Inventory is often the largest current asset in a business. How effectively it’s managed, tracked, and sold can mean the difference between healthy cash flow and going broke. Before you develop an effective inventory management strategy you need to understand what inventory is, its various types, and how it works in a business.
What is inventory?
Inventory is the stock of goods and materials currently owned by a business.
Different types of inventory are accounted for differently in a company’s books. Some of the more common inventory types include raw materials, components and parts, work-in-progress products, and finished goods.
Businesses must ensure they have enough available inventory to meet customer demand even through unexpected spikes and supply chain disruptions. But too much inventory in the warehouse means higher storage costs, tied-up cash flow, and requires more resources to manage.
Inventory management is the process of maintaining this balancing act.
Product businesses must develop a system that prevents stockouts while minimising the risk of overstocking. And understanding the different kinds of inventory and how they impact inventory accounting is a crucial first step towards cost-saving inventory management.
Inventory is used widely across numerous industries and sectors. It can mean different things to different organisations, so let’s look at some common inventory examples in various business models.
Retail is one of the hardest sectors for getting the balance of inventory right. The nature of retail businesses means inventory turns over faster and there’s a high potential for unexpected surges in demand.
Retailers largely deal with merchandise inventory – goods that have already been produced to the point at which they can be marketed and sold.
Common examples of retail inventory include:
- Consumer electronics
- Sports equipment
- Books and magazines
Manufacturing businesses typically deal with more inventory than wholesalers or retailers. This is because all the parts and materials they use to produce finished goods also qualify as manufacturing inventory.
Manufacturing inventory refers to all raw materials, components, work-in-progress goods, and packaging used to produce finished products. It also covers the finished products until they are sold.
Common examples of manufacturing inventory include:
- Nuts, bolts, and screws
- Sheets of soft fabric or metal
- Assemblies and sub-assemblies
- Spare parts
- Drill bits
- Welding rods
- Paints and dyes
Like brick-and-mortar stores, ecommerce outlets need warehouses of inventory to meet customer demand. But unlike physical stores, 100% of ecommerce inventory is kept in storage and packed up for delivery once sold.
Ecommerce provides a frictionless buying experience for online shoppers. This means that it often sells faster than wholesale or retail goods, making inventory management a tougher challenge.
Common examples of popular ecommerce inventory include:
- Digital products
- Private label goods
- Custom clothing
Pharmaceutical inventory often comes with unique requirements, such as storage at a particular temperature or a must-sell-by expiry date. Warehousing pharmaceutical inventory requires precise tracking of the different goods to ensure they aren’t spoiled or kept overlong.
Common examples of pharmaceutical inventory include:
- Cough medicine
- Prescribed drugs
- First aid supplies
Types of inventory
Inventory can be categorised in different ways depending on how it’s being assessed. This means that some items will often fall under two or more categories.
Here’s a quick rundown of the most common types of inventory you’re likely to encounter in a product business.
Raw materials inventory refers to the materials used to create a final product. These goods are most commonly found in manufacturing businesses, where goods are assembled on a factory line before being sold to another business or a consumer.
Work-in-progress goods are unfinished products that have begun to be assembled but are not yet ready for sale. This includes incomplete assemblies and product bundles.
Finished goods or merchandise inventory is stock that requires no further production or labour efforts before they are sold. In other words, it covers the goods ready for purchase right up until the sale is made.
Once finished goods have been purchased, ownership changes to the buyer and the goods are no longer inventory from the perspective of the seller.
Safety stock is the finished goods inventory kept by a company in case of supply chain delays or sudden shifts in customer demand.
Inventory optimisation tools help businesses determine roughly how much stock they are likely to sell throughout the year. But because it’s impossible to perfectly predict future demand or mitigate every supply chain risk, a buffer of safety stock can help meet demand when reality doesn’t match what was forecasted.
Consignment inventory is goods owned by one company but held by another until they’re sold. For example, a manufacturer supplies consignment inventory to a retailer so that it’s available immediately for resale; however, the retailer does not pay for (or own) the consignment inventory until it has been resold.
Stock inventory refers to the goods or products that are held by a company, ready to be sold. It covers the items you’d find on retail shelves or packed up and ready to ship in a wholesale warehouse.
The total value of stock inventory is an important factor for evaluating how much a business is worth, how effectively its inventory management strategy is, and where a company is making or losing the most money.
Inventory management encompasses all the workflows, planning, and inventory systems used to control the flow of goods in and out of a business. It’s about balancing the necessary amount of stock required to meet demand without overstocking (storing an uneconomical quantity of goods).
There are many methods and best practices for achieving optimal inventory control. Here are some of the most common ones.
