Inventory Management Guide: Definition, Process & Techniques

accounting for inventory management

Inventory Management Guide: Definition, Process & Techniques

Inventory management is a crucial component of running a successful business. It involves overseeing and controlling the ordering, storage, and use of components that a company uses in the production of the items it sells. It also manages the quantity of finished products available for sale. A well-organized inventory management system can lead to smoother operations, reduced costs, and increased profitability. In this article, we will delve into the benefits, types, and techniques of inventory management.

What is Inventory Management?

Inventory management is the systematic approach to managing and coordinating the movement of goods within an enterprise. It encompasses the monitoring of stock levels, analyzing stock flow, and fine-tuning restocking strategies to ensure consistent product availability, reduce expenses, avert stock shortages, and enhance the efficiency of the supply chain.

The primary objective of inventory management is to strike a balance in inventory levels, ensuring you’re neither overstocked nor understocked. This balance helps in determining the right time to reorder products or procure materials for production, ultimately leading to cost optimization.

Here are the various categories of inventory that businesses typically handle:

  • Raw Goods: These are the foundational materials or elements utilized at the initial stages of production. Examples include metals, wood, fabrics, or plastics that are transformed into final products. These materials are typically sourced from various suppliers.
  • Work-in-Progress (WIP): This refers to products that are in the midst of the production process but aren’t yet complete. The costs associated with WIP encompass labor, machinery, raw materials, and other related equipment. Once the production is complete, these costs are shifted to the finished goods account and factored into the cost of sales.
  • Finished Goods: This category denotes the products ready for purchase by consumers. When a product transitions from WIP status, it’s added to the finished goods inventory.
  • Maintenance, Repair, and Operations Goods (MRO): MRO items are essential for the production process but don’t form part of the end product. This category includes items like safety gear, cleaning agents, office essentials, and technological equipment.

Read more: A Step-by-Step Guide to QuickBooks Online Inventory Tracking

The Process of Inventory Management

Inventory management is a systematic approach to sourcing, storing, and selling inventory—both raw materials (components) and finished goods (products). Effective inventory management is crucial for ensuring a business has enough stock on hand to meet customer demand, while also minimizing the costs associated with holding, storing, and ordering inventory. Here’s a breakdown of the process:

  1. Demand Forecasting:
    • Predict the quantity of a particular product that consumers might purchase in a given timeframe.
    • Use historical data, market trends, seasonality, and other factors.
  2. Inventory Ordering:
    • Decide when to order and how much to order using methods like Economic Order Quantity (EOQ).
    • Consider lead time (the time between placing an order and receiving it).
  3. Inventory Receipt and Verification:
    • When inventory arrives, check it against the purchase order to ensure accuracy.
    • Inspect for damaged goods.
  4. Inventory Storage:
    • Organize inventory for efficient picking and packing.
    • Use techniques like FIFO (First-In-First-Out) for perishable items.
  5. Inventory Tracking:
    • Use systems like RFID, barcoding, or manual tracking to monitor inventory levels.
    • Implement an Inventory Management System (IMS) or Warehouse Management System (WMS) for real-time tracking.
  6. Order Processing:
    • When a customer places an order, pick the right items from storage.
    • Pack them securely and dispatch them for delivery.
  7. Inventory Reporting:
    • Regularly analyze inventory levels, sales rates, and reorder points.
    • Generate reports to understand stock turnover, holding costs, and potential stockouts.
  8. Inventory Auditing:
    • Periodically, physically count inventory items to ensure the actual stock matches what’s recorded in the system.
    • Methods include full stock-takes, cycle counting, or spot checking.
  9. Inventory Optimization:
    • Adjust inventory levels based on sales data, seasonal trends, and forecasts.
    • Minimize holding costs while preventing stockouts.
  10. Inventory Disposal and Write-offs:
  • Identify obsolete or slow-moving items.
  • Decide on strategies like discount sales, donations, or disposal.
  1. Continuous Improvement:
  • Regularly review and refine inventory processes.
  • Stay updated with new technologies and best practices in inventory management.

By following this structured process, businesses can ensure they maintain optimal stock levels, reduce costs, and meet customer demand efficiently.

