What Is Inventory Management?

Jim Hearson | Content Strategist | June 6, 2024

In This Article

Inventory ties up a company’s cash and incurs carrying costs, so all businesses look to strike a balance between inventory levels and demand. Whatever the type of organization, companies must maintain tight control over inventory to conserve cash while maintaining enough stock to meet production schedules or actual orders and forecasted customer demand. This is where inventory management comes into play.

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. Inventory management is generally performed at two levels: aggregate inventory management and stocking location and item-level inventory management.

Key Takeaways:

  • Inventory management requires striking a balance by having enough stock to meet production schedules and demand, but not so much that funds are tied up in carrying costs.
  • As well as saving money, strong inventory management practices can help businesses increase efficiency, improve financial reporting, mitigate risk, cut waste, and maintain good relationships with suppliers and customers.
  • Different industries have their own challenges when it comes to managing inventory; for example, restaurants need to consider perishable ingredients in a way that car manufacturers don’t.
  • The more inventory data that can be collected, monitored, and analyzed, the more efficient inventory management can be.
  • Automating the inventory management process with a cloud-based system allows many organizations to track stock more accurately from purchase to production and sale.

Inventory Management Explained

The procurement or purchasing department must source the required goods from reliable suppliers and purchase new inventory with the right documentation to reduce delays—while also striving not to tie up excess cash in unsold inventory or incur carrying costs.

Inventory managers are responsible for ensuring stock is at a level that meets customer demand and complies with the organization’s inventory policies, which dictate how much inventory is stored and where. These policies also cover how the business will assign costs to inventory—via costing methods such as first in, first out and first in, last out—and value inventory, using methods such as ABC classification to help focus on profitable items.

Importance of Inventory Management

Inventory management is important because it helps ensure the company has enough stock on hand to meet customer demand without keeping so much that it incurs unnecessary costs or detracts from operational efficiency. For example, overstocking inventory can result in excess carrying costs, or the costs associated with storing, transporting, and handling inventory. By employing inventory management best practices to optimize stock levels, businesses can reduce these and other extraneous costs while safeguarding customer satisfaction.

Areas where inventory management can be an important factor for businesses include the following:

  • Cost control
  • Cash flow
  • Customer satisfaction
  • Production efficiency
  • Risk mitigation
  • Financial reporting
  • Competitive advantage
  • Waste reduction
  • Supplier relationships
  • Strategic decision-making
  • Inventory visibility

We will look at how each of these can be optimized by good inventory management processes in the benefits section below.

Types of Inventory

Inventory can be broadly classified into three categories: raw materials/components, work in progress, and finished goods.

  • Raw materials/components
    Manufacturing companies purchase raw materials or components and store them until they’re ready for production. For example, a car manufacturer might purchase aluminum, steel, and glass to build a car frame, while also purchasing finished components such as computer chips and engine parts from suppliers.
  • Work in progress (WIP)
    Manufacturing companies transform their raw materials and components into finished goods. WIP inventory is in production and not ready for customer purchase. In our car manufacturer example, this could be an engine that has been completed in one factory but needs to be transported to another site to be put into the vehicle.
  • Finished goods
    In a manufacturer’s process, this is the final stage of inventory where it’s ready to be sold—for example, cars taken fresh off the production line and sent straight into dealerships for customers to buy. Nonmanufacturing companies, such as wholesale distributors and retailers, stock finished goods for sale to final consumers.

There can be crossover between WIP and finished goods, depending on the inventory’s intended purpose. For example, while external car paneling is considered WIP within a factory that intends to install it in a vehicle, it can also be viewed as a finished good if it’s destined to be sold as-is to auto repair shops.

How Does Inventory Management Work?

Once an organization has set its inventory management policies, inventory cycles through five stages.

  1. Order the required inventory from suppliers, checking the quality and quantity of what is received to ensure stock levels are where they need to be.
  2. Store the inventory as required; are there perishable goods that need to be used first or popular components that need to be quickly at hand?
  3. Monitor consumption. For manufacturers, production requires raw materials and components, so teams monitor inventory use rates to inform future purchasing decisions.
  4. Sell finished goods, adjusting documented inventory levels so it’s clear how many units are left in stock.
  5. Restock the materials required to begin the process again, using data collected in the earlier stages to avoid over- or understocking.

