Inventory management is the process of managing the movement and activity of all physical assets required to produce goods in the manufacturing process. It starts with the purchase of components and ends with the sale of the product.
Inventory isn’t just a warehouse of “items needed to do business”. It is a critical, dynamic part of the production effort that informs many aspects of the larger business operation from order fulfillment and production planning to the supply chain and warehousing. Inventory is itself as much a capitalized asset as a piece of equipment and must be managed with the same level of care. In fact, inventory value can often exceed the value of production equipment.
Inventory includes all materials and components that need processing or assembly. It can include consumables such as chemical solutions needed for processing, as well as complete sub-assemblies like circuit boards, housings, and everything in between. The function of inventory management stretches from the procurement of raw materials through to managing finished goods and beyond. Depending on the industry or mode of production, it often also includes work-in-process (WIP) items.
Inventory management is an integral part of overall supply chain management. It consists of the planning and ordering process for materials and components needed to produce finished goods, as well as storage and warehouse management, along with organizational processes like inventory receipt and handling procedures, stock lot tracking, stock movement documentation and reporting, order management and order picking for shipment, and much more.
Due to the wide variety and range of complexity in modern manufacturing and distribution companies, not all inventory management systems are equally suitable in all cases. Next to universally important functionality like keeping track of large numbers of Stock Keeping Units (SKUs) on their journey through the supply chain, certain approaches work better than others in specific use cases. A dedicated inventory management software or a broader manufacturing Enterprise Resource Planning or ERP system might be needed. Some of the popular types of inventory management that can be applied to increase efficiency in distinct use cases include Just-in-Time (JIT), Materials Requirement Planning (MRP), or Reorder Point/Reorder Quantity (ROP/ROQ).
The Importance of Inventory Management
The best way to understand the importance of inventory and having a dependable and accurate system in place to manage it is to look at the two extremes opposites of balanced inventory levels – stockouts and overstocking. Herein lies one of the key failings of old-school inventory management practices that rely on spreadsheets, paper counting, and manual inputs. In attempts to avoid stockouts or overages, traditional approaches have few means of tethering stock levels to a desirable optimum. As a result, companies often find themselves veering from one extreme to another.
This back-and-forth between depleted and excess inventory highlights the dangers of manual inventory management. It presents a multifaceted drain on any manufacturer or distributor, however, it can be especially destructive to the cash flow and overall financial health of SMBs. It also brings to attention the importance of dependable, accurate, and real-time inventory management.
Conversely, good inventory management aims to keep stock levels at the goldilocks zone. Among the many benefits like streamlined workflows and increasing operational efficiencies, this also helps companies to reduce costs. With the right balance of materials, cash is only spent for what is needed when it is needed. Even then, it is spent as close as possible to the point of invoice.
This balance allows companies to fulfill orders more reliably, driving customer satisfaction – customers can get what they want when they want it, leading to a stronger brand reputation and better business opportunities.
Good inventory management is also important for the long-term financial health of a business. By knowing the trends and seasonality of inventory with a higher degree of accuracy, business owners can find pathways to better cost management and innovation for new products. What’s more, they can offer value-added services and negotiate more lucrative supply contracts with vendors.
Types of Inventory
Before manufactured products can reach customers as finished goods, they must go through various stages in the manufacturing process, constituting different types of inventory in each stage. Having a good understanding and keeping track of these different types of inventory allows producers to reduce business costs and increase efficiency.
The raw material inventory consists of procured materials and components that the production staff needs in order to create finished products. For example, a wooden furniture manufacturer’s raw material inventory may consist of different types of lumber, varnishes and paints, paddings, and textiles. If the furniture manufacturer builds their products using premade components, their raw material stock may include tabletops, furniture legs, armrests, backrests, etc.
Work-in-Process or WIP inventory consists of stock items that have already been processed to various degrees and are “in the asdadkwprocess” of becoming finished goods. For example, when the frame of a sofa has been built and the carcass is taken back into inventory to wait for the padding to be added, it is part of the WIP inventory.
Since WIP designates half-finished products that have already had some value added to them in the manufacturing process, it is especially important to have an accurate overview of WIP for accounting purposes. This is because WIP goods have already incurred some production costs (raw materials, labor, and overhead costs) which need to be accounted for to ensure accurate inventory valuation and bookkeeping. In accounting, WIP is considered a current asset – items that could be turned into revenue within a year.
Finished goods are products that have been through the whole production process and are ready to be sold. The finished goods inventory, therefore, constitutes in-stock items that are ready for shipping to distributors or clients.
