Chapter 10: Inventory Management

What is inventory?

Inventory is the accounting of items, component parts and raw materials a company uses in
production, or sells.

• The verb “inventory” refers to the act of counting or listing items. As an accounting term,
inventory refers to all stock in the various production stages and is a current asset.
• By keeping stock, both retailers and manufacturers can continue to sell or build items.
• Inventory is a major asset for most companies. However, while inventory is an asset on the
balance sheet, too much inventory can become a practical liability.

PURPOSE OF INVENTORY

The main function of inventory is to provide operations with an ongoing supply of materials.

• To achieve this function effectively, your business should strive to find a sweet spot between
too much and too little, without ever running out of stock.
• This successful balance will improve cash flow and profitability, and keep your company
running smoothly.

WHAT IS INVENTORY MANAGEMENT?

Inventory management is how you track and control your business’ inventory as it is bought,
manufactured, stored, and used. It governs the entire flow of goods — from purchasing right through to
sale — ensuring that you always have the right quantities of the right item in the right location at the
right time.

• Inventory management is the entire process of managing inventories from raw materials to
finished products.
• Inventory management tries to efficiently streamline inventories to avoid both gluts and
shortages.

Too Much Inventory:

• The function of inventory is to have what you need when you need it, without accumulating
more than you can use.
• Aim to only keep on hand an amount that your business will turn over in a reasonable time
frame. There are industry averages for inventory turnover rates, and these averages make
useful guidelines and target amounts. However, it is more important that your business
maintain adequate supplies without generating clutter than that you meet a targeted average
benchmark.
• If you purchase and store too much inventory, your cash flow may suffer, because your cash is
tied up in items that are sitting on your shelves unused or unsold rather, than being available
for immediate needs such as rent and payroll.
• Excessive inventory amounts can also cost you money in storage and handling, and occupy
space that could be better used for other purposes.

Too Little Inventory:

• If you don’t have enough inventory, you won’t be able to meet customers’ needs and they
could end up taking their business elsewhere.
 • This loss of business may not be just a matter of losing a particular sale on a particular day, but
also losing longer term business if your customers come to believe that other alternatives are
more dependable.
• On the surface, it may seem that keeping lower inventory levels saves you money in purchasing
expenses, but it will cost you more in lost sales but you won’t have enough product on hand to
sell.

Successful Inventory Management:

• Inventory levels will most effectively fulfill their purpose, if you develop successful systems for
managing and replacing supply.
• Create metrics for optimal inventory levels, based on sales records over time.
• Identify the critical points at which you should reorder, and introduce digital or paper systems
for communicating to your purchasing department when inventory levels drop below these
points.
• Build relationships with suppliers who can resupply your stock quickly if you experience a
sudden surge in demand.
• It’s worth paying extra to restock your inventory quickly in an emergency, as long as you use
less expensive options as your default, and you don’t allow stock to drop to precarious levels
too often.

4 Different Types of Inventories:

1.Raw materials/components

is the total cost of all component parts currently in stock that have not yet been used in work-in-
process or finished goods.

• Materials that are needed to turn your inventory into a finished product are raw materials.
• These inventory items are bits and pieces of component parts that are currently in stock but
have not yet been used in either work-in-process or finished goods inventory

There are two types of raw materials:

• Direct materials — These are materials incorporated into the final product.

For example, this is the wood used to manufacture a cabinet.

• Indirect materials— These are materials not incorporated into the final product, but which are
consumed during the production process.

For example, this is the lubricant, oils, rags, light bulbs, and so forth consumed in a typical
manufacturing facility.

2. WIP / Work In Progress:

Work in progress (WIP) refers to partially-completed goods that are still in the production process.

• These items may currently be undergoing transformation in the production process, or they
may be waiting in queue in front of a production workstation.
• Work in progress items do not include raw materials or finished goods.
• Work in progress is usually comprised of the full amount of raw materials required for a
product, since that is added at the beginning of production, plus the cost of additional
processing as each unit progresses through the various manufacturing steps.
 • Work in progress is typically measured at the end of an accounting period, in order to assign
a valuation to the amount of inventory that is on the production floor.
• WIP is one of the three types of inventories, of which the others are raw materials and finished
goods.
• Work in progress may be reported on the balance sheet as a separate line item, but is usually
so small in comparison to the other types of inventories that it is aggregated with the other
inventory types into a single inventory line item.