Benefits of Inventory Management

Inventory management, irrespective of whether you’re a budding startup or a large-scale enterprise utilizing an enterprise resource planning (ERP) system, is the backbone of many businesses. It offers a plethora of advantages:

Preventing Product Expiry

Products with a limited shelf life, such as perishables like coffee or tea, require timely sales to prevent spoilage. Effective inventory management ensures these products move efficiently from shelves to customers, thereby reducing waste and ensuring freshness.

Tackling the Dead Stock Dilemma

Dead stock is a silent profit killer. These are items that, due to changing seasons, evolving trends, or shifts in consumer preferences, become unsellable. A proactive and strategic approach to inventory can significantly reduce the accumulation of such stock, ensuring resources aren’t tied up in unsellable products.

Economizing on Storage

The costs associated with warehousing often fluctuate based on the volume and duration of storage. Overstocking, especially of slow-moving items, can lead to inflated storage costs. Efficient inventory management ensures optimal stock levels, leading to significant savings on storage costs.

Optimizing Cash Flow

Inventory plays a dual role, influencing both sales potential and expenditure. An efficient inventory system ensures that you’re not over-investing in stock, thereby freeing up cash for other essential business operations or investments.

Streamlining Order Deliveryhug

In today’s fast-paced world, customers expect swift deliveries. Effective inventory management, especially strategies like inventory distribution across multiple locations, ensures products are closer to customers. This not only reduces delivery times but also cuts down on shipping costs, leading to increased customer satisfaction. Furthermore, a well-managed inventory system ensures that returns are processed efficiently, and products are quickly reintroduced into the sales cycle.

Challenges of Inventory Management

While the advantages of inventory management are numerous, it’s not without its challenges:

The Phantom Stock Conundrum

One of the more perplexing challenges is phantom inventory. This occurs when digital records indicate stock availability, but a physical check reveals a shortfall. Such discrepancies can lead to missed sales opportunities and can skew decision-making processes based on inaccurate data.

Adapting to Fluctuating Demand

The business landscape is dynamic. Events like the pandemic can lead to abrupt changes in consumer demand, catching businesses off-guard. Such sudden shifts can lead to stock shortages or overstock situations, both of which are detrimental to profitability.

Mitigating Supply Chain Disruptions

The global supply chain is a complex web, susceptible to disruptions from socio-political events, natural disasters, or economic downturns. An efficient inventory management system must factor in such potential disruptions and have contingencies, like safety stock, to mitigate their impact.

Overcoming Counting Hurdles

The traditional manual counting of inventory is a mammoth task. It’s not only time-consuming but also prone to human errors. Such errors can lead to misinformed business decisions and potential financial discrepancies.

Organizing Storage Spaces

A cluttered storage space or warehouse can severely hamper operational efficiency. Products may be misplaced, leading to inaccurate stock counts. Moreover, disorganization can slow down order processing, leading to delays in order fulfillment.

inventory management guide

11 Inventory Management Methods 

1. Embrace the Six Sigma Approach

Six Sigma offers a comprehensive toolkit aimed at enhancing business processes. Within the realms of inventory and supply chain management, it’s instrumental in minimizing the write-offs of surplus and outdated stock. Such inventory often finds its way to sales at reduced prices or gets donated, leading to financial losses for small businesses.

Edwin Garro, the visionary behind PXS School of Excellence, which specializes in Six Sigma training and certification, advocates for a structured five-stage approach known as DMAIC to address these challenges:

  • Define: Pinpoint the issue at hand, ensuring it’s quantifiable. For instance, if the challenge lies in erratic tracking, then the measurable metric might be operational efficiency.
  • Measure: Evaluate the existing scenario using basic metrics. Determine the efficiency ratio of inputs to valuable outputs, which will shed light on the core issue.
  • Analyze: Delve into the primary reasons and devise a strategy for their mitigation. Taking the aforementioned example, the central issue might be the dispersion of tracking mechanisms across multiple platforms. A potential solution could be the inception of a unified inventory tracking system.
  • Implement: Roll out the devised inventory strategy, initiating pilot projects to gauge its efficacy. This could involve experimenting with innovative inventory tools or adopting models like hub-and-spoke for swifter product movement.
  • Control: Monitor the revamped process. Employ metrics to ensure the inventory system’s effectiveness and consistency in outcomes. Once success is achieved, it’s time for acknowledgment and celebration!

