Inventory Management

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What is Inventory Management?

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 “things needed for business”. It is a dynamic and critical part of the production effort itself. Inventory is as much an asset like 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 and is an important capitalized asset.

Inventory includes materials that need to be processed or assembled and can include consumables such as chemical solutions needed for processing as well as complete sub-assemblies like circuit boards, housings, and other items. Inventory management also stretches from raw materials through finished goods, and depending on the industry or mode of production, may include work in process (WIP). 

Inventory management is an integral part of overall supply chain management and consists of the planning and ordering process for materials and components needed to produce finished goods, storage of the items, the organization of the warehouse, and organizational processes like inventory receipt and handling procedures, stock lot tracking, documentation of stock movements, order picking for shipment, and much more.

Because modern manufacturing covers a large range of complexity and must keep track of an enormous number of Stock Keeping Units, there is more than one way of managing inventory. To be effective, narrow-focused inventory management software or broader manufacturing ERP software are needed. Also, methods such as Just in Time (JIT), Materials Requirement Planning (MRP), or Reorder Point/Reorder Quantity (ROP/ROQ) are some of the popular approaches that could be applied to become more effective. What is used will depend on the type of the business.

The Importance of Inventory Management

The-Importance-of-Inventory-Management
Good inventory management is also important to the long-term financial health of a business.

The best way to understand the importance of inventory and the importance of having a dependable and accurate system in place to manage it is to look at the extremes – stock-outs and overages. But here lies one of the failings of “old-school” inventory management that relies on spreadsheets, paper counting, and manual inputs. For while stock-outs and overages account for the extremes, there is little middle ground, and companies can find themselves veering from one extreme to another.

The reason for this back and forth between “too much” and “not enough” highlights the dangers of manual inventory management but also highlights the importance of good, dependable, accurate, and real-time inventory management. And while this is a drain on any manufacturer or distributor, it can be especially destructive to the cash flow and overall, health of SMBs.

Good inventory management strikes a balance in that “thin” middle ground to help a company reduce costs. With the right balance of materials, cash is only expended for what is needed, and even then, it is expended as close as possible to the point of invoice.

That balance allows companies to fulfill orders and drives customer satisfaction. Customers can get what they want when they want it without having to seek alternate sources. This provides better customer service and strong brand recognition.

But good inventory management is also important to the long-term financial health of a business. By knowing with a high degree of accuracy the trends and seasonal aspects of inventory, companies can find pathways to better cost management and innovation for new products, offer value added services, and negotiate more lucrative supply contracts with vendors.

Types of Inventory

Before a manufactured product reaches the customer, it goes through various stages of life in your inventory. Understanding and accounting for these different types of inventory allows you to reduce business costs and increase efficiency.

Main Categories

Raw Materials

Raw material inventory consists of materials or components that the production staff needs to create final products. For example, a wooden furniture manufacturer’s raw material inventory may consist of different types of lumber, varnishes and paint, paddings, and textiles. If the furniture manufacturer builds their products using premade components, these may include tabletops, furniture legs, armrests, backrests, etc.

Work-in-Process (WIP)

Work-in-Process or WIP inventory is the items in stock that are neither raw materials nor finished goods, rather they are something in between. 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.

Work-in-Process inventory is especially important for accounting. Because WIP goods have already incurred some production costs (raw materials, labor and overhead), it is important to account for it in order to ensure accurate valuation and bookkeeping.

Finished Goods

Finished goods are products that have been through the whole production process and are waiting to be sold. Some companies (such as sawmills, chemical companies, metal fabricators, etc.) can sell their finished goods to other manufacturers to be used in another facility as materials or components in further manufacturing. Distributing companies buy goods from manufacturers and resell them.

Additional Categories

Non-Inventory Items

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 software, non-inventory items (as a technical functionality) are also often used to define services in order to be able to add these to purchase and sales documents, but naturally, their inventory is not tracked.

Consignment Inventory

Consignment inventory is inventory held and owned by separate parties. In this case, 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. When done right, this supply chain management method can help both parties to become more efficient, cut costs, and ensure a healthy cash flow.

