What is Inventory Management?

Inventory management is the process of ordering, handling, storing, and using a company’s non-
capitalized assets - AKA its inventory. For some businesses, this involves raw materials and
components, while others may only deal with finished stock items ready for sale.
Either way, inventory management all comes down to balance - having the right amount of
stock, in the right place, at the right time. And this guide will help you achieve just that.

Retail inventory management

Retail is the general term used to describe businesses that sell physical products to consumers.
While not exclusive to retail, inventory management tends to play more of a role in this industry
than any other.
We’ll therefore be focusing mainly on inventory management from a retail perspective within
this guide.
Retail can be split into several areas:

● Offline. Where a company sells via a brick-and-mortar store or physical location.

● Online. Where a company sells over the internet via an ecommerce website or
marketplace.
● Multichannel. Where a company sells in multiple different places, usually a
combination of online websites and marketplaces.
● Omnichannel. Where a company provides a unified, integrated experience for
customers across all the different online and offline channels it sells on.
Businesses may also choose to trade via wholesale channels. This involves selling inventory
(usually in bulk) directly business-to-business (B2B) or taking part in B2B ecommerce
A company’s inventory will therefore need to be managed in accordance with which of these
retail models it operates within.

Inventory management in action

We’ve covered the broad definition of inventory management. But what’s actually involved when
it comes to making good inventory management happen?
Bottom line:

You want to keep inventory levels balanced at all times without ever having too much or too
little of each product in stock

And there are a few key aspects in achieving this:

● Types of inventory. So you know what type of inventory is where and can have full
visibility over it.
● Forecasting. So you know how much stock is needed to satisfy demand over an
upcoming time period.
● Purchasing. So you know when and how to create purchase orders to re-order new
stock.
● Storage. So you know how much of each inventory item can be suitably housed, and
where to send it.
● Analysis. So you can use metrics to make more informed decisions about your
inventory as time goes on.
● Techniques. So you can quickly and efficiently book-in, put away, pick, pack and
ship inventory as and when needed at your various locations.
● Tracking. So you have visibility on where exactly your inventory is as well as
additions (purchases) and subtractions (sales), to give as close to a live stock figure
as possible.
● Accounting. So you can properly record your inventory on financial documents.
 ● Systems & tools. So you know which software is right for your business, and when
the right time is to implement it.

These are the basic ingredients of quality inventory management. And you’ll need to take a
systematic approach to them in order to best equip your business for long term growth.

The importance of inventory management

A retail business is useless without its inventory. And so while it may not be the most exciting
subject, inventory management is vitally important to your business’s longevity.
Good inventory management helps with:

1. Customer experience. Not having enough stock to fulfill orders you’ve already
taken payment for can be a real negative.
2. Improving cash flow. Putting cash into too much inventory at once means it’s not
available for other things - like payroll or marketing.
3. Avoiding shrinkage. Purchasing too much of the wrong inventory and/or not storing
it correctly can lead to it becoming ‘dead’, spoiled, or stolen.
Optimizing fulfillment. Inventory that’s put away and stored correctly can be picked, packed
and shipped off to customers more quickly and easily.

Key inventory management terms

Inventory management is a complex subject. And there’s a lot of systems, processes and general
pieces that go into the puzzle.
Here’s a glossary of key terms you’re likely to come across:

● Barcode scanner. A device used to digitally identify items via a unique barcode,
then perform inventory and fufillment tasks like booking-in, picking, counts, etc.
● Bundles. A group of individual products in an inventory that are brought together to
sell as one under a single SKU.
● Cost of goods sold (COGS). Direct costs of purchasing and/or producing any goods
sold, including everything that went into it – materials, labor, tools used, etc. Does
NOT include indirect costs – like distribution, advertising, sales force costs, etc.
● Beginning Inventory (BI). The value of any unsold, on-hand inventory at the start of
an accounting period.
● Ending Inventory (EI). The value of any unsold, on-hand inventory at the end of an
accounting period.
● Inventory valuation. The process of giving unsold inventory a monetary value in
order to show as a company asset in financial records.
● First-in-first-out (FIFO). An inventory valuation method that assumes stock that was
purchased first, is also the first to be sold.
● Last-in-first-out (LIFO). An inventory valuation method that assumes the most
recent products added to your inventory are the ones to be sold first.
● Average inventory cost. An inventory valuation method that bases its figure on the
average cost of items throughout an accounting period.
● Average inventory. The average inventory on-hand over a given time period,
calculated by adding Ending Inventory (EI) to Beginning Inventory (BI) and dividing by
two.
● Back order (BO). An order for a product that is currently out of stock, and so cannot
yet be fulfilled for the customer.
● Sales order (SO). A document created when a customer makes a purchase, detailing
which products are to be received and how much has been paid or is owed.
● Purchase order (PO). A commercial document created by a business to its supplier,
detailing quantities, items and agreed prices for new products to add to on-hand
inventory.
● Stock keeping unit (SKU). A unique alphanumeric code applied to each variant in a
 company’s inventory, helping to easily identify and organize a product catalogue.
● Third-party logistics (3PL). Refers to the use of an external third party to handle
warehousing, inventory, fulfillment and/or customer service on behalf of a retail
company.
Order fulfillment. The process of getting a customer’s sales order from your warehouse or
distribution center to it being in their possession.

