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What is inventory management?

Inventory management is the process of orchestrating the flow of goods through a company in a continuous cycle of ordering, storing, producing, selling, and restocking goods. Inventory management is generally performed at two levels: aggregate inventory management and item inventory management. In aggregate inventory management, companies make decisions between minimizing inventory costs or holding more inventory to maximize customer service or production efficiency. Aggregate inventory management bridges to item inventory management through policies, such as safety stock (described later), and to inventory controls through polices, such as ABC classification or order quantities, which take item level attributes, such as cost, lot sizes, and order lead times, into account.

Inventory can be broadly classified into three categories: raw materials/components, work in progress, and finished goods. Manufacturing companies purchase raw materials or components, store them until ready for production, and transform them into finished goods. Nonmanufacturing companies, such as wholesale distributors and retailers, stock finished goods for sale to final consumers.

All companies must strike a balance between inventory levels and demand because inventory uses a company’s cash and incurs carrying costs. Regardless of the type of business, companies must maintain tight control over inventory to conserve cash while ensuring they have enough stock to meet production schedules or forecasted customer demand and actual orders.

Inventory management: Financial implications

Inventory management involves making trade-offs between revenue, cost, and risk. Classified on the balance sheet as a current asset, inventory is a use of company cash. Careful attention must be paid to the length of its conversion cycle—the time between purchasing raw materials (for a manufacturer) to the final sale of finished products. During that time, cash remains tied up, and companies must ensure their inventory is sold in a timely manner (called inventory turns) to return the cash to the business. Slow moving inventory incurs holding costs, risks, and adversely affects a company’s cash flow. Accordingly, companies require a disciplined process to ensure that the level of inventory investment is in line with the expected level of customer demand.

The role of inventory management

Inventory management and supply chain management

Inventory management is a critical component of supply chain management in that a supply chain’s reason for being is the movement of goods, either delivering raw materials and subcomponents to manufacturers or fulfilling orders for finished goods to consumers. Both help companies reduce costs, improve cash flow, and increase profit margins.

Inventory management is complex and varies depending on your industry, your function within the company, and the type of item being managed. Deciding how to plan and manage inventory is a collaborative effort full of trade-offs, risks, and rewards.

No two companies are alike. Depending on their business models, companies use a number of different methods to manage inventory. Inventory costs the company money, but it is necessary for superior customer service and to maximize operational efficiency. For example, manufacturers with expensive machine and people operations will sometimes carry excess inventory to avoid shutting down these operations due to a lack of inventory—which would cost the company more money. Almost all companies maintain safety stock inventory to protect against unexpected changes in supply and demand. In this way, inventory functions as a protection against the unexpected, and as a buffer against production shutdowns. Safety stock represents a balance between service or fill rates (the percentage of customer orders that a company can ship immediately from stock) and the additional cost of ordering and holding more inventory. The consequence of not having enough inventory are stock-outs, which can be detrimental to a business especially if customers have alternatives, such as ecommerce-based businesses where rapid fulfillment is expected. Stock-outs represent lost revenue and can adversely affect customer loyalty.

Manufacturers typically establish inventory controls, such as minimum and maximum stocking levels and reorder points, within their ERP systems. Distributors establish reorder points in a decentralized manner, allowing each distribution center to determine their inventory levels based on local factors or demand-driven methods. Local factors can include SKU-level demand, lead times, or seasonal patterns. Demand-driven methods can include point-of-sale data from their retail customers. Many procurement organizations take pricing discounts into consideration in their purchasing strategy and may buy more supply than required to obtain favorable price points.

Read our blog on how to minimize supply chain disruptions with better inventory management

Digital inventory management systems

Modern, cloud-based enterprise software solutions are designed to manage end-to-end business processes, automate transactions, and integrate data across multiple systems to provide an integrated view across an entire business process. Inventory management systems are complete materials management solutions that effectively manage the flow of goods across your company and its global supply network. In conjunction with specialized warehouse management systems, they provide accurate and timely visibility into inventory, efficient distribution, and improved productivity. Combined with supply chain planning systems, they take the guesswork out of inventory management by better matching demand with supply, ensuring more accurate stocking levels and improving working capital utilization and profitability.

