Updated: Sep 22
In this article, we’ll learn about inventory and the best practices for proper inventory management. Let’s dive in.
What is Inventory?
Inventory is what your business builds up whenever it buys stuff that it doesn’t immediately sell, including the raw materials, components, and finished goods a company sells or uses in production.
What is Inventory Management?
Inventory management helps companies identify how much stock they have, when to order more, and at what time. It tracks inventory from ordering, storing, processing, and selling the goods. This includes the management of raw materials to finished products, as well as the warehousing and processing of such items.
The practices identify and respond to trends to ensure there’s always enough stock to fulfill customer orders and to avoid the gluts of inventories.
Why Is Inventory Management Important?
Inventory management is vital to a company’s health because it helps efficiently streamline inventories to avoid both gluts and shortages on hand, and limit the potential risk of stockouts and inaccurate records.
Public companies must follow requirements of tracking inventory for compliance with Securities and Exchange Commission (SEC) rules and the Sarbanes-Oxley (SOX) Act.
Benefits of inventory management for small business
Inventory management is important for businesses of any size because of its benefits. The management of inventory is necessary to ensure you’re able to fulfill incoming or open orders and raises profits. Inventory management also:
Tracking stock trends means you see how much of and where you have something in stock so you’re better able to use the stock you have. This also allows you to keep less stock at each location (store, warehouse), as you’re able to allocate to the right places to fulfill orders — all of this decreases costs tied up in inventory and decreases the amount of stock that goes unsold before it’s obsolete.
Improves Cash Flow:
Too much stock costs money and reduces cash flow. Therefore, proper inventory management helps you spend money on inventory that sells, then the cash is always moving through the business.
One element of developing loyal customers is ensuring they receive the items they want without waiting too long.
Accounting For Inventory
Accounting considers inventory as a current asset since a company typically intends to sell its finished goods within a short amount of time, typically a year. Inventory has to be physically counted or measured before it can be recorded on a balance sheet.
There are three accounting methods used for inventory: first-in-first-out (FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing. Typically, An inventory account consists of four separate categories:
Raw materials — represent various materials a company purchases for its production activities. These materials must undergo significant work before a company can transform them into a finished product ready for sale.
Work in process (also known as goods-in-process) — are raw materials in the process of being transformed into a finished good.
Finished goods are completed products ready for sale to a company's customers.
Merchandise — represents finished goods a company buys from a supplier for future sale
Inventory Management Method
Depending on the type of business or product being analyzed, a company will develop different inventory management methods. Several common methods include just-in-time (JIT) manufacturing, materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).
Just-in-Time Management (JIT) - This method originated in Japan in the 1960s and 1970s and Toyota Motor (TM) contributed the most to its development.
This manufacturing model allows companies to save significant amounts of money and reduce waste by keeping only the inventory they need to produce and sell products. This method decreases storage and insurance costs, as well as the cost of liquidating or discarding excess inventory. JIT inventory management can be risky If demand unexpectedly spikes and the manufacturer may not be able to source the inventory it needs to meet that demand, damaging its reputation with customers and driving business toward competitors.
Materials requirement planning (MRP) — This inventory management method depends on sales forecasts, meaning that manufacturers must have accurate sales records to enable accurate planning of inventory needs and to communicate those needs with materials suppliers in a timely manner.
Economic Order Quantity (EOQ) — This model calculates the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory while assuming constant consumer demand. The costs of inventory include holding and setup costs. The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand. It assumes that there is a trade-off between inventory holding costs and inventory setup costs, and total inventory costs are minimized when both setup costs and holding costs are minimized.