Inventory management is the process of organizing and managing stock throughout the supply chain.
The goal of inventory management is to minimize the cost of holding inventory, while keeping stock levels consistent and getting products into customers’ hands, faster. It’s the heart of a successful retail business.
Not sure where to get started with inventory management? This guide will walk you through the leading inventory management techniques, formulas, and tips for managing stock and keeping your customers happy.
Table of Contents
What is inventory management?
Inventory management is the system you build to organize inventory through the supply chain. It covers all steps, from raw goods to finished goods, storing, and selling. It also tracks your company’s stocked goods and monitors their weight, dimensions, amounts, and location.
The goal of inventory management is to minimize the cost of holding inventory by helping you know when it’s time to replenish products or buy more materials to manufacture them. This helps you maintain optimal inventory levels and minimize costs.
Inventory control can be used interchangeably with inventory management. Essentially, it refers to when you have control over your stock, typically due to effective inventory management processes. It’s much easier to maintain control of your inventory with centralized inventory management.
Why is inventory management important?
Effective inventory management is essential for ensuring a business has enough stock on hand to meet customer demand. If inventory management is not handled properly it can result in a business either losing money on potential sales that can’t be filled or wasting money by stocking too much inventory.
Whether you’re a small business or company using enterprise resource planning (ERP), inventory management helps your business do a number of important things:
1. Avoid spoilage
If you’re selling a product that has an expiry date, like food or makeup, there’s a very real chance it will go bad if you don’t sell it in time. Managing inventory effectively helps you avoid unnecessary spoilage.
2. Avoid dead stock
Dead stock is stock that can no longer be sold but not necessarily because it expired—it could have gone out of season, out of style, or otherwise become irrelevant. By adopting a diligent strategy, you can address this costly inventory mistake.
3. Save on storage costs
Warehousing is often a variable cost, meaning it fluctuates based on how much product you’re storing. When you store too much product at once or end up with a product that’s difficult to sell, your storage costs will go up. Avoiding this will save you money.
4. Improve cash flow
Not only is good inventory management more cost efficient, it improves cash flow in other ways too. Remember, inventory is product you’ve likely already paid for with cash (checks and electronic transfers included), and you’re going to sell it for cash, but while it’s sitting in your warehouse, it’s definitely not cash. Try paying your landlord in dog collars or phone cases.
This is why it’s important to factor inventory into your cash flow management. Inventory directly affects sales (by dictating how much you can sell) and expenses (by dictating what you have to buy). Both of these elements factor heavily into how much cash you have on hand. In short, better inventory management leads to better cash flow management.
When you have a solid inventory system you’ll know exactly how much product you have in real time, and based on sales you can project when you’ll run out so you can replace it before then. Not only does this help ensure you don’t lose sales (critical for cash flow), it also lets you plan ahead for buying more by ensuring you have enough cash set aside.
Money spent on inventory is money that is not spent on growth. Manage it wisely.
5. Optimize fulfillment
Good inventory management helps improve order fulfillment for your business. You can use tactics like inventory distribution, which refers to using fulfillment centers closer to your customers. So if they order a product online, the order is shipped and sent faster, saving you time and shipping costs.
Types of inventory
So now that we know what inventory management is, let’s look at the common types of inventory you’ll be tracking:
- Raw goods
- Work-in-progress (WIP)
- Finished goods
- Maintenance, repair, and operations goods (MRO)
Raw goods are materials or substances used in the early production or manufacturing of goods. Raw materials can include wood, metals, plastics, or fabrics used in the creation of finished goods. A business owner or manufacturer acquires these materials from one or more suppliers or producers.
You can divide raw materials into two groups:
- Direct materials, which are used in the final product. For example, the fabric you use to make clothing.
- Indirect materials, which are used throughout production, but are not included in the final product. For example, the oil you use to maintain a machine.
Raw materials represent an asset on your company’s balance sheet. You pull raw materials over time and use them to produce finished goods.
When you use direct and indirect materials in production, you must recognize the move of materials into works-in-progress (WIP). WIP describes a partially finished product awaiting completion.
On a balance sheet, WIP represents all production costs: labor, machinery, raw materials, and other equipment. It reflects only the value of products in this production stage. Costs are then transferred to the finished goods account and attributed to the cost of sales.
Finished goods inventory refers to the number of products in stock available for customers to buy. Once a WIP is complete, it becomes part of the finished goods inventory.
Finished goods undergo a markup, which means the price they’re sold at is higher than the items cost you.