How to Calculate Ending Work in Progress:

Beginning WIP + Manufacturing costs - Cost of goods manufactured = Ending work in progress

3. Finished goods

Finished goods are goods that have been completed by the manufacturing process, or purchased in a
completed form, but which have not yet been sold to customers.

• Goods that have been purchased in completed form are known as merchandise.
• The cost of finished goods inventory is considered a short-term asset, since the expectation is
that these items will be sold in less than one year.
• The total amount of finished goods inventory on hand as of the end of a reporting period is
typically aggregated with the costs of raw materials and work-in-process, and is reported
within a single "Inventory" line item on the balance sheet.

4. MRO

MRO stands for Maintenance, Repair and Operations — or sometimes Maintenance, Repair and Overhaul
— and refers to the equipment, tools and activities associated with the daily operations of a business.

• It doesn’t include materials, products and services that are directly used in production, but
rather the glue that holds everything together.
• MRO may include HVAC (Heating, ventilation, and air conditioning) maintenance, facility
lighting, janitorial services, CNC (Computer Numerical Control) machinery, drill presses,
forklifts, jacks, PPE, powered and manual hand tools, mops, brooms and even furniture.
• MRO can be routine, planned maintenance activities, also called preventive MRO; it can be
predictive, when data indicates machinery is deteriorating and needs maintenance; or it can be
corrective, after an incident occurs.

Types of MRO

MRO is often divided into four categories, according to industrial sourcing platform Thomas:

• Infrastructure repair and maintenance keeps a business’ facilities up and running, in top
condition.
• Production equipment repair and maintenance ensures all equipment and systems run
smoothly.
• Material handling equipment maintenance involves maintaining equipment and systems for
transporting raw materials and final products to and from production lines.
• Tooling and consumables is the management of any smaller, handheld tools required in day-to-
day operations.
INVENTORY MANAGEMENT TECHNIQUES

Eight Common Inventory Management Techniques:

1. Just-in-time (JIT) inventory. JIT involves holding as little stock as possible, negating the costs
and risks involved with keeping a large amount of stock on hand

2. ABC inventory analysis. This technique aims to identify the inventory that is earning you
profit, by classifying goods into different tiers

3. Dropshipping. Businesses that use dropshipping essentially outsource all aspects of managing
stock — with several benefits but a few key drawbacks

4. Bulk shipments. This technique is based on the assumption that buying in bulk is cheaper. The
method is great if a business is sure that their products will sell but can pose challenges when
demand suddenly changes

5. Backordering. A backorder is when a customer places an order for stock that is not yet
available. Learn more about how backordering impacts inventory control.

6. Consignment. This technique allows a consignor, usually a wholesaler, to give their goods to a
consignee, usually a retailer, without the consignee paying for the goods up front. The
consignor still owns the goods, and the consignee pays for the goods only when they actually
sell. This sounds great but it also carries major risks.

7. Cross-docking. This system virtually eliminates the need to hold inventory. Products are
delivered to a warehouse where they are sorted and prepared for shipment immediately. They
are usually reloaded into other trucks at the same warehouse and sent out for delivery
immediately

8. Cycle counting. This technique involves counting a small amount of inventory on a specific day
without doing an entire stock take. This method helps your business regularly validate accurate
inventory levels in your inventory management software

INVENTORY MANAGEMENT PROCESS

Inventory management is a technique of controlling, storing, and keeping track of your inventory
items.

• Inventory management is an essential component of supply chain management, as it regulates

all the operations that are involved from the moment an item enters your store until it has
been dispatched.
• To put it in simple words, inventory management helps you streamlining your operations,
organize your resources, and maximize your returns.
INVENTORY CONTROL

Inventory control, also called stock control, is the process of managing a company’s inventory levels,
whether that be in their own warehouse or spread over other locations.

• It comprises management of items from the time you have them in stock to their final
destination (ideally to customers) or disposal (not ideal).
• An inventory control system also monitors their movement, usage, and storage.

The importance of inventory control

• Quality control

Having an inventory management system allows you to implement greater quality control. If you can
track and manage all aspects of your stock, you better control quality

• Organizational control

Inventory control means that you have organizational control in your business. A well-organized
stockroom lets you manage your merchandise and make the most of your investment in physical
inventory.