Benefits of Effective Inventory Management

Effective inventory management helps businesses fulfill orders accurately and quickly, thus maintaining customer satisfaction. It also helps them reduce costs and boost cash flow. All these benefits contribute to higher profitability.

  • Accurate, timely order fulfillment. A real-time view of stocking levels and stock location helps businesses better manage production schedules and customer order processing. For example, if a delivery is held up due to transportation problems, managers can cover the temporary shortfall by shifting stock from one distribution center to another where higher demand levels warrant more inventory.
  • Cost control. Keeping inventory on hand incurs costs related to storage, labor, transportation, and more. These inventory-related costs, or carrying costs, tie up cash that could be invested elsewhere. Inventory management helps companies stay in the stocking sweet spot: holding just the right amount of stock that can be turned quickly into profit, without understocking and compromising production or delivery.
  • Cash flow. Effective inventory management can allow for high inventory turnover, which indicates how efficiently stock is sold and returns cash to the business. This consistent cash flow bodes well for a company’s liquidity, flexibility, and general financial wellbeing.
  • Customer satisfaction. Running out of inventory or delaying order delivery can sour relationships with customers. Managing inventory levels to avoid stockouts and enable orders to be fulfilled quickly can increase customer retention, boost satisfaction, and ultimately attract even more purchasers.
  • Production efficiency. By tracking inventory, managers can anticipate stockouts of raw materials and components. They can then shift production to other items or move personnel or equipment to another manufacturing site as needed to optimize production.
  • Risk mitigation. Strong inventory management helps protect a business from the effects of supply chain issues, such as manmade or natural disasters and supplier disruptions. Businesses can mitigate such risks by maintaining an appropriate amount of safety stock and establishing alternate strategies, such as shifting production (as mentioned earlier).
  • Financial reporting. Effective inventory management can boost cash flow, which plays a crucial role in the financial health of a business. Close monitoring also helps ensure that the balance sheet accurately reflects the value of the business’s inventory while the income statement accurately reflects profits.
  • Competitive advantage. Each benefit of inventory management works together to give businesses a significant competitive advantage. Marginal gains in cost effectiveness, efficiency, and quality add up to a stronger overall market position. That may stem from a reputation for consistently delivering quality products on time, or the ability to undercut competitors by keeping overhead costs—and, therefore, prices—low.
  • Waste reduction. Particularly when working with perishable items, effective inventory management allows as much raw material as possible to be transformed into finished goods. For instance, food manufacturers can make sure ingredients don’t expire before they can be used. Inventory management also helps reduce obsolescence, when inventory becomes too old to be used or sold.
  • Supplier relationships. Businesses with strong inventory management can give their suppliers more accurate forecasts about when they’ll need more inventory, which helps those suppliers plan their own production more effectively. Consistent, predictable orders also can help suppliers maintain financial health, building goodwill between the two parties.
  • Strategic decision-making. Effective inventory management requires analyzing not only inventory levels but also inefficiencies and trends. This helps companies create more accurate forecasts regarding the mix of inventory to produce and stock at a given time, then plan their use of resources accordingly. As a result, businesses can reduce waste, cut costs, and continue to foster strong customer relationships.

    Challenges in Managing Inventory

    Inventory management involves making trade-offs between revenue, cost, and risk. This can present a range of financial and logistical challenges for businesses aiming to stay on top of their stock levels.

    • Because it’s classified on the balance sheet as a current asset, inventory consumes company cash. As such, businesses have to pay careful attention to the length of the cash conversion cycle—i.e., the time between purchasing raw materials (for a manufacturer) or merchandise (for wholesaler or retailer) and the final sale of finished products.
    • Inventory management also requires rigorous costing to support internal management reporting and statutory financial reporting. Inventory costs used in production must comply with absorption costing methods for allocating both direct and indirect labor, as well as overhead, to products as they take shape on the production line. And the finished goods—also referred to as merchandise inventory—require the allocation of any costs accrued preparing them for sale.
    • Along with labor, transportation and other handling expenditures need to be considered, as the sum of all inventory across the company will be used to determine the inventory line item on the balance sheet and the cost of goods sold on the income statement.
    • Tracking inventory manually makes it virtually impossible to see stock levels in real time, which is crucial to fulfillment, production, and sales plans. Without a consistent view of stock levels, it’s also difficult to make strategic decisions for the future, such as where to store inventory among multiple warehouses to minimize transportation costs and better serve customers.
    • Variable consumer demand can also be a nightmare for inventory managers, as a sudden spike or slump could unravel a previously smooth inventory management process. The damage can be compounded if technology systems aren’t integrated—for example, if production isn’t in the loop about inventory that has been sold, they may not be able to proactively replenish it and avoid a stockout. Businesses combat this by determining the economic order quantity, or the ideal order size required to meet demand without overspending. They also calculate the necessary level of safety stock, establish the lead time to order, and determine their reorder point.
    • Perishable stock adds another layer of complexity to inventory management, as it introduces a limited time frame for storage. In addition to accurate labelling and tracking, perishable inventory can also require frequent physical movement to ensure it’s in the most appropriate location for use when required.
    • Finally, inventory management requires minimizing waste in the form of stock that expires or becomes obsolete before it’s sold. Production can also incur waste—for example, offcuts generated while making furniture—as can overproduction and mishandling of inventory during transit.

