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What Is Inventory Management?

Inventory management is the coordination of the receipt, storage, costing, and outbound shipment of goods and materials. At a high level, there are two classes of inventory:

  • Direct inventory includes raw materials, components, and subassemblies that are used in the manufacture of final products. This production inventory is further classified as either raw materials, work in progress, or finished goods.
  • Indirect inventory refers to materials that are not directly used in a final product. This class of inventory can include office supplies, furniture, and other goods used by a company’s employees. Indirect materials can also include supplies called maintenance, repair, and operations supplies that are used to maintain and repair a company’s plant and equipment such as those used to manufacture a company’s products. For example, spare parts and maintenance supplies such as lubricants for a manufacturing line are considered indirect inventory. Hospitals also maintain stocks of indirect inventory that include disposable items such as operating room supplies.

In addition, inventory management involves certain processes that relate to moving inventory:

  • Receiving. Inventory enters the inventory management process such as raw materials entering a manufacturing facility. The items are scanned and entered in the system and added to the inventory balance.
  • Internal transfers. Materials are moved within the company, either between facilities where they are needed or from warehouse stocks to the next stage of the manufacturing process.
  • Outbound shipping. This shipping usually occurs when finished goods are moved within the business or to third parties to ensure that supply is available to final customers.

Inventory Management and Supply Chain Management

Inventory management is a component of supply chain management in that a supply chain’s reason for being is the movement of inventory—either delivering raw materials and subcomponents to manufacturers or fulfilling orders by delivering finished goods to consumers. In addition to inventory management, supply chain management also covers activities such as planning, logistics, order management, and procurement.

Tracking the Cost of Inventory

Inventory management involves actively monitoring and maintaining inventory balances and their costing. Direct and indirect inventory are managed and accounted for on a company’s balance sheet. Direct inventory is managed as an asset. However, when finished goods are sold to a final consumer, the company records revenue based on the sales price. The company must also record the costs associated with the finished goods as an expense item (referred to as cost of goods sold or COGS). The expense is netted against the revenue to determine a company’s gross margin. Indirect inventory is primarily managed as an expense and is either represented as a sale, general, or administrative line item, or a cost of manufacturing on the income statement (i.e. lubricants or spare parts used to maintain a company’s production machinery).

When inventory is received or shipped, it is accounted for on the balance sheet as either an increase or decrease in the inventory balance. Internal transfers are not represented on a company’s financial statements.

Responsibility for Inventory Management

The responsibility for inventory management depends on the business function, the business type, and the industry in which it is classified. The manufacturing function manages raw materials, component parts, and subassemblies. However, prior to manufacturing, the company’s planning function determines how much inventory is required, depending on the quantity of finished goods the company plans to produce. Operations managers and production managers share responsibility for monitoring and managing both raw material and work-in-progress inventory to determine whether they have enough materials on hand to meet production plans.

Inventory can also be managed by parties further down the supply chain. For example, when finished goods come out of the factory, they’re moved into warehouses and distribution centers for sale and delivery to final consumers. Warehouse and logistics managers are responsible for keeping track of the day-to-day orders and managing the receiving and shipping of finished goods as they move in and out of distribution centers as well as while they are in transit to their final destination.

Goods in transit add another layer of complexity to the inventory management process, particularly when the title or ownership transfers to a third party.

Challenges in Inventory Management

As you might expect, inventory can have a significant financial impact. It is represented as an asset on the balance sheet. When it is consumed or sold, it represents an expense item (either COGS or a manufacturing expense). Inventory can also be a financial burden. Inventory stocks represent a use of cash because the company must pay its suppliers when items are purchased. Prior to being consumed or sold, inventory represents tied-up cash that cannot be used. Excess inventory—raw materials, work in progress, or finished goods that are never purchased by a final consumer—must be written off at the end of the cycle as an expense that directly affects the company’s net income. The management of inventory affects the company’s business cycle and involves several significant challenges.

  • Maintaining the right level of inventory. Companies need to carefully plan so they have enough inventory on hand to fill customer orders. In some cases, companies include extra inventory in the event that orders exceed expectations (this excess inventory is known as safety stock). Maintaining enough safety stock for unexpected orders is essential. If the business cannot fill orders due to a lack of inventory, it will lose revenue and end up with unhappy customers.
  • Avoiding excess inventory. Poor planning can lead to unused or obsolete inventory. Unused inventory―whether raw materials or finished goods― represents a risk to the business because it is costly to store and ties up cash. And the longer materials sit without being moved through the process (which is tracked in a measurement referred to as inventory turns or inventory turnover), the greater the risk of it not being sold and resulting in a costly write-off.
  • Anticipating obsolescence. Excessive inventory can lead to the risk of that inventory becoming obsolete. For example, if the product itself is replaced by a new version or model. In this situation, a company is left with inventory it can never use. Accounting rules require that this inventory be written off, which negatively impacts the business’s income statement.
  • Addressing location issues. To provide better service to customers, organizations try to locate finished goods near where they will be consumed. This is an added level of complexity in inventory management that can drive up inventory costs. Businesses need to be able to analyze demand patterns, plan inventory purchases, and anticipate where goods will be needed. Fortunately, digital technology provides the visibility required to perform real-time planning.