• Accounting accuracy

Keeping an accurate record of your inventory is vital for managing your assets. It will also help you in
the event of an audit. Knowing what you have in assets allows you to know your overall spoilage and
understand the value of your company.
Challenges of inventory control

Inventory control is vital for effective business operations. It can also come with challenges. It may
seem difficult to find the time and resources, and developing a complete picture of your inventory can
be difficult, especially if you have a larger company or multiple inventory locations.

• Finding the time and resources

Doing inventory management manually requires substantial resources. Money and staff hours are
required for manual inventory control.

• Visibility

Companies with large stock, complex warehousing, or that are selling on multiple channels can have
many moving parts to their inventories. This can create challenges with visibility. Businesses must have
a complete picture of their business’s inventory for replenishment, accounting, cash flow, and sales
purposes. Losing sight of your inventory can lead to the degradation of inventory quality and can lead
to dead stock.

• Human error

Human errors are unavoidable when businesses have a constant flow of inventory in and out of their
warehouses. For example, vendors need to send accurate invoices and they need to be matched with
purchase orders and physical inventory. Any inaccuracies that occur at this stage can impact your
inventory control.

Bulk Shipments

Bulk shipping is the transportation of products in large quantities usually not packed but directly
loaded into a vessel.

• As such, these products are sent without any protective packaging or packing, and the object
that is transporting them, usually the hold of a ship, acts as the container.
ABC inventory management

ABC inventory management is an approach that identifies and optimizes top-selling products based on
their order of economic importance: “A” being the most valuable; “C” being the least.

ABC analysis typically segregates inventory into three categories based on its revenue and control
measures required: A is 20% of items with 80% of total revenue and hence asks for tight control; B is
30% items with 15% revenue; whereas ‘C’ is 50% of the things with least 5% revenue and hence
treated as most liberal.
Backordering

A backorder is an order for a good or service that cannot be filled at the current time due to a lack of
available supply.

• The item may not be held in the company's available inventory but could still be in production,
or the company may need to still manufacture more of the product.
• A backorder is an order for a good or service that cannot be filled at the current time due to a
lack of available supply.
• The backorder is an indication that demand for a company's product outweighs its supply. They
may also be known as the company's backlog.
• A backlog is a buildup of work that needs to be completed.

Advantages of Backorders

• The term backorder may conjure up negative images, but there can be positives to businesses
that have these orders on the books.
• Keeping a large supply of stock requires storage space, which, in turn, requires money.
Companies that don't have their own storage centers have to pay for services to hold their
inventory.
• By keeping a small amount of stock in supply and the rest on backorder alleviates the need for
excess/extra storage, and therefore, reduces costs.
• This cost reduction can be passed on to consumers, who will likely return because of a
company's low prices.
• This is especially true when sales and demand for certain products is high.

Problems with Backorders

• If a company consistently sees items in backorder, this could be taken as a signal that the
company's operations are far too lean.
• It may also mean the company is losing out on business by not providing the products
demanded by its customers.
• If a customer sees products on backorder—and notices this frequently—they may decide to
cancel orders, forcing the company to issue refunds and readjust their books.
 • When an item is on backorder, a customer may look elsewhere for a substitute product,
especially if the expected wait time until the product becomes available is long.
• This can provide an opportunity for once loyal customers to try other companies' products and
potentially switch their loyalties. Difficulties with proper inventory management can lead to
the eventual loss of market share as customers become frustrated with the company's lack of
product availability.

Just In Time (JIT) inventory management

The just-in-time (JIT) inventory system is a management strategy that aligns raw-material orders from
suppliers directly with production schedules.

• Companies employ this inventory strategy to increase efficiency and decrease waste by
receiving goods only as they need them for the production process, which reduces inventory
costs.
• This method requires producers to forecast demand accurately.
• The just-in-time (JIT) inventory system is a management strategy that minimizes inventory and
increases efficiency.
• Just-in-time manufacturing is also known as the Toyota Production System (TPS) because the
car manufacturer Toyota adopted the system in the 1970s.
• The success of the JIT production process relies on steady production, high-quality
workmanship, no machine breakdowns, and reliable suppliers.
• The terms short-cycle manufacturing, used by Motorola, and continuous-flow manufacturing,
used by IBM, are synonymous with the JIT system.
Consignment

Consignment is an arrangement in which goods are left in the possession of an authorized third party to
sell.