Markup amounts differ, but the average markup is around 50%, according to data from Freshbooks.
Maintenance, repair, and operations goods (MRO)
MRO inventory refers to maintenance, repair, and operation supplies. These are materials and equipment used in the production process, but are not a part of the final product.
MRO inventory items include:
- Personal protective equipment like face masks, gloves, and safety glasses
- Clearing supplies such as disinfectants, brooms, and buckets
- Office supplies like notebooks, pens, and tape
- Tech equipment like laptops, printers, scanners, and more
- Lab equipment for any testing and research to create products
- Repair tools
10 inventory management strategies
Inventory management is a highly customizable part of doing business. The optimal inventory control method is different for each company.
However, every business should strive to remove human error from inventory management as much as possible, which means taking advantage of inventory management software. If you run your business with Shopify, inventory management is already built in.
Regardless of the system you use, the following will improve your inventory management—and cash flow.
Implement Six Sigma
Six Sigma is a method and tool set for business process improvement. It’s used in inventory and supply chain management to reduce excess and obsolete inventory write-offs. This inventory is often sold below cost or donated, which costs small business owners cash.
Edwin Garro, founder of PXS School of Excellence, a Six Sigma certification and training company, says, “In the Six Sigma world, we hate two things: waste and variation.”
He explains that:
- Waste is anything that adds cost but does not add value to the product or service.
- Variation is the lack of uniformity in a product or service that is perceived by the customer.
“Inventory is a major source of waste and variance,” Edwin says.
If you have more inventory than you need, you are wasting money, space, and personnel dedicated to caring for that inventory. If you have variation, inventory can end up lost, damaged, or hidden, which can result in less stock and unsatisfied customers.
Having the correct inventory to meet demand reduces waste and variance problems.
Six Sigma is a great methodology for solving inventory problems. It has order and reliability. Edwin describes a five-step process he calls DMAIC to solve these issues using the Six Sigma model:
- Define the problem you’re going to solve. It needs to have a clear metric. For example, if your problem is inconsistent tracking, the metric could be productivity.
- Measure the current state using simple stats. How much input is turning into useful outputs? This will give you an idea of the problem’s root cause.
- Analyze the root causes and create an action plan to eliminate them. From the example above, the root cause could be that tracking procedures are spread across different software and spreadsheets. The action plan could be to create a centralized inventory tracking system.
- Implement your action plan by running pilot tests to see if it eliminates the problem. Maybe you can try a new inventory management tool or test a hub-and-spoke model to move products faster.
- Control the new process. Track a metric to verify that the process works and you’re seeing consistent results. Then celebrate!
FURTHER READING: Learn how to set up your model by reading Lean Six Sigma to Reduce Excess and Obsolete Inventory.
Set par levels
Make inventory management easier by setting par levels for each of your products. Par levels are the minimum amount of product that must be on hand at all times. When your inventory dips below these predetermined levels, you know it’s time to order more.
Ideally, you’ll typically order the minimum quantity that will get you back above par. Par levels vary by product and are based on how quickly the item sells and how long it takes to get back in stock. Although setting par levels requires some upfront research and decision making, they’ll systemize the ordering process. Not only will it be easier for you to make decisions quickly, it will allow your staff to make decisions on your behalf.
Remember that conditions change over time. Check on par levels a few times throughout the year to confirm they still make sense. If something changes in the meantime, don’t be afraid to adjust your par levels up or down.
By using a smart third-party fulfillment provider, you can set these tripwires early and use them to build better demand forecasting and understand your seasonal inventory needs.
The Shopify Fulfillment Network offers smart inventory allocation across our warehouses, coupled with a Success Team to consult on your fulfillment strategy—ultimately helping you set par levels, manage the relationships with all warehousing partners, and spot check your product. Learn more about scaling with Shopify’s fulfillment solution.
First in, first out (FIFO)
First-in, first-out (FIFO) is an important principle of inventory management. It means your oldest stock (first in) gets sold first (first out), not your newest stock. This is especially important for perishable products so you don’t end up with unsellable spoilage.
It’s also a good idea to practice FIFO for non-perishable products. If the same boxes are always sitting at the back, they’re more likely to get worn out. Plus, packaging design and features often change over time. You don’t want to end up with something obsolete that you can’t sell.
In order to manage a FIFO system, you’ll need an organized warehouse. This typically means adding new product from the back or otherwise making sure old product stays at the front. If you’re working with a warehousing and fulfillment company, they probably do this already, but it’s a good idea to confirm.
