The Complete Guide to Inventory Management

Every retail (B2C) or wholesale (B2B) business owner needs to get an understanding of questions such as “What is inventory management?” very early on. Managing inventory is the key to running a successful operation, as it prevents the dreaded “out of stock” situations, as well as losses due to overstocking.

To help you implement a great inventory management system in your business, our team of inventory management experts at ADP Distribution have put together this useful guide to inventory management which will give you information about: 

• What is inventory management? 
• Inventory management vs inventory control
• The inventory management process
• Important inventory management terminology
• Inventory management techniques
• How to calculate inventory
• Contingency planning 
• Why is inventory management important? 
• How to organise your inventory management?

What is inventory management? 

Inventory management is defined as the process of keeping track of your stock, ensuring that you know how much you have, where it is, as well as whether you need to order any more of a certain item or if you have enough stock to satisfy the sales demand. 

Overseeing the goods your business sells, whether they are raw materials or complete products, is extremely important to order fulfilment and your overall profit. If you are on top of your inventory management, you are less likely to run out of a product (rendering you unable to fulfil orders) or to have overstocked products sitting on shelves for a long period of time while you accumulate losses. 

As a business owner, you already have a lot on your plate, so inventory management should be as simplified as possible, yet accurate. To help you manage it all, you can either appoint a responsible person to take care of inventory management for you or you could implement an effective inventory management system that allows you to see everything at a glance, enabling you to make the right purchase decisions. 

 

Inventory management vs Inventory control

Sometimes you may hear the terms inventory management and inventory control being used interchangeably; however, they are different (albeit similar). Inventory control is the process of keeping track of the quantity and quality of the inventory that you have in stock, right now in your warehouse.

Inventory management, on the other hand, is much broader. It actually encompasses the process of inventory control but at the same time, it also looks at forecasting demand, making purchasing decisions and making sure that inventory is managed in a cost-effective manner. 

Also, inventory management oversees the entire journey of your product from the supplier to manufacturing, stocking, sales, fulfilment and accounting. Managing your inventory is designed to help you sell your product better and improve your business model by making informed decisions on stocking, as well as by improving your existing practices (such as stock taking, fulfilment partners, supply chain etc).

The inventory management process

Inventory management is the process of overseeing your stock from the moment it leaves your supplier to the moment it reaches your final customer. It covers the following steps:

• Buying stock: Purchasing your product (whole or in parts) from your supplier
• Manufacturing: If you are assembling your product, then production is part of the inventory management process
• Holding stock: Ensuring adequate storage solutions for your goods 
• Fulfilment: Making sure that your stock is delivered promptly to the customer
• Reporting: Analysing the profitability of your business is important and keeping track of inventory management allows you to improve your existing processes 

Inventory management terminology

Before we take a deep dive into the topic of inventory management, it’s important to understand some of the key terminology associated with the process. Here are some of the most commonly used terms in the field of inventory management:

• Barcode scanner: A handy inventory management tool used to scan items in and out of a warehouse
• Cost of goods sold (COGS): This is the cost of producing goods, including materials, labour and storage
• Deadstock: Goods you have in stock that have not been sold and aren’t likely to sell
• Economic order quantity (EOQ): The ideal quantity of goods to order based on demand and holding cost
• Holding costs: How much it costs to store your inventory in a warehouse until it’s sold 
• Lead time: The time needed between placing an order to replenish stock and receiving it 
• Order fulfilment: The entire process from receiving an order to delivering the product to the buyer
• Purchase order (PO): A document sent by the buyer to the supplier which specifies the products ordered, their quantity, agreed price, payment method and delivery
• Reorder point: The right time to reorder stock based on demand and lead time
• Safety stock: Extra stock available if the main stock is running low 
• Stock levels: The amount of inventory you have in stock 
• Third-party logistics (3PL): A third party that you can outsource part or all of your inventory management, stocktaking, warehousing, fulfilment and distribution to

Inventory management techniques

Inventory management is a big task and there is no one-fits-all type approach to it. In fact, there are dozens of different inventory management techniques and which one is the best fit for your business will depend on many factors, such as the type of business you run, the type of goods you offer, the storage space you have and more. Below we’ll take a look at the most commonly used inventory management techniques.