Vendor-Managed Inventory

vendor-managed-inventory

Vendor-managed inventory is another supply chain management method where there is a high-degree of cooperation between the supplier and the supplied. In this case, the supplier takes on the responsibility of optimizing and replenishing the stock held by the buyer. The buyer shares their inventory data with the supplier who then makes the decision of when and how much extra inventory to stock in the buyer’s facility.

This method can lead to considerable reductions in inventory costs and in the effects of the bullwhip effect as demand and supply are balanced more effectively.

Goods in Transit

Goods in transit (also called transit inventory) is inventory that has left the facility of the seller but has not yet reached the buyer. This framework is used to designate the owner of the merchandise once it leaves the shipping dock of the supplier, leaving this party responsible for transportation costs and recording the goods in transit in their books.

There are two options for indicating the ownership:

  • 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 means that the buyer takes ownership of the goods when they arrive at their receiving dock.

Not accounting for the goods in transit may create accounting discrepancies when accounts payable are recorded before receiving the goods.

How to Keep Physical Inventory Organized?

Good organization is one of the keys to efficient inventory management. Smaller businesses often think that they can handle their inventory processes without meticulously organizing their physical inventory. But as a business grows, it gets more and more difficult to efficiently manage and safely handle stock, and to create a system for doing so. That is why proper warehouse organization should be an essential part of any company, large or small.

Results of poor and good inventory organization

Warehouse Layout Tips

Setting up a warehouse takes plenty of planning to ensure an optimal flow of materials. A typical warehouse consists of five areas dedicated for the handling of goods:

  1. Loading dock is where stock enters and exits the facility. It is a good practice to create separate areas for incoming and outgoing inventory.
  2. Reception area is where incoming goods are recorded, unpacked, labeled, and prepared for storage.
  3. Storage area is where the goods are kept waiting for further processing.
  4. Picking area is a link between storage and packing or production. Picking areas for shipping and production should also be separated.
  5. Packing and dispatch is where shipments are prepared and recorded.

A warehouse also has auxiliary areas not related to handling goods such as office spaces, washrooms, break rooms, etc. These should also be planned so they would not impede an efficient flow of goods.

These are some of the golden rules for designing an efficient warehouse layout:

  1. Draw up a highly detailed layout scheme with everything from shelves and racks to doors, windows, and support columns marked.
  2. Create separate areas for incoming and outgoing goods.
  3. Use both horizontal and vertical space as much as possible.
  4. Allocate enough room to reception for sorting and inspecting the goods.
  5. Store raw materials and WIP close to production.
  6. Store finished goods close to packing and dispatch.
  7. Store goods that are often picked together close to each other.
  8. Store fast-moving items in easy-to-access places close to the picking area.
  9. Leave space for employees and forklifts to move and turn.
  10. Make sure all areas are well lit.

Warehouse Organization Steps

After finding an inventory space and creating a warehouse layout, it is time to start physically organizing your stock. We have compiled a step-by-step guide to ensuring smooth workflows, high efficiency, and traceability in the warehouse.

1. Mark the areas in your warehouse or stockroom by using signs, paint, and marking tape. Create visual indicators for both pedestrian and forklift traffic pathways, divide the space into areas, workstations, and different storage locations. Visual cues improve safety conditions and efficiency in the workplace.
2. Create a SKU code system for your inventory. Stock Keeping Units represent distinct goods in the warehouse, allowing for inventory tracking. Even a small variation in a product should demand a separate SKU code.
3. Label everything from materials and finished goods to aisles, racks, shelves, bins, workstations, and equipment. This is a clear indication that everything in the warehouse has its proper place.
4. Record every movement to keep track of what is coming in and going out to production or shipping. This is necessary for keeping records clear and to track both physical inventory as well as inconsistencies in quality or handling. This is much easier done with inventory management software than manually.
5. Use barcoding for inventory tracking. Barcodes used along with a perpetual inventory system (such as an ERP software) make it easy to record inventory movements and keep inventory data always up to date. This automates many administrative tasks, increases transparency, and reduces human errors.
6. Track expiry dates if you are working with perishable goods. This way you will avoid a situation where a portion of your inventory becomes unusable without your knowledge. Mark down the expiry dates of your stock lots and use the FEFO (First Expired First Out) method to use stock lots in the order they expire.
7. Use ABC analysis to physically organize your inventory according to the goods’ movement frequency. ABC analysis (also called the 80/20 rule) helps you categorize your SKUs into classes A, B, and C. A class items comprise 80% of the total movements and should be stored closest to production (materials) or dispatch (finished goods), B class items comprise 15% of the total movements and should be stored next to A class ones, and C class items comprise 5% of the total inventory movements during a set period and should be stored the furthest. This ensures that the items that are moved most frequently take up the least amount of time in the picking process.
8. Perform quality checks in the reception area. This minimizes the chance of defective goods ending up on the production floor or in the hands of the customer.
9. Clean and maintain your inventory areas. Regular maintenance and cleaning is 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.
10. Implement continuous improvement to consistently better your inventory processes and to eliminate potential issues in their early stages, before they become larger problems. This can be done, for example, by using the Theory of Constraints – a method that helps you focus on one pressing problem at a time.

