Choosing the right inventory management strategy can make all the difference in managing working capital. Here’s a rundown of some of the top techniques and their pros and cons.
For many companies, the production of finished goods from basic materials is key to operations. But those goods and materials, referred to collectively as inventory, can be difficult to manage efficiently – especially at scale.
Ineffective management of inventory can be extremely harmful to operational success. If a company finds itself with too little inventory, it may be unable to continue manufacturing or shipping products to match demand. Too much inventory and it will suffer from storage costs that are higher than necessary, reducing the amount able to be spent on fueling growth.
Getting this formula right – ensuring that inventory is always available when needed, but never a burden – is the central aim of inventory management. But, to complicate matters, there’s more than one inventory management strategy to choose from.
What is an inventory management strategy?
Inventory – generally consisting of finished goods, products still in the manufacturing process, and raw materials – needs to be managed appropriately for a company to fulfill orders on time, keep costs under control, and drive growth.
Inventory management is the process of doing just that. It’s a highly flexible operation that dictates how a company orders, stores, uses, and sells its goods and materials.
Making improvements in the way inventory is managed – in other words, having the right products and materials at the right time in the right place – can increase the resilience and efficiency of the supply chain, resulting in lower costs, optimized production, and faster sales.
More efficient inventory management can thereby accelerate the company’s growth, turning inventory into cash more quickly to develop a strong working capital position.
But there is a range of inventory management strategies and techniques that companies can make use of, and choosing the right one is a critical part of achieving success.
The goal of an inventory management strategy is to optimize the management of raw materials and finished products to meet the unique needs of the company. These needs may include ensuring that the company has enough product and materials to fulfill orders, fulfilling orders to a certain timeframe, or minimizing storage requirements.
With inventory management strategies, there is no ‘one size fits all’ approach. Different approaches are suited to different types of businesses, depending on their business model and their working capital goals.
Periodic vs perpetual
Before moving on to look at specific inventory management techniques, it’s first important to understand the different ways of carrying out inventory counts, or measuring inventory. There are two main accounting methods to consider: periodic and perpetual:
- With periodic inventory, a manual count of physical items is undertaken at set intervals, such as quarterly or annually. This can be more cost-effective, and as such may be appropriate for smaller businesses. However, it has the disadvantage of not providing any information for the intervening time periods.
- With perpetual inventory, the measurement of inventory is continually updated. With access to current information about their inventory levels, companies can drive more effective ordering strategies. As such, perpetual inventory provides the most value to larger businesses with greater inventory requirements.
Inventory management strategies
There are various inventory management strategies, and each one operates differently and has diverse pros and cons. Common inventory management techniques include the following:
1. Economic order quantity (EOQ)
Economic order quantity (EOQ) is a metric that looks at all costs related to the purchase and delivery of goods and materials, including discounts and warehousing, while at the same time factoring in demand for the product.
One popular formula for calculating the economic order quantity is:
EOQ = √ [2 * Annual demand in units * Average order cost / Holding costs per unit per year]
- Advantages: Reordering is triggered if inventory levels fall. As such, EOQ minimizes costs while ensuring correct inventory levels are maintained during periods of high or low demand.
- Disadvantages: EOQ does not account for seasonal or other fluctuations. It also assumes immediate availability of new stock, and assumes fixed costs of inventory units, ordering charges, and holding charges.
2. Bulk orders
Buying in bulk (also known as ‘just-in-case’ inventory purchasing) is where a business buys large quantities to supply a forecasted demand. This approach relies on the assumption that buying and receiving inventory in bulk is almost always cheaper.
- Advantages: Bulk orders take advantage of discounts, resulting in a lower cost per unit. Handling and shipping costs may also be lower. As a result, companies can increase their profit margins or drive more competitive pricing.
- Disadvantages: Storage costs are higher, and this approach lacks the flexibility to adapt to changes in demand. If forecasting is inaccurate, cash may be tied up in unnecessary stock with the possibility that obsolete stock will need to be written off.
3. Just-in-time (JIT)
The just-in-time (JIT) inventory system is an inventory management technique designed to minimize waste and increase efficiency by receiving goods only when production is scheduled to begin. For it to work, suppliers need to be extremely reliable, and production must be steady and problem free.
- Advantages: Holding costs are reduced as inventory is minimized, while working capital availability is increased.
- Disadvantages: With little margin for error, unexpected surges in demand can disrupt the system, while problems with suppliers can halt production. As such, there is a risk of stock levels dropping to uncomfortable lows or complete stock outages which can cause difficulties in fulfilling orders. Adopting the JIT strategy also means management and processes need to be highly sophisticated.
4. Safety stock
Safety stock is a method whereby companies deliberately order more inventory than they need. Some can then be set aside as safety stock in order to protect against future stock outages.
- Advantages: This approach mitigates the risk of future supply chain disruptions. As such it is highly resilient in an environment where demand is increasing rapidly, and/or disruption to future supply is likely.
- Disadvantages: Inventory holding costs are higher, while more working capital is tied up in inventory.
Safety stock comes at a cost. However, this can be mitigated with an inventory ownership service such as Taulia’s Inventory Management software solution, whereby Taulia can procure, own and hold safety stock near your destination.
5. ABC analysis
ABC (also known as selective inventory control) categorizes inventory into different classes – typically A, B, and C – according to their importance. Different inventory management strategies are then adopted for each class.
- Advantages: ABC is highly flexible. For example, safety stock can be secured for the most important inventory, with JIT delivery used for the least important. This approach also allows for greater oversight and control over high-cost items.
- Disadvantages: Without agreed-upon standards, categorization can be arbitrary or subjective. ABC may also be costly in terms of time and effort.
Improving approaches to inventory management
Choosing the right inventory management approach means understanding how inventory impacts your business: Can you measure inventory constantly or just occasionally? Are product demand and purchasing costs stable or fluctuating? Are a few key products produced, or does your company produce thousands?
Both shortages and excesses of inventory can have serious consequences for a business. As such, improving inventory management can bring multiple benefits, from minimizing costs to guarding against fluctuations in supply and demand.
Choosing an effective inventory management system is one step that can help companies drive positive change. A system that tracks and manages inventory as it moves through the supply chain can help companies improve visibility over the movement of goods and materials, pinpoint inefficiencies, and ensure that the chosen inventory management approach aligns with the company’s cash flow needs.