 inventory systems for tracking cost?
While inventory accounting methods determine how you account for the cost of your inventory, there are two different systems for tracking inventory quantity and costs: the periodic method and the perpetual method.
Periodic Inventory System
The periodic system relies on physical stock counts to track inventory levels at regular intervals. All purchases made in an interval are recorded in a purchases account. At the end of that interval, the inventory account is adjusted with the cost of whatever purchases remain in stock.
Perpetual Inventory System
Under the perpetual system, the inventory account is continuously adjusted as you buy from suppliers and sell to customers. There is no purchase account, but the inventory account increases with every purchase and decreases with every sale.
What's the best inventory management metric?
If you’re researching inventory, you will come across a lot of formulas that can intimidate or confuse you. There’s no reason to get anxious. Good inventory practices give you a lot of useful data to track your business’ health, and these formulas help you make sense of that data. Below are some of the more common formulas.
Inventory Turnover Rate
This formula, also known as Stock Turn, tells you how many times you sell and replace your inventory in a given period. Retailers with a high turn are thought to be effectively marketing their products and/or carrying an optimal amount of inventory. A low turn can indicate weak sales due to product or marketing issues or overstocking related to inventory planning. Here’s the formula:
Where sales = a dollar value and where average inventory = (inventory value at the start of a given period + inventory value at the end)/2
Alternatively, you can replace sales with cost of goods sold for a more precise cost calculation.
The sell-through rate measures your inventory efficiency. It is the percentage of the finished goods in your inventory that you’ve actually sold in a given period. This is a common and important metric for all retailers and will be familiar to anyone who has sold on Amazon, eBay or other online marketplaces. The higher your sell-through rate, the more efficient you are at selling and marketing a product. This is the sell-through rate formula:
Where stock sold = a quantity of stock sold in a given period, and stock on hand is the quantity of that stock on hand for that period.
Inventory shrinkage is a simple formula that shows the difference between your inventory ledger and a physical count of your inventory. Shrinkage is a notable problem for brick-and-mortars and costs the retail industry a lot of money every year. Generally speaking, it indicates how much inventory was lost in the warehouse, stolen or incorrectly tracked in a given year. Here is how you measure shrinkage:
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What is an inventory management system?
In another era, the only tool available to retailers for recording and tracking inventory was a pencil and a physical inventory ledger. The information age gave retailers more choices including spreadsheets and inventory management systems (IMS) and inventory management software.
An IMS is the software and hardware technology that you use to track and control raw materials and finished goods from the time of purchase to the time of sale. It typically revolves around a database of all your purchases and sales, and your stock levels—the amount of finished goods and raw materials in your factory, warehouse or store waiting to be produced or sold—as it changes with each purchase and sale.
What is the best inventory management software?
Inventory management software come in a wide range of capability and sophistication. These include very simple apps, technology with limited functionality that is built-into accounting solutions or eCommerce platform, and feature-rich inventory management software. The best inventory management software is the technology that suits your business as it grows. Great inventory management software allows you to:
- Manage multiple channels and stock locations simultaneously
- See actual stock levels in real-time
- Track accurate costs, in real-time
- Easily add sales channels or stock locations
- Scale operations as products and sales increase
- Integrate easily with accounting and other business-critical software
- Extend control to your private warehouse or 3PL warehouse
If you’re finishing the calendar year and you aren’t sure what is really in your inventory, or if you’re having trouble fulfilling orders quickly, or if you don’t know your actual inventory value, it may be time for you to change how you’re managing inventory and look into adopting inventory management software in the new year.Back to top