Inventory Tracking

What is Inventory Tracking?

Inventory tracking is the act of recording the movements and monitoring the state of goods and materials, as well as their requirements. This helps companies in:

  • planning and scheduling production;
  • optimizing their inventory processes;
  • avoiding stock-outs and overstocking;
  • preventing inventory from becoming dead stock;
  • providing customers with accurate lead times;
  • increasing traceability and achieving regulatory compliance;
  • efficiently organizing callbacks;
  • improving communication within the company as well as with suppliers and customers;
  • making better-informed business decisions.

Inventory tracking can be done either manually, by recording movements in physical or digital spreadsheets, or with the help of designated software. As the former option is quickly becoming outdated even in small businesses, utilizing digital solutions is highly recommended.

What is Stock Lot Tracking?

Stock lot tracking is an important part of inventory tracking. A stock lot is one batch of a single stock keeping unit (SKU). Manufacturers that produce goods in batches, such as food or chemical manufacturers, 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.

Read more about Lot Tracking.

Manual Inventory Management Basics

What is a Periodic Inventory System?

A periodic inventory system is an approach where inventory balance is updated periodically, in the end and at the beginning of an accounting period. Stock takes are used to physically count the inventory and compare the actual numbers to those derived from reception and dispatch documents. This also means that inventory numbers as well as WIP and the cost of goods sold (COGS) are only current once per period. Additionally, counting tens or hundreds of thousands of items could be overwhelming for a small business. That is why even the smallest companies today opt for a perpetual inventory system such as a WMS or ERP software.

What is a Perpetual Inventory System?

A perpetual inventory system is an approach where all inventory movements and the books are updated continuously (as opposed to periodically). This means all the information in the inventory records, including the WIP and COGS, is always up to date, and all departments can make informed decisions when it comes to purchasing goods, creating production schedules, providing lead times to customers, etc.

One of the most important reasons for implementing perpetual inventory software like WMS or ERP systems 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 cannot be efficiently scaled – it requires incrementally more labor and time as the inventory grows. Adding stock locations is also a nightmare for inventory managers as information cannot be easily shared among different facilities when manual systems are used. Software solutions that enable the management of multiple warehouses and production sites gives companies real-time visibility into their inventories, and a one source of truth for all operations. As all businesses strive for growth, it would be smart to start using software early on.

How to Track Inventory Manually?

When managing inventory manually, it is necessary to create a paper trail for everything that is received into stock and for everything that goes out of the facility. These are the actions that have to be recorded:

  1. Reception of goods
    • PO delivery
    • MO consumption
    • Returned merchandise
  2. Dispatch of goods
    • MO
    • Shipment
  3. Stocktakes
    • Positive adjustment (write-in)
    • Negative adjustment (write-off)

As the next step, when all these documents are gathered, they are recorded in a spreadsheet to gain an accurate overview of your inventory movements and current situation.

Example: inventory tracking spreadsheet for a procured item:

Example: inventory tracking spreadsheet for a procured item

Example inventory tracking spreadsheet for a manufactured item:

Example inventory tracking spreadsheet for a manufactured item:

This is easier said than done. As a solution, manufacturing and inventory software automate many of the tracking steps and automatically keep records of the stock movements.

How to Perform a Cycle Count?

When dealing with inventory, you should count the goods in your stock periodically. There are good reasons both from inventory planning and accounting perspectives to do this rather often than not.