● Order management. The systematic process behind organizing, managing and

fulfilling all the sales orders coming into a business. From receiving orders and
processing payment, right through to picking, packing, shipping, handling returns
and communicating with customers.
● Inventory variant. The variations of a single product that a company may hold in its
inventory. For example, stocking a t-shirt in various colors and sizes.
● Inventory visibility. The ability of a person or business to see exactly where its
inventory is and how it is being used.
● Pipeline inventory. Any inventory that has not yet reached its final destination of a
company’s warehouse shelves, but is currently ‘en route’ somewhere within their
supply chain - e.g. currently being manufactured, or being shipped by the supplier.
● Lead time. The time it takes for a supplier to deliver new stock to the desired
location once a purchase order has been issued.
● Carrying costs. The total costs associated with holding and storing inventory in a
warehouse or facility until it is sold on to the customer.
● Inventory count. Also known as a stock take, this is the systematic process of taking
a physical count of inventory in order to verify accuracy.
● Dead stock. Inventory that remains unsold for a long enough period of time for it to
be deemed outdated and virtually unsellable.
● Inventory shrinkage. An accounting term to indicate inventory items that have been
stolen, damaged beyond saleable repair or otherwise lost between the point of
purchase and point of sale.
● Supply chain. The complete flow a product or commodity takes from origin to
consumer - including raw materials, to finished goods, wholesalers, warehouses and
final destination. A retailer might only be directly responsible for certain chunks of
this supply chain, but should still be aware of it in its entirety for the products they
sell.
● Multichannel. A retail model that sells in multiple different places, usually online
via a combination of websites and marketplaces.
● Omni channel. A retail model that goes beyond multichannel to integrate all of a
company’s online and offline sales channels into one, unified customer experience.
● Overselling. Taking online orders for a product that turns out to be out of stock
(usually through poor inventory management). Preventing overselling is key to
providing a high-quality experience for online customers.

Key inventory management formulas

It’s not just common terminology you need to know when it comes to inventory management.
There are some specific formulas to take note of too.
We’ll be going into greater depth with how and when to use these formulas later on in this guide.
But here’s a quick run through to use as a reference point:

1) Inventory turnover
Inventory turnover measures the number of times a company has sold and replaced inventory
over a given time period:
This gives an insight into the overall efficiency of a company and its inventory management
processes. The higher the inventory turnover rate, the more efficient a business is at getting
through its inventory.

2) Sell through rate

Sell through rate takes the amount of inventory a retailer receives, and compares it against what
is actually sold over a given period. It’s usually expressed as a percentage:

This helps analyze if your investment in a particular product is working out well. Low sell through
rates indicate you either overbought or priced too high, while high sell through rates indicate you
may have under bought or priced too low.

It’s a great way to make decisions on future purchase quantities for a product or from a
particular supplier.

1) Days of inventory outstanding (DIO)

Days of inventory outstanding (DIO) measures the typical number of days it takes for inventory to
turn into sales.
It’s hard to draw insights from just one calculation. But you should look into typical industry
standards, and also keep track of whether you are trending up or down as time goes on.

2) Safety stock
Safety stock is the backup stock needed to meet unexpected supply problems and/or sudden
changes in demand.

Bear in mind that you want to have enough safety stock to meet demand. But not so much that
increased carrying costs puts a strain on cash flow.
1) Reorder point
The reorder point helps determine when to order new inventory. It is a specific point in time
that acts as a trigger to re-order as soon as stock has diminished to that certain level.
It’s important to consider the lead time for new stock to be delivered when setting reorder
points. Enough stock should be leftover to keep up with demand before the newly purchased
inventory becomes available for sale.

2) Economic order quantity (EOQ)

EOQ is a formula that helps calculate exactly how much inventory to order. It takes into account
a company’s typical demand, ordering costs and carrying costs to provide the most economical
figure possible:

This is obviously quite a complicated formula to use. But we cover this in greater depth in
Chapter 4: Purchasing Inventory.

Types of Inventory

There are several different types of inventory a company might come across. All are critical to
understand in the pursuit of effective inventory management.
This chapter covers all these different types, so your business is best equipped to manage, plan
and budget for stock going forward.

Basic types of inventory

There are five fundamental types of inventory when it comes to the products a business might
sell.
 1) Raw materials
Raw materials are any items used to manufacture finished products, or the individual
components that go into them. These can be produced or sourced by a business itself or
purchased from a supplier.
For example:

A business that makes its own bespoke furniture may purchase materials from a supplier. While a
small business supplying specialty herbs may actually grow these itself.
Either way, raw materials are still considered a type of inventory. And so must be managed,
stored and accounted for accordingly.

2) Work-in-progress (WIP) inventory

Work-in-progress (WIP) inventory again refers to retailers that manufacture their own products.
These are unfinished items or components currently in-production, but not yet ready for sale.
For our furniture business, this may be products that have been put together without yet being
painted or packaged.

3) Finished goods
Finished goods are products that are complete and ready for sale. These may have been
manufactured by the business itself, or purchased as a whole, finished product from a supplier.
Most retailers will either purchase whole, finished products from a supplier, or have custom
products manufactured for them by a third-party. Finished goods are therefore often (but not
always) one of the only types of inventory needing to be handled within retail inventory
management.

4) Maintenance, repair & operations (MRO) goods

MRO goods are items used within the manufacture of products, but without directly making up
any part of a finished product.
This can include items such as:

● Production & repair tools.

● Uniforms & safety equipment.
● Cleaning supplies.
● Machinery.
● Batteries.
● Computer systems.

And all items that are consumed or discarded during the production process.

Small types of inventory like this may seem menial. But MRO is inventory that still needs to be
purchased from a supplier, stored somewhere and accounted for in financial records.