 

Just-in-time (JIT) inventory 

The JIT inventory strategy involves keeping as little stock as possible and receiving goods as close to the moment they need to be shipped out. It’s usually used by smaller businesses to avoid cash flow issues and deadstock or to negate the need for investing in a larger storage facility. 

This approach has its risks though, as a small delay in shipment from your suppliers or a slight miscalculation of the sales cycles on your part can lead to stockouts and being unable to fulfil orders on time. If your supplier has given you any reasons to doubt their capability to deliver goods on time, JIT probably isn’t the right technique for you. 

 

Backordering inventory

Another inventory management technique that helps reduce holding costs and overstocking, while ensuring a steady cash flow, is backordering. If your business allows backordering that means that your customers are able to purchase items that are not in stock and you order them only after the sale has been made. 

This approach gives your business flexibility as you are working in direct response to the actual demand. However, if there are dozens if not hundreds of out-of-stock items that you have to order, all of a sudden logistics can get really messy really quickly. 

Also, you have to take into consideration customer expectations and satisfaction. Having to wait a long time to receive an order may put off some potential customers or dissuade existing customers from making repeat purchases from you. One way to manage expectations is to amend your CTA from ‘buy now’ to ‘pre-order’ for items that are out of stock.

You may be able to justify longer waiting times if you are selling larger, more expensive items but the approach probably won’t work well for smaller items as your competitors could potentially be offering those with next-day delivery. 

 

Bulk shipment

When cash flow isn’t a problem, bulk shipment is often a go-to option. It’s common knowledge that when you buy in bulk you pay less than if you buy items individually or in small quantities. Therefore, if you order bulk shipments of goods you can make a larger profit on each sale and you can save on shipping costs when you receive orders from suppliers. It’s a great solution for businesses that work with products that have a long shelf life, especially when the demand is easily stable and easily predictable. 

As with any other inventory management strategy, bulk shipment has its downsides. The cost of stocking is one of the biggest concerns here. To hold large quantities of goods, you need to have a suitably large warehouse or storage facility, which incurred a cost. Also, once you start ordering in bulk it becomes very hard to adapt to sudden changes in demand. 

For example, if an influencer makes a negative comment about a cereal variety that was previously one of your most popular products, you may see a sudden drop in purchases, leaving you with a warehouse full of cereal boxes that no one wants to buy and with no cash to buy a different product instead. 

 

Dropshipping

Dropshipping is essentially the complete opposite of bulk shipping – it requires holding no stock whatsoever. You simply outsource the entire stock management and fulfilment process to your supplier or to a wholesaler. When a customer places an order, you pass their details to the supplier/wholesaler and they have the full responsibility of delivering the purchased product. 

No holding cost and no inventory management responsibilities may sound like a dream come true. The problem is that you have no control over fulfilment and your customers are unaware that you are using a dropshipping strategy. So, if anything goes wrong, your customers will be disappointed with your business and you will have no means to correct the problem as you are completely reliant on your suppliers. 

Cross-docking

If you like the idea of entirely removing the need for warehousing and the costs associated with it, then cross-docking could be the inventory management approach for you. What happens in this approach is that the products leave the supplier’s warehouse in a vehicle and are then moved directly to another vehicle which delivers the goods to the buyer. 

Cross-docking allows you to move products quickly and efficiently without having to pay for or manage a warehouse. However, it requires a very sophisticated logistics system and a large fleet of transport vehicles, which, of course, carries its own cost and responsibility. 

 

ABC inventory management

In ABC inventory management, products are analysed and prioritised based on their value. The value categories are marked A, B or C, with A being the most valuable and C – the least. 

The reasoning behind this approach is founded on the Pareto Principle, which states that 20% of your goods are responsible for 80% of your profit. Therefore, more attention and resources should be directed towards the most valuable products in your inventory. 

