In this comprehensive Guide to inventory management, you will learn everything from the definition to the basics of inventory handling, the processes involved and how to make them work in a business scenario.
What is inventory?
Inventory is anything that you store. In a retail context, very simply, Inventory refers to your raw material as well as the stock finished goods of products that you sell. It is measured in units of stock as well as value of stock you hold.
What is inventory/Stock management?
Inventory Management is the science of purchasing, supervising, controlling and dispensing of Stock for Sale which is stored in a facility. It covers all aspects of stock management across the supply chain from the manufacturer to the point of sale manned by the retailer.
The process of inventory management begins from the time you raise a purchase order and ends (for every order) when an order is fulfilled/ delivered to the end customer. As a retailer, your job is to manage inventory smoothly and at as low a cost as possible so that you can
- sell the right products
- block the least possible working capital at all times
- fulfill orders on time so as to build customer loyalty
- sustain your sales model.
What are the elements of Inventory management?
Inventory Management is a broader topic that covers the following aspects:
- A system of naming for your inventory items (also known as Stock Keeping Units, or SKUs)
- Naming your physical locations, down to the shelf level
- Movement of inventory from one location to another
- Purchasing products from Suppliers
- Sale of products to customers
- Frequent review and adjustment of Inventory
- An overall reduction in dead stock
Efficient Inventory Management is critical for manufacturers, retailers, and brands because it is how they treat their core business and extract value from the process of buying and selling.
Why is Inventory Management important?
You may have often wondered why you even have any inventory at all. Is it not just simpler to ask a supplier to send you products as and when you have some demand for them? The issue, however, lies in the fact that we never know for sure what a customer’s spending pattern is.
For example, it is possible that your manufacturer cannot keep up when your demand peaks. Or your vendor may increase the price of a product you agreed to sell for way lesser.
Having your own inventory helps hedge against the great uncertainty that is consumer behavior. When you buy in bulk, you also have an advantage when it comes to price negotiations. Moreover, you can significantly reduce the time between order and delivery by having your own stock.
The fundamental principle of inventory management revolves around placing an order for goods at the right time, with the right source that can provide you with the right quantity at the right price and the right quality.
Key Inventory Management Terms You Need To Know
Well, at least it may seem like jargon, but these terms that are casually thrown around in inventory management can help you understand better.
1. Maximum Stock Level
As the name implies, this is the level of stock indicated by a number beyond which you simply shouldn’t stock up on a particular product. This number is influenced by several factors- the perishability of goods, the amount of warehouse space you have, changes in consumer preferences, etc.
Maximum Stock Level = Reorder Level + Reorder Quantity – (Minimum Consumption x Minimum Reordering Period)
For example, if you know that when inventory touches 1000 units (reorder level), you must order 500 units (reorder quantity), and that your goods take at least 5 days to reach you from a vendor (minimum reordering period), and also that you sell a minimum of hundred units every day (minimum consumption), the maximum amount of stock that you need to keep in the inventory is a 1000 units.
2. Minimum Stock Level/Safety Stock
This is the absolute minimum number of products you need to have in order to fulfill market demand. The calculation for this number depends on the lead time. Lead time is the amount of time it takes for you to receive a product from the vendor, from the time that you’ve placed an order for it. Another factor that influences the Minimum Stock Level is the rate at which your product is being sold during the lead time.
Minimum Stock Level = Reorder Level – (Normal Consumption x Reordering Period)
Before we get into an example, let’s also talk about the reorder level, which is always higher than the minimum stock level.
3. Reorder Level
This number represents the point at which you must raise a reorder request from your vendor so as to ensure that you stay above the minimum stock level.
Reorder Level = Daily Consumption x Lead Time
For example, let’s consider that there’s a seller of wall clocks of a certain model. He is able to sell 500 clocks every day, and the lead time is a week, which means it takes a week for him to restock.