Some companies (such as sawmills, chemical companies, metal fabricators, etc.) can sell their finished goods to other manufacturers to be used in facilities as raw materials or components for further manufacturing processes. Distributing companies buy goods from manufacturers and resell them.
Items that a company uses in its operations but does not track are called non-inventory items. These are items that are generally purchased in bulk and used in very small quantities per product (such as screws or glue in furniture), or as auxiliary items in the business. Items falling in the latter category are also called MRO (Maintenance, Repair, and Operation supplies) and include safety equipment, janitorial supplies, repair tools, office supplies, etc.
In inventory management software, some services are often also defined as non-inventory items. This is done to enable adding them to purchases and sales documents. Naturally, their inventory is not tracked.
Consignment inventory is inventory that is held and owned by separate parties. In a consignment agreement, the consignor retains ownership of the goods while the consignee keeps them in their inventory to be used. The consignee pays the consignor according to consumption, i.e. when materials are used in production or when products are sold.
Consignment inventory is often held and tracked separately from a company’s owned stock. When done right, consignment inventory is a supply chain management method that can help both parties become more efficient, cut costs, and ensure a healthy cash flow.
Vendor-Managed inventory (VMI)
Vendor-Managed Inventory or VMI is a supply chain management method where a supplier not only sells their goods to a buyer but also takes responsibility for keeping the buyer’s inventory optimally stocked with the goods.
VMI is another supply chain management method that is characterized by a high degree of cooperation between the supplier and the supplied. The buyer shares their inventory data with the supplier, the supplier is responsible for deciding when and how much extra inventory to maintain in the buyer’s facility. This method can lead to considerable reductions in inventory costs and reduce the bullwhip effect as supply is balanced more effectively with customer demand.
Goods in transit
Goods in transit (sometimes also called transit inventory, pipeline inventory, or expected on-order inventory) is inventory that has left the facility of the seller or an intermediary but has not yet reached the buyer. Managing this type of inventory is useful for planning ahead production for items with long lead times.
It is also necessary for designating the party responsible for transportation costs and recording the goods in transit in their books once they leave the shipping dock of the supplier. There are two options for indicating ownership – The freight on board (FOB) shipping point signifies that as soon as the goods leave the supplier’s facility, the buyer is responsible for the shipment. FOB destination, on the other hand, means that the buyer takes ownership of the goods when they arrive at their receiving dock. Not accounting for in-transit goods may create accounting discrepancies when accounts payable are recorded before receiving the goods.
How to Keep Physical Inventory Organized?
Keeping the inventory organized is one of the key tasks of inventory management. Smaller businesses often think that they can handle their inventory processes without meticulously organizing physical inventory. But as a business grows, it gets increasingly difficult to effectively and safely handle stock. This is why proper warehouse organization should not go overlooked for any company, large or small. Creating a system early on is also much simpler than having to reorganize later when the inventory has grown in complexity.
Setting up a warehouse takes plenty of planning to ensure an optimal flow of materials. A typical warehouse usually consists of five areas dedicated to the handling of goods:
The loading dock. Thisis where stock enters and exits the facility. It is a good practice to create separate areas for incoming and outgoing inventory.
The reception area. Thisis where incoming goods are recorded, unpacked, labeled, and prepared for storage.
The storage area. Thisis where the materials, assemblies, or finished goods are held while they are waiting for further steps like processing.
The picking area. Thisis a linking section. Goods designated to move from storage into processing or shipping are brought here for easy access. Picking areas should also be separated for shipping and production.
Packing and dispatch. Thisis where shipments are prepared and recorded for departure.
A warehouse also has auxiliary areas, not directly related to handling goods, such as office spaces, washrooms, break rooms, etc. These should also be planned out carefully so as to not impede an efficient flow of goods.
10 tips for an efficient warehouse layout
Draw up a highly detailed layout scheme. Mark everything from shelves, racks, and access paths to doors, windows, and support columns.
Create separate areas for incoming and outgoing goods.
Maximize the use of both horizontal and vertical space.
Allocate enough room to the reception area for hassle-free sorting and inspecting.
Store raw materials and WIP close or easily accessible to production.
Store finished goods close to packing and dispatch.
Store goods that are often picked together proximate to each other.
Store fast-moving items in easy-to-access places close to the picking area.
Plan ample space for employees and forklifts to move and maneuver.
Make sure all areas are well-lit and use other ways to optimize energy savings.
Organizing the warehouse
Once a space is designated for a warehouse and its layout is planned out, it is time to start physically organizing the stock. Here is a step-by-step guide to warehouse organization that helps to ensure smoother workflows, higher efficiency, and traceability.
