What is Inventory Management?
Inventory is arguably the most critical asset in any business. If your business doesn’t maintain enough inventory on hand, you won’t have enough product to meet customer demand. But, if you build too much, you may have product expiring in your warehouse before it’s sold.
Further complicating the equation, it is expensive to store inventory. It consumes cash flow from the business, and it costs money to store goods in a secured (and sometimes refrigerated) warehouse. For these reasons, it’s never advisable to keep more inventory on hand than you need.
So, how do you get this right? How do businesses determine the appropriate amount of inventory to keep on hand at any point in time?
To manage the appropriate level of inventory, businesses will employ an Inventory Management policy. Inventory management is simply the process of procuring and storing sufficient inventory to meet customer demand. There are different techniques to manage inventory levels, and each business will employ an inventory management strategy that is aligned with their business.
Every Business is Different
Imagine you own a restaurant. How much inventory of fresh ingredients will you keep on hand? Most experienced restauranteurs will tell you they buy produce on a daily basis, and only keep enough fresh fruits and vegetables for a day (or two) at most. Thus, their inventory management strategy is dictated by the short shelf life of their products.
Now, imagine you are an importer of marble tile. The product originates from Turkey, and requires a three month lead time on all orders. Your inventory doesn’t have a shelf life, and customer demand is highly volatile. In this case, you likely hold a minimum of 3 months of inventory (likely quite bit more) to ensure you meet customer demand.
The inventory management policy employed by a restaurant owner will be very different than an importer of specialty construction products.
In short, each business deploys an inventory management policy that is aligned to the needs of the business. Below I summarize the primary inventory management techniques used by businesses today:
Inventory Management Techniques
Just In Time (JIT)
Just in time (JIT) inventory management is a technique in which raw inputs arrive as needed during the production process. Historically, manufacturers would maintain a safety stock all the components of their products in a warehouse, and they would draw from these components as the final product was assembled.
With JIT, the manufacturer receives components at just the right time in the production cycle. This greatly reduces the amount of safety stock the manufacturer must keep in stock.
Stock review is an inventory management technique that compares existing inventory with predicted future demand. As example – You have 10,000 units of Product A in your warehouse, and you expect to sell 40,000 units in the next three months. Based on the stock review method, you would buy (or build) 30,000 more units over the course of the next three months.
With stock review, you utilize a forecasting process, also known as demand planning, to predict the demand for each product. You then align your inventory purchases with this prediction model.
In ABC Analysis, a business prioritizes items that have the highest value, and therefore the most impact on business success. As the name implies, businesses that utilize ABC Analysis will segment their products into three groups:
- Group A: High value or high volume products that generate 80% of total revenue. This group includes a small number of products that are the best-sellers.
- Group B: Moderate value or volume products that typically generate about 15% of total revenue. This is a larger group of products that don’t sell as well as the products in Group A.
- Group C: This is sometimes referred to as the ‘product tail’. Each company typically maintains a large number of product variations for which demand is very low. These low value or low-volume products typically generate about 5% of total revenue.
By segmenting a product portfolio based on generated sales, operations personnel can give higher priority to the products that have the most value to the company.
You likely want to avoid running out of products in Group A at all costs, so you will likely keep extra safety stock of products in this group. In contrast, you may keep minimal safety stock of products in Group C, as it is less cost-effective to store vast amounts of slow-moving products.
Which Technique is Right For Me?
In short – All of them. These inventory management techniques are not exclusive, and nearly every company will use some combination of JIT, Stock Review, and ABC Analysis to yield the most effective inventory management in their business.
I recently reached out to several business owners to understand their best practices for inventory management. As expected, their responses all varied with the type of business. But, each of them utilized a combination of the above techniques to manage inventory in their own businesses.
An Example: Bicycle Manufacturer
You manage the supply chain for a popular bicycle manufacturer, and you need to determine how much inventory to stock for the upcoming three month period. What steps would you take?
First, you will establish a forecast of bike sales over this period. You compare this to the existing inventory of bikes in your warehouse, and you will plan to build enough bicycles to meet demand over the three month period. This is an application of the Stock Review Method.