Part of successful inventory management is being able to adapt quickly. Whether you need to return a slow-selling item to make room for a new product, restock a fast seller very quickly, troubleshoot manufacturing issues, or temporarily expand your storage space, it’s important to have a strong relationship with your suppliers. That way, they’ll be more willing to work with you to solve problems.
In particular, having a good relationship with your product suppliers goes a long way. Minimum order quantities are often negotiable. Don’t be afraid to ask for a lower minimum so you don’t have to carry as much inventory.
A good relationship isn’t just about being friendly. It’s about clear, proactive communication. Let your supplier know when you’re expecting an increase in sales or generating a lot of purchase orders so they can adjust production. Ask them to notify you when a product is running behind schedule so you can pause promotions or look for a temporary substitute.
A lot of issues can pop up related to inventory management. These types of problems can cripple unprepared businesses. For example:
- Your sales spike unexpectedly and you oversell your stock.
- You run into a cash flow shortfall and can’t pay for product you desperately need.
- Your warehouse doesn’t have enough room to accommodate your seasonal spike in sales.
- A miscalculation in inventory means you have less product than you thought.
- A slow-moving product takes up all your storage space.
- Your manufacturer runs out of your product and you have sales orders to fill.
- Your manufacturer discontinues your product without warning.
It’s not a matter of if problems arise, but when. Figure out where your risks are and prepare a contingency plan. How will you react? What steps will you take to solve the problem? How will this impact other parts of your business? Remember that solid relationships go a long way here.
Regular inventory reconciliation is vital. In most cases, you’ll be relying on software and reports from your warehouse management system to know how much product you have in stock. However, it’s important to make sure the facts match up. There are several methods for doing this.
A physical inventory, or stock take, is the practice of counting all your inventory at once. Many businesses do this at their year end because it ties in with accounting and filing income tax. Although physical inventories are typically only done once a year, it can be incredibly disruptive to the business and, believe me, it’s tedious. If you do find a discrepancy, it can be difficult to pinpoint the issue when you’re looking back at an entire year.
If you do a full physical inventory at the end of the year and you often run into problems, or you have a lot of products, you may want to start spot checking throughout the year. This simply means choosing a product, counting it, and comparing the number to what it's supposed to be. This isn’t done on a schedule and is supplemental to physical inventory. In particular, you may want to spot check problematic or fast-moving products.
Instead of doing a full physical inventory, some businesses use cycle counting to audit their inventory. Rather than a full count at year end, cycle counting spreads reconciliation throughout the year. Each day, week, or month a different product is checked on a rotating schedule. There are different methods of determining which items to count when but, generally speaking, higher-value items will be counted more frequently.
Prioritize with ABC
Some products drive more revenue than others. You can use an ABC analysis report to grade the value of your stock based on a percentage of your revenue:
- A = % of stock that represents 80% of your revenue
- B = % of stock that represents 15% of your revenue
- C = % of stock that represents 5% of your revenue
Therefore, your A stock represents your most profitable and valuable products. You’ll want to make sure you always have these products on hand so you don't miss out on future sales. Your C stock is your slow-moving or dead stock. This is stock you might want to sell at a discount, so you can get it off your shelves and free up cash from your inventory.
A huge part of good inventory management comes down to accurately predicting demand. Make no mistake, this is incredibly hard to do. There are countless variables involved and you’ll never know for sure exactly what’s coming—but you can try to get close. Here are a few things to look at when projecting your future sales:
- Trends in the market
- Last year’s sales during the same week
- This year’s growth rate
- Guaranteed sales from contracts and subscriptions
- Seasonality and the overall economy
- Upcoming promotions
- Planned ad spend
If there’s something else that will help you create a more accurate forecast, be sure to include it.
Last in, first out (LIFO)
The last in, first out, or LIFO, inventory management method assumes that the merchandise you acquired most recently was also sold first. The last to be bought is assumed to be the first to be sold. It’s essentially the opposite of FIFO.
This works under the assumption that prices are steadily rising, so the most recently purchased inventory will also be the highest cost. That means that higher costs will yield lower profits, and, therefore, lower taxable income—this is pretty much the only reason it makes sense to use LIFO.
In general, LIFO is a really difficult method to actually use to manage inventory. If you keep your oldest merchandise on the back of the shelf, it’s more likely to become obsolete and unsellable at a certain point. This rings true for both perishables and non-perishables. Items can get damaged, worn, and outdated.