Mark areas. Create intuitive visual indicators by using signs, paint, and marking tape in your warehouse or stockroom. Signage can designate separate paths for on-foot employees and forklift traffic. Divide the space into visually clear areas, workstations, and different storage locations. Visual cues go a long way in improving worker safety and raising the efficiency of the layout.
Create an SKU code system. Stock keeping units or SKUs differentiate all distinct items in the warehouse and are an essential building block for inventory tracking. Even a small variation in a product should demand a separate SKU code. Consider organizing the physical storage space by SKUs.
Label everything. From materials and finished goods to aisles, racks, shelves, bins, workstations, and equipment, labeling helps to ensure that everything in the warehouse has its proper place.
Record every movement. Keep track of what is coming in, going out, or heading to production or shipping. This is necessary for tracking physical inventory and processes, as well as assuring compliance and detecting inconsistencies in quality or handling. It is essential that every move leaves a digital trace – tracking automation provided by inventory management systems helps save time and cut costs.
Use barcoding. Barcodes used along with a perpetual inventory system (such as offered by many ERP or MRP systems) are an essential tool for recording inventory movements. This often happens in real-time and helps keep inventory data always up to date. Implementing barcodes can automate many administrative tasks, increase transparency, and reduce human errors.
Track expiry dates. If working with perishable goods, tracking expiration dates will help to avoid parts of inventory going bad. Marking down the expiry dates of stock lots and using the FEFO (First Expired First Out) inventory costing method enables using stock lots in the order they expire.
Use ABC analysis. ABC analysis (also called the 80/20 rule) helps to categorize SKUs into classes to physically organize inventory according to the goods’ movement frequency. Class A items comprise 80% of total movements and should be stored closest to production (materials) or dispatch (finished goods). Class B items comprise 15% of total movements and should be stored next to class A. Class C items comprise 5% of the total inventory movements during a set period and should be stored the furthest. This helps to ensure that the items that are moved most frequently take up the least amount of time in the picking process.
Perform quality checks. The reception area is not only useful for organizing, unpacking, and sorting incoming goods. It is also a perfect time and place to conduct QC. This minimizes the chance of defective goods ending up on the production floor or in the hands of the customer.
Clean and maintainphysical storage. Regular maintenance and cleaning are necessary to improve safety in the workplace and to prevent equipment from breaking down. Proper maintenance includes regular inspections, cleaning, machine servicing, lighting and structural checks, dead stock removal, etc.
Implement continuous improvement. A well planned-out and maintained storage area is great. However, consistent effort in improving inventory processes and eliminating potential issues as they emerge is even better. This can be achieved, for example, by using the Theory of Constraints – a method that helps to focus on one pressing problem at a time.
What is inventory tracking?
Inventory tracking is the process of recording and tracking the movements, locations, requirements, and status of in stock goods and materials. By extension, in-transit goods (a.k.a pipeline inventory) that is yet to arrive or that has already left, on its way through the supply chain to the point of sales or client, may also be included in the realm of inventory tracking.
All this helps to effectively plan and schedule production by tracing goods from the moment a purchase order is put in. Additionally, inventory tracking enables companies to:
optimize their inventory processes and simplify inventory counts,
avoid stock-outs and overstocking,
prevent inventory from becoming dead stock,
organize customer orders and provide customers with more accurate lead times,
increase overall traceability and achieve regulatory compliance,
organize callbacks and return merchandise authorization (RMA),
improve communication within the company as well as with suppliers and customers,
make overall better-informed business decisions.
Inventory tracking can be conducted manually, by recording movements in physical or digital spreadsheets, or with the help of traceability software. With the former option quickly becoming outdated even in small businesses, utilizing digital solutions is highly recommended.
Serial number tracking and stock lot tracking
There are many methods that altogether make up inventory tracking. Next to implementing a SKU rationalization system, barcodes, investing in an RFID system, or utilizing other digital tracking tools, the core function of inventory tracking often relies on tracking serial numbers and/or stock lots.
Serial numbers are unique identifier codes assigned to individual items. They differ from SKUs in that all identical items have the same stock keeping unit (SKU), while serial numbers are unique per item, regardless of whether there are other identical items in stock. Tracking serial numbers implies appointing them to all individual items that are needed to be traced and implementing a system, either manual or software-based, that logs their movements, locations, and processes.
A stock lot is one batch of a single SKU. For manufacturers that produce goods in batches, such as food or chemical producers, need to mark their products with stock lot numbers to ensure traceability. When inconsistencies appear later on, the faulty goods can be traced back to specific stock lots for further inspection of the batch or to organize a callback.
How to track inventory manually?