• Consignment is an arrangement in which goods are left with a third party to sell.
• The party that sells the goods on consignment receives a portion of the profits, either as a flat
rate fee or commission.
• Selling via a consignment arrangement can be a low-commission, low-time-investment way of
selling items or services.
• Most consignment shops and online dealers will offer terms, but some are willing to negotiate.
• Consignment is a good workaround if you don't possess a physical store or online marketplace in
which to sell your goods.

Drop shipping and cross-docking

Drop shipping is an order fulfillment method that does not require a business to keep products in
stock.

• Drop shipping is a handy retail fulfilment method that frees up space for your business, as you
don’t have to keep the products you sell in stock.
• The vendor usually pays for the item at a discount by working directly with a manufacturer or
wholesaler; their profit comes from the difference in the initial item cost and whatever price
they sell it at.
Cross-docking is the practice of unloading goods from inbound delivery vehicles and loading them
directly onto outbound vehicles.

• Cross docking is a logistics procedure exactly where products from a supplier or manufacturing
plant are distributed straight to a consumer or retail chain with marginal to no handling or
storage time.
• Cross-docking usually takes place in a dedicated docking terminal in a warehouse, where
inbound goods are first received at a dock and sorted according to their final destinations.
• Cross-docking works best with products that need to be transported quickly, such as food, that
have already been sorted and labeled for customers, do not need quality inspections or have
steady demand.
Benefits of Cross Docking

• Streamlines the supply chain from origin location to location location

• Much less inventory handling means decreased labor costs
• Reduces amount of warehouse space needed might get rid of warehousing from supply chain
altogether
• Quicker delivery of product to retailer/ consumer
• Reduced risk of broken inventory due to handling
• Elevated retail sales space
• Consolidates numerous smaller loads into 1 mode of transportation

Cycle counting

Cycle counting is a method of checks and balances by which companies confirm physical inventory
counts match their inventory records.

• This method involves performing a regular count and recording the adjustment of specific
products. Over time, they have counted all their goods.
• Warehouse managers and supply chain professionals often prepare the plan for staff to audit
inventory. The most efficient inventory management plans lead to minimal transaction error
rates and extremely high stock record accuracy without taking away from staff's essential
tasks.
Physical Inventory vs. Cycle Counting

A physical inventory counts all stock one time a year. Cycle counting counts small, preselected sections
of inventory multiple times a year, sometimes as often as daily.

REORDER POINT FORMULA

Reorder point formula is the mathematical equation used by businesses to calculate the minimum
amount of inventory needed to order more product to avoid running out of inventory.

The reorder point formula is as follows:

• Demand during lead time

Lead time is the number of days between when you place a purchase order with your manufacturer or
supplier for a product and when you receive the product.

Lead time demand = lead time x average daily sales

 • Safety stock

It’s not enough to know the average demand for a product, as that demand can increase suddenly or
problems with a supplier can prevent you from restocking inventory as quickly as you expected. Safety
stock, as the name suggests, is the extra “just in case” inventory you keep on hand to anticipate
variability in demand or supply.

Safety stock level = (Max daily orders x max lead time) – (average daily orders x average lead time).

To calculate:

Reorder Point (ROP) = Demand during lead time + safety stock

OR

OR

Why is the reorder point important?

Reorder points ensure that you don’t fall behind on your next batch of inventory. With an accurate
reorder point for each SKU, you’ll always have enough stock on hand to satisfy customer demand —
without tying up excess capital in inventory.
 ✓ A Stock Keeping Unit, or SKU, is an alphanumeric code used by online or retail
stores to identify a specific product. SKUs are often on scannable bar codes and
represent different product characteristics such as color, size, and brand, and are
used for inventory management.

Importance of Reorder:

• Minimize costs

Storing more inventory than what can be sold in a timely fashion is not a productive use of capital.
Reorder points provide businesses with greater financial flexibility by allowing them to keep minimum
amount of inventory on hand without running out of products.

• Minimize stockouts

Too much inventory is expensive, but too little inventory can result in stockouts, which are harmful for
your business: Orders are delayed or cancelled, your business loses customers, and your reputation can
suffer. Reorder points help prevent stockouts in the first place.