In order to avoid running out, he needs at least 500 X 7 which is 3500 clocks ready in his inventory at all times. Whenever the level of clocks in his warehouse falls to 3500, he needs to reorder immediately so he has new stock ready once the seven day period lapses and he runs out of whatever he already has.
4. Reorder Point
In the simplest of terms, the reorder point is that point in time when you need to reorder stock for a product, to avoid the risk of running out of stock. The crude way to do this would be to keep an eye on your stock and order whenever it is coming close to being over.
Reorder Point = (Average Daily Sales x Lead Time) + Safety Stock
If you have 10 units in your safety stock, and you know that you sell 5 units a day and that your vendor takes 5 days to deliver your products to you, your reorder point is reached at (5 x 5)+10 or 35 units. In other words, you reorder a product with these attributes when your stock level for them reaches 35 units. Read more to know how to calculate the reorder point.
Inventory Management Formulas to Help You Along
1. Average Monthly Inventory
In order to estimate how much inventory you have on hand in a month, quarter or year, you use the average monthly inventory.
Average Monthly Inventory= (Inventory at month beginning + Inventory at month ending) /2
2. Inventory Turnover Ratio
Stock turn or inventory turnover ratio is a measure of how many times you have entirely replaced your existing stock with new ones.
Inventory Turnover = Net Sales/ Average Stock
where net sales are the revenue you have after accounting for returns, and average stock is calculated as above for any period of time you need. Read more about inventory turnover ratio.
3. Safety Stock
There are several ways to calculate safety stock levels, and the easiest to use estimate is to take the two months in the year when the highest and lowest number of products were sold, and subtract one from the other.
Safety Stock= Highest number of products sold in a month- Lowest number of products sold in a month
Do note that this is a very simple formula that is good for giving you an estimate. Read more to know how to calculate the safety stock.
4. Average Monthly Sales
If your product sales remain fairly stable across all months in a year, the formula to calculate critical stock is fairly simple. But first, we need to know the average monthly sales, which is the average number of products you sell in a month.
Average Monthly Sales = Total number of products sold in a year/ 12
Do remember that if your product has seasonal surges, this formula is practically useless and you’d need a much more sophisticated system to make this calculation.
5. Critical Level
The critical level is basically like finding the middle ground between too much safety stock and too little inventory on hand. This number helps you figure out how much stock you need to keep on hand without accumulating too much.
Critical Level = (Monthly Order Quantity + Safety Stock)/ 2
While these easy to use formulae will hold you in good stead when you need a quick check, if you sell multiple products or products that have sales variations, they may end up giving you results that aren’t very dependable. If that is the case, it is always better to depend on a sophisticated system than on manual calculations.
Inventory management process
As discussed above, effective management of inventory begins from the time you place your purchase order and continues until an order is fulfilled. In the online context, this end is marked either by delivering the product or accepting a return/ replacement request. Let’s look at each aspect in detail.
Raising a purchase order
On what basis should you raise a purchase order? For new retailers, raising a purchase order is the first order of business. You first need the products you’d like to sell. After this, there are two factors to take into consideration when raising a purchase order:
a. When should I raise a purchase order?
You need your products to be available on a certain date and time. If you know this, you can simply calculate backward to find out when you need to raise a purchase order (PO). For example, you know that your vendor takes one week to deliver the goods, so you should always raise a PO at least a week before you need the goods.
In the real world, such a scenario is not possible. For instance, your vendor may take longer than a week at times. In such cases, you either use the average lead time, or you hold some stock as a safety net in case your vendor delays a delivery.
What is the lead time? In the above example, one week is the lead time or the time it takes for your vendor to fulfill your purchase order.
b. For what quantities should I raise a purchase order?
How many products do you need until you’re ready to raise the next PO? Continuing from the last example, you know that your vendor can deliver products every week. It is, therefore, a better idea to order just the amount of goods you’ll be selling in that week than to hold more stock.
The basic tenet of managing inventory is that holding too much stock blocks up your free cash. You want to hold just enough stock to prevent running out, and no more.