If managing inventory manually, it is necessary to create a paper trail of everything that is received into stock and everything that goes out of the facility. Let us look at the actions that need to be recorded:
Reception of goods including delivery of purchase orders, consumption of manufacturing orders, and returned merchandise.
Dispatch of goods including manufacturing orders and shipments.
Stocktakes – positive adjustment (write-in) and negative adjustment (write-off).
When all these documents are gathered, they are recorded in a spreadsheet to gain an accurate overview of inventory movements and the current inventory situation.
This is easier said than done. The number of interrelated data points that need to be aligned can quickly skyrocket. As a solution, manufacturing and inventory software automates many of the tracking steps and hugely simplifies keeping records of stock movements.
Digital inventory tracking tools
There are various tools available that help manufacturers largely automate the gruesome data entry tasks traditionally associated with inventory tracking. Instead of using a pen and paper for recording incoming and outgoing stock, as well as consumption, inventory professionals can use tools that feed the necessary information into automated inventory management software.
In such systems, each employee simply reports their part, e.g. by using a tablet or a smartphone, and the inventory is automatically kept up to date by the system.
When a PO is received, the stock clerk marks the specific PO “received”. As a result, the inventory is automatically updated.
When the system tells the worker to pick some material for production, the worker picks the material and marks it “picked” in the system. The system again updates the inventory levels.
When a shipment is picked from the loading dock, the worker reports a planned shipment as picked, and the finished goods inventory is updated in real-time.
There are additional tools that can be used together with such systems, which allow to speed up the data entry even further. A few examples commonly used today include barcodes and QR-codes.
Barcodes and QR-codes
Barcodes are simple unidimensional representations of numberic codes in a machine readable form. They are used to convey small amounts of information such as an SKU code and the price of the item. These are traditionally read with a barcode scanner, however, some cloud-based ERP/MRP systems also allow workers to use a smart device like a tablet or a phone to read them.
Quick Response or QR-codes, on the other hand, are an evolution of barcodes and consist of black squares and dots on a bidimensional plot. QR-codes can convey up to 60 times more information than traditional barcodes. They are more readable in difficult conditions such as inconvenient angles or when labels have experienced some wear and tear. QR-codes are also better when using smart devices to read the labels.
How to perform a cycle count?
An essential part of keeping inventories in check and everything neatly accounted for is conducting stock takes and cycle counts. Stock takes are comprehensive inventory audits wherein all stock items are counted along with information on their status and condition. Cycle counts, however, are more localized. Here, parts of inventory are routinely counted to ensure everything fits the bill. There are good reasons from inventory planning, control, and accounting perspectives to do this rather often.
In a manual cycle count, the first step is usually to prepare a spreadsheet that compiles expected inventory quantities according to the inventory tracking process, usually accompanied by information on the goods’ locations. This will be used to compare data to physical inventory counts.
As stated, cycle counts need not be conducted for all of a company’s inventory at once. They are often used together with ABC analysis, an inventory management technique that helps prioritize items by their value, thereby giving an indication of which items should be counted more frequently and which items need less attention. More on that later.
What to do if a cycle count is not adding up?
Once the physical count is complete, it is compared to the expected quantity of the books. Any differences must then be investigated. If the reason is found, it is fixed at the source. For example, if a shipment was not documented, it can be documented. This will make the quantity in the books match the physical quantity on hand.
If any reason for the discrepancy cannot be uncovered, then a write-off (negative adjustment) or a new stock lot (positive adjustment) can be generated to adjust for the difference. It is important to carefully consider the cost of the item being written off or into the stock.
The procedure should also be discussed with the accountant to determine the best course of action. In case of a negative adjustment, which lot will the write-off affect? In case of a positive adjustment, which costing method should be used, the last cost, average cost, or something else?
Once all these issues are resolved, the cycle count is finished. As a result, the quantity on books matches the quantity on hand.
If the cycle count or general stocktake results in items that turned out of nowhere and are seemingly without function, there is a dead stock situation. Dead stock refers to inventory items that have lost their purpose and will probably not find utility. This can happen due to several reasons. For example, changes in the BOM of a product, improper storage conditions, inefficient inventory management practices, poor sales, etc.
There are several different types of dead stock including obsolete items that lack demand, items that are damaged due to accidents or bad storage conditions, expired goods, defective goods, and also forgotten inventory – items that have been received into stock without proper tracking and accounting.
Cumulating dead stock should be avoided as holding onto it can be detrimental to a company. It can create cash flow problems, accrue hidden costs, waste inventory space, and ultimately eat away at profit margins. Apart from tracking inventory and using inventory control techniques, dead stock can be avoided by creating more accurate demand forecasts, revamping procurement practices, evaluating supplier performances, performing quality inspections, and putting more emphasis on marketing and sales.