The challenges in inventory management extend beyond the stocking and movement of materials. Increased consumer demands, shorter product lifecycles, and a more competitive, global marketplace have transformed today’s inventory management.

Just-in-Time Inventory Management

The most important control point over inventory is a company’s planning process. Planning in conjunction with inventory management is called inventory optimization. The goal of inventory optimization is to achieve an optimal balance between inventory stocks and inventory consumption. This can only be achieved through both planning and active inventory management. The ideal model for inventory optimization—one that attempts to solve the above challenges—is based on the Japanese concept known as Kanban, which enables “just-in-time” availability.

In a Kanban-based inventory optimization system, raw materials and component parts arrive at the plant just in time to meet current production needs (either planned or requested orders). Under this model, cash is conserved because the inventory balances, and the time between purchasing inventory and selling the finished goods to final consumers is minimal. Digital technology and advanced planning systems enable Kanban-based inventory optimization by carefully orchestrating inventory purchases, transformation, and the sale of finished goods across the entire enterprise.

Managing Suppliers to Optimize Inventory Management

Choosing the right suppliers is the responsibility of the procurement function, but suppliers can also have an impact on inventory management. For example, achieving just-in-time availability depends on having reliable and qualified suppliers who can meet timelines for just-in-time delivery. If they can’t, production ceases.

The Importance of Orchestrated Inventory Management

Under an orchestrated inventory management approach, inventory managers can make better decisions that optimize costs, minimize risk, and maximize the ability to generate revenue. Joint planning and aligned execution between the sales and manufacturing/operations functions that carefully orchestrates inventory levels is fundamentally important to business success.

The goals of an orchestrated inventory management approach are to:

  • Ensure a great customer experience. When orders are fulfilled quickly in a way that exceeds customers’ expectations, the business thrives. When inventory management problems interfere with effective fulfillment, the business suffers. Everything that takes place within the inventory management system must be geared toward meeting or exceeding customer expectations.
  • Preserve working capital. Inventory is typically the second-largest item on a company’s balance sheet, behind cash. Companies that tie up too much working capital in inventory are unable to make other investments that can further their business objectives.

Today’s businesses have unprecedented visibility, enabled by up-front order management systems, digitized point-of-sale systems, social media monitoring, and the Internet of Things (IoT) devices―including sensing technology. Demand-sensing capabilities are allowing companies to move inventory to where it’s most needed, in near real time. This macro view of inventory management allows companies to make the critical adjustments that can help them keep loyal customers and preserve liquidity at the same time.

Technology, the Cloud, and Inventory Management

Advanced technologies that take advantage of the speed, cost savings, and scalability provided by the cloud are transforming inventory management. By using planning technology, companies can quickly respond and adapt to changing business conditions that can affect inventory such as increases in demand and sourcing issues.

For example, sensing and predictive technology allows inventory managers to understand anomalies that affect demand levels—such as weather, trade wars, and fashion trends—so that they can move inventory where it is needed to ensure uninterrupted availability. The ability to combine and apply data with machine learning through predictive modeling puts enterprises in the position to more effectively optimize inventory for better results.

The Benefits of Digital Inventory Optimization

A key advantage of digital inventory optimization is that it can bring together a variety of data in one place: machine data, experience data, operational data, product data, and usage data. For the first time, a company can gain a unified view of all of its data to better manage business outcomes across the enterprise.

Enterprise software solutions today leverage intelligent processes to go beyond just automation, enabling businesses to be predictive instead of reactive. These solutions combine varied data in planning systems to provide organizations with multiple benefits such as eliminating human error, effort, and guesswork in inventory management. These combined capabilities lead to cost savings and the greater profitability— driven by more satisfied customers.

The Future of Inventory Management

The inventory management of the future will focus on optimization. The combination of agile planning and execution will enable a systematic alignment of business objectives with sales and operations, along with better supply and demand planning. This technology-driven model will leverage integrated business planning, inventory management, and execution in a nimbler and more aligned way across the entire business and its supply network.

The cloud plays an important role in this transformation, providing visibility across the supply chain and bringing decision-makers the insights they need in real time. An organization’s success will depend on its ability to run the enterprise with cost-effective, precise inventory management that only modern cloud solutions can deliver.

To succeed with inventory management in the future, your business must be capable of managing a more complex, demand-driven marketplace. Getting there means being able to transform your end-to-end business processes to drive innovation and growth.

Where Are You in Your Inventory Management Journey?

If you’re ready to learn more about future-ready inventory management, a good place to start is by asking yourself the following questions:

The goals of an orchestrated inventory management approach are to:

  • Are we optimizing our inventory by aligning it with planning?
  • Is fragmentation of inventory hindering our ability to execute?
  • How are we managing our safety stocks?
  • How much of our working capital is tied up in inventory?
  • How can we improve our inventory turns?

Many manufacturers are still using spreadsheets for some aspect of inventory management. With today’s technology, this is unnecessary and counterproductive. To compete in this economy, you need better alignment between planning and production, as well as a single source of truth for inventory balances. Enterprises can now combine planning and inventory management into one platform.

Look for an integrated planning and inventory management system that unites other crucial systems such as reporting, financials, manufacturing, and procurement. With a connected enterprise, you have greater visibility across your organization and can plan more effectively in real time.

Where are you in your journey to integrated inventory optimization? How can we help?