So, if you know from past sales trends that you’ll be selling fifty units of that product in one week, you should order only fifty products more in weekly intervals. Some retailers also choose to hold safety stock, or the basic minimum required to keep selling in case a purchase order is not fulfilled in time.
Bottom line, here are a few factors to remember about purchase orders:
- For retailers already selling goods, past data and trends are the best places to look for help in forecasting future sales.
- However, keep an eye out for sales fluctuations or a product going ‘out of vogue’.
- For new retailers, market research and competitor analysis form the basis for deciding how much you should raise your first purchase order for.
Receiving goods in the warehouse/ store
Once a vendor ships products to your warehouse, you must conduct a quality check. It seems rather obvious, but many retailers do not do this, leading to returns and replacements further down the line.
Also, examining products at the time they’re delivered helps you identify the source of a damaged product. It is getting damaged after being received in your warehouse, or is it arriving in a damaged condition?
The only way to tell for sure is to do a quality check on each consignment you receive.
Stocking products in a warehouse/ store
In your warehouse, you’ll likely have tens, if not hundreds, of different product categories. Their storage depends on factors like:
- Whether they can be kept in boxes or need to be exposed to the air
- If they can be exposed to light/ humidity or not
- Whether they move fast, or slow
In any case, start by labeling every shelf and every aisle in the warehouse. When an order comes in, it is easier to find products that have shelf and aisle numbers assigned to them in a system. Also, as you grow, you’ll be fulfilling hundreds of orders each day, and the last thing you want to do is scramble around looking for the products.
Things To Keep In Mind
Every product has a specific code attached to it, which can help you immensely in keeping track of your inventory. When you sell across more than one channel, a product code can help you keep inventory levels accurate at all times.
Another factor to consider is the frequency at which a product sells. If it sells more often, you should stock it at different locations through the warehouse. This way, you increase the chances of fulfilling other orders faster, since you are not always running to the same single location to get a certain product.
For slower-moving orders, you can stock them all in one place.
Consider what physical conditions your products need to have the longest possible shelf life. If there are any issues in the warehouse such as water leakage, be sure to move all products to a safer location until the problem is resolved.
In a store setting, the warehouse may simply be a storeroom at the back. If this is the case, be extra-diligent in moving products from the storeroom to the shelves and vice-versa, as a mix up can cause you to lose track of your inventory.
Accepting an order from a customer
In An Online Store/ Marketplace:
If you are an online retailer, a customer visits your online store or adds your products to a marketplace cart. Once the order is placed, you receive a notification for fulfillment.
At the backend, inventory adjustment needs to take place. In olden days, someone would manually reduce the stock count for that order’s products. You may have also noticed how supermarket staff count products on the shelves each day and reconcile that number with the number of sales made that day.
Today, manual inventory management is almost obsolete. Many systems and products have been developed that can automatically adjust inventory every time an order is placed.
In A Retail Outlet:
If you sell through your store, using a Point Of Sale (POS) system can help you manage inventory seamlessly. When you set it up for the first time, you need to do a stock count for each product and update that number in the system. From then on, the system will automatically reduce/ add inventory based on your orders.
B2B retailers need to pay special attention to inventory management as they handle bulk orders. You can consider having a website to help your customers place orders with ease. Else, you can also accept purchase orders from your customers and fulfill them.
In both scenarios, inventory management is important. If you have a website, you can integrate it with an inventory management system for all your B2B orders as well.
The order fulfillment process
Here’s what order processing in a warehouse entails:
In An Online Store/ Marketplace:
- They sort orders into bins and pick products in sequence. Usually, the same product across different orders is added first to the bin.
- Once all items in an order are in one place, they print an invoice for that order.
- If using a manual inventory system, stock levels for these products are adjusted.
- If using an integrated software product, inventory count is already adjusted in the earlier step, as soon as the order is placed.
- Based on the shipping partner’s guidelines, orders are packaged in different boxes/ containers. The delivery details and shipping labels are attached to the outside of the package.
