Inventory Management: Definition, How It Works, Methods & Examples

What Is Inventory Management?

Inventory management refers to the process of ordering, storing, using, and selling a company's inventory. This includes raw materials, components, and finished products, as well as the warehousing and processing of these items. There are different methods of inventory management, each with its pros and cons, depending on a company's needs.

The Benefits of Inventory Management

A company's inventory is one of its most valuable assets. In retail, manufacturing, food services, and other inventory-intensive sectors, a company's inputs (such as raw materials) and finished products are the core of its business. A shortage of inventory when and where it's needed can be extremely detrimental.

At the same time, inventory can be thought of as a liability (if not in an accounting sense). A large inventory carries the risk of spoilage, theft, damage, or shifts in demand. Inventory must be insured, and if it is not used up or sold in time it may have to be disposed of at clearance prices—or simply destroyed.

For these reasons, inventory management is important for businesses of any size. Knowing when to restock, what quantities to purchase or produce, and when to sell and at what price can easily become complex decisions. Small businesses will often keep track of stock manually and determine the reorder points and quantities using spreadsheet (Excel) formulas. Larger businesses may use specialized enterprise resource planning (ERP) software. The largest corporations use highly customized software as a service (SaaS) applications. Companies are also calling on artificial intelligence to optimize these processes.

Appropriate inventory management strategies vary depending on the industry. An oil depot is able to store large amounts of inventory for extended periods of time, allowing it to wait for demand to pick up if necessary. While storing oil is expensive and risky—a fire in the U.K. in 2005 led to millions of pounds in damage and fines—there is no risk that the inventory will spoil or go out of style. For businesses dealing in perishable goods or products for which demand is extremely time-sensitive—2024 calendars or fast-fashion items, for example—sitting on inventory is not an option, and misjudging the timing or quantities of orders can be costly.

For companies with complex supply chains and manufacturing processes, balancing the risks of inventory glut and shortages is especially difficult. To achieve these balances, they may call on several methods for inventory management, including just-in-time (JIT) and materials requirement planning (MRP).

Accounting for Inventory

For accounting purposes, inventory represents a current asset since a company typically intends to sell its finished goods within a short period of time, usually no more than a year. Inventory has to be physically counted or measured before it can be put on a balance sheet. Companies often maintain sophisticated inventory management systems capable of tracking inventory levels in real time.

Inventory can be accounted for in several ways: first-in-first-out (FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing. An inventory account typically consists of four separate categories: 

1. Raw materials represent the various materials a company purchases for its production process. These materials must undergo significant work for a company to transform them into a finished good ready for sale.
2. Work in process (also known as goods-in-process) represents raw materials in the process of being transformed into a finished product.
3. Finished goods are completed products readily available for sale to a company's customers.
4. Merchandise represents finished goods a company buys from a supplier for future resale.

Inventory Management Methods

Depending on the type of business or the product involved, a company may use various inventory management methods. These include just-in-time (JIT) manufacturing, materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).

While there are others, those are the four most common methods used to manage inventory. Here is how each one works.

1. Just-in-Time Management (JIT)

This manufacturing and inventory management model originated in Japan in the 1960s and 1970s. Toyota Motor (TM) is credited with contributing the most to its development. JIT allows companies to save significant amounts of money and reduce waste by purchasing and keeping on hand only the inventory they need to produce and sell products within a certain time frame. This approach reduces storage and insurance costs, as well as the cost of liquidating or discarding excess inventory.

JIT inventory management can be risky. If demand unexpectedly spikes, the manufacturer may not be able to source the inventory it needs to meet that demand, damaging its reputation with customers and driving business to competitors. Even the smallest delays can be disruptive; if a key input does not arrive "just in time," a bottleneck can result.

2. Materials Requirement Planning (MRP)

This inventory management method is sales-forecast dependent, meaning that manufacturers rely on detailed sales records to anticipate their inventory needs and communicate those needs to suppliers in a timely manner. For example, a ski manufacturer using an MRP inventory system might ensure that materials such as plastic, fiberglass, wood, and aluminum are in stock based on forecasted orders. Inability to accurately forecast sales and plan inventory acquisitions will result in the manufacturer's inability to fulfill orders.

3. Economic Order Quantity (EOQ)

This model is used in inventory management by calculating the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory while assuming constant consumer demand. The costs of inventory in the model include holding and setup costs.

The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand. It assumes that there is a trade-off between inventory holding costs and inventory setup costs, and total inventory costs are minimized when both setup costs and holding costs are minimized.

4. Days Sales of Inventory (DSI)

This financial ratio indicates the average time in days that a company takes to turn its inventory, including goods that are a work in progress, into sales. DSI is also known as the average age of inventory, days inventory outstanding (DIO), days in inventory (DII), days sales in inventory, or days inventory and is interpreted in multiple ways.

Indicating the liquidity of the inventory, the figure represents how many days a company's current stock of inventory will last. Generally, a lower DSI is preferred as it indicates a shorter duration to clear off the inventory, though the average DSI varies from one industry to another.

Inventory Management Red Flags

If a company frequently switches its method of inventory accounting without reasonable justification, it is likely its management is trying to paint a brighter picture than reality would indicate.

Frequent inventory write-offs can mean that a company is having issues with selling its finished goods or with inventory obsolescence. This can also raise red flags regarding a company's ability to stay competitive and make products that appeal to consumers going forward.

The Bottom Line

Inventory management is a crucial part of business operations. Proper inventory management depends on the type of business and the products it sells. There may not be one perfect type of inventory management because there are pros and cons for each. But taking advantage of the most appropriate type of inventory management can go a long way toward ensuring a company's success.