Inventory tracking refers to the traceability of goods – where they’re coming from, where they’re located, and in the case of manufacturing businesses, what stage of production they’re in.
It plays a critical role in inventory management – not just within a warehouse, but along the entire supply chain. You need to know when materials will arrive and manage customer expectations around delivery status and lead time.
Closely tracking stock at both ends of the chain supports effective auditing, forecasting, and decision-making.
Inventory forecasting is the process of analysing historic data and trends to plan future inventory requirements. The aim is to identify what quantity of stock will be required throughout the year and what external factors may affect demand.
This process feeds into inventory planning, where a business uses the information gathered to set reorder points and create mitigation strategies for any supply risks or demand shifts.
Warehouse planning is key to ensuring labour and costs are minimised when the stock comes in or goes out. It includes ensuring the faster-moving stock is placed within easy reach, while some of the longer-lead products are placed further back or on higher shelves.
It also requires the calculation of minimum and maximum stock levels, safety stock maintenance, and storage capacity utilisation.
Inventory control refers to processes and strategies used to maintain optimal inventory levels. These include the methods covered in the next three sections. Inventory control uses key inventory formulas to ensure maximum efficiencies at the lowest cost.
Suppliers should be constantly audited and compared to ensure they remain a competitive choice. This includes analysing:
- Average lead times
- Volume of overdue orders
- Lead time variance
- DIFOT rate
- Rate of returns
Contracts should be regularly renegotiated to acquire better terms and prices as you prove your ongoing loyalty to a supplier. This will help you grow faster and protect your cash flow. For example, the cash conversion cycle can be improved by establishing better credit terms and lower minimum order quantities (MOQs).
Economic Order Quantity
Economic Order Quantity (EOQ) is a formula used to determine the optimal amount of inventory to keep in stock. It considers order and carrying costs, demand patterns, customer behaviours and seasonal shifts.
The formula for calculating EOQ is:
√(2DS/H) = Economic Order Quantity
In this formula:
- D = Number of units purchased of a particular product per year (annual demand)
- S = Order cost per purchase order
- H = Annual holding cost per unit
This calculation tells you the optimal quantity size they should order goods and materials in and how often they should be ordered annually.
The reorder point is the level at which stock should be purchased to prevent a stockout. It varies between SKUs and uses the rate of consumption, lead times, and safety stock to determine the optimal level.
The reorder point formula can be calculated as:
(Daily Sales Velocity) × (Lead Time in Days) + Safety Stock = Reorder Point
In this formula, the daily sales velocity refers to the average number of units sold per day. Remember that each SKU will have a different reorder point and must be calculated individually.
Inventory turnover considers how fast stock is ‘turned over’, or shifted from supplier to customer, within a certain time frame. This helps you figure out if you’re operating in the most effective way.
If inventory turnover is high, goods are being sold relatively quickly. If inventory turnover is low, goods are moving relatively slowly and may need investigating.
The formula for inventory turnover is:
Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio
This formula uses the Cost of Goods Sold (COGS) data point, which is important for determining production cost, revenue, and profits. Learn more about COGS here.
Inventory analysis and planning
Inventory planning – backed by thorough inventory analysis – enables companies to sufficiently prepare for the next accounting period. It’s the process of examining which products and trends are worth capitalising on based on historic data, and which products or activities are costing your business.
ABC analysis is loosely based on the Pareto principle or the 80/20 rule. It’s about identifying which minority of products are responsible for the majority of profits.
The idea is to categorise goods based on their value to the business and then prioritise them to maximise profits. Items are classified as A (high value), B (mid value), and C (low value).
This inventory analysis method is helpful for deciding which items to cull from your product line, where to focus your marketing efforts, and whether you need to adjust your pricing for low- or non-profitable goods.
HML unit price analysis
This is a planning method that considers inventory based on price. The categories are H, which refers to high unit value items, M, or medium unit value items, and L, or low unit value items.
Like ABC analysis, this process can be relatively simple to implement, making it a useful starting point for any business looking to improve inventory planning. It supports inventory budgeting and control of costs.
Demand forecasting is about predicting how many sales of an item are likely to occur in a given period – typically a year. Historic sales datasets, market trends and customer behaviour can all be pulled into the analysis and offer insights into future demand. In turn, this can then be used to support the supply chain, warehouse management, and marketing teams.
Accounting for inventory
Inventory accounting is the task of valuing and reporting on the inventory held by a business. It’s a critical part of running a product business as it’s necessary both for accurate tax calculations and to gain financial visibility across the company.
Inventory is listed as a current asset on the balance sheet until it is sold. But because the costs associated with producing and selling products are never stable, inventory accounting can be challenging to get right.
- Learn more: The Ultimate Guide to Inventory Accounting