Inventory management refers to the process of ordering, storing, using, and selling a company’s inventory. This includes the management of raw materials, components, and finished products, as well as warehousing and processing of such items. Various methodologies can be employed for inventory management, depending on a company’s needs.
Key Takeaways
- Inventory management spans from raw materials to finished products.
- Effective inventory management aims to avoid gluts and shortages.
- Major inventory management methods include just-in-time management (JIT), materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).
- Each method has its pros and cons based on the specific needs of the business.
The Benefits of Inventory Management
A company’s inventory is one of its most valuable assets. In sectors such as retail, manufacturing, food services, and others, where inventory plays a crucial role, running out of stock when needed can be highly detrimental.
Conversely, excess inventory can be a liability, leading to spoilage, theft, damage, or obsolescence. Managing inventory effectively also includes considerations about insurance and the potential need to liquidate stock at reduced prices.
For these reasons, businesses of all sizes need to employ strategic inventory management. Knowing when to restock, what quantities to purchase, the prices involved, and optimal selling times can be complex tasks. Small businesses may use manual tracking and spreadsheets, whereas large corporations typically utilize specialized enterprise resource planning (ERP) software or highly customizable software-as-a-service (SaaS) applications.
Appropriate inventory strategies will differ based on industry specifics. For instance, an oil depot can store large amounts of inventory for extended periods, while businesses dealing with perishable goods or fast-moving consumer goods need to be far more agile.
For complex supply chains, maintaining a balance between inventory gluts and shortages is particularly challenging. To address these issues, firms have developed multiple inventory management methodologies, such as just-in-time (JIT) and materials requirement planning (MRP).
Accounting for Inventory
Inventory is a current asset typically intended for sale within a short timeframe, without exceeding one year. Inventory must be accurately counted and recorded before it can appear on a balance sheet. Sophisticated inventory management systems are often employed to maintain real-time inventory levels.
Inventory accounting utilizes one of the following methods: first-in, first-out (FIFO), last-in, first-out (LIFO), or weighted-average costing. Inventory can be divided into four main categories:
- Raw Materials: Items purchased for production, requiring significant work before becoming finished products.
- Work in Process: Raw materials currently being transformed into finished goods.
- Finished Goods: Products ready for sale to customers.
- Merchandise: Finished goods bought from suppliers for resale.
Powerful Inventory Management Methods
Various inventory management methods are leveraged based on the business sector and product types. The most common techniques include Just-in-Time (JIT), Materials Requirement Planning (MRP), Economic Order Quantity (EOQ), and Days Sales of Inventory (DSI).
1. Just-in-Time Management (JIT)
Originating from Japan in the 1960s and further developed by Toyota, this model aims to reduce waste and costs by only keeping inventory necessary for immediate production and sales, thus minimizing storage and insurance expenses. However, JIT poses risks, such as the inability to meet unexpected demand spikes, which can hurt reputation and business.
2. Materials Requirement Planning (MRP)
Based on sales forecasts, this method requires precise sales records to plan inventory needs and communicate with suppliers effectively. For example, a ski manufacturer using MRP ensures stock of necessary materials like plastic and aluminum based on forecasted sales. The reliable prediction of sales is crucial to avoid missed orders.
3. Economic Order Quantity (EOQ)
The EOQ model calculates the optimal number of units to add to inventory in each batch to minimize the overall costs, including holding and setup costs. It assumes a balance between these costs and seeks to minimize total expenses, thereby preventing frequent ordering and overstocking.
4. Days Sales of Inventory (DSI)
This financial ratio measures the average time taken to turn inventory, including in-progress goods, into sales, indicating the inventory’s liquidity. A lower DSI is generally preferred; however, average DSIs vary by industry.
Inventory Management Red Flags
If a company frequently switches its inventory accounting methods without solid rationalization, it could be attempting to mask its real business performance. Similarly, frequent inventory write-offs might signal difficulties in selling products or inventory obsolescence, indicating potential long-term competitiveness issues.
The Importance of Strategic Inventory Management
Different inventory management types vary in their suitability based on the specific business and product nature. Here is a recap of the four main approaches: Just-in-Time (JIT), Materials Requirement Planning (MRP), Economic Order Quantity (EOQ), and Days Sales of Inventory (DSI). Each has distinct advantages and drawbacks.
Insight from Tim Cook
Tim Cook, renowned for his inventory management expertise, once remarked, “Inventory is like dairy products. No one wants to buy spoiled milk.” Efficient inventory management can save a company substantial amounts of money.
Practical Example of Inventory Management
Consider a just-in-time (JIT) system implementation: A car manufacturer receives airbags for installation as the cars arrive on the assembly line, avoiding the need for an excess stockpile.
Conclusion
Inventory management is essential for business efficacy, tailored according to the business type and product specifics. While there isn’t a one-size-fits-all method, leveraging the most suitable inventory management practice can substantially benefit business operations.
Related Terms: just-in-time manufacturing, materials requirement planning, economic order quantity, days sales of inventory, enterprise resource planning, first-in-first-out, last-in-first-out, weighted-average costing.
References
- Competent Authority. “Buncefield: Why Did it Happen?”, Page 34.
- Toyota. “Toyota Production System”, Pages 1-2.
- Chartered Institute of Procurement and Supply. “How to Do Effective Material Requirements Planning”.
- Kumar, Rakesh. “Economic Order Quantity (EQQ) Model”. Global Journal of Finance and Economic Management, vol. 5, no 1, 2016, pp. 1-2.
