What Is Inventory Management?

What Is Inventory Management?

Let me explain inventory management directly: it's the process where you oversee ordering, storing, using, and selling your company's inventory. This covers raw materials, components, and finished products, along with how you warehouse and process them. You'll find different methods for this, each with its own advantages and drawbacks based on what your business needs.

Key Takeaways

Inventory management covers the full cycle from raw materials to finished products. It aims to streamline your inventories efficiently to prevent gluts and shortages. The four major methods are just-in-time management (JIT), materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI). I'll review the pros and cons of each below.

The Benefits of Inventory Management

Your company's inventory is one of its most valuable assets. In sectors like retail, manufacturing, or food services where inventory is central, your inputs like raw materials and finished products form the core of your operations. A shortage when you need it most can seriously harm your business.

On the flip side, inventory can become a liability if it sits too long, risking spoilage, theft, damage, or shifts in customer demand. You have to insure it, store it, and if it doesn't sell, mark it down or even destroy it.

That's why inventory management matters for any business size. You need to know when to restock, how much to buy or produce, and when and at what price to sell—these decisions get complex quickly. Small businesses might track stock manually with spreadsheets like Excel to set reorder points. Larger ones turn to specialized ERP software, while the biggest use customized SaaS applications. Increasingly, companies are using artificial intelligence to optimize these processes.

Strategies vary by industry. An oil depot can store large amounts for long periods, waiting for demand to rise, even though storage is expensive and risky—think of the 2005 UK fire that caused millions in damage and fines—but there's no spoilage risk. For perishable goods or time-sensitive products like 2024 calendars or fast fashion, holding inventory isn't viable, and mistakes in timing or quantities can cost you dearly.

If your business has complex supply chains and manufacturing, balancing glut and shortage risks is tough. That's when methods like JIT and MRP come into play. Note that some companies, like financial services, don't deal with physical inventory and focus on service process management instead.

Accounting for Inventory

In accounting terms, inventory is a current asset since you typically plan to sell finished goods within a year. You must physically count or measure it before listing it on your balance sheet. Many companies use advanced systems to track levels in real time.

You can account for inventory using methods like first-in-first-out (FIFO), last-in-first-out (LIFO), or weighted-average costing. Your inventory account usually breaks into four categories: raw materials, which are purchases for production that need transformation; work in process, raw materials being turned into finished products; finished goods, ready for sale; and merchandise, finished items bought from suppliers for resale.

Inventory Management Methods

Depending on your business or product, you might use various inventory management methods, including just-in-time (JIT), materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI). These are the four most common, and here's how they work.

Just-in-Time Management (JIT)

This model started in Japan in the 1960s and 1970s, with Toyota playing a big role. With JIT, you save money and cut waste by keeping only the inventory needed for immediate production and sales. It lowers storage, insurance, and liquidation costs for excess stock.

But it's risky—if demand spikes unexpectedly, you might not source enough inventory, hurting your reputation and sending customers to competitors. Even small delays can create bottlenecks if key inputs don't arrive just in time.

Materials Requirement Planning (MRP)

MRP relies on sales forecasts, so you use detailed sales data to predict inventory needs and communicate them to suppliers promptly. For instance, a ski manufacturer would stock materials like plastic and wood based on expected orders. If forecasts are off, you can't fulfill orders.

Economic Order Quantity (EOQ)

EOQ helps you find the ideal order or production batch size to minimize costs, assuming steady demand and factoring in holding and setup costs. It ensures you don't order too often or hold excess inventory, balancing the trade-off between those costs to minimize total inventory expenses.

Days Sales of Inventory (DSI)

This ratio shows the average days to turn inventory into sales, including work-in-progress. Known also as days inventory outstanding, it measures inventory liquidity—a lower DSI is generally better, indicating faster turnover, though it varies by industry.

Inventory Management Red Flags

If a company switches inventory accounting methods often without good reason, it might be trying to make things look better than they are. Frequent write-offs could signal problems selling goods or obsolescence, raising concerns about competitiveness and product appeal.

What Are the 4 Main Types of Inventory Management?

The four main types are just-in-time management (JIT), materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI). Each suits different businesses variably.

How Does Tim Cook Use Inventory Management at Apple?

Apple's CEO Tim Cook emphasizes inventory management, comparing it to dairy products that spoil. He implemented just-in-time practices, reducing Apple's inventory turnover to as little as five days in 2012 from months.

What Is an Example of Inventory Management?

Take a just-in-time system: a car manufacturer receives airbags right as cars hit the assembly line, avoiding constant stockpiles.

The Bottom Line

Inventory management ensures you have the right products in the right amounts at the right time. Order too little, and you lose sales; too much, and you tie up cash or discard items. Since every business differs—like an auto parts supplier versus a bakery—there's no perfect method. Choose what fits your operations and products to boost profitability and success.