5) Packing materials
Packing materials are anything you use for packing and protecting goods - either while in
storage, or during shipping to customers.
This is therefore particularly important for online retailers. And may include things like:

● Bubble wrap.
● Padding.
● Packing chips.
● A variety of boxes.

Many retailers don't think about packing materials when managing their inventory. But stocks of
these items need to be used and maintained regularly - and it's therefore important to include
them in overall inventory reporting and accounting.

Finished good types of inventory

Within a retail context, it’s also useful to further subdivide finished goods into a few other types
of inventory. This gives a business much greater inventory visibility, allowing for improved
allocation and management.

 Ready for sale. Also known as ‘available inventory,’ this is stock that has been
manufactured/purchased and put away in the warehouse ready for sale. It could
be picked, packed and shipped without complication at any desired moment
 Allocated. This is inventory that has been bought by a customer and allocated to a
sales order. It is therefore not eligible for sale again, and must be removed from
the available inventory figure.
 In-transit. This is unsold inventory that is currently on the move - e.g. a purchase
order delivery in transit, or stock being moved to another warehouse.
 Seasonal. Also known as ‘anticipation stock,’ this is inventory that has been
manufactured or purchased to specifically cover a forecasted upturn in demand.
For example, to cover Black Friday sales, or your peak season.
 Safety. This acts as a buffer cushion of stock to cover you in the event of any
unforeseen upturns in demand, or problems with supply.
Knowing (and using) these different types of inventory is critical to good inventory management.
In the next chapter, we’ll go into the art and science of inventory forecasting.

Inventory Forecasting

Inventory forecasting is crucial to the financial success of any retail business. It helps strike a
balance between sinking too much cash into inventory at once, while ensuring demand can
always be satisfied without going out of stock.
However, this is also one of the most difficult aspects of inventory management to get right. So
in this chapter, we outline all the techniques and best practices retailers can use to forecast
inventory requirements.

What is inventory forecasting?

Inventory forecasting is essentially making an informed projection on how much stock will be
needed to satisfy demand over a given time period. It starts with a simple demand forecast, then
uses what’s already in stock to plan how much inventory is required going forward.
It’s important to note that forecasting will always be educated guesswork. No forecast is set in
stone, and there are several factors that can affect accuracy - such as seasonality and sales
history.
Good demand and inventory forecasting will therefore take these factors into account, and be
agile enough to allow for adjustments when circumstances change.

Purchasing Inventory

Purchasing inventory is about more than just raising a purchase order. Serious businesses pay
close attention to how much inventory they should order and exactly when to do it in order to
minimize carrying costs and achieve steady growth.
This whole practice is therefore a critical aspect of effective inventory management. And
something we discuss how to optimize in this chapter.

Methods of purchasing inventory

There are several methods you can use for purchasing inventory. Each one has its own benefits
and drawbacks, and so what might work for one business may not for another.
 1) Bulk buying
Also referred to as ‘just-in-case’ inventory purchasing, this is where a company would buy its
inventory in bulk batches. Stock will then be held at a warehouse, third-party logistics (3PL)
facility or location of some kind in order to supply a forecasted demand.
Bulk buying is perhaps the most well-known way of purchasing inventory. It could involve
purchasing finished products or raw materials in a vast array of quantities - depending on what’s
best for a business at that particular time.
Pros:

● Take advantage of bulk buying discounts.

● Potential for greater profit margins due to smaller cost-per-unit.
● Relatively simple purchasing system to set up.

Cons:

● Costs associated with a warehouse or 3PL partner for inventory storage.

● Risk of sinking cash into too much stock if forecasting is inaccurate.

Best for: Growing or established businesses that have a good handle on expected demand and
profit margins.

2) Dropshipping
Dropshipping is a method of purchasing inventory where the retailer doesn’t keep any of the
products it sells in stock. Instead, items are purchased from a third-party supplier as and when
each customer order comes in, with the supplier shipping products directly to the customer.
As a result, the retailer usually doesn’t ever see, handle, stock or own any of the inventory
themselves. This method may sound appealing, but it does have several drawbacks too.
Pros:

● Effectively removes the need for any inventory management by the retailer.
● Removes risk of cash getting tied up in inventory that doesn’t sell.
● Lower overall costs of not needing a warehouse, 3PL or fufillment team.
● Easy to find, source and test new products.

Cons:

● Profit margins can be thin from lack of bulk buy savings.

● Little to no control over fufillment speed and product/package branding.
● Products are easily accessible to other dropshippers, meaning you’ll likely be facing
stiff competition.
Best for: Startup retail brands, or more established brands wanting to test the waters for a new
product without investing in lots of inventory.

3) Just-in-time (JIT)
Just-in-time (JIT) is usually better associated with retailers that manufacture their own products.
This would involve ordering raw materials and assembling each product as and when an order
comes in - hence, it’s produced ‘just-in-time’ for fufillment.
This method can result in holding much less ‘on-hand’ inventory, but requires seamless
management of the manufacturing process and a highly reliable supply chain.
Pros:

● Reduced warehouse costs from needing to store on-hand inventory and materials.
● Maintain control of your product quality and branding.
● Less waste of raw materials.
Cons:

● Any supply chain hiccup can have large effects on production.

● Supply chain lead times will need to be factored into overall order fufillment speed.
● Requires highly sophisticated management and processes to get right.

Best for: Larger businesses manufacturing their own products with sophisticated production
processes in place. These businesses will also tend to rely on fewer orders that contain many
quantity units in each one.

