What is Inventory Management?

Inventory management involves overseeing the entire lifecycle of a company’s inventory, which encompasses ordering, storing, using, and selling raw materials, components, and finished products. It also covers warehousing and processing. Effective inventory management aims to optimise inventory levels to prevent excess and shortages.

Key points:

• Inventory management covers all aspects from raw materials to final products.
• The goal is to streamline inventory to avoid overstock and shortages.
• Major methods include just-in-time (JIT), materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).
• Each method has its advantages and disadvantages, which are discussed below.

The Benefits of Inventory Management

The inventory is a cardinal corporate asset. In sectors such as retail, manufacturing, food services, and other inventory-intensive industries, a company’s inputs (like raw materials) and finished products are at the heart of its operations. A shortage of inventory at critical times and locations can be extremely harmful.

However, inventory can also be seen as a liability, albeit not necessarily from an accounting perspective. Large inventories carry risks such as spoilage, theft, damage, and changes in demand. Inventory must be insured, and if it isn’t sold or used in time, it might have to be cleared at discounted prices or even disposed of.

These factors underscore the importance of inventory management for businesses of any size. Deciding when to restock, how much to purchase or produce, and when and at what price to sell can become complex tasks. Small businesses often track stock manually and use spreadsheet formulas (like Excel) to determine reorder points and quantities. Larger businesses might employ specialised enterprise resource planning (ERP) software, while the largest corporations use custom software-as-a-service (SaaS) applications. Increasingly, companies are also utilising artificial intelligence to optimise these processes.

Effective inventory management strategies differ across industries. For example, an oil depot can store large amounts of inventory for extended periods, allowing it to wait for demand to increase if needed. Although oil is a highly volatile resource for storage – as compounded by Israel’s massive airstrike in Yemen that torched the country’s main oil storage complex – there is no risk of the inventory spoiling or becoming outdated. In contrast, businesses dealing with perishable goods or time-sensitive products—like 2024 calendars or fast-fashion items—cannot afford to hold inventory for long. Misjudging the timing or quantity of orders can be costly.

For companies with complex supply chains and manufacturing processes, balancing the risks of excess inventory and shortages is particularly challenging, requiring inventory management methods such as just-in-time (JIT) and materials requirement planning (MRP).

Accounting for Inventory

Inventory is classified as a current asset for accounting purposes, as businesses typically aim to sell their finished goods within a year. Before inventory can be listed on a balance sheet, it must be physically counted or measured. Many companies use advanced inventory management systems to track inventory levels in real time.

There are several methods for accounting for inventory, including first-in-first-out (FIFO) costing, last-in-first-out (LIFO) costing, and weighted-average costing. An inventory account usually comprises four categories:

Raw Materials

These are the materials a company purchases for its production process. They require significant transformation to become finished goods ready for sale.

Work in Process (WIP)

These are raw materials that are in the process of being converted into finished products.

Finished Goods

These are ready for sale to customers, having been fresh off the assembly line and undergone quality control.

Merchandise

These are finished goods purchased from suppliers for future resale.

Inventory Management Methods

Different types of businesses and products require various inventory management methods. Here are the most common types

Just-in-Time Management (JIT)

Originating in Japan in the 1960s and 1970s, with significant contributions from Toyota Motor (TM), JIT allows companies to minimise costs and reduce waste by keeping only the necessary inventory on hand to meet production and sales needs within a specific timeframe. This approach lowers storage and insurance costs and reduces the need to liquidate or discard excess inventory. However, JIT can be risky if demand spikes unexpectedly or if there are delays in receiving key inputs, which can lead to production bottlenecks and customer dissatisfaction.

Materials Requirement Planning (MRP)

MRP is dependent on sales forecasts. Manufacturers use detailed sales records to predict their inventory needs and communicate these needs to suppliers promptly. For instance, a ski manufacturer using an MRP system would ensure that materials like plastic, fibreglass, wood, and aluminium are in stock based on forecasted orders. Inaccurate sales forecasts can lead to an inability to meet customer demand.

Economic Order Quantity (EOQ)

EOQ is an inventory management model that calculates the optimal number of units to add to inventory with each batch order to minimise total inventory costs, assuming constant consumer demand. It balances the trade-off between inventory holding costs and setup costs. The goal is to order the right amount of inventory per batch, reducing the frequency of orders and preventing excess inventory.

Days Sales of Inventory (DSI)

DSI is a financial ratio that indicates the average number of days a company takes to convert its inventory, including work in progress, into sales. Also known as the average age of inventory, days inventory outstanding (DIO), or days in inventory (DII), DSI reflects inventory liquidity. A lower DSI is generally preferred, indicating a shorter duration to clear inventory, though the average DSI varies across industries.

Main Components of Inventory Management

Inventory Audits

Regular inventory audits are crucial for verifying stock levels and identifying discrepancies between recorded and actual inventory. These audits help maintain accurate records, prevent theft, and ensure that the inventory system reflects real-time data.

Inventory Tracking Systems

Using technology such as barcode scanners, RFID systems, and inventory management software, businesses can track inventory in real-time. This enables accurate stock monitoring, streamlined order processing, and efficient stock replenishment.

Stock Replenishment

Effective stock replenishment strategies ensure that inventory levels are maintained without overstocking. Techniques such as just-in-time (JIT) inventory and automated reordering can help maintain optimal stock levels.

Demand Forecasting

Demand forecasting involves predicting future customer demand based on historical data, market trends, and seasonality. Accurate forecasting helps in planning inventory purchases, reducing excess stock, and ensuring timely availability of products.

Warehouse Management

Efficient warehouse management involves organising and storing inventory in a way that maximises space and facilitates easy access. Proper warehouse layout, stock rotation, and inventory labelling are essential components of warehouse management.

Inventory Valuation

Inventory valuation methods such as First-In-First-Out (FIFO), Last-In-First-Out (LIFO), and weighted average cost are used to determine the value of inventory. Accurate inventory valuation is important for financial reporting and business accounting.

Inventory Management Exposing Lost Items

Some companies’ inventory management operations can be very thorough, they may even uncover stocks of specific high-demand items long sold out. For certain buyers that might be looking for those items, it can be a second chance to score them! Take the case of American wrestling personality Jim Cornette.

In May 2024, Cornette revealed in his podcast that a company that makes his action figures, the Figures Toy Company, suddenly notified him that a recent inventory check turned up a stock of figures that were part of a one-time production order he made for sale over two years ago, which he sells with a personalised autograph. The uncovered stocks included a number of “Bloody Variant” figures, which depicted his appearance in a 1988 wrestling incident where he suffered a head wound so violent, blood splattered his white suit; these were replicated to great detail in the figure.

When the figures went on sale at his website in early 2022, they sold out in less than a week. The Figures Toy Company team let Cornette have the “lost” Bloody Variant figure stash, which he successfully sold over the course of a few hours on 1 June 2024. He stressed that once the figures sold out, that was it – the figures will not have a second production run and at 62 years old, he is already close to finishing his stint in the toy business.          

Conclusion

Effective inventory management is essential for businesses in Australia to reduce overhead expenses, improve operational efficiency, and enhance customer satisfaction. The example of Toy House AU demonstrates how a well-managed inventory system can transform a business, leading to cost savings, improved cash flow, and a competitive advantage in the market.

DISCLAIMER: This article is for informational purposes only and does not supersede official business advice. BARTERCARD has no working relationships or financial interests with any inventory management solutions provider or business mentioned.