As the first step, the best thing to do is to prepare a spreadsheet, where you have the inventory quantity according to your tracking, and possibly the locations, which you will compare to physical inventory.

Inventory count on MM/DD/YYYY

To make this process less disruptive to business, you do not need to count all the items at once. Cycle count is often used together with ABC analysis that helps prioritize items by their value, thereby giving an indication of which items should be counted more frequently and which items should get less attention.

What to Do If Numbers Differ When Doing a Cycle Count?

Once you have physically made the count, you compare it to the expected quantity on books.

Inventory count difference

If there is a differences, the reason must be investigated as a first step.

If a reason is found, it must be fixed at the source.

  • For example, if a shipment was not documented, it must be documented. This will make the quantity on books match the physical quantity on hand.

If a reason cannot be uncovered, then as a last resort a write-off (negative adjustment) or a new stock lot (positive adjustment) could be generated to adjust for the difference. In this case, you must carefully decide what the cost of the item you are writing off or into the stock is. The procedure should also be discussed with the accountant.

  • If you are making a negative adjustment, from what lot are you doing the write-off?
  • If you are making a positive adjustment, will you use the last cost, average cost, or something else?

Once you have resolved all the issues, you can consider the cycle count finished. As a result, the quantity on books matches the quantity on hand.

Also read about Inventory Adjustments within an ERP System.

Inventory Accounting

Inventory is considered a current asset that must be indicated on a company’s balance sheet. Regardless of the product, all companies must count their inventory accurately to be able to count it on their balance sheet. In the manufacturing industry, that inventory usually consists of raw materials, finished goods, and merchandise.

Manufacturing also includes the important category of Work in Process (WIP) but this can vary from company to company depending on the mode of manufacture. Companies with a strong Assemble to Order (ATO) production mode will hold significantly less WIP than those who have a lot of midstream sub-processing steps where material may be in some state of production for hours, days or weeks.

Inventory Valuation Methods

Inventory valuation is usually done using one of the following methods: FIFO, LIFO, weighted cost average, or FEFO.

  • FIFO (First In First Out) is an approach where items are utilized in the order they are taken into stock. It is most useful during times of deflation as older and cheaper materials are used.
  • LIFO (Last In First Out) means that the latest arrivals are put into use first. This is best used during periods of inflation as the most expensive goods are assumed to be used first (and included in the cost of goods sold) while the lowest-cost goods are included in the ending inventory.
  • Weighted average cost (WAC) is used when inventory cannot be accurately taken. To calculate the WAC, the cost of goods available for sale is divided by the number of units available to be sold. This approach is used when systems are not developed enough to use FIFO or LIFO, if products have little to no variation, or when items are highly mixed and cannot be assigned a cost per unit.
  • FEFO (First Expired First Out) means that items are used in the order of their expiration dates. This is the best approach for businesses that use/sell perishable goods such as foodstuff or some chemicals.

The advantage of each approach will vary from company to company and the method used is usually determined by the regulations that your company complies with (e.g. GAAP vs IFRS) and the impact it will have on taxes.

The Cost of Goods Sold (COGS)

COGS is an important accounting term used to determine the cost of producing or purchasing goods that have been sold during a set period.

COGS in Distributing

For distributors, the formula is fairly straightforward:

COGS = beginning inventory + purchases – ending inventory

Let’s say there is $40,000 worth of inventory at the beginning of the period and the company purchases $70,000 worth more during the period. At the end of the period, bookkeeping (corroborated with a stock take) 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 their gross profit by subtracting COGS from the revenue of the period.

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

COGS in Manufacturing

In manufacturing, the formula gets a little bit more complex because manufacturers do not only have to account for used materials, but also include direct labor used for manufacturing the products sold, as well as manufacturing overhead.

COGS formula in manufacturing uses an array of additional calculations in the following order:

1. Start with the Beginning Raw Materials Inventory value and add all raw materials purchased during the accounting period. Then, subtract the ending inventory value.

This is the valuation of the direct materials used in production:

Direct Materials Used = Beginning Raw Materials + Cost of Raw Materials Purchased Ending Raw Materials Inventory

2. Next, add the value of the direct labor and factory overhead. (Factory overhead will include factory expenses like rent and utilities). Then, add this sum to the direct materials from step 1.