    Examples of Inventory Management

    While inventory management is common across most industries, there are those with unique requirements that warrant specialized systems. Notable examples are retail and food service (I.e., restaurants).

    Retail Inventory Management

    Today, retailers must offer flexible customer buying options for goods that are sold through different channels. Intense competition from large ecommerce vendors and increasingly demanding customers have forced retailers to operate a mixed business model that combines brick-and-mortar stores with online buying experiences. This is referred to as omnichannel retail.

    Omnichannel retail provides buyers with flexible options, such as order in store; ship to home; buy online, return in store; and ship from a distributor to a store for pickup. The goal is to deliver an excellent end-to-end customer experience that could mean the difference between success and going out of business.

    To provide the best customer experience through an omnichannel approach, retailers need real-time visibility into their on-hand stock to ensure that the customer shopping experience results in orders. Stockouts prevent specific orders from being filled and can drive frustrated customers to look for similar items at a competitor’s store or website. Today, loyalty is fleeting and brand switching is common. Those lost customers may never return, affecting potential future sales.

    In light of this, retailers must stock enough inventory to fill the highest possible percentage of their customer orders but not so much that it strains their cash flow and results in unsellable, leftover stock at the end of a buying season. Retail inventory management software, combined with order management systems, allows retailers to swiftly react to changes in buying behavior and adjust their channel strategies and inventory levels.

    Restaurant Inventory Management

    Restaurant inventory management requires real-time ingredient monitoring, since many ingredients are fresh with short shelf lives and must be carefully tracked through to consumption. The system must also carefully monitor stock levels, trigger restocking orders, record new inventory receipts, and help manage menu costs.

    Managing fresh ingredients poses inherent challenges. At best, spoilage results in wasted money. In the worst cases, it can cause food poisoning, thereby triggering actions from health authorities and potentially serious reputational damage.

    Restaurant inventory management software can help restaurants manage their unique challenges. By automatically connecting sales with inventory levels, restaurants can have a complete view of orders, consumption, and insight into ingredient stock levels, helping to avoid spoilage and manage their margins. Inventory management software can also help reduce time spent on administrative tasks by sending alerts to managers about potential shelf-life expirations and automating reorders when items pass their spoilage dates or fall below set replenishment levels.

    Types of Inventory Management Systems

    Businesses employ a variety of inventory management systems depending on their operations, complexities, or needs. The three primary inventory management systems are manual, periodic, and perpetual. Perpetual systems are the most advanced and accurate inventory management systems, whereas the manual method is the least sophisticated way to oversee inventory operations.

    Manual Inventory System

    This inventory management method depends on physically counting items as they move in and out of the business and recording the details on paper or in a spreadsheet. This process is widely used by small businesses that have not moved to inventory management software solutions.

    Periodic Inventory System

    This inventory management system involves physically counting inventory at specific time intervals, such as weekly, monthly, or yearly. It typically includes simple technologies, such as hand-held barcode scanners, and the data is entered into inventory tracking software. Smaller businesses with fewer goods typically use periodic inventory tracking, but this system is also prevalent in non-commercial enterprises, such as healthcare or the public sector.