- All orders shipped in a day are considered a consignment and are handed over to the shipping partner. The partner assigns Airway Bill Numbers (AWB) for each package.
- In case more than one shipping partner is involved, each partner’s consignment is different. Thus, there can be more than one consignment sent out in a day.
In A Retail Outlet:
For retail outlets, order fulfillment is a very straightforward affair. You need to bill the products (if you use a POS system, the inventory is adjusted at this point) and the customer pays for it. You may choose to accept returns and replacements for a given amount of time after the sale.
The warehouse team consolidates all orders placed before the shipping cut-off for the day.
Shipping Online Orders
Once the products are shipped, you can track them using the AWB number provided by the shipping partner. Depending on your shipper’s Service Level Agreement (SLA), products may be delivered in a matter of days, or take a few weeks (when shipped globally).
Usually, customers expect that you provide them with the AWB number so they, too, can track the order. Once an order is delivered to a customer, your shipping/ delivery partner will send you an update. At this point, an order is considered fulfilled.
In a day or two, you can send out a feedback request to your customers to see how you can do better.
Returns and replacements
In An Online Store/ Marketplace:
In some cases, a customer may choose to return a product or ask for a replacement. If the purchase was made online, the retailer usually pays for shipping in the opposite direction or enters into an agreement with the shipping partner to offer one return/ replacement for free.
There are several different ways to handle your returns, and some of them are discussed in this article.
In A Retail Outlet:
In the context of a retail outlet, the customer would bring the product back to your store with a bill. If you have multiple different stores, consider accepting returns at all stores to increase customer satisfaction levels. When inventory is managed as a single entity, this will not be an issue.
Usually, returns and replacements are indicators of either a faulty product or inaccurate descriptions.
Whenever a product is returned, you need to check for faults and damages, and if the product is fine, add it back to your inventory and update the count. Else, you may discard the product and write it off.
Whenever a replacement request is made, you need to update the inventory with the returned product and reduce the inventory count for the shipped product.
Inventory Management Best Practices
Strong fundamentals – Name your SKUs correctly
The way you name your products and SKUs will determine how inventory management is standardized across your company across all team members without any confusion. Note that there is a difference between SKU codes and Barcodes which is important to know.
Know how much inventory you have
At any time, the hallmark of great inventory management is the ability to know instantly how much stock is available for any given SKU. Sometimes while running a retail business it is common to misplace items. There is also the issue of pilferage. This, along with not knowing how your sales stand against your inventory, is a recipe for disaster.
Predictable stock holding
Closely monitoring sales and purchases across customer segments and seasonality will help you have efficient stock levels and optimize your working capital. Use historic sales data to forecast how much stock you might need during different time periods in the future.
Setting reorder points for each product helps you determine when you need to raise a purchase order. Luckily, inventory management is not guesswork. You can use these inventory calculations to help you decide how much stock you need.
Your suppliers add a great deal of value to your business by ensuring that you never go out of stock for longer than your business allows. Fewer reliable suppliers are always better managed than numerous distributed suppliers.
The process of a stock audit is discussed in detail down below. Every retail business must set aside time for stock audits as they help you gain an accurate picture of your inventory.
One of the roles of an inventory manager is to use past trends, industry forecasts and prevailing trends to identify how much stock you’ll need in an upcoming time period. The better the process used for calculating these numbers, the less your chances of making inventory mistakes.
Planning For Emergencies
Selling too much during a spike is a happy accident. However, you need to still ensure that you don’t run out of stock. Inventory calculations are not set in stone. Always review them every month, and adjust for periods when you last had a spike.
We have discussed above the case when a vendor takes longer than usual to deliver your products to you. We recommend that you maintain safety stock for these periods.
Inventory management techniques :
First In, First Out
This is especially applicable to perishable goods and those that have an expiry date. First-in-first-out ensures that products move in a single stream and you’re not left with extra, spoilt goods. Read more about the inventory valuation methods.
Dropshipping is one method of doing business more than it is an inventory management technique. In this method, you do not hold any stock. Your vendor ships and fulfills your orders in packages bearing your name and label.