This is the Total Manufacturing Cost:

Total Manufacturing Cost = Direct Materials + Direct Labor + Manufacturing Overhead

3. Using the beginning Work in Process (WIP) inventory, subtract the ending WIP inventory value and add to the Total Manufacturing Costs in step 2.

This is the Cost of Goods Manufactured (COGM):

COGM = Beginning WIP Inventory + Total Manufacturing Cost Ending WIP Inventory

4. Finally, use the Finished Goods beginning inventory value and subtract the Finished Goods ending inventory value and add this sum to the Cost of Goods Manufactured.

This is the total Cost of Goods Sold (COGS)

COGS = Beginning Finished Goods Inventory + COGM Ending Finished Goods Inventory

Such calculations are done periodically for producing detailed financial reports. However, at this point it may be already too late to spot an issue.

For early feedback, MRP/MES software can automatically calculate the COGS in real-time and even estimate it up-front already in the planning phase. It can calculate the cost of each manufactured good from real-time reporting information (start-stop of operations by workers on specific workstations and usage of materials per each job) and by combining it with purchasing and sales information.

Read more about the Cost of Goods Sold in Manufacturing.

Work-in-Process (WIP) Inventory

WIP essentially means half-finished products that already have had some value added to them in the manufacturing process, but are not yet finished goods. Even though many companies struggle with keeping tabs on their WIP, it is a very important aspect when it comes to accurate accounting. As WIP is considered a current asset (items that could be turned into revenue within a year), it needs to be properly accounted for in the cash flow statement of the company.

When determining the value of WIP inventory, only those raw materials, overhead, and direct labor costs should be included which are already incurred by the end of the accounting period.

How to Avoid Inaccuracies?

Inventory is a critical component of any manufacturer’s or distributor’s operation, and inventory accounting is an equally critical part of proper bookkeeping. Doing everything manually takes a lot of resources while being very prone to human errors. But the good news is that with today’s modern software programs, especially those included in advanced, cloud-based and modular ERP and MRP systems, all of the issues above can be managed with a high degree of accuracy and a with real-time, actionable results to give buyers optimized data and the lowest inventory cost possible for their type of business.

Software-Aided Inventory Management Basics

Digital Inventory Tracking Tools

There are various inventory tracking 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 an inventory management software with a push of the button.

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.

For example:

  • 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 dock, the worker reports a planned shipment as picked, and the finished goods inventory is kept up to date 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 are barcodes and QR-codes.

Barcodes

barcode-inventory-system

Barcodes are linear one-dimensional codes that 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, but some cloud-based ERP/MRP systems also allow workers to use a smart device like a tablet or a phone.

QR-codes

Quick Response codes are two-dimensional and consist of black squares and dots that can convey much more information than a traditional barcode. They are also 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.

Read more about Barcodes vs. QR-codes.

Inventory Management Software for SMEs

It is easy for a company to find itself in the extreme of shortages or overages. Both can cause headaches and impact the bottom line of manufacturers and distributors alike. But software exists that can help companies find that narrow “middle” where a balanced, accurate, and reliable inventory exists.

In the past, inventory could be an all-day or all-week affair with manual counting, Excel spreadsheets, and manual input of the data followed by a nerve-wracking “reconciliation”. Because the system was manual, many companies didn’t know the results of their inventory until they were at the reconcile stage. At that point, the losses and inefficiencies were long past, and the money expended, never to return.

Today, manufacturers and distributors have a lot of options for effective inventory management software. There are many good standalone software packages, and these are in themselves much better than the old way of taking inventory. However, the most optimal path to better inventory management is a software system that includes an inventory management component or module as part of an overall ERP or MRP system.

Because inventory isn’t just a stock review, it is important that it be integrated as part of a whole. By tying inventory to an overall supply chain, production, labor, and maintenance planning system, accuracy is improved, and data is actionable for the entire enterprise. 

Companies also carry another type of inventory. To keep complex operations going, they require a lot of spare parts and consumables that never make it into the finished product. Nuts, bolts, screws, housings, lubricants, and other items are also required to be kept as part of a company’s Maintenance, Repair, and Operations goods that keep the equipment and facility running smoothly.