When to order new inventory

Dropshipping and JIT speak for themselves when it comes to placing a new purchase order - you
do it as and when each sales order comes in.
But most growing retailers will most likely be going down the bulk buying route. And this begs
the question, when’s the right time to place a new bulk buy order?
There are three methods to use:

1. Order pattern method. This would involve simply making regular fixed purchases of
the same amount. It’s perfect for retailers who know they’re sales numbers will
rarely change, with a review taking place maybe 1-2 times a year.
2. Control rhythm method. This would involve checking inventory at fixed intervals
and purchasing inventory amounts that have been adjusted accordingly. It’s perfect
for retailers that have a good grasp of their demand and inventory forecasting.
3. Reorder point method. This involves reordering stock once it gets below a certain
level, usually set via a calculation. It tends to work better for retailers with fewer
products, and who aren’t reliant on bulk buying discounts from large purchase orders
of multiple products at a time.
Determining which method to use depends completely on how your business operates. For
example:
Order pattern method could be catastrophic if you have products that are highly seasonal or
fluctuate in sales. But the reorder point method might not make sense if smaller, more regular
purchase orders means you’d miss out on significant bulk buying discounts.

Calculating reorder point

Purchasing inventory based on reorder points is a very common method to use.

In essence, an item’s reorder point needs to be as soon as its safety stock levels are hit.

But we also need to make sure we don’t run out of stock in the time it takes for our new
inventory to be delivered. So the lead time between ordering and receiving the order needs to
be taken into account.
Here’s the formula to use:
For example:

Imagine we typically sell 11 blue t-shirts each day. If we aim to always keep 50 in safety stock,
and it usually takes seven days to receive and put away new inventory - then reorder point would
look like this:
Reorder point = (7 x 11) + 50

Reorder point = 77 + 50 Reorder point = 127

So a new purchase order needs to be created for our blue t-shirts as soon as inventory levels hit
127 units.

How much new inventory to order

We’ve covered when the best time is to place a new purchase order. Next comes the question,
how much stock is best to order at one time?
To answer this, there are several things to consider:

● Forecasted demand.
● Bulk buying discounts.
● Carrying/storage costs.
● Ordering costs.

One option is to manually take these into account with your thought process each time you go
about purchasing inventory.
But we can also use a more scientific method known as economic order quantity (EOQ).

EOQ is a calculation that helps work out the most economical quantity of inventory to order for a
specific product. The three variables involved are:
1. Demand. The number of units sold over a given time period (usually a year).
2. Relevant ordering cost. Total ordering cost per purchase order. This includes all
staff, transportation and any other costs associated with making each purchase order
- but not the actual cost of the order itself.
3. Relevant carrying cost. Assume the item is in stock for the entire time period in
question and decipher the carrying cost per unit.
You’ll then put this into the following equation:
This helps to determine the best amount of inventory to order each time. Helping to strike a
balance between minimal ordering and carrying costs, while still satisfying demand.

Inventory Storage

Inventory storage is critical to long term retail success. Fail to look after your stock properly, and
you run the risk of it getting lost, stolen or damaged - wasting cash that could be used on other
important business expenditures.
So this chapter is all about how to most efficiently store, organize, maintain and generally
preserve the life of your inventory.

Broad inventory storage options

The first thing to assess is exactly where you’ll be storing inventory. To do this, you typically
have a few options.

1) Dropshipping
Dropshipping is a way of purchasing inventory where the retailer doesn’t keep any of the
products it sells in stock. Instead, items are purchased from a third-party supplier as and when
each customer order comes in, with the supplier shipping products directly to the customer.
It therefore entirely negates the need for inventory storage or keeping stock on-hand.

Pros:

● Inventory storage is entirely taken care of by the supplier.

● Supplier is liable for any inventory shrinkage.
● Lower overall costs of not needing a warehouse, 3PL or fufillment team.
● Less risk when starting out.

Cons:

● Little to no control over product quality or branding.

● Puts someone else in control of how well products are stored.
● Shipping speeds can be incredibly slow.
● Highly competitive with razor thin margins.

Best for: Startup retail brands that want to test the waters before investing in bulk inventory.

2) Third-party logistics (3PL) service

A third-party logistics (3PL) service allows retailers to effectively rent space in another
warehouse. You can then send inventory units directly to the 3PL location for them to store and
ship on your brand’s behalf.

This usually incurs housing and shipping fees, but again eliminates the need to worry about
having to store inventory.
Pros:

● Inventory management is entirely taken care of by the 3PL service.

● Can take advantage of bulk inventory discounts without the need for a self-
fufillment warehouse.
● Usually involves significantly faster shipping times and more control over product
quality compared to dropshipping.

Cons:

● Monthly storage fees can eat into profits for slow moving stock.
● Trusting someone else to ship products on your brand’s behalf.
● Usually requires investing in bulk stock quantities.

Best for: Growing retail brands that have proven, consistent sales and want to buy stock in bulk
without a dedicated warehouse.

3) Self-fufillment warehouse
A self-fufillment warehouse is a location set up by a retailer in order to specifically store its own
inventory and ship orders.
This usually comes with significant up-front investment of both capital and time - like signing a
lease and hiring a team. But if the sales are there and numbers make sense, then the result is
more control and lower operational costs in the long run.
Pros:

● Complete control of the fufillment experience delivered to customers.

● Initial investment can result in long term savings compared to a 3PL.

Cons:

● Usually involves signing a long term lease, which can be risky.

● Will need to hire and train a team, and possibly invest in WMS software.
● May require moving to new locations several times as the business grows.

Best for: Established retail brands planning for long term growth.

Setting up your warehouse

The main goals of s etting up your warehouse for optimal inventory storage are:

Safety. Any inventory should be stored safely to prevent both injury to staff members and
damage to the inventory itself.