The downside of the ABC technique is that it looks at existing patterns and may not foresee the increased demand for products that are just beginning to trend. Also, the valuation analysis itself is a process that requires skill and expertise, which means you have to have the resources to do it. 

 

Cycle counting

Cycle counting is another balanced technique for ensuring an effective inventory management process. Instead of doing a full stocktake, you only validate the inventory availability of certain products on certain days. This is a sampling technique that if done regularly can significantly reduce stocktaking time. 

Another benefit is that it eliminates the need to close down the entire warehouse while a full stocktake is taking place. Instead, all areas but the one where the count is taking place are functional. It’s a far less disruptive approach, which is why many businesses prefer it. 

On the downside, cycle counting is a shortcut and as such, it is not as reliable as a full stocktake. Things can be missed and you may not be able to account for seasonality. 

To avoid the issues pointed out above, you can use different cycle counting troubleshooting techniques, such as:

• Control group cycle counting – This involved doing a repeat count of the same items over a short period of time to uncover potential mistakes in the counting procedure. 
• Random sample cycle counting – Randomly selecting goods from a group of similar items to count each cycle means you don’t have to cut off access to the entire group of items while counting. This ensures even fewer disruptions to your daily workflow. 
• ABC cycle counting – Applying the ABC principle to cycle counting means that you are always keeping in control of your most popular products minimising the risk of mistakes happening with your more valuable assets.

Consignment

With consignment, the wholesaler (consigner) places goods in the hands of a retailer (consignee) but the retailer pays for them only after the goods are sold. This means the consignee holds the stock, markets, advertises and sells it on the behalf of the consigner.  

This technique has more benefits for the retailer because it allows them to offer a larger variety of products without having to worry about the cost of buying the stock. If a product doesn’t sell, it isn’t a problem as it can be returned to the wholesaler for no cost. Also, the retailer will likely never run out of stock due to delivery delays. 

The wholesaler in this scenario faces a whole lot of uncertainty but there are reasons to overlook those. Selling on consignment allows for new products to be tested and to gather data about the popularity of existing products. Also, the marketing side of the sales funnel becomes the responsibility of the retailer. 

If you are to consider consignment as your preferred inventory management method, you should go over a list of important questions to preempt potential problems. The things to discuss before you agree to this type of relationship, whether you act as a consignor or a consignee, include responsibility for returns, exchanges and product insurance, as well as customer data confidentiality. 

 

How to calculate inventory

Inventory management involves some advanced calculations using a set of inventory management formulas to optimise your stock levels. 

Economic order quantity (EOQ) formula

EOQ helps you keep your costs to a minimum while still satisfying customer demand. It calculates how many products you should order to pay as little as possible for ordering and holding the goods. 

It looks like this:

 EOQ = √(2DK / H)

D = cost per order per year including handling and shipping 

K = demand ratio (number of items demanded per year)

H = carrying or holding cost per items per year 

EOQ can be a huge asset when trying to optimise your cash flow efficiency. However, it has one major downside – it works under the assumption that demand is constant. This means that seasonal changes in cost and demand are not accounted for.  

Reorder point formula

While EOQ tells you how much you need to order, the reorder point formula tells you when you should replenish your stock. The calculation works like this:

 (Average Lead time in days × Average daily usage) + Safety stock

Safety stock is added to the formula to account for the fact that the formula uses average values. With safety stock in the calculation, you could potentially order stock a bit earlier than needed but you reduce the risk of running out of stock. 

Safety stock formula

Looking at the previous paragraph you might be thinking: What is safety stock and how do I work it out? 

Safety stock works as a safety net, it’s your emergency stock back-up that you tap into if you are close to running out of a certain product. It’s always good to have a plan B but the trick is calculating how much safety stock is too much.

The formula works like this:

Safety stock = (max daily usage x max lead time) – (average daily usage x average lead time) 

Having accurate data is key to ordering the right amount of additional stock. If your forecast isn’t reliable, you may end up ordering too much extra stock. 