• Better forecasting

Calculating reorder points goes hand in hand with having a clear idea of purchasing trends over a given
time period.

WHAT IS DEAD STOCK?

Dead stock refers to any unsold items which are lying in your warehouse or your store for a long time.
Causes of Dead Stock:

• Ordering inconsistencies

This means that you’re either ordering too many items at once, or ordering them at the wrong time.

• Poor sales

This can happen if your target market doesn’t like your product because of its price, because it’s
obsolete or out of fashion, or because your competition is more appealing.

• Defective products

If your stock isn’t selling because it’s defective, quality checking standards can help you sort things
out.

INVENTORY MANAGEMENT APPS, SYSTEM & SOFTWARES

Inventory control systems are technology solutions that integrate all aspects of an organization’s
inventory tasks, including shipping, purchasing, receiving, warehouse storage, turnover, tracking, and
reordering.

How Do Inventory Control Systems Work?

• Inventory control systems, such as inventory control apps, offer a variety of functions that help
companies manage various types of inventories.
 • Inventory control systems typically consist of inventory management apps paired with barcode
tagging to identify inventory assets, and information about each item is stored in a central
database.

Four Types of Inventory Control Systems in Two Category Types:

First Category - Main Inventory Control System Types:

• Perpetual Inventory System

A perpetual inventory system keeps continual track of your inventory balances. Updates are
automatically made when you receive or sell inventory.

• Periodic Inventory System

Periodic system examples include accounting for beginning inventory and all purchases made during the
period as credits.
Second Category - Types of Inventory Management Systems within Inventory Control Systems

• Barcode Inventory Systems

Inventory management systems using barcode technology are more accurate and efficient than those
using manual processes. When used as part of an overall inventory control system, barcode systems
update inventory levels automatically when workers scan them with a barcode scanner or mobile
device.

• Radio Frequency Identification (RFID) Inventory Systems

Radio frequency identification (RFID) inventory systems use active and passive technology to manage
inventory movements. Active RFID technology uses fixed tag readers throughout the warehouse; RFID
tags pass the reader, and the movement is recorded in the inventory management software.
Lead time demand

Lead time is the amount of time that passes from the start of a process until its conclusion.

• Lead time measures how long it takes to complete a process from beginning to end.
• In manufacturing, lead time often represents the time it takes to create a product and deliver
it to a consumer.

Understanding Lead Time

• Production processes and inventory management can affect lead time.

• In regards to production, building all elements of a finished product onsite may take longer
than completing some items offsite.
• Transportation issues can delay delivery of necessary parts, halting or slowing production and
reducing output and return on investment (ROI).
Safety stocks

Safety stock is simply extra inventory held by a retailer or a manufacturer in case demand increases
unexpectedly.

• This means it’s additional stock above the desired inventory level that you would usually hold
for day-to-day operations.

How to Calculate Safety Stock?

Why Do You Need a Safety Stock?

1) Demand Uncertainty

Every retailer and manufacturer will have products that sell well all year round and products that
fluctuate in demand.
For example, products like razor blades are bought year round which makes it easier to define reorder
quantities. If the supply and demand are consistent, you may not require large amounts of safety stock.

2) Lead Time Uncertainty

For manufacturers and companies that assemble products using different components, lead time is a
critical factor to determine minimum inventory and safety stock requirements.

• Just-in-Time manufacturing is used in the automobile industry and relies on parts arriving at
the factory sometimes just hours before they need to be used on the production line.
• Production delays with suppliers and issues with customer delivery delays can have a huge
impact, causing whole lines to be shut down.
• This in turn can cause your own lead times to be affected.
• If you have deliveries arriving earlier or later than expected, a safety stock formula will help
you to cover unexpected delays and demand fluctuation to maintain a consistent output.

Source/References

https://www.netsuite.com/

https://www.sortly.com/

https://www.accountingtools.com/

https://sphera.com/

https://www.investopedia.com/

https://smallbusiness.chron.com/

https://www.tradegecko.com/

https://businessjargons.com/

https://www.investopedia.com/

https://squareup.com/

https://www.swainsmith.com/

https://www.zoho.com/inventory

https://www.brightpearl.com/

https://www.zoho.com/inventory

https://www.investopedia.com/

https://www.skuvault.com/

Prepared by:

Prof. Lee D. Kabigting, BA (Hons), MBA, MPA