1. Security. Warehouses with large amounts of valuable stock will be a target for
thieves, so this should be prevented as best as possible.
2. Accessibility. Inventory will need to be stored in a way that’s easy to receive and
put away when new, then pick, pack and ship out to customers later on.
In order to do this, there are several things to think about:

1) Warehouse layout
Your warehouse will need to balance having enough storage space for inventory, while providing
enough working space for staff to move around and complete tasks.
Exact requirements will depend on each individual business, but the following areas tend to be
needed in a warehouse layout:
● Delivery/receiving area.
● Unpacking and book-in area.
● Warehouse office.
● Main storage area.
● Area for excess, obsolete or dead stock.
● Packing table(s).
● Shipping station(s).

This can be tricky – especially when dealing with a limited space. So it’s best to sketch out your
warehouse layout to scale before setting it up or changing what you already have.

Space and manoeuvrability is a key thing to remember.

Pickers need to be able to walk up and down aisles without getting in each other’s way. And
should also have enough room to actually pick items.

1) Warehouse labeling
Specific locations and clear labeling are essentials for effective inventory storage. Your team
should be able to look at your inventory system and see exactly where any product is located.
Practicality is king here.

Stick with simple alphanumeric combinations labeling specific rows, shelves and then exact bin
locations:
So you always know, for example, that all your blue t-shirts sized medium will be in Row A –
Shelf B – Bin 1. And the pattern can be continued like this.
Larger warehouses can extrapolate forward as much as needed with the same concept:

The bigger your facility, the more in-depth you’ll need to go with your location labeling to
achieve optimal inventory storage.

1) Arranging inventory
Another key part of inventory storage is determining the exact location each product should be
stored within your warehouse.
Ideally, sales volume should be taken into account for this.

V eeqo research found that 60% of a company’s sales tend to come from just 20% of their
products. Meaning you can severely reduce picker walking time by:
● Identifying that 20% of products from past sales data in your business;
● and then storing these as close to the packing desk as possible.

ABC Analysis is an inventory management technique that can become very useful here. This
divides all on-hand inventory into three groups – A, B and C:
A Items: Are of high value with low sales frequency.

B Items: Are of moderate value with moderate sales frequency.

C Items: Are of low value with high sales frequency.

You can then decide that ‘C items’ will be placed closest to the packing desk, while ‘A items’
will be farthest away. Like this:
Some small and lightweight items may even be sold frequently enough to warrant being stored on
shelves above the packing desks themselves.
Finally:

You can take this concept another layer deep by also identifying which products are most
commonly sold together.

Inventory Analysis

Inventory analysis is the regular auditing of inventory in the pursuit of continuous improvements
to how it is managed. This can be done through a variety of commonly used inventory KPIs and
ratios.
Regular monitoring of these metrics is a key part of inventory management, and so we explore
each one in-depth within this chapter.

The goals of inventory analysis

Before getting into any metrics, it’s important to understand what the specific goals are when it
comes to doing inventory analysis.
The general objective is to improve overall inventory efficiency. But breaking this down even
further would involve aiming to:
● Identify improvement areas. Metrics should be compared to past results and
industry benchmarks to identify where problem areas lie.
● Reduce stock-outs. Stock-outs should be seen as huge red flags for retailers, and
inventory analysis will help minimize them as much as possible.
● Improve cash flow. Analysing inventory now will prevent sinking too much cash into
stock at any one time going forward.
● Waste less inventory. Analysis and improvements will help minimize inventory
shrinkage, such as stock that gets lost, stolen or damaged beyond repair.
This all has the bottom line effect of making the business more profitable, while also
improving the experience for customers.

ABC analysis
ABC analysis is a commonly used inventory analysis method that helps to identify your most
valuable inventory.
It’s based on the P areto principle - AKA the 80/20 rule. Applied to retail, this would suggest
that around 80% of sales would typically come from 20% of a company’s total inventory.
ABC analysis uses this theory to sort inventory into three buckets:

A inventory. Is inventory with the highest value - typically your 20% that brings in 80% of
sales/profits. These are usually items with the best profit margins and/or most sales revenue
B inventory. Is inventory that sells regularly, but doesn’t have quite as much value as A - often
due to having slimmer margins or higher carrying costs.
C inventory. Is the remainder of inventory that doesn’t sell as much as A or B, generates the
least revenue and is generally least valuable.
This kind of analysis helps identify the key players in a retail business’s inventory.

A inventory, for example should rarely (if ever) stock-out and be given the highest priority and
focus. While C inventory may not warrant quite so much attention.

Inventory analysis metrics

ABC analysis isn’t the only way to draw conclusions from your inventory. There are several key
metrics that can be used to measure performance and uncover ways to optimize operations.

Average inventory
Average inventory measures the average volume of inventory kept on-hand throughout a given
period.
It comes from adding together the beginning inventory (BI) value at the start of a period and the
ending inventory (EI) value at the end of the period. Then simply dividing by two to find the
average:

This helps to even out seasonal fluctuations to see whether too much or too little inventory is
typically kept on-hand at any one time.

Inventory turnover
Inventory turnover measures how many times your inventory is sold over a given time period.
It’s therefore a critical metric showing how effectively inventory is being managed overall.
The formula takes cost of goods sold (COGS) over a specific period, and divides it by average
inventory over the same period:
This is affected by two key factors:

1. Purchasing. Getting forecasting and inventory buying correct to ensure the right
amount of stock is purchased in the first place.
2. Sales. Ensuring the marketing and conversion sides of the business are on point in
order to back up the projected sales with actual orders.
Poor inventory turnover performance could be stemming from failures in either one (or both) of
these elements.
Generally speaking, higher inventory turnover rates indicate better performance and efficiency.
This is because the company would be getting through its inventory stocks more often -
minimizing carrying costs per unit.