2. Set par levels

Baseline inventory levels, often referred to as ‘par levels,’ represent the essential quantity of a product that should always be available in stock. If your inventory falls beneath this benchmark, it’s a clear indicator to replenish.

The optimal reorder quantity should ideally elevate your stock back to or above the baseline. These levels aren’t static; they differ based on the product, its sales velocity, and the restocking duration. 

It’s prudent to review and recalibrate these baseline levels periodically throughout the year. Market dynamics change, and so should your inventory strategies. By adjusting these levels as needed, you ensure that your inventory remains balanced and responsive to demand.

3. Follow the first in, first out principle

The First-In, First-Out (FIFO) methodology is pivotal in calculating the Cost of Goods Sold (COGS). In essence, it prioritizes the sale of older stock over newer arrivals. This principle is particularly crucial for items with a limited shelf life, ensuring that products are sold before they reach the end of their usability, preventing potential losses from unsold perishable goods.

4. Cultivate Supplier Partnerships

Maintaining a robust relationship with suppliers is paramount. Whether it’s about returning items that aren’t selling well, quickly replenishing bestsellers, addressing manufacturing hiccups, or seeking additional storage, a strong bond with suppliers ensures smoother problem resolution.

A well-established rapport with suppliers often provides flexibility in terms of order quantities. Instead of sticking to high minimum order requirements, consider negotiating for a reduced quantity, ensuring you don’t overstock.

However, a fruitful relationship transcends mere cordiality. It’s rooted in transparent and proactive communication. Keep your suppliers in the loop about anticipated sales surges or significant purchase orders, enabling them to tweak their production schedules and lead times accordingly. Similarly, encourage them to alert you about potential delays, allowing you to adjust marketing campaigns or seek alternative products.

5. Develop Backup Strategies

Inventory management is riddled with unforeseen challenges that can disrupt even the most organized businesses:

  • A sudden surge in sales leading to stock depletion.
  • Encountering cash flow issues, hindering product procurement.
  • Insufficient warehouse space during peak sales seasons.
  • Inventory miscalculations resulting in stock discrepancies.
  • Excessive storage occupied by stagnant products.
  • Manufacturers running out of a product you heavily rely on.
  • Unexpected product discontinuation by manufacturers.

Challenges are inevitable; it’s the preparedness that counts. Identify potential risks and devise backup plans. Consider the following: How will you navigate these challenges? What corrective measures will you employ? How will these challenges ripple through other business facets? Remember, the strength of your supplier relationships can be a significant asset during such times.

6. Conduct regular auditing

Consistently verifying inventory is crucial. While many businesses lean on warehouse management software to gauge stock levels, it’s essential to ensure that digital data aligns with actual stock. Various techniques can facilitate this:

  • Full Stock Review: This involves a comprehensive count of all items in the inventory. Typically done at the fiscal year-end, it aligns with accounting practices and tax filing requirements.
  • Random Stock Verification: Here, specific items are randomly selected and counted to ensure the recorded numbers are accurate. This unscheduled check complements the full stock review and helps maintain accuracy throughout the year.
  • Rotational Counting: Instead of an annual comprehensive count, this method involves counting different items on a regular basis, be it daily, weekly, or monthly, ensuring that all items are periodically verified over a set timeframe.

7. ABC Analysis

Harness the ABC analysis to segment your inventory, aiding in understanding product movement and order frequency.

The ABC analysis categorizes stock based on its contribution to revenue:

  • A = % of stock that represents 80% of your revenue
  • B = % of stock that represents 15% of your revenue
  • C = % of stock that represents 5% of your revenue

Your A stock represents your most profitable and valuable products. You’ll want to make sure you always have these products on hand so you don’t miss out on future sales.

Your C stock is your slow-moving or dead stock. This is stock you might want to sell at a discount, so you can get it off your shelves and free up cash from your inventory.