There are a few avenues to explore in attempts to still get some utility out of it. For example, the items might still be useful for another company or organization that might agree to buy them at a good price. Otherwise consider donating the goods. The materials might also be able to be recycled.
Periodic and Perpetual Inventory Systems
What is a periodic inventory system?
A periodic inventory system is a tried and tested approach to the inventory management process. As the name suggests, the inventory balance is updated periodically, most often at the end and at the beginning of an accounting period. Stock takes are used to physically count the inventory and compare the numbers to those derived from reception and dispatch documents.
For companies utilizing only a periodic inventory system, inventory numbers, as well as WIP and the cost of goods sold (COGS), are current or truly objective only once per period. This is technically no cause to worry for very small or very simple inventories. However, relying on counting tens of thousands or more items to ensure balanced books can quickly get overwhelming for a business no matter its size. That is why even the smallest companies today opt for a perpetual inventory system such as on offer by warehouse management (WMS) or ERP software.
What is a perpetual inventory system?
A perpetual inventory system is a modern approach in which all inventory movements and corresponding books are updated continuously (or perpetually) within a unified software solution. This brings a wealth of advantages and means that all the information in the inventory records, including the WIP and COGS, is always up to date. All relevant departments can make informed decisions on procurements, streamline production schedules, provide accurate lead times to customers, and starkly reduce the chance that an overlooked item might have gone out of stock unnoticed.
One of the chief reasons for implementing software with a perpetual inventory system is that these solutions help companies deal with growing pains much more easily. Even if a company has no problem tracking small quantities of stock at first, manual tracking is practically impossible to efficiently scale – it requires incrementally more labor and time as the inventory grows. Manually adding stock locations can also be a nightmare for inventory managers as information cannot be shared, let alone in real-time, among different facilities. Software solutions that enable the management of multiple warehouses and production sites enable real-time visibility into inventories and a single source of data-driven truth for all operations.
Inventory is considered a current asset that must be indicated on a company’s balance sheet. Regardless of the product or business model, all manufacturing or distribution companies need to count their inventory accurately to ensure the balance sheet stays in balance. In the manufacturing industry, the inventory in question usually consists of both raw materials, Work In Process, and finished goods inventories.
It is worth noting that just like with inventory tracking, manually conducting inventory accounting can eat up huge amounts of time and resources while being prone to human errors. Modern software like cloud-based ERP and MRP systems that are purpose-built with the needs of manufacturers and distributors in mind, includes powerful inventory accounting functionality and is an affordable remedy to these issues.
Inventory valuation methods
InInventory valuation is an accounting procedure that determines the monetary value of stock. It is a crucial part of both accounting and inventory management processes as the value of stock items in their different states directly affects a company’s financials. Different stock valuation methods are usually chosen based on how the inventory is used in the manufacturing process. The most common valuation methods are FIFO, LIFO, FEFO, WAC, and SI:
FIFO (First In, First Out) is an approach where items are utilized in the order they are taken into stock. With FIFO, the ending inventory – items left in stock at the end of a financial period, is usually valued higher due to inflation. This means a higher gross profit, but, also a higher taxable income.
LIFO (Last In, First Out) means that the latest arrivals are sold or put into use first. This is best used during periods of high inflation as the most expensive goods get used first, guarding against more losses. The lowest-costing goods are included in the ending inventory, which means a smaller tax burden and a reduced net income.
FEFO (First Expired, First Out) is similar to FIFO, except the valuation also takes into account the expiration dates of items. This is the best approach for businesses that use or sell perishable goods such as foodstuffs, chemicals, etc.
The weighted average cost (WAC) is a median method in which the value of goods is determined by dividing it by their total numbers, returning a weighted average cost per unit. This approach is mostly used when systems are not developed enough to use FIFO or LIFO, if products have little variation, or when items are highly mixed and cannot be assigned a cost per unit.
The specific identification (SI) method assigns value to each individual stock item as precisely as possible. This is most useful for engineer-to-order manufacturers creating custom-made or unique goods, or when the inventory simply consists of many high-value items.
Deciding which method to use can vary from company to company and relies on the regulations that a company needs to comply with (e.g. GAAP vs IFRS), the impact it will have on taxes, the manufacturing method being utilized, and even market considerations like which sales channel to opt for at a given time.
The cost of goods sold (COGS)
COGS is a crucial accounting metric used to determine the cost of producing or purchasing goods that have been sold during a financial period. Together with the manufacturer-oriented KPI, cost of goods manufactured (COGM), COGS is one of the chief metrics in inventory accounting, required to determine a company’s gross profit and net income.