Inventory write-off
Inventory write-off is a measure of any unsold inventory that has become defunct or no longer
has any value for the business over a given period. Usually due to loss, theft, damage or
generally becoming obsolete and unsellable.
It involves identifying the inventory, disposing of it and officially writing off its value in
accounting records. So is more a procedure and final value, rather than a specific formula.
But it’s worth regularly reviewing and tracking how much inventory is being written-off.

High or continually increasing amounts could indicate problems with forecasting for certain
products, or how inventory is being stored in the warehouse.

Gross margin return on investment (GMROI)

GMROI is a simple ratio to measure the profitability of your inventory over a certain period. It
gives the gross profit a retailer makes for every dollar of inventory that’s purchased.
Here’s the formula:
(Note: gross margin is found by subtracting COGS from net sales.)

Any GMROI ratio below 1.0 means a business is not profitable, and is losing money for every
dollar invested in inventory. Anything above 1.0 means a business is selling goods for more than
what it costs the firm to acquire them.
It’s important to note that this is not a measure of bottom-line profitability - as only COGS is
taken into account as a cost, not total expenditure.
But this does give a clear indication as to how profitable your inventory is with current price
points and buying procedures.

Sell through rate

Sell through rate takes the amount of inventory a retailer receives, and compares it against what
is actually sold over a given period. It’s usually expressed as a percentage:

This can be used on a ‘per product’ (or even ‘per variant’) basis to analyze how quickly the
investment in inventory is paying off.
It’s useful when comparing one product or variant against another. Or when comparing the sell-
through of a specific product from one month to another.
Low sell through rates indicate you either overbought or priced too high, while high sell through
rates indicate you may have under bought or priced too low.

Days inventory outstanding (DOI)

Days of inventory outstanding (DOI) is simply how many days it typically takes to create or buy
inventory and turn it into a sale. It’s even sometimes referred to simply as average days to sell.
The formula involves dividing average cost of inventory over a time period by COGS over the
same period, then multiplying by number of days in the time period (all usually a year):
It’s hard to draw insights from just one calculation. But you should look into typical industry
standards, and also keep track of whether you are trending up or down as time goes on.
Increases and/or poor performance could indicate a problem with manufacturing/purchasing
and/or the sales process.

Back order rate

Back order rate shows the percentage of your total orders over a given period that ended up
being placed on back order.

This gives an indication of how well you forecast, replenish and track inventory. A high back
order rate could stem from:
● Not buying the right amount of inventory.
● Not re-ordering at the right time.
● Not syncing and tracking multichannel inventory efficiently enough.

As well as a host of other reasons.

However, it’s also important to note this doesn’t account for sales that may have been lost from
poor inventory management. You could still have a zero back order rate, but have lost sales from
having to mark online store products as ‘pre-sale’ or ‘out-of-stock’.

Conducting inventory analysis

Inventory analysis is not about simply looking at these equations once. It’s about setting aside
regular time to properly track, monitor and draw conclusions from them.
It’s worth creating a spreadsheet, then setting aside monthly time to compare trends and truly
analyze the data.

Inventory Management Techniques

In essence, all the inventory management techniques a retailer needs are covered throughout
the different chapters of this guide. These span across a number of different areas and tasks
within the field of inventory management - forecasting, purchasing, storing, analysing, etc.
So in this chapter, we give a summary of key techniques and ideas you can use to control and
manage your inventory in the best way possible.

Inventory management techniques

For ease of consumption, here's a quick run-down of all the inventory management techniques
we mention in this article:

1. Choose an appropriate fufillment option.

2. Take forecasting seriously.
3. Set reorder points for each product.
4. Use EOQ for optimal order quantities.
5. Give each variant a dedicated warehouse bin.
6. Sell older inventory first.
7. Prioritize with ABC analysis.
8. Always track your metrics.
9. Verify accuracy with regular counts.
10. Automate as much as possible.

Let’s explore each one of these further below:

1)Choose an appropriate fufillment option

As a retailer, the whole point of having inventory is to sell it. And with ecommerce, this usually
means having to store and ship it somewhere too.
So deciding exactly how this fufillment process will be done is one of the most crucial inventory
management techniques to get right.
Your general options are:

● Dropshipping. This is where you never see or hold inventory yourself. Instead, it is
purchased as each sales order comes in, and shipped directly to the customer.
Third-party logistics (3PL). This is where you would purchase inventory in bulk, but have it sent
to a 3PL service. They would then manage inventory and ship orders to your customers for a
monthly fee.

● Self-fufillment. This involves setting up your own facility and team. You’d be totally
responsible for controlling, managing and shipping inventory.
Each of these options has its own benefits and drawbacks, with the best one depending entirely
on individual business requirements. We discuss this in greater depth in Chapter 5: I nventory
Storage of this guide.

2)Take forecasting seriously

It’s tempting to skimp out on forecasting inventory requirements. Instead, many retailers will
simply guess, or just buy inventory and hope they sell it.
The problem?

This leaves you extremely susceptible to ending up with way too much (or too little) stock
on-hand at any one time. And the extra carrying costs involved will be eating into profits every
single day.
Make sure to use your past sales data in two ways:
 1. Short term. Look at sales over the past 30-90 days to indicate your short term sales
trends and demand for the inventory you hold.
2. Long term. Look at what sales were like at particular points in the year to indicate
where sales tend to spike and dip.
We discuss this in greater depth in Chapter 3: Inventory Forecasting of this guide.