Days inventory outstanding (DIO) 

The DIO formula is a calculation that helps you find out if you are turning inventory into sales fast enough. This is how it’s worked out:

DIO = average inventory cost/cost of goods sold x number of days

You are hoping for a low DIO score. A high DIO result suggests that it takes too long for your inventory to be sold, so you should optimise your current processes. What is a high or a low DIO score depends heavily on the industry and the products you sell. 

Contingency planning

You have all the basic calculations and inventory management techniques down, no what? It’s time to think about contingency planning. This relates to the ability to foresee issues before they arise and it is invaluable for efficient inventory management. 

The issues

Some of the problematic scenarios that your contingency plan should account for include: 

• An unexpected rise in demand
• Lack of storage space for extra seasonal stock
• Lack of storage space due to deadstock 
• Cash flow shortage in peak season
• A product has been ordered and paid for but you are out of stock
• Your supplier is suddenly unable to satisfy your demand
• A product you sell is being discontinued

The solution 

Once you’ve identified the problems, you need to find ways to preempt them. Creating your contingency plan usually relies on having good relationships with your:

• Suppliers: If you choose your suppliers well, they will likely be willing and proactive in trying to help you resolve any issues that arise. 
• Customers: Communication is the key to good customer relations. If there is a problem with an order you must have ways of getting in touch with your customers and keeping them informed. 
• Employees: Managing inventory shouldn’t be a one-man job. Make sure you assign the responsibilities in your team clearly from the start to avoid human error. 

Always have a back-up 

Having a back-up is a must when things go wrong. Whether it’s a back-up of your documents, a list of back-up suppliers if yours fails to deliver or a back-up person who double-checks the calculations and counting – it can all save you in a time of crisis. 

Why is inventory management important

Inventory management is a complex process but it is well worth investing time and resources into it because it is essential to the success of any retail or wholesale business and here are 5 reasons why. 

Improved cost-efficiency

Being in control of your stock at all times means that you are ordering the optimal amount of stock to meet demand without overstocking. Overstocking is a serious issue because having a lot of money tied up in unused inventory can cause major cash flow problems and even destroy your business. 

Higher customer satisfaction

Nobody would be happy if they placed an order and ended up receiving their purchases with huge delays or even worse – not receiving it all, because the retailer has run out of stock. Inability to answer the demand could cause a loss of customers, as well as irreparable damage to your reputation.

Better warehouse management

If your business model includes taking care of holding goods, warehouse management is a crucial factor to ensure efficiency and productivity. Knowing what goods are in demand and are more likely to bring you profit (ABC model) allows you to arrange your inventory in the warehouse to accommodate for better and faster handling of the important goods. 

Opportunity for growth

Smart inventory management means better cash flow, which in turn gives you the freedom to invest money in the future growth of your business. 

Peace of mind

When you have done your part to keep your customers happy, preempt unpleasant surprises due to stock problems and have a steady cash flow, you can enjoy peace of mind and build the confidence to set bigger goals for your business. 

How to organise your inventory management? 

Depending on the size of your business you may require a more or less sophisticated inventory management system. There are three ways to handle inventory management: 

Low-tech (manual) inventory management

If you run a small business you might do your own inventory management manually. We are talking about the good, old-school pen and paper method. In this scenario, you assign people to do stock-taking, write down the number and make all the calculations. 

Choosing this method doesn’t require investment in technology but it can be quite time-consuming and inefficient. Also, this type of inventory management might have a negative impact on the overall accuracy of the data due to human errors. 

Inventory management software

Having a modern inventory management software can be a great way to streamline the whole process. It makes keeping inventory records easier and helps reduce the risk of human error. 

However, implementing such software comes at a cost and you will also have to account for the cost of training, as well, as your staff will have to be taught how to use the new software. 

Outsourced inventory management

If you don’t have the time and resources to do inventory management efficiently in-house, then you might want to consider outsourcing the process to a third party. 

As an outsourced inventory management and stocktaking company, ADP Distribution, can offer immediate access to a modern warehousing facility in Cradley Heath, where your goods will be taken care of by an entire, dedicated inventory management team, using a top-of-the-range inventory management software to organise the process for you.  

Get in touch with ADP Distributions to learn more.