8. Practice Accurate Forecasting

Effective inventory management hinges on the ability to anticipate demand with precision. While this task is daunting due to the myriad of influencing factors, striving for accuracy is paramount.

When forecasting upcoming sales, consider the following indicators:

  • Prevailing market trends
  • Sales data from the corresponding week of the previous year
  • Current year’s growth trajectory
  • Assured sales stemming from contracts and subscriptions
  • Seasonal fluctuations and broader economic conditions
  • Forthcoming promotional activities
  • Allocated budget for advertising

Always be open to integrating any additional data or insights that can refine your forecasting accuracy.

9. Adopt the LIFO Approach

The Last-In, First-Out (LIFO) technique in inventory management operates on the premise that the most recently acquired items are the first to be sold. This stands in contrast to the FIFO method.

LIFO is particularly relevant in an environment where prices are on an upward trend. The rationale is that the latest inventory, which is presumably procured at a higher cost, will be sold first. Consequently, elevated inventory expenses result in diminished profits and subsequently reduced taxable income, making LIFO a strategic choice in such scenarios.

10. Embrace the Just-In-Time (JIT) Strategy

The Just-In-Time (JIT) approach to inventory management is tailored for those willing to embrace a bit of risk, though adept inventory practices can significantly reduce potential pitfalls. With JIT, you maintain minimal inventory levels, ensuring you can meet demand and restock just before an item becomes unavailable.

This method demands meticulous planning and precise forecasting. However, it’s particularly effective for burgeoning brands that have regular product launches and expansions.

 11. Outsource Your Inventory Storage And Fulfillment

One of the challenges businesses face in inventory management is the constraint of resources, both in terms of physical storage space and manpower. Ensuring that inventory is efficiently distributed and handling product returns can become overwhelming, especially for growing businesses.

To address these challenges, many businesses opt to outsource their inventory storage and fulfillment. By partnering with third-party logistics providers or fulfillment centers, businesses can leverage the expertise and infrastructure of these entities.

Retail Inventory Management Tips

Retail Inventory Management Tips

For both budding businesses and established retail chains, these inventory management guidelines can be invaluable:

  • Real-time Record Updates: Ensure that your inventory data is updated in real-time. Accurate and up-to-date information is crucial for efficient product movement.
  • Consistent Inventory Audits: Conduct regular inventory checks, both monthly and annually, to maintain alignment between your physical stock and financial records.
  • Evaluate Supplier Performance: Regularly assess your suppliers. Recognize areas for improvement and know when it’s time to part ways.
  • Designate an Inventory Lead: Appoint a dedicated inventory manager. This individual should oversee restocking, liaise with suppliers, and handle invoice payments.
  • Adopt Inventory Management Tools: Invest in a robust inventory management system. Opt for software that seamlessly integrates with your existing business tools and can accommodate future multi-channel sales.

Read more: Top 9 E-commerce Accounting Mistakes to Avoid for Financial Success

The Evolution of Inventory Management

With rapid technological advancements, several emerging tools and techniques are reshaping the landscape of inventory management.

  • RFID: Radio Frequency Identification (RFID) is carving its niche in modern inventory management. Many businesses are already harnessing RFID tags to locate inventory swiftly. These tags can be instrumental in addressing phantom inventory issues and minimizing surplus stock.
  • AI: The realm of Artificial Intelligence (AI) is expanding, with numerous applications in inventory management. Advanced AI solutions that self-adjust can enable businesses to automate inventory-related decisions and respond to real-time customer demands.
  • IoT: The Internet of Things (IoT) can expedite inventory location processes by offering real-time location insights. Such data can also bolster inventory decisions by providing precise stock counts and locations.


Inventory management is more than just keeping track of what’s in a warehouse. It’s a strategic approach to ensuring that a business has the right products, in the right quantities, at the right time. By understanding the benefits, types, and techniques of inventory management, businesses can make informed decisions that boost profitability and customer satisfaction. As technology continues to evolve, the tools and methods used in inventory management will become even more sophisticated, offering businesses greater control and insights into their operations.

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