3)Set reorder points for each product

Reordering your products needs to be done in a timely manner.

Leave it too long and you’ll run out of stock. Go too early and you’ll pile up way more inventory
than you need.
This is why each product (and ideally each product variant) should have its own reorder point,
taking into account:
● Safety stock. So you don’t eat into this emergency, backup stock unnecessarily.
● Lead time. So you can still cover sales demand while new products get shipped to
your warehouse.
Here’s the formula to work out exact reorder points:

Apply this to each product in your inventory. As soon as a product hits this level, it’s time to
place a new purchase order with suppliers.

4)Use EOQ for optimal order quantities

It’s not enough to know when to place a new purchase order. You need to work out exactly how
much stock to order at once to keep carrying costs to a minimum.
And economic order quantity (EOQ) is one of the best inventory management techniques to help
here.
This is a calculation that helps determine the best amount of inventory to order each time.
Helping strike a balance between minimal ordering and carrying costs, while still satisfying
demand.
The three variables involved are:

1. Demand. The number of units sold over a given time period (usually a year).
2. Relevant ordering cost. Total ordering cost per purchase order. This includes all
staff, transportation and any other costs associated with making each purchase order
- but not the actual cost of the order itself.
3. Relevant carrying cost. Assume the item is in stock for the entire time period in
question and decipher the carrying cost per unit.

You’ll then put this into the equation:

So you always know, for example, that all your blue t-shirts sized medium will be in Row A –
Shelf B – Bin 1. And the pattern can be continued like this.
We discuss this in greater depth in Chapter 5: Inventory Storage of this guide.

1)Sell older inventory first

For most retailers, the last thing you want is to be always using the newest stock to fufill
orders. This leaves older inventory sitting in the warehouse and susceptible to damage, decay
or passing best before dates.
So it’s worth making a rule to store new inventory from the back of shelves and then take
from the front - automatically enforcing a first-in-first-out (FIFO) system:

However:

It’s always worth discussing this with your accountant too as they may use a different
inventory valuation method for your end-of-year accounts
5)Prioritize with ABC analysis
ABC analysis is a very common inventory management technique that helps to identify your
most valuable inventory.
This means retailers can prioritize inventory better. Allowing them to place greater focus on
the particular items and products that bring in the most revenue.
The whole process is about sorting inventory into three buckets:

● A inventory. Inventory with the highest value – typically your 20% that brings in
80% of sales/profits. These are usually items with the best profit margins and/or
most sales revenue.
● B inventory. Inventory that sells regularly, but doesn’t have quite as much value
as A – often due to having slimmer margins or higher carrying costs.
● C inventory. The remainder of inventory that doesn’t sell as much as A or B,
generates the least revenue and is generally least valuable.
It might not make sense to prioritize like this at first. Surely all inventory is important -
otherwise you wouldn’t have it, right?
But in reality, some products will sell much better than others. And these are the ones to
focus on most to ensure they are readily available and never stock-out.

6)Always track your metrics

Tracking simple metrics and KPIs is one of the inventory management techniques that often
gets lost amongst other fancy ideas. But it can still be one of the most powerful.
It’s essential to regularly track at least the following metrics:

● Inventory turnover. Measures how many times your inventory is sold over a given
time period, giving a critical insight into overall inventory management
performance.
● Inventory write-off. A measure of any unsold inventory that has become defunct
or no longer has any value for the business over a given period.
● Gross margin return on investment (GMROI). Measures the profitability of your
inventory over a certain period, giving the gross profit made for every dollar of
inventory that’s purchased.
● Sell through rate. Takes the amount of inventory a retailer receives, and
compares it against what is actually sold over a given period.
● Days of inventory outstanding (DOI). Measures how many days it typically takes
to create or buy inventory and turn it into a sale.
Back order rate. Shows the percentage of your total orders over a given period that ended up
being placed on back order.
We discuss ABC analysis and these metrics (including the actual calculations needed) in
greater detail in Chapter 6: Inventory Analysis.

1)Verify accuracy with regular counts

Unfortunately, errors are inevitable when it comes to your stock. Even with all the inventory
management techniques and automations mentioned in this chapter.
So taking a physical count of inventory with regular stock takes is critical.

The traditional way of doing this is to shut the warehouse down for a night (or longer) and
complete a big count once or twice a year. But this can be an extremely time-consuming and
complex task, especially for large inventories or facilities.
Instead, try spreading it out through the year:

● Cycle counting. This is where team members would be given ‘counting tasks’ of a
 small number of items to do each week. Over the year, each product has then
usually been counted and verified several times.
● Spot checking. This isn’t done with any specific regularity. It can simply be done
if a product is proving particularly problematic or if a team member finds they
have some spare time and needs something to do.
Good inventory systems will manage this for you. Assigning regular counting tasks to your
team and allowing for easy corrections via digital barcode scanners.

2)Automate as much as possible

Inventory management is a complex job. And it becomes even more complex the more you
grow and the more products that get added into your catalogue.
So taking advantage of automation can be possibly the most important inventory management
technique out there.
This means utilizing quality inventory management software to do most of the heavy lifting
for you. Helping take care of tasks like:
● Tracking. So you can sync inventory in real-time across multiple channels without
overselling and back orders.
● Forecasting. To remove the guesswork and never have too much or too little
inventory on-hand.
● Purchasing. So you can handle all suppliers and create and manage POs in one
place.
Counts. To keep inventory numbers accurate by automatically assigning weekly cycle
counting tasks to your team.