COGS in distributing
For distributors, COGS can be determined fairly easily.
For example, say there is $40,000 worth of inventory at the beginning of the period and the company purchases an additional $70,000 worth of stock during that period. At the end of the period, bookkeeping confirms that there is $35,000 worth of inventory left. That means the COGS for that period is:
COGS = $40,000 + $70,000 – $35,000 = $75,000
After determining the COGS, the company can calculate its gross profit by subtracting COGS from the period’s revenue.
Let’s say that the same company accumulated a revenue of $160,000 during the period.
Gross Profit = $160,000 – $75,000 = $85,000
COGS in manufacturing
In manufacturing, the formula is a little bit more complex because manufacturers do not only have to account for procured goods and materials but also direct labor costs and manufacturing overhead costs. This is where the cost of goods manufactured – COGM, comes into play along. Calculating COGM means knowing the values of all three basic inventory types at the beginning and end of the financial period (raw materials, WIP, and finished goods).
For manufacturers, the COGS calculation is as follows:
To clarify the role of COGM, here is a 4-step rundown of the COGS calculation for manufacturers :
Start with the beginning raw materials inventory value and add all raw materials purchased during the accounting period. Then, subtract the ending raw materials inventory value. This is the valuation of the direct materials used in production, a.k.a direct material cost.
Direct material cost = beginning raw materials inventory + purchases – ending raw materials inventory
Next, add the value of direct labor, packaging and shipping, and factory overhead (factory expenses like rent and utilities). This is the total manufacturing cost.
Total manufacturing cost = direct material cost + direct labor + factory overhead
Determine COGM by adding the value of the beginning WIP inventory and total manufacturing cost, then subtracting the value of the ending WIP inventory.
COGS calculations used to be done periodically at the end of financial periods for producing detailed financial reports. With modern perpetual inventory systems as implemented in most MRP/MES software, COGS can be calculated automatically and continuously in real-time and even estimated up-front in the production planning phase. This helps companies keep their eye on the financial pulse of the operation and enables data-based decision-making on profitability and taxation.
By and large, data-centered knowledge gives the best insights into the performance of a business. There are dozens of inventory-centered metrics that a company can track to increase its efficiency. Some examples include process efficiency KPIs like average picking time or time to receive, cost and sales-centered metrics like inventory holding cost and stock-to-sales ratio, or even labor KPIs like labor cost per item. While inventory managers can measure nearly every aspect of stockroom activities, there are few metrics out there as versatile as inventory turnover ratio and days sales of inventory.
Inventory turnover ratio
The inventory turnover ratio or inventory turnover rate is a KPI used to determine the number of times a company depletes and restocks its inventory within a set period. It weighs the cost of goods sold against the average inventory value of the company to produce a numeric ratio. A low inventory turnover ratio could indicate weak sales and excess stock while a very high one could be a sign of insufficient inventory levels and a danger of frequent stockouts.
Inventory turnover ratio = cost of goods sold / average inventory
The average inventory value is the arithmetic mean of the ending inventory values for multiple periods. For example, a year’s average inventory is the value of the past twelve months’ ending inventories divided by 12. It is used instead of more precise valuation methods in order to compensate for possible fluctuations in inventory value.
There are different estimations as to the ideal inventory turnover rate, ranging from between 4 and 6 or between 5 and 10. However, since the metric depends on a host of variables like the type of industry and the products sold, market fluctuations, and supply chain characteristics, there really is no golden rate to always aim for. For example, fast-moving consumer goods like foodstuffs need to have a much higher inventory turnover rate than a custom furniture manufacturer.
Days sale of inventory
Days sale inventory (DSI), also known as days on hand or the average age of inventory, is similar to the inventory turnover ratio but instead of providing a rate, it indicates the number of days it would take to sell the stock at hand. Similar variants of the KPI preferred by some planners are weeks sale of inventory or quarter sale of inventory, which returns the number of weeks or quarters to sell on-hand stock respectively.
Days sales of inventory = (average inventory / cost of goods sold) x 365
DSI can be very helpful in determining whether a company is carrying too much or not enough on-hand stock. Analyzing it enables decision-makers to measure business performance and spot opportunities for increasing liquidity and decreasing overheads. DSI also informs other, more advanced financial KPIs like the cash conversion cycle which measures the period that net cash input spends in stock before converting to cash from sales.
Inventory planning methods
The inventory needs of companies can be very different, depending on the type of product manufactured or business model employed, the scale of the company, the supply chain method used, and everything in between. Stock can be planned out in a number of different ways. The advantage of a good inventory management system is that it can be adapted to any variation or inventory type. Here we go through some common inventory planning methods and models that manufacturers and distributors often deploy.