Managing suppliers to optimize inventory management

Choosing the right suppliers is the responsibility of the procurement organization. Suppliers can have an impact on inventory. For example, achieving just-in-time availability depends on having reliable, qualified suppliers that can meet specific timelines for just-in-time delivery. If they cannot meet specific ship dates, production can be delayed and customers left hanging.

Inventory visibility

A key benefit of modern enterprise cloud solutions is their ability to provide a view into inventory across multiple nodes of the supply chain, such as production facilities, suppliers, goods in transit, and distribution centers. This visibility gives decision-makers the key insights they need to manage demand, inventory levels, and ensure customer satisfaction. This is particularly critical for companies with extended supply networks comprised of suppliers, transportation providers, production facilities, and regional distribution centers. Having a real-time view of quantities on hand, goods in transit, and their location helps them better manage customer demand. For example, if a delivery is held up due to a plant shutdown or an equipment breakdown, managers can cover the temporary shortfall by shifting stock from one distribution center to another located closer to the customer. Inventory visibility is also critical to having real-time data on order volumes to help planners determine how much of a particular item they need, where it should be located, and how frequently they need to restock in order to meet actual or forecasted demand levels.

Warehouse management systems

A warehouse management system (WMS) provides specialized inventory management capabilities that streamline distribution center operations, such as streamlining receiving, stocking, order processing, and multichannel fulfillment. They can also manage materials in locations other than traditional warehouses, such as retail stores or stock rooms. A WMS provides end-to-end inventory visibility from inbound shipments through receiving, stocking, inventory cycle and physical counts, omnichannel fulfillment, and returns. Warehouse management systems also maximize materials handling efficiency and order fulfillment to ensure customer satisfaction.

Integrated demand planning

As supply chain complexity increases, companies are challenged to align supply with demand to determine inventory levels with greater precision. To accomplish this, they need sophisticated demand planning solutions, which can incorporate a wide range of item/location combinations and inventory policies into multiple scenarios for generating the optimal demand plan. The net requirements plan incorporated through manufacturing resource planning (MRP) into the demand plan must be able to handle the complexity that comes with global supply chains. At the same time, the role of inventory needs to be considered when applying manufacturing or distribution constraints to the plan. As discussed earlier, inventory policies for safety are directly implemented to manage supply chain exposure to demand fluctuations and simulations. What-if scenarios play a vital role in ensuring optimal inventory is included in the plan to meet customer demand, avoid stock-outs, and ensure resiliency.

Integrated business planning that combines statistical forecasts with actual demand signals helps ensure more accurate forecasts and inventory levels that meet your desired or target customer service levels. It helps you manage any uncertainty in demand and supplier lead times. Replenishment orders are generated whenever an inventory position falls below a minimum threshold. These orders incorporate estimated lead times to ensure adequate stocking levels. Based on the specified inventory policy, the replenishment order may be a fixed order quantity or computed quantity, calculated as a difference between the maximum threshold and inventory position, and can be adjusted for minimum order quantities.

Where are you in your inventory management journey?

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

  • Are we optimizing our inventory by aligning it with demand and supply planning?
  • Are we using the right inventory policies to minimize inventory cost and maximize customer service?
  • 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 companies are still using spreadsheets or inflexible legacy systems for some or all aspects of inventory management. While that approach might seem adequate, not taking advantage of today’s technology can be counterproductive and can lead to suboptimal business outcomes. To compete in a fast-paced economy, you need better alignment between planning and production as well as an integrated view of your inventory. Integrated supply chain management (SCM) suites help companies develop synergies across their planning and inventory management, as well as other crucial supply chain functions, such as procurement, manufacturing, logistics, and order management. The result: greater efficiency, improved customer service, and higher profit margins.