● Organization. Recording exact bin locations for variants so you can find and pick
inventory quickly and accurate

Inventory Accounting

On-hand inventory isn’t simply stock that hasn’t sold yet - it’s a business asset, and must
legally be treated as such. Inventory accounting is the practice of correctly valuing this
business asset, so it can be properly documented in end-of-year financial records.
This chapter covers the basics of inventory accounting for greater understanding of inventory
management as a whole. But it is highly recommended to seek the services of a professional
accountant and/or bookkeeper when it comes to submitting any financial documents.

What is inventory accounting?

Inventory accounting is all about how a business would show the stock it holds in its financial
records - balance sheets, profit & loss (P&L) reports, etc. This is typically more complex than
it sounds as inventory is often a 'live figure' that's constantly changing as sales are made and
more stock purchased.

In retail, this can cover three types of inventory or production phases:

1. Raw materials.
2. In-progress items.
3. Finished products ready for sale.
Your on-hand, unsold inventory needs to be included as an asset in end-of-year financial
records. Meaning the crux of the matter in all this is to correctly track both the cost of any
inventory sold and place an accurate value on the unsold inventory being held at the end of
each accounting period.

Any increase or decrease in the value of goods affects your inventory value figure. This then,
in turn, affects the value of your overall business.

Inventory accounting key terms

There are two key terms retailers need to be aware of when it comes to inventory
accounting:

1. Cost of goods sold (COGS). The direct costs of producing any goods sold by a
company.
2. Ending inventory (EI). The value of any unsold, on-hand inventory at the end of
an accounting period.

Let's take a deeper look at each of these...

1)Cost of goods sold (COGS)

Cost of goods sold (COGS) is a core element of measuring a retail business’s profitability and
inventory value.

As the name suggests, COGS refers to the amount it cost a business to produce the products it
sold, including everything that went into it - materials, labor, tools used, etc. But (crucially)
without factoring in costs not directly tied to the production process - like shipping,
advertising and sales force costs, etc.

As a result, COGS helps you determine the amount of gross profit made in one or more sales.
For example:
If you sell an item valued at $50 and the COGS is $30, your company has achieved a gross
profit of $20. It’s a simple formula, though it can become more complex if manufacturing
your own products.

All inventory sold will be listed under the COGS account in your income statement at the end
of each business year.

Calculating COGS

To calculate cost of goods sold (COGS) for an accounting period, you'll need to:

1. Determine what costs can be associated with the production process of your
specific products - like labor, raw materials, tools, etc.
2. Take the cost of beginning inventory (BI).
3. Add the cost of newly purchased inventory during the period in question.
4. Subtract leftover, unsold inventory at the end of the accounting period.
 2)Ending inventory (EI)

It's highly likely that a business will not sell the entirety of its inventory at the end of each
accounting period. Meaning any on-hand, unsold stock becomes an asset that must be valued
and included in financial statements.

This is referred to as ending inventory (EI), and is actually quite simple at first glance.

1. Take the beginning inventory (the units carried over from the end of the previous
financial period).
2. Add any newly purchased inventory throughout the accounting period.
3. Subtract any units sold.
4. And this leaves the final inventory figure to be included as a company asset.

However:

We need to assign an actual value to the unsold inventory figure (i.e. how much this
company asset is worth in monetary terms). And this is where it can become a lot more
complicated.
This is because:

● Numerous purchases of new stock and raw materials are usually made during a
typical 12-month accounting period.
● Each purchase may have come at a different cost per unit.
● Sales are also being made at the same time, turning inventory into cash.

So which cost per unit figure do you use to value unsold inventory when there are so many
moving parts in a typical accounting period?

This is where inventory valuation methods come into play.

Inventory valuation methods

Sticking to a specific method for inventory valuation is critical for consistent, accurate and
(most importantly) legally acceptable financial statements.

There are three main valuation methods retail companies use for inventory accounting:

1. First In, First Out (FIFO).

2. Last In, First Out (LIFO).
3. Average Cost Method.

You'll just need to stipulate which one is being used when submitting financial records and
accounts.

1)FIFO

FIFO is a useful inventory management technique to actually use in the handling of stock in
your warehouse. But it's also a method of valuing unsold inventory.

It assumes inventory that was purchased first, is also the first to be sold. So the oldest on-
hand inventory available is what will be used to fufill an order.

There are a number of benefits to the FIFO method. Primarily, companies selling perishable
goods (food and drinks) face less risk of their products spoiling or crossing best-before sale
date. They can establish a smooth supply chain and ensure their clients receive the freshest
items in their inventory.

All products received and sold must be recorded individually when using the FIFO accounting
method. It’s possible that the FIFO system can lead businesses to under or overestimate the
value of inventory in the future, due to market changes down the line.

2)LIFO

The LIFO approach works on the assumption that the most recent products added to your
inventory are the first ones to be sold first.

This system works well for retail businesses specializing in non-perishable goods or those with
a low risk of obsolescence. It can also increase COGS and lessen net profit (therefore reducing
annual tax liability) if more recently purchased goods are more expensive.
Note: LIFO is an acceptable inventory accounting method in the US only.

3)Average Cost

Average Cost (or weighted-average) inventory accounting method is totally different to the
previous two.
This applies to businesses that choose not to track cost per inventory unit for each separate
purchase delivery. Instead, inventory value is based on the average cost of items throughout
the relevant period.

You can work out the average cost by simply dividing the overall cost of products for sale by
the total number in the inventory.