The Just-in-Time or JIT model of production attempts to meet demand as exactly as possible, thereby minimizing holding costs and improving liquidity. It has tremendous potential advantages. However, making sure that the right quantity of materials arrives at the facility at the right time and in the right quantity just as production is scheduled to begin, is not an easy feat and requires impeccable material planning and effective communication with suppliers.
Just-in-Time therefore largely depends on specifically determining production rates and work cycles. This entails an intricate setup and precise knowledge of the market and supply chain. If the demand shifts up or down suddenly due to external factors, the company can find itself short of critical components. It can also result in bottlenecks as entire production lines may wait on a single component.
Material Requirements Planning (MRP) is a complex system for planning production and identifying the requirements needed for it. It is chiefly a production scheduling and planning system, however, inventory control is a crucial component in achieving that goal. Therefore, most MRP systems include powerful inventory management functionalities.
MRP itself does not use statistical methods to forecast demand for materials. A good sales forecast or an otherwise firm planning phase are prerequisite for utilizing it to its fullest. The system then consolidates data from across the organization to know where, when, and how finished goods will be produced. Inventory is ordered confidently based on preemptive knowing and key components and raw materials can be stocked based on the sales forecasts and master production schedule.
Material requirements planning starts with predefined quantities of products to be made and the timeframe for doing so. The production plan is tied to the bills of materials of the products so that the MRP software can determine which materials and in which quantity are needed. If the software also has a procurement module, it can use supplier data to indicate when missing materials have to be ordered so they would reach the production floor on time.
ABC analysis is an inventory management method used for determining the significance of inventory items to a company. Many companies have a wide range of complexity and diversity present in their inventories. Stock may have a wide range of costs, from a few cents for a material or consumable to tens of thousands of dollars for a specialized component. Based on the Pareto principle, according to which the relationship between inputs and outputs is unequal, ABC analysis splits stock into groups or categories based on their value to a company.
In ABC analysis, inventory is usually split into three categories: class A constitutes high value/low quantity goods, class B is moderate value/moderate quantity stock, and class C is made up of low value/high quantity items. Prioritizing stock has a wealth of potential advantages like knowing where and when to focus the most effort, increasing transparency in inventory processes, helping to better organize the stockroom and supply chain, etc.
Safety stock is the extra inventory that a company keeps in order to avoid a stockout due to unforeseen circumstances such as demand spikes or supply issues. This buffer can be a crucial lifeline when the market experiences fluctuations. Setting a safety stock level on a whim is strongly inadvisable. It is hugely preferable to rely on data and mathematical analysis of consumption rates when determining the safety stock levels for goods.
Thankfully, many different formulas exist for calculating the optimal level of safety stock, each one suitable for a specific situation, e.g. when lead times are inconsistent, when demand is inconsistent, or when they are both either consistent or inconsistent.
The reorder point or ROP is an inventory control method that triggers the replenishment process for stock. It can be viewed either as the lowest stock level at which new stock should be ordered, or the last moment in time to do so. In inventory management software, reaching an ROP prompts a notification or automatically triggers the replenishment of an SKU.
Reorder point uses the consumption rate of an SKU, its lead time, and the level of safety stock to calculate the best inventory level for triggering a replenishment. The basic formula is:
ROP = average lead time x average demand + safety stock
This, along with predefined safety stocks, helps companies minimize stock-outs, avoid overstocking, and achieve an optimal service level. There is another statistical method for controlling stock levels wherein the reorder point is paired with a reorder quantity value, or ROQ. This method is often referred to as ROP-ROQ.
Economic order quantity or EOQ (also called the economic buying quantity) is an inventory planning method for calculating how much product needs to be ordered to keep inventory cost consistent in the face of steady demand. The idea behind EOQ is to balance the amount of inventory with the scheduled run of a batch so that production runs for specific products do not have to run too frequently. This is helpful in companies where changeover times are very long or complex.
EOQ relies on stable and constant lead times, demand, and ordering and carrying costs. It is thus mostly used as an inventory planning tool for larger-scale make-to-stock workflows. If done right, however, utilizing it can result in big reductions to carrying and operating costs, as well as improved inventory turnover and cash flow.
Companies may often find themselves in the frantic pendulum of stock shortages and overages. Thankfully, software exists that can help companies achieve optimized stock levels and maintain them on a day-to-day basis. A properly managed inventory can improve cash flow, optimize production, and propel a factory or a distributing center to higher efficiency, making the difference between a good company and a “best-in-class” one.