Just-in-time, or JIT, inventory management is for the risk takers out there, though effective inventory management mitigates a lot of that risk. With JIT, you keep the lowest inventory levels possible to still meet demand and replenish before a product goes out of stock.
This requires careful and accurate planning and forecasting, but works well for rapidly growing brands with calculated launches and product line extensions.
💡 TIP: If you need to receive direct notifications of low stock levels, then install an inventory alert app from the Shopify App Store.
Inventory management formulas
Use the following inventory management formulas to understand your stock flow and maximize your inventory dollars:
- Inventory turnover
- Sell-through rate
- Days inventory outstanding (DIO)
- Economic order quantity (EOQ)
- Safety stock
- Reorder point
Inventory turnover is a raio showing how many times a business sold and replaced inventory over a given time period. Also known as stock turn, inventory turns, and stock turnover, this formula is calculated by dividing the cost of goods sold (COGS) by average inventory.
Use the following formula to calculate stock turnover:
cost of goods sold (COGS) / [(beginning inventory) + (ending inventory) / 2]
Using the formula above, track your inventory each month. Your beginning inventory is how much you have in stock on the first of the month, and your ending inventory is how much stock is left on the last day of the month.
Calculating inventory turnover can help you make better decisions on pricing, manufacturing, and buying new inventory. A slow turnover rate suggests low sales and excess inventory, while a high ratio suggests strong sales or insufficient inventory.
Sell-through rate is a percentage that shows how much received inventory you sold over a period of time. You can use this formula to determine how quickly finished goods inventory is sold and how quickly you turn inventory into revenue.
You can determine sell-through for your inventory as a whole or you can use it for inventory from specific manufacturers or product lines. This helps you figure out which suppliers and product lines are your best investment.
The formula for sell-through is:
sell-through rate = number of units sold / number of units received) x 100
It varies by industry, but the general sell-through rate is between 40% and 80%, according to data from Accelerated Analytics.
A high sell through means you have the right amount of inventory for demand. It also indicates you’re efficiently moving inventory through the pipeline. A low sell through could mean you’re ordering too much inventory or people aren’t buying inventory at the set price.
Days inventory outstanding (DIO)
Days inventory outstanding is the average number of days you hold inventory before selling it. This formula shows how fast you can turn inventory into cash. Also known as “days-in inventory,” “inventory day of supply,” or “the inventory period,” the DIO formula is calculated as:
inventory days = (average inventory / COGS) x number of days
Managing your inventory levels is crucial, especially when selling physical products. While this formula is similar to inventory turnover, which indicates your ability to turn inventory and make sales, the DIO ratio puts that figure into a daily context and can give you a more accurate picture of your inventory management efficiency.
Economic order quantity (EOQ)
Economic order quantity refers to the ideal quantity you should purchase to minimize inventory costs. This includes holding costs, shortage costs, and order costs.
The formula is calculated as:
EOQ = square root of [2SD] / H
- S = setup costs per order, including shipping and handling
- D = demand rate, or quantity sold per year
- H = Holding costs per year, per unit
By calculating EOQ, you can make smarter decisions on how much product to order in a given time.
Safety stock is like an emergency fund—it’s basically inventory you “set aside” for use in case of emergency. It acts as more of a threshold for when you need to reorder merchandise before dipping into your emergency stock allocation.
Safety stock has a formula:
safety stock = (maximum daily usage x maximum lead time) - (average daily usage x average lead time)
It’s a good idea to work safety stock into your inventory management strategy in case your supply chain is disrupted, your merchandise is damaged, or some other unforeseen circumstance prevents your ability to receive or manage merchandise.
The reorder point tells you the level at which it’s time to replenish your stock. Once you know your safety stock level, you can consider lead time with your supply chain to determine the ideal point at which it’s time to place your order.
You can use the following formula to calculate the reorder point in your business:
reorder point = lead time demand + safety stock
Calculating reorder points is vital for effective stock management, but it can be incredibly time consuming when dealing with a large number of products. A powerful inventory management system makes it a lot easier.
Inventory management software for retailers
While many small businesses start out with the old-school pen-and-paper method, this gets unwieldy quick—especially if you have growth goals. Not to mention it makes you more vulnerable to human error, which can lead to costly business mistakes.
When you use a powerful inventory software to help you track stock, you get access to benefits like stock alerts, automated purchase orders, year-end inventory reporting, and user permissions and accounts. Combined, inventory tracking software features give you complete control and insight into your business and how inventory moves from suppliers to customers and everywhere in between.