In this method, the vendor management process and forecasting are improved to such an extent that you do not need to hold any safety stock at all. Read more about this method and how it may apply to your business.
Consignment Inventory Handling
In this method, your agreement with your vendor is that you only pay the vendor when their product sells. Usually, a minimum agreement is in place for such contracts. Read more about consignment inventory here.
In backordering, you only place an order with your vendor when you receive an order from a customer. Backordered products have a longer shipping time but they virtually eliminate the need for inventory holding. Read more about the pros and cons here.
What does an inventory manager do?
An inventory manager is often in charge of a warehouse or storage facility. Broadly, their role involves:
- identifying shortages or the probability of running out of stock, before it happens
- Conducting regular stock audits
- Reporting on the levels of inventory
- Calculating how much stock is needed and raising purchase orders
- Use inventory management methods to optimize its procurement and use
- Educate warehouse staff on correct inventory handling
- Forecast how much inventory may be needed in that particular facility in the next order cycle
Someone who enjoys working with data and can draw the right conclusions from past statistics is the right person for the role of an inventory manager.
If you hate math, this role is probably not for you. Also, retailers managing more than one warehouse should consider hiring one inventory manager for each facility.
Stock counting and audit
We have covered the different methods of stock reconciliation in this article. There is no right or wrong way to do it, just one that works. Most often, you always conduct the first count by suspending business for that time period to count the entire warehouse together and organize it efficiently. You can do subsequent counts in parts of the warehouse.
The process of stock counting is as follows:
- Choose a day and time when you will have staff available for counting, and it will not hinder regular business. Counting after the last consignment goes out is well worth the overtime you may need to pay your staff.
- Use this opportunity to label all shelves and aisles correctly. Designate one area of the warehouse as a ‘command center’ of sorts, where people can bring doubts and damaged products.
- Count the stock in its existing location. If it is being moved to a different location, count once before moving, and once after.
- Use current data. Do not count products that customers have already ordered from you and are awaiting shipping.
- Integrate all data into an inventory management system. From then on, the system adjusts the inventory based on orders.
- Count everything- don’t take boxes at face value. If a box says it contains ten staplers, check anyway.
A stock audit helps you reconcile your book and actual inventory values. For a variety of reasons, discrepancies arise in these two numbers, such as:
- using a manual inventory management method and losing track after a point
- Stock loss due to theft and damages
- Products from purchase orders rejected after a quality check but added to the inventory
- Returns and replacements not processed correctly
Read more about warehouse management and how you can improve your operational efficiency here.
The need for inventory management software
- Automate your purchase orders, or alert you when stocks run low
- Dynamically update stock levels based on orders received, 27X7
- Display all orders in one place for easy of fulfillment
- Allow you to track, fulfill and ship online orders
- Allow for a POS setup for your retail outlets to integrate with other channels
- Account for returns and replacements when needed
- Show you an analysis of your sales trends so you can forecast more accurately
- Integrate all your sales channels, offline and online
- Expand as your business grows- you can set up as many channels as you like
- Integrate with QuickBooks Online for accounting and directly export invoices to the accounting system
- Integrate with shipping partners around the world for seamless order fulfillment and tracking
Types of inventory software
Spreadsheets are typically not inventory software, but you can use them for that purpose. Indeed, up until a few years ago, many retailers did do that. However, spreadsheets need continuous and diligent manual intervention, and still, do not guarantee accurate inventory management.
Native inventory management systems
The first inventory management systems were POS software typically installed on systems. With the advent of online retail, some of these systems were employed to manage online orders as well. However, the greatest disadvantage of these systems is that they are installed on one or a few systems at a time. They aren’t accessible from everywhere, and there is always the risk of data loss.
Cloud-based inventory management systems work on a subscription model. Your data is securely stored in a remote server and is accessible through the right credentials. Data loss is not a possibility and you can increase the benefits you avail as your business grows. These applications are not restrictive and are designed to grow with you.