Next, you will decide how many of each model to build. Your trail bikes are best sellers, with the most popular colors being Black and Blue. You don’t want to risk running out of inventory on these bikes, so you make sure to have plenty of safety stock of trail bikes in colors black and blue. You also occasionally sell some old-fashioned bikes in pastel colors. You don’t sell too many of these, and they aren’t a big contributor to your profit. You order a handful of these, but aren’t worried if you sell out. This is an example of the ABC Method, since you are prioritizing inventory purchases based on worth to your business.
With the above, you have a forecast of how much inventory you will need of each bicycle model over the next three months. You rely on a series of vendors to supply you with bike frames, tires, sprockets, and the like. However, you don’t have room in your warehouse to store three months of inventory for each of these components. Thus, you place orders with your vendors and stage the delivery times over the course of the three month period. This way, bicycle components arrive just in time for final assembly of the bicycle. This is an application of JIT Inventory Management.
Conclusion: Combination of All Three Methods.
With this example, it is clear the bicycle manufacturer uses a combination of technique for effective inventory management techniques. Depending on your specific business, you may utilize one method more than the other, but in all likelihood your supply chain is using a combination of Stock Review, ABC, and JIT.
Inventory Management in Practice
It is now common for a manufacturer to sell products through retail and warehouse channels, as well as ecommerce platforms. This multi-channel sales strategy requires an inventory management strategy that can accommodate sales across these distinct sales platforms.
These types of businesses utilize multi-channel inventory management, which is the process of managing and tracking inventory across multiple sales channels. This adds substantial complexity to the inventory management process, as each channel likely has unique requirements that are hard to manage. The wholesale channel may generate fewer orders of large quantities at one time, so you have to be prepared to make bulk shipments as needed. Conversely, the retail channel is a constant hum of low-volume orders that require nearly real-time order fulfilment.
For these reasons, multi-channel businesses typically utilize robust inventory management systems that are capable of managing inventory levels across the channels.
What are the Benefits of Multi-Channel Inventory Management?
The key benefit of multi-channel inventory management is that it can smooth out spikes in demand. If you sell into only one channel, increased demand from a few large customers may cause you to sell out of inventory. Or, the loss of a big customer could leave you holding large amounts of excess inventory that may take a long time to sell.
In a multi-channel business, common inventory can be used to satisfy either an ecommerce order, a wholesale order, etc. While adding complexity to inventory management, it generally results in more predictable demand for products.
Retailers typically utilize a point of sale system that tracks purchases on a daily (or hourly) basis, and helps the retailer to know the inventory levels of each product in the store. The point of sale systems are typically connected to the retailer’s inventory management software, so the store management knows when to reorder various merchandise.
Retailers Are Less Complex
Inventory management for retailers is typically less complex compared to a manufacturer – They don’t need to worry about maintaining inventory levels for raw materials, nor do they need to worry about staffing for a manufacturing facilities. They simply need to track sold inventory and plan for future demand based on prior sales history.
Fulfillment by Amazon (FBA) is very nearly a turn-key inventory management system for online retailers. For a fee, Amazon will store your product in their warehouse, and ship orders for both your ecommerce customers and your orders from Amazon’s site. Amazon FBA essentially provides a third party supply chain for their participating retailers.
Amazon provides substantial reporting metrics on all inventory managed in its warehouse – The FBA dashboard shows the age of each inventory unit, dead stock, as well as a forecast of expected demand in the future. Once tuned correctly, the vendor simply needs to ship inventory to the Amazon fulfillment center as directed by the FBA inventory management systems.
Is Amazon FBA Cost-Effective for Inventory Management?
Product Type. Small products with long shelf-life are best suited for FBA. Amazon charges a monthly cost for volume of warehouse space consumed by your inventory. Depending on the season, the monthly charges range from $0.75 to $2.40 per cubic foot. For this reason, small products (i.e. electronics) are well suited for Amazon FBA. If you sell large appliances, then FBA is probably not the right solution for you.
Existing Inventory Management Processes. Amazon FBA is best suited for businesses that do not have in-house inventory management processes. If you already have an inventory management process and dedicated warehouse space, then it’s likely FBA would not be cost-effective. However, if you are a new business without the supply chain infrastructure, then FBA may provide you with a reasonably good inventory management solution with no capital investment.