An inventory management system like Stocky, Shopify's inventory management solution for Shopify Point of Sale Pro, provides you with these advanced inventory management features and syncs with your Shopify store in real time. The best part is it grows with you—so you can scale your business with a tech stack capable of handling your inventory now and in the future.
Try Shopify POS free for 14 days—no credit card required!
Shopify POS Pro costs equal: your Shopify plan + $89/month per location. The only requirements are an iPad or iPhone, the Shopify POS app, a Shopify store, and products to sell. Your Shopify ecommerce store syncs with your Shopify POS to automate and manage your entire business from one dashboard. Any inventory updates you make in your Shopify admin instantly take effect in Shopify POS.
Inventory management tips
Whether you’re a new business or building your third retail store, keep these inventory management tips in mind:
Categorize your inventory
Prioritizing your products into groups helps you understand which need to be ordered frequently and how slow they move out of your inventory. This allows you to spend more time and resources on profitable products.
To maximize your inventory dollars and improve efficiency, divide your inventory into several groups based on turnover and profitability. Start with three:
- Group A: Low-priced items that sell fast
- Group B: Mid-priced items that move slower
- Group C: High-priced items that sell the slowest
All products aren’t created equal. If you lend equal inventory time on all products, you’ll likely shortchange the ones that deserve your attention. By categorizing items in priority groups, you’ll get more efficient inventory counts and assure that levels of your highest value items are maintained.
Update inventory records in real-time
Keep records of product information for all items in your inventory. Access to fresh, correct inventory data is key to move products quickly and efficiently. You’ll want to record information such as SKUs, bar code, suppliers, and lot numbers. Plus, know when the last transactions took place.
Holding dead inventory can cost you in warehousing fees. Factors like seasonality or trends can impact how fast products move. If it’s been months since a product sold, or if turnover has decreased, you may want to sell the item at a loss and use the revenue to invest in a more profitable product.
Audit inventory regularly
Real-time tracking also makes it easier to audit your inventory regularly. Some retailers audit inventory once per year, while others can do monthly or weekly spot checks on their items. Regardless, run audits to ensure accuracy between your stock quantity and financial records. This will help you understand your stock flow and profits and losses, and keep inventory flowing smoothly.
Go over supplier performance
A bad supplier can cause chaos for your business. If they are constantly late with deliveries or send the wrong amount of items, it can throw off your operation. A supplier audit is a chance to identify where suppliers can improve or when to cut them off.
Discuss any issues with suppliers. Don’t be afraid to switch suppliers if you don’t feel the problem can be solved. You don’t want to deal with pending stock levels and running out of inventory. Your goal is to create supply chain resilience so you can run your business with confidence.
Put one person in charge of inventory management
It’s true that many retailers are small enough to be a two- or three-person operation. But if your business continues to grow, you may want to assign the role of inventory manager to one person.
Your inventory manager can keep track of all items and be first-in-charge when it comes to ordering restocks, negotiating with suppliers, and paying invoices. You’ll also want to work with them on creating a process for receiving stock.
Always keep customer satisfaction in mind
Your goal is to avoid excess stock in your inventory. But obsessing over minimizing stock level steals your attention from the most crucial element of your business: customer satisfaction. If your inventory runs too low and customers can’t buy, it’ll lead to lost sales. Even worse, it’ll lead to lost customers.
Invest in inventory management technology
Small businesses often run with minimal technology. If you’re still working off spreadsheets and notebooks, that’s only doable while you’re still small. Say you open an online store or a second location—you’ll spend more time on inventory than your actual business. Keeping inventory synced across all your channels can become exhausting.
Stocky made it simple to move a lot of our inventory from the retail store to our warehouse and then distribute it through our online channel. Our online business increased by 500% for several months.
A good inventory management software makes the process of managing your stock easier. Besides saving you time and sanity, it can also help:
- Lower risk of overselling
- Improve cost savings
- Avoid excess stock and stockouts
- Improve inventory accuracy
- Provide greater insights into your business
Look for a software that can integrate with your business tools and handle your future multi-channel sales. You’ll want a POS system that connects with your stock management system to keep data synchronized and maintain consistency across your sales channels.
Taking control of your inventory
Remember that with an effective inventory management system in place you can help reduce costs, keep your business profitable, analyze sales patterns and predict future sales, and prepare for the unexpected. With proper inventory management, a business has a better chance for profitability and survival.
It’s time to take control of your inventory management and stop losing money. Choose the right inventory management techniques for your business and start implementing them today.