Inventory Management 101

In the world of small business, one crucial aspect that often gets overlooked is inventory management. Properly managing your inventory can have a major impact on your bottom line, cash flow, and overall business success. In this article, we’ll explore the fundamentals of inventory management, why it’s essential, and methods you can apply to keep your business financially healthy.

Why inventory management matters

Inventory management is the art of overseeing and controlling the goods your business holds for resale. It encompasses everything from stocking products, tracking inventory levels, and ensuring a smooth flow of goods in and out of your business.

Getting it right can help improve cash flow by ensuring you’re not tying up excess cash in unsold products. It allows you to allocate resources where they’re needed most, such as paying bills or investing in growth. It can also bolster customer satisfaction, as running out of popular products can lead to lost sales and disappointed customers. On the other hand, having too much inventory can result in storage costs and potential product obsolescence. “A large inventory carries the risk of spoilage, theft, damage, or shifts in demand,” writes Investopedia finance expert Adam Hayes. Finally, efficient inventory management helps you minimize carrying costs, reduce the risk of shrinkage, and avoid overstocking, all of which can impact your profitability.

Inventory management methods

According to Hayes, some of the most common inventory management methods you can use are just-in-time manufacturing (JIT), materials requirement planning (MRP), economic order quantity (EOQ), and days in inventory (DII).

JIT manufacturing, a method largely developed and popularized by Toyota, “allows companies to save significant amounts of money and reduce waste by keeping only the inventory they need to produce and sell products,” says Hayes. This approach has many benefits, such as reducing storage and insurance costs, but is vulnerable to supply-chain disruptions or sudden changes in demand.

MRP is based on sales forecasts. For this method to work, businesses must have accurate sales records, so that they can precisely plan inventory needs. They also need good communication with suppliers who are able to provide materials on time.

EOQ is “the optimal number of units a business should purchase when replenishing inventory while minimizing inventory costs that could eat into profit margins,” says NerdWallet author Benjamin Din. EOQ is all about balancing demand for your product with the setup cost and holding cost of procuring and storing that product. The goal is to avoid making frequent orders, which would drive up costs, without having excess inventory.

Finally, DII is an efficiency ratio that measures the average number of days a business holds its inventory before selling it. It’s a method for businesses to measure the liquidity of their inventory, helping them identify how much of it they need at any given time.

The best inventory management strategy for your business depends on the industry, the scale of your company, and your strengths and weaknesses as a manager.

Identifying poor inventory management

Failing to manage your inventory correctly can result in adverse consequences for your business. Excess inventory is one of the most common problems. Through insurance, storage fees, and the risk of obsolescence, it ties up capital that could be invested elsewhere. Lost sales due to insufficient stock is another risk. Noticing these symptoms can help you identify that your inventory management needs extra focus. For example, if you find that you are frequently placing orders for materials, your business may benefit from EOQ calculations.

If you are often unexpectedly running out of inventory, your business may need more precise sales records and forecasts. And while JIT manufacturing can be very advantageous, it’s not likely to be suitable for businesses that operate in an industry fraught with unpredictable changes in demand.

As Hayes says, “balancing the risks of inventory glut and shortages is especially difficult.” While small businesses tend to keep track of numbers manually, larger businesses often use specialized software and dedicated personnel. Even if you’re alone and working with a limited budget, you can benefit from temporarily hiring a professional who can help you identify what is and isn’t working for your business. They may even show you how to apply the methods described above to set you on the path for success.