    Perpetual Inventory System

    This is the most sophisticated system, using automated software solutions to deliver real-time insights. When any stock enters a facility or is moved, sold, used, or discarded, the business tracks and updates the inventory count via shipment tracking numbers, barcodes, RFID tags, and other automated methods. This process can include machines such as scanners and conveyor belts. The data is fed automatically into an inventory management system, so inventory managers can readily see key indicators such as items on hand, shipment delays, low-stock warnings, backordered goods, and goods in transit.

    Radio frequency identification (RFID) is a tracking technology that supports inventory management efforts. RFID systems use specialized tags attached to every item, or group of items, to collect and track location data. RFID simplifies inventory management by scanning newly arrived or outbound shipments using fixed or mobile scanners. RFID tags can be active, continually broadcasting a signal, or passive, requiring physical readers to track items. RFID tags are ideal for providing real-time information on exactly where inventory is at all times.

    The Future of Inventory Management

    The development of inventory management doesn’t end with RFID tags. Digitalization and automation are only going to become more significant factors in the field, benefitting the companies that invest in them.

    Other developments that are shaping the future of inventory management include the following:

    • Artificial intelligence. AI-driven inventory management systems can analyze reams of data in real time to help determine optimal stock levels, help ensure inventory numbers are accurate, and efficiently allocate resources based on current orders and demand forecasts. They can also make recommendations to help managers make more-informed decisions, faster.
    • Internet of Things. Internet of Things (IoT) technology brings networks of sensors, software, and other technology to bear to improve inventory management. For example, inventory can be equipped with sensors that monitor location and track temperature in real time, logging the results in an inventory management system and alerting teams if temperatures threaten spoilage.
    • Blockchain. Inventory managers can use blockchain solutions to track goods along every step of the production process—from raw materials to finished products—by creating an immutable ledger of intercompany transactions. This traceability helps business partners verify authenticity, quality, and compliance to prevent issues such as contaminated raw materials or fraudulent components. Blockchain can also help companies avoid suppliers that violate regulatory, ethical, or sustainability requirements—for example, companies that employ child labor or fail to comply with global trade regulations.
    • Intelligent order management. These technology solutions use AI to help orchestrate orders across multiple systems, simplify product configuration, and improve dynamic pricing and global order promising. Inventory managers can also leverage AI to analyze current and predicted trends to help automate material orders and allocate resources to proactively keep up with demand.

    Manage All Types of Inventory in One Place with Oracle

    As a modern, cloud-based inventory management system, Oracle Fusion Cloud Inventory Management provides comprehensive stock tracking and organization capabilities to effectively manage the flow of goods across companies and global supply networks.

    In conjunction with warehouse management systems, Oracle Inventory Management provides accurate and timely visibility into inventory levels, restocking plans, and order fill rates—all of which impact the customer experience. Combined with supply chain planning systems, Oracle Inventory Management takes the guesswork out of inventory management by matching demand with supply. The system helps to optimize stocking levels, increase order fill rates, facilitate on-schedule production runs, and improve operating cash flow. Comprehensive dashboards, reports, and integrated AI support proactive decision-making so organizations can stay ahead of disruption and formulate detailed purchasing and sales plans for the coming months and years. The system can scale along with businesses, as it’s capable of maintaining healthy sales and customer satisfaction amid any level of growth.

    Inventory Management FAQs

    What is the meaning of inventory management?
    Inventory management is the practice of tracking the amount, location, quality, and other attributes of a company’s stock from initial purchase to the sale of finished goods. Companies use inventory management to help production processes work efficiently, maintain enough stock to fulfill customer orders, and minimize costs.

    What are the 3 types of inventory management systems?
    The three types of inventory management systems are manual, periodic, and perpetual. In a manual system, teams count stock by hand and update records on paper or in spreadsheets. In a periodic system, staff members record stock at a single point in time—say, monthly or quarterly—typically using barcode scanners and inventory software. In a perpetual system, machines continuously scan shipment tracking numbers, barcodes, or RFID tags to track inventory movement, and the inventory management system is automatically updated as goods are received, ordered, picked, and shipped.

    What are the 5 main steps in inventory management?
    The five main steps in inventory management can be summarized as order inventory, store inventory, commence production, sell the finished goods, and reorder stock. Exactly how each stage is carried out depends on the requirements and policies of the industry or organization.

    What is the main purpose of inventory management?
    The main purpose of inventory management is to ensure that ideal volumes of raw materials, works in progress, and finished goods are in the correct locations at the correct time to maximize profits and keep customers happy via fulfilled orders.

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