These parts can number in the thousands. And today’s strong inventory management software can keep an accurate inventory of these parts as well. Because Maintenance, Repair, and Operating supply (MRO) goods are usually considered “overhead” or “non-value-added” in relation to finished goods, there is usually a high level of concern over cost. And inventory management software can help manage and optimize those costs.

These systems are also flexible and agile. Regardless the mode of production – MTS, MTO, ETO – or whether a company is a process manufacturer, a Just in Time producer, or a distributor, inventory management software can make the difference between a good company and a “best in class” one.

Done right, a well-managed inventory can improve cash flow, optimize production, and propel a factory or a distributing center to higher efficiency. Done wrong, a poorly managed inventory will tie up valuable cash and lead to increased waste, lower efficiency, higher costs, and reduced fulfillment rates due to stock-outs.

But with the arrival of agile, cloud-based ERP systems, inventory management isn’t out of reach for small and medium-sized businesses. Now, with advanced software, companies of all sizes can enjoy the same benefits as larger companies and control their inventory with effective and accurate inventory management.

Inventory Management KPIs

There are tens of inventory metrics a company can track. From process efficiency KPIs like average picking time and time to receive to cost-related ones like inventory holding cost, numbers give the best insights into the performance of a business. Although inventory managers could measure nearly every aspect of stockroom activities, there are few metrics that are as versatile as inventory turnover ratio and days sales of inventory.

Inventory Turnover Ratio

The inventory turnover ratio formula is used to determine how many times a company depletes and restocks its inventory within a set period. It weighs the cost of goods sold (COGS) against the average inventory value of the company to produce the ratio.

Average inventory is used because every company has fluctuations in their inventory value period-by-period. Average inventory is found by calculating the arithmetic mean of the ending inventory values for multiple periods. For example, a year’s average inventory would be calculated by adding together the twelve months’ ending inventories and dividing this sum by 12.

Then, to find the inventory turnover ratio, the COGS is divided by the average inventory.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

A low inventory turnover ratio could indicate weak sales and excess stock while a high one could be a sign of either good sales or insufficient inventory levels that cause frequent stock-outs.

Although some say that the ideal inventory turnover ratio is between 4 and 6 or 5 and 10, there really is no universal ideal ITR. The perfect ratio differs depending on the industry and the products sold. For example, fast-moving consumer goods like food needs to have a much higher inventory turnover rate than a custom furniture manufacturer.

Read more about Inventory Turnover Ratio.

Days Sale of Inventory

Days sale of inventory is similar to the inventory turnover ratio, but instead of providing you with a rate, it indicates the number of days it would take to sell the stock at hand.

Days Sales of Inventory = (Average Inventory / Cost of Goods Sold) x 365

Many companies with long cycles in net terms for customers experience significant swings on cash flow. As a result, they may tie the value of their inventory to short term financing in the form of bridge loans – also called “factoring”. In cases such as this, the value and age of inventory is used to determine the amount of short-term financing is made available to cover cash flow. The number of turns per quarter or year is a critical part of these calculations.

Inventory Planning Methods

Inventory Planning Methods

Every company’s inventory needs are different. This may be due to the type of product they produce or the scale of the company itself. The advantage of a good inventory management software is that it can be adapted to any variation of inventory type:

Just in Time

The Just-in-Time (JIT) model of production has some tremendous advantages. By only purchasing and holding the amount needed for a short term of production, companies can save a significant amount of money in inventory costs, holding costs, and can realize improved cash flow. 

Just in Time depends on very specific and knowable production rates and cycles. 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.

Making sure that the right quantity of materials arrive to the facility just when production is scheduled to begin is not an easy feat and requires impeccable material planning and effective communication with suppliers.

Material Requirements Planning

Material Requirements Planning (MRP) is often used both for process and discrete manufacturing and for goods that have been largely commodified. MRP is dependent upon an accurate sales forecast so that inventory is ordered confidently based on knowing where, when, and how the finished goods will be produced. Key components and raw materials are stocked based on the sales forecasts and master production schedule.

It is important to understand that MRP itself does not use statistical methods to forecast demand for materials. But you must have either a good sales forecast or already firm orders in the planning period to start with. MRP then uses a lot of data and calculations from across your organization to reach a result.

Material requirements planning starts from defining the quantity 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.

