Inventory Management

What Is Inventory Management?

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.

KEY TAKEAWAYS

 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.
 Two major methods for inventory management are just-in-time (JIT) and
materials requirement planning (MRP).
Understanding Inventory Management
A company's inventory is one of its most valuable assets. In retail, manufacturing,
food services, and other inventory-intensive sectors, a company's inputs and
finished products are the core of its business. A shortage of inventory when and
where it's needed can be extremely detrimental.

At the same time, inventory can be thought of as a liability (if not in an accounting
sense). A large inventory carries the risk of spoilage, theft, damage, or shifts in
demand. Inventory must be insured, and if it is not sold in time it may have to be
disposed of at clearance prices—or simply destroyed.

For these reasons, inventory management is important for businesses of any

size. Knowing when to restock inventory, what amounts to purchase or produce,
what price to pay—as well as when to sell and at what price—can easily become
complex decisions. Small businesses will often keep track of stock manually and
determine the reorder points and quantities using spreadsheet (Excel) formulas.
Larger businesses will use specialized enterprise resource planning
(ERP) software. The largest corporations use highly customized software as a
service (SaaS) applications.

Appropriate inventory management strategies vary depending on the industry. An

oil depot is able to store large amounts of inventory for extended periods of time,
allowing it to wait for demand to pick up. While storing oil is expensive and risky
—a fire in the UK in 2005 led to millions of pounds in damage and fines—there is
no risk that the inventory will spoil or go out of style. For businesses dealing in
perishable goods or products for which demand is extremely time-sensitive—
2021 calendars or fast-fashion items, for example—sitting on inventory is not an
option, and misjudging the timing or quantities of orders can be costly.

For companies with complex supply chains and manufacturing processes,

balancing the risks of inventory gluts and shortages is especially difficult. To
achieve these balances, firms have developed several methods for inventory
management, including just-in-time (JIT) and materials requirement planning
(MRP).

 
Some firms like financial services firms do not have physical inventory and so
must rely on service process management.

Accounting for Inventory

Inventory represents a current asset since a company typically intends to sell its
finished goods within a short amount of time, typically a year. Inventory has to be
physically counted or measured before it can be put on a balance sheet.
Companies typically maintain sophisticated inventory management
systems capable of tracking real-time inventory levels.

Inventory is accounted for using one of three methods: first-in-first-out

(FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing. An
inventory account typically consists of four separate categories: 

1. Raw materials — represent various materials a company purchases for its

production process. These materials must undergo significant work before
a company can transform them into a finished good ready for sale.
2. Work in process (also known as goods-in-process) — represents raw
materials in the process of being transformed into a finished product.
3. Finished goods — are completed products readily available for sale to a
company's customers.
4. Merchandise — represents finished goods a company buys from a supplier
for future resale.

Inventory Management Methods

Depending on the type of business or product being analyzed, a company will
use various inventory management methods. Some of these management
methods include just-in-time (JIT) manufacturing, materials requirement planning
(MRP), economic order quantity (EOQ), and days sales of inventory (DSI).

 Just-in-Time Management (JIT) — This manufacturing model originated in

Japan in the 1960s and 1970s. Toyota Motor (TM) contributed the most to
 its development.1  The method allows companies to save significant
amounts of money and reduce waste by keeping only the inventory they
need to produce and sell products. This approach reduces storage and
insurance costs, as well as the cost of liquidating or discarding excess
inventory. JIT inventory management can be risky. If demand
unexpectedly spikes, the manufacturer may not be able to source the
inventory it needs to meet that demand, damaging its reputation with
customers and driving business toward competitors. Even the smallest
delays can be problematic; if a key input does not arrive "just in time," a
bottleneck can result.
 Materials requirement planning (MRP) — This inventory management
method is sales-forecast dependent, meaning that manufacturers must
have accurate sales records to enable accurate planning of inventory
needs and to communicate those needs with materials suppliers in a timely
manner. For example, a ski manufacturer using an MRP inventory system
might ensure that materials such as plastic, fiberglass, wood, and
aluminum are in stock based on forecasted orders. Inability to accurately
forecast sales and plan inventory acquisitions results in a manufacturer's
inability to fulfill orders.
 Economic Order Quantity (EOQ) — This model is used in inventory
management by calculating the number of units a company should add to
its inventory with each batch order to reduce the total costs of its inventory
while assuming constant consumer demand. The costs of inventory in the
model include holding and setup costs. The EOQ model seeks to ensure
that the right amount of inventory is ordered per batch so a company does
not have to make orders too frequently and there is not an excess of
inventory sitting on hand. It assumes that there is a trade-off between
inventory holding costs and inventory setup costs, and total inventory costs
are minimized when both setup costs and holding costs are minimized.
 Days sales of inventory (DSI) — is a financial ratio that indicates the
average time in days that a company takes to turn its inventory, including
goods that are a work in progress, into sales. DSI is also known as the
average age of inventory, days inventory outstanding (DIO), days in
inventory (DII), days sales in inventory or days inventory and is interpreted
in multiple ways. Indicating the liquidity of the inventory, the figure
represents how many days a company’s current stock of inventory will last.
Generally, a lower DSI is preferred as it indicates a shorter duration to
clear off the inventory, though the average DSI varies from one industry to
another.

There are other methods to analyze inventory. If a company frequently switches

its method of inventory accounting without reasonable justification, it is likely its
management is trying to paint a brighter picture of its business than what is true.
The SEC requires public companies to disclose LIFO reserve that can make
inventories under LIFO costing comparable to FIFO costing.2

Frequent inventory write-offs can indicate a company's issues with selling its
finished goods or inventory obsolescence. This can also raise red flags with a
company's ability to stay competitive and manufacture products that appeal to
consumers going forward.