In the not-so-distant past, managing inventory could easily be an all-day or all-week affair with manual counting, spreadsheets, and hosts of repetitive manual data entry inputs, followed by the nerve-wracking reconciliation phase. Because inventory was taken manually, companies often lacked knowledge of stock imbalances and were only informed once the losses had already been incurred.
Today, manufacturers and distributors have different options for effective inventory management software with many standalone packages on offer. The most optimal path to better inventory management lies in software systems that include an inventory management component as part of an overall ERP or MRP system. These solutions directly tie inventory with the overall supply chain, production, labor, and maintenance planning system, improving accuracy and making critical business data accessible system-wide.
Modern inventory management software is flexible and adaptable to whichever mode of production a company has set up like MTS, MTO, ETO, process or discrete manufacturing, Just-in-Time, etc.
Bespoke ERP, MRP, and inventory management systems of yesterday used to cost an arm and a leg in both upfront and maintenance costs, often taking years to implement and negatively impacting the bottom line in the meantime. With the arrival of agile, cloud-based ERP systems, however, powerful yet affordable inventory management systems are well within reach for small and medium-sized businesses.
Inventory management is a broad term that refers to all kinds of inventory-related activities of manufacturing and distribution companies. It encompasses many aspects of the larger supply chain management process. Chief aspects of inventory management include inventory control, inventory optimization, inventory tracking, and warehouse management.
What is the purpose of inventory management?
The main purpose of inventory management is to make sure that stock levels of both raw materials, Work-in-Process, and finished goods inventories are always kept at an optimum. As such, inventory management attempts to avoid two extremes – overstocking and stockouts, from occurring, as both of these can be hugely detrimental to the financial and operational health of a company. Additionally, inventory management is also aimed at minimizing overhead costs, increasing manufacturing or distribution efficiency, and ensuring compliance by way of stock traceability.
How does inventory management affect the customer?
A company with effective inventory management methods in place will have greater insight and control over its inventory movements and can thus ensure both shorter production as well as customer lead times. This also means more precise quotes and greater accuracy, leading to increased customer satisfaction. Inventory tracking also helps make sure that if there are any delays or problems with a product down the line, the root cause of the issue can be determined quickly. Inventory management thus also contributes to better customer support and issue resolution.
What are the main inventory planning methods?
Common inventory planning methods or inventory management techniques, as they are sometimes referred to, include Material Resource Planning or MRP, Just-in-Time or JIT, Economic order quantity or EOQ, Days sale of inventory or DSI, ABC analysis, and others. Which method or mix of methods to choose will depend on many variables such as whether a company is a make-to-stock (MTS) or a make-to-order (MTO) manufacturer, whether it utilizes discrete or process manufacturing, whether it needs to account for consignment goods, etc.
MRPeasy makes inventory management easy
Stay on top of inventory, stock movements, and procurement. Effortlessly track stock lots, serial numbers, and expiry dates. Set reorder points and receive notifications when inventory levels drop below them.
Integrated Inventory Software for Manufacturing Companies
Accurate automatic planning and realistic production schedule. Reschedule dynamically by just dragging and dropping manufacturing orders and operations in the calendar or Gantt chart.
Inventory management, stock movements, batch and serial number tracking. Set and optimize stock levels and avoid stock-outs. Have a clear history of your stock operations.
CRM (Sales Management)
Just a few clicks to calculate the product cost and the best delivery time. Send quotations and invoices, prepare shipments. Send confirmed customer order to production. Track the sales process all the way from quotation right down to delivery using a simple pipeline view.
Simple environment for line workers to follow tasks on desktop or mobile device. Real-time shop floor reporting. Real-time overview of the need and availability of human resources.
Manage purchases and raise pre-filled purchase orders with a single click. Vendors, prices, lead times, it’s all there. Manage your supply chain with the help of accurate statistics. Forecast your procurement needs.
Enjoy clear visibility to your business performance. Follow your cash flow, balance sheet and profit/loss in real time. Understand the profitability of the business, and more.
You guys are truly the best and the software is such a lifesaver for small companies like ours. Also just a note, our ISO auditors really liked everything that MRPeasy had. Everything is documented within the system!! And we do not need any additional systems.
CEO, Sox Trot
Best value in the small manufacturing space by far. With MRPeasy, our capacity doubled. It streamlined our production, and procurement so well that I’m now able to spend a lot more time on growth and sales. Extremely comprehensive and works seamlessly with Xero and Shopify.
CEO, Anicell Biotech
MRPeasy gives us the ability to track all of our manufacturing lot costs right down to the individual serial number of our products. MRPeasy provides the software as a remote service and has never been unavailable to us except in very rare maintenance windows.
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