Inventory management is the supervision of noncapitalized assets -- or inventory -- and stock items. As a component of supply chain management, inventory management supervises the flow of goods from manufacturers to warehouses and from these facilities to point of sale. A key function of inventory management is to keep a detailed record of each new or returned product as it enters or leaves a warehouse or point of sale.
Organizations from small to large businesses can make use of inventory management to track their flow of goods. There are numerous inventory management techniques, and using the right one can lead to providing the correct goods at the correct amount, place and time.
Inventory control is a separate area of inventory management that is concerned with minimizing the total cost of inventory, while maximizing the ability to provide customers with products in a timely manner. In some countries, the two terms are used synonymously.
Why is inventory management important?
Effective inventory management enables businesses to balance the amount of inventory they have coming in and going out. The better a business controls its inventory, the more money it can save in business operations.
A business that has too much stock has overstock. Overstocked businesses have money tied up in inventory, limiting cash flow and potentially creating a budget deficit. This overstocked inventory, which is also called dead stock, will often sit in storage, unable to be sold, and eat into a business's profit margin.
But if a business doesn't have enough inventory, it can negatively affect customer service. Lack of inventory means that a business may lose sales. Telling customers they don't have something, and continually backordering items, can cause customers to take their business elsewhere.
An inventory management system can help businesses strike the balance between being under- and overstocked for optimal efficiency and profitability.
The inventory management process
Inventory management is a complex process, particularly for larger organizations, but the basics are essentially the same, regardless of the organization's size or type. In inventory management, goods are delivered in the receiving area of a warehouse -- typically, in the form of raw materials or components -- and are put into stock areas or onto shelves.
Compared to larger organizations with more physical space, in smaller companies, the goods may go directly to the stock area instead of a receiving location. If the business is a wholesale distributor, the goods may be finished products, rather than raw materials or components. Unfinished goods are then pulled from the stock areas and moved to production facilities where they are made into finished goods. The finished goods may be returned to stock areas where they are held prior to shipment, or they may be shipped directly to customers.
Inventory management uses a variety of data to keep track of the goods as they move through the process, including lot numbers, serial numbers, cost of goods, quantity of goods and the dates when they move through the process.
Inventory management systems
Inventory management software systems generally began as simple spreadsheets that track the quantities of goods in a warehouse but have become more complex since. Inventory management software can now go several layers deep and integrate with accounting and enterprise resource planning (ERP) systems. The systems keep track of goods in inventory, sometimes across several warehouse locations. Inventory management software can also be used to calculate costs -- often in multiple currencies -- so accounting systems always have an accurate assessment of the value of the goods.
Some inventory management software systems are designed for large enterprises and can be heavily customized for the particular requirements of an organization. Large systems were traditionally run on premises but are now also deployed in public cloud, private cloud and hybrid cloud environments. Small and midsize companies typically don't need such complex and costly systems, and they often rely on standalone inventory management products, generally through software as a service (SaaS) applications.
Inventory management techniques
Inventory management uses several methodologies to keep the right amount of goods on hand to fulfill customer demand and operate profitably. This task is particularly complex when organizations need to deal with thousands of stock-keeping units (SKUs) that can span multiple warehouses. The methodologies include:
- Stock review, which is the simplest inventory management methodology and is, generally, more appealing to smaller businesses. Stock review involves a regular analysis of stock on hand versus projected future needs. It primarily uses manual effort, although there can be automated stock review to define minimum stock levels that then enables regular inventory inspections and reordering of supplies to meet the minimum levels. Stock review can provide a measure of control over the inventory management process, but it can be labor-intensive and prone to errors.
- Just-in-time (JIT) methodology, in which products arrive as they are ordered by customers and is based on analyzing customer behavior. This approach involves researching buying patterns, seasonal demand and location-based factors that present an accurate picture of which goods are needed at certain times and places. The advantage of JIT is customer demand can be met without needing to keep large quantities of products on hand and in close to real time. However, the risks include misreading the market demand or having distribution problems with suppliers, which can lead to out-of-stock issues.
- ABC analysis methodology, which classifies inventory into three categories that represent the inventory values and cost significance of the goods. Category A represents high-value and low-quantity goods, category B represents moderate-value and moderate-quantity goods, and category C represents low-value and high-quantity goods. Each category can be managed separately by an inventory management system. It's important to know which items are the best sellers to keep enough buffer stock on hand. For example, more expensive category A items may take longer to sell, but they may not need to be kept in large quantities. One of the advantages of ABC analysis is that it provides better control over high-value goods, but a disadvantage is that it can require a considerable amount of resources to continually analyze the inventory levels of all the categories.
- Economic order quantity (EOQ) methodology, in which a formula determines the optimal time to reorder inventory in a warehouse management system. The goal here is to identify the largest number of products to order at any given time. This, in turn, frees up money that would otherwise be tied up in excess inventory and minimizes costs.
- Minimum order quantity (MOQ) methodology, in which the smallest amount of product a supplier is willing to sell is determined. If a business can't purchase the minimum, the supplier won't sell it to them. This method benefits suppliers, enabling them to quickly get rid of inventory while weeding out bargain shoppers.
- First in, first out (FIFO) methodology, in which the oldest inventory is sold first to help keep inventory fresh. This is an especially important method for businesses dealing with perishable products that will spoil if they aren't sold within a specific time period. It also prevents items from becoming obsolete before a business has the chance to sell them. This typically means keeping older merchandise at the front of shelves and moving new items to the back.
- Last in, first out (LIFO) methodology, in which the newest inventory is typically recorded as sold first. This is a good practice when inflation is an issue and prices are rising. Because the newest inventory has the highest cost of production, selling it before older inventory means lower profits and less taxable income. LIFO also means the lower cost of older products left on the shelves is what's reported as inventory. However, this is a difficult technique to put into practice, as older items that sit around have a chance of becoming obsolete or perishing.
- Safety stock methodology, in which a business sets aside inventory in case of an emergency. The safety stock approach also provides a signal that it's time to reorder merchandise before dipping into the safety stock. It's a good idea for businesses to work safety stock into their warehouse management strategy in case their supply chain is disrupted.
Inventory management vs. inventory control
Both inventory management and inventory control are essential to running a successful direct sales and channel operation. Inventory management is the overall strategy to ensure adequate inventory, and inventory control encompasses the processes and tools used to track existing inventory. Businesses may choose to use an inventory control system on its own but will benefit from using both together. Here are the essential differences:
Inventory management is a strategy that ensures businesses always have the right amount of inventory at the right time and in the right place. Inventory management tools enable businesses to:
- calculate safety stock;
- calculate reorder points;
- accomplish demand planning and forecasting;
- identify obsolete items;
- optimize warehouse layout; and
- identify fill rate percentage.
Inventory control addresses inventory already in a business's possession. It works at the transactional layer of an ERP system and enables businesses to:
- receive inventory;
- process interbranch transfers;
- process receipts;
- pack and ship stock;
- process customer invoices; and
- process supplier purchase orders.