Furthermore, 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

Some companies have a wide range of complexity of inventory depending on the product. They may also have a wide range of costs from a few cents for the cost of a material or consumable to tens of thousands of dollars for a specialized component.

Because of the wide range of variation in the cost of inventory, many are not comfortable with simply counting units and assigning a cost. Rather, the inventory value as a function of cost significance is used as a tool to control higher cost inventory items. Goods are generally split into three categories including high value/low quantity, moderate value/moderate quantity, and low value/high quantity.

Read more about ABC Analysis.

Safety Stock

Safety stock is the extra inventory a company keeps to be able to continue serving their customers when there is a sudden spike in demand or a decrease in supply. This buffer can be a lifeline when the market experiences fluctuations, but it is necessary to rely on numbers and mathematical analysis when determining the level of safety stock for the goods in your inventory.

Safety stock can be calculated using statistical methods (in practice, gut feeling is used more often, unfortunately). There are many different formulas 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, when they both are inconsistent, and when both are consistent.

Read more about Safety Stock.

Reorder Point

Reorder point (ROP) is an inventory control method where reaching a set inventory level triggers the replenishment order of an SKU. This, along with mathematically defined safety stocks, helps companies minimize stock-outs, avoid overstocking, and achieve an optimal service level.

This is another a statistical method for controlling your stock levels, where reorder point (ROP) is paired with a reorder quantity (ROQ) (which is why this method is often referred to as “ROP-ROQ”).

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 formula for reorder point is:

ROP = Average Lead Time x Average Demand + Safety Stock

Read more about Reorder Point.

Economic Order Quantity

Economic Order Quantity (EOQ) is an inventory management type whereby a company calculates how much product is needed with each run to keep inventory cost consistent in the face of steady demand. The idea 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.

Economic Order Quantity Formula

Dead Stock and How to Handle it

Dead stock refers to inventory items that have lost their purpose and will probably not be used in your facility. This can happen due to several factors, e.g. changes in the BOM of a product, improper storage conditions, inefficient inventory management practices, or poor sales.

There are several different types of dead stock:

  1. Obsolete inventory consists of goods that lack demand.
  2. Damaged goods are items that have become unusable due to mistakes or sub-par conditions.
  3. Expired goods are items that have reached their expiration date.
  4. Defective goods are items that are faulty, e.g. due to a production or engineering error.
  5. Forgotten inventory is items that have been received into stock but without the proper tracking and accounting.

Holding onto dead stock can be detrimental to your company by creating cash flow problems, accumulating hidden costs, wasting inventory space, and ultimately eating away your profits.

Even though much can be done on the inventory management side of the business to avoid dead stock, a business has to work as a single organism to ensure maximum efficiency and minimum dead stock. Apart from tracking your inventory and using inventory control techniques, dead stock can be avoided by creating accurate demand forecasts, reviewing your purchasing practices, evaluating supplier performance, performing quality inspections, and putting more emphasis on marketing and sales.

If you have, however, accumulated dead stock and want to get rid of it, there are some ways to put it to good use:

  1. Sell it off to another company
  2. Recycle the materials
  3. Donate the goods
  4. Bundle obsolete inventory with items that sell

If these options do not work, then it is time to count your losses and throw the garbage out.

See the functionalities offered by MRPeasy inventory management software.

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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.

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Integrated Inventory Software for Manufacturing Companies

  • Production Planning

    Accurate automatic planning and realistic production schedule. Reschedule dynamically by just dragging and dropping manufacturing orders and operations in the calendar or Gantt chart.

  • Stock

    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.

  • Team

    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.

  • Purchasing

    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.

  • Accounting

    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.

More than 1000 manufacturers and distributors trust MRPeasy

Reviews

Brandon Ames

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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Tim Grant

CEO, Business Solution Providers, Inc

“Ahead of its time” Easy of use and simplicity to understand. This is one of the best programmed software out there for this industry. We setup, train and implement manufacturing software for multiple companies, and clients find it easy to understand and operate.

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Benjamin Raffiani

CEO, Sox Trot LLC

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.

Some of our customers

  • Skin Actives Scientific
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MRPeasy is a simple yet powerful inventory software for manufacturing that helps small manufacturers organize production. Just sign up to test MRPeasy, select the features plan that meets your requirements, and access additional functionality as you grow your business.