Inventory Management Software
Up to this point, we’ve covered the basics of inventory management – We’ve covered the three major types of inventory management techniques, and how it looks in practice. It’s probably obvious by this point, but it is virtually impossible to mange inventory without dedicated inventory management systems.
In this section, I’ll review the key elements of an inventory management system, and key features to look for when selecting inventory management software for your business.
What does an inventory management system do?
- Stock Visibility. You need to know where your inventory is at all times, regardless if it is in a warehouse or in transit between locations. Inventory management software tells you exactly where your inventory is at any point in time. You can keep track of how much inventory is located in each warehouse, in the store, and on the vehicle in near real time.
- Automation. By integrating with your point of sale and accounting software, you can automate many of the tasks associated with tracking inventory. This eliminates human error.
- Economic Order Quantity. The software will calculate the cost-optimized order quantity that yields the lowest unit cost. It’s probably not cost-effective to order one unit at a time (shipping alone would be horrendous!) Conversely, you don’t want to order 9 months of inventory at one time. A robust inventory management system will help you find the right balance.
- Reduce Physical Counts. Businesses perform physical inventory counts of their inventory on a regular basis to ensure they know how much stock is actually on hand. A good inventory management system will provide a more accurate read of inventory levels in real time, reducing the need (and frequency) of physical counts.
Each industry has different requirements for their inventory management systems. Retailers generally only deal with the sale of finished goods inventory. Thus, they will need point of sale integration and a simple notification when reorder point is reached.
Conversely, manufacturers require inventory tracking of raw materials, work in process, and finished goods. Below I highlight some of the features needed by these types of businesses:
Choosing an Inventory Management System
- Integration with Point of Sale: As soon the cashier scans products at the register, the stock levels of the related inventory should be updated at the same time. This provides near real-time inventory tracking for the retailer.
- Inventory Catalog: Retailers frequently maintain various variations of a product – For each style of shoe, you will have several size combinations for both men and women. Thus, you need software that can update the stock levels of each product variation as soon as products are scanned.
- Automated Ordering: Some inventory management software is capable of reordering inventory once you hit a predetermined order point. To accomplish this, your inventory management system needs to be integrated with the vendor’s order entry system. However, once in place, automated reordering can eliminate several hours of work each month.
- Ecommerce Integration: Nearly every retailer has at least some online presence. In addition to the physical storefront, they frequently sell into Amazon, eBay, and other ecommerce platforms. It is important that your inventory management platform is capable of managing inventory across all these channels, so that you don’t accidentally fulfill more orders than available inventory.
Manufacturers have more sophisticated requirements for inventory management. They typically employ supply chain management to oversee purchase orders, inventory tracking, product assembly, and fulfillment. Below are some of the key features that manufacturers require in their inventory management systems:
- Product Costing Detail: The true cost of a manufactured product includes raw materials, labor costs, and plant / machinery costs. Manufacturers typically deploy software that is capable of consolidating all these costs to build a true inventory cost.
- Demand Forecast: Manufacturers may employ software that predicts inventory needs in the future. While the business likely employs a demand planner to build a forecast of product demand, a robust inventory management system will convert this demand into a forecast of actual inventory needs in the future.
- Barcoding: Many software packages include built-in barcoding feature, which allows you to rapidly place barcodes on each inventory item for tracking, such that you know exactly where each piece of inventory is in your warehouse at all times.
- E-Commerce: Just like with retailers, manufacturers are also branching out into ecommerce platforms. Many employ a direct-to-consumer model, so it is necessary to find an inventory management platform that integrates with popular ecommerce platforms.
Conclusion: Effective Inventory Management
An effective inventory management program is crucial to ensuring your business maintains the right amount of inventory at any given time. As a refresher, we reviewed the following inventory management techniques in this article:
- Just in Time Inventory
- ABC Analysis
- Stock Review
These techniques are not mutually exclusive, and virtually every business employs some combination of all these methods for inventory control. Once you identify the most appropriate inventory management process for your business, you can then select an appropriate software tool to help automate inventory management going forward.
Remember, inventory is the heart of any business, and it’s definitely worth the investment to ensure you always have the right amount of inventory at the right time!