From raw materials to finished items, inventory includes all the products you sell. Inventory management involves knowing when to restock, quantities to buy, how much to pay, when to sell and pricing.
Learning how to have the right amount of the right products available at the right time is a critical balance to maintain for your business’ success. Too little inventory, and you can’t fulfil customer orders. Too much inventory, and you risk theft, products spoiling or becoming irrelevant, lost inventory due to inaccuracy or disorganization, and the cost of insuring or storing excess goods. The goal is to cut costs associated with holding stock while keeping consistent levels.
A small business should spend about 25% to 35% of its operational budget on inventory, according to Forbes. But this depends on your business type and margins. For example, if you're a business that has high inventory turnover (like grocery or fast fashion stores), you’re going to spend a different amount on inventory than a business that has slower turnover (like luxury car dealerships) or seasonal fluctuations (like a Halloween costume shop or garden centre).
Your company’s profitability depends on your inventory management. The goal is to be at the point where inventory sells and you're replenishing it regularly. You might do yourself a disservice if something isn’t selling and takes up precious shelf space.
Accounting for inventory
Inventory is accounted for using these inventory costing methods:
- First in first out: selling inventory in the order you bought it.
- Last in first out: last unit to arrive is the first you sell.
- Average cost: assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced.
Whatever method you choose to go with, an inventory account includes:
- Raw materials your company needs for the production process
- Works in progress, which represent raw goods that are in the process of being transformed into a finished product.
- Finished goods, which are completed products that are ready to be sold.
- Merchandise, finished goods your company buys from a supplier for resale.
How to forecast demand
Until you’ve been about a year or two in business, you’ll predict demand for your products based on seasonality and where the industry is going, plus doing market research. Once you have some sales history, you can better predict fluctuations and calculate what you need and what areas of your business are growing.
Common methods of buying inventory include:
- Just in time: keeping the lowest number of units to meet demand. This method reduces storage costs, but can be risky if demand increases.
- Bulk buying: buying inventory in a large volume. With this option comes discount opportunities, along with storage costs and the risk of over-buying.
- Dropshipping: a partner with a third-party supplier ships the product directly to the customer, instead of you holding stock. This removes the need for inventory management but reduces your profit margins.
When and how much to buy
Methods for when to place a purchase order include:
- Order pattern method: regular fixed purchases. This method is a great choice if your sales are steady.
- Control rhythm method: checking inventory at fixed intervals and buying stock based on that. If you have an understanding of your customer demand and forecasting, this could be the option for you.
- Reorder point method: reordering stock once it’s below a certain level. This option works for companies with fewer products that don’t need bulk buying discounts. The reorder point is the minimum number of units your company needs to have in stock to fill sales orders or meet production targets. Use this formula to determine yours:
Reorder point = (average daily sales volume x time it takes for a shipment to arrive in days) + safety stock
How much inventory to order depends on your industry, demand forecasting, shelf life, bulk buying discounts, ordering and storage costs, production needs and distribution capabilities. To find your optimal inventory quantity, use the economic order quantity formula:
EOQ = square root of: [2(setup costs per order)(units sold per year)] / holding costs per year per unit
Do the math
To evaluate your inventory management efficiency (and to figure out when you need to restock products), use the stock turnover ratio. It measures the number of times inventory has been sold and replaced in a certain period.
First, calculate the average inventory value, which can inform you of your company’s state, competitiveness, areas of improvement and further sales opportunities.
Average inventory value = (inventory at start of period + inventory at end of period)/2
Next, plug that number into the inventory turnover formula.
Turnover ratio = cost of goods sold/average inventory value
A high inventory turnover ratio means you're selling products efficiently. A lower number means sales are slow or you’re overstocked. However, seasonal items (like skis or air conditioners) can skew your results.
Another useful formula to figure out how fast you cycle through products is the days sales of inventory: days in a year/inventory turnover rate. The answer tells you how many days it would take to sell out of your current inventory.
At a glance: inventory management tips
- Track what you have and figure out the smallest quantity of products that have to be on hand.
- Many industries choose the first in, first out (FIFO) rule for stock, which means the oldest inventory is sold first. This allows the business owner to have an up-to-date breakdown of what inventory is costing the business. This is especially important during times of inflation, because your oldest inventory likely cost less than your newer inventory.
- Identify stock that hasn’t sold in a certain time frame.
- Build strong relationships with suppliers. Manage suppliers in inventory management software, like Sortly, Square or Lightspeed, specific to your industry.
- Figure out risks, then develop a contingency plan for when—not if—problems like supply chain snags happen.
- If it makes sense within your business, you could hire someone to be in charge of buying inventory.
- Make inventory management a part of your daily or weekly routine.
- If you create your own inventory (like selling goods at a farmer’s market), track stages of your works in progress, keep raw materials on hand, implement a reordering system, set targets/deadlines, maintain a production schedule, plan inventory based on where you’ll be selling and keep records of what sells well.
You know the basics about how to manage your business' inventory. Next up, learn how to set your prices.