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by Shaz K

Inventory Management 101: Your Ultimate Guide

Friday 31, Jan 2020

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Inventory management is a complex and involved process, but it’s also a necessary one. It’s essential to ensure that you have enough inventory on hand. You want to have the equipment your team needs to do their job well and enough product keep the business running smoothly. 

You never want to have the downright terrifying experience of being understocked or finding yourself with a warehouse full of inventory that’s unlikely to sell soon or for a high profit. 

With the right strategies and strong inventory management software in hand, however, this is actually a doable task. 

In this Inventory Management Guide, we’re going to break down everything you need to know about inventory management. This includes what’s involved with the process, the formulas you need to understand your inventory, and how to find the right inventory management method for your business. 

What Is Inventory Management?

Inventory management is the process of the careful assessment of the products that you have or plan to get in stock. This includes tracking which products need to be ordered, which are most profitable, and which sell most frequently.  

True inventory management requires more than simply ordering new inventory when you think you’ll run low. 

Inventory management includes the following tasks:

  • Keeping track of your inventory, including knowing what you currently have in stock. 
  • Identifying which items are used or purchased most frequently, and which items are the most high-value for your business. (You probably don’t want to fill your warehouse with products that sell for low profit or that sit for long periods of time in storage.) 
  • Understanding which items move quickly so that you’re always prepared and never short on supply. 

There are tools that can help you keep track of your current inventory so that you always know what is and isn’t in stock. There are also other tracking methods and formulas that you can use to help you with the rest. 

8 Key Inventory Formulas & Ratios

Inventory formulas and ratios allow you to track everything that’s happening with your products at all levels of the supply chain. They can help you do everything from assessing how much capital you’ve got tied up in your current inventory to successfully predicting product turnover rate. 

These are the 8 essential inventory formulas that most businesses should use: 

Inventory Turnover Ratio

Formula for inventory turnover.

Also referred to as “stock turn,” this ratio tells you how often an individual product is sold and then replaced within a set time period. 

Some products will sell the second you stock them while others may sit for months, if not longer. This formula can help you assess how profitable something is and can help you assess the quantity you’ll need in stock.

Divide sales (cost of goods sold) by inventory (average inventory) for a specific time period.

Cost of Goods Formula

Formula for cost of goods sold

This formula helps you assess the value of your inventory. 

You’ll likely need it for other inventory formulas, but it can also help you assess your current investments and the calculations can be used to claim your inventory as a business expense for your annual tax filing. 

(Cost of Beginning – Year Inventory + Additional Inventory Costs) – Cost of End-Year Inventory = Cost of Goods Sold 

Average Inventory Ratio

The formula for average inventory

You’ll need this calculation to complete the inventory turnover formula, so you’ll likely use it often. It tells you the average inventory that you have on hand, and it looks at what you have at the beginning and end of a set period of time. 

This formula requires you to add your ending inventory and beginning inventory balances together, and divide it. You’ll divide it by 2 if the time period in question is a month, 7 if it’s for an entire season, and 13 if it’s a year.

Take your beginning inventory for a given period of time (usually a month). 

Add that number to your end of period inventory (month, season, or year), and then divide by 2 (or 7, 13).

Days’ Sale Ratio

The formula for Days' Sale Average is visualized.

You use this ratio to calculate the average number of days it takes to move a product. 

You want this metric to be as low as possible; it indicates that you’re selling your inventory quickly. This can also help you manage your purchasing process and help you predict when you’ll need more supply. 

Divide 365 (the number of days in a year) by your industry turnover ratio. The result is your days’ sale average.

Note: If you don’t know your industry turnover ratio, multiply your cost of goods by 365, and then divide your inventory by that number. 

Sell-through Rate

Your sell-through rate helps you assess the overall number of products you’re selling within a set time frame. It’s also useful in the ordering process, and it can help you determine how well your overall inventory translates into direct sales.

Units Sold ÷ Units Received = Sell-Through (%)

Ending Inventory Ratio

The formula for ending inventory is visualized.

This is also known as “closing stock,” and it reveals how much of a product is available at the end of a specific time period, like a week, month, or season. 

This formula can help you see how much inventory you’re moving and if you’re keeping your stock balanced.  It can also be used to assess your financial status. 

(Beginning Inventory + Purchases) – Cost of Goods Sold = Ending Inventory

Reorder Point Formula

The formula for reorder point formula is visualized.

Used to determine the reorder point, which signals when you should order in new inventory. This will be different for each individual product that you have because some move faster than others and some require more time to receive after ordering. Note that the reorder point isn’t foolproof and you can experience rises in popularity for products. Keep an eye on trends in your industry or upcoming holidays and prepare accordingly. 

(Average daily use rate x Lead time) + Safety stock = Reorder Point 

Safety Stock Formula

The formula for safety stock is visualized.

Safety stock is the extra “emergency” stock you have on hand in case unforeseen events put them close to the point of selling out.

In Florida, for example, particularly stormy summers might result in a surge of customers requesting new windshield wipers. The trick here is finding the right balance so you have enough to get through spikes in demand, but not so much that they don’t sell quickly enough and that you’re likely to lose profitability. 

(Maximum daily usage x Maximum lead time in days) – (Average daily usage x Average lead time in days) = Safety Stock Formula 

What Are Inventory Control Methods? 

Inventory control methods are different techniques used to help you squeeze the most profit out of your inventory, in addition to simply knowing what stock you have on hand and when you need to order more.

You can use these methods to prevent low stocks and backorders, and to ensure that nothing is sitting on the shelves so long it’s costing you money instead of earning it. They’ll help you track high- and low-value products, and look at what’s sitting the longest. Inventory control actually reduces your labor costs, because the inventory is where it should be, the process is organized, and there’s no scrambling involved. 

Let’s take a look at a few common inventory control methods so you can see what’s right for you. As you’re doing so, keep in mind that all of these methods are most effective when used alongside the right inventory management tool

Economic Order Quality

The formula for economic order quantity is displayed.

The Economic Order Quantity (EOQ) method is incredibly popular, partially because it’s tried-and-true and has been around for quite some time. EOQ tells you the number of inventory units that you should order at once in order to reduce costs based on the factors of company holding costs, ordering costs, and the rate of demand. 

It costs money to store your inventory for long periods of time, if for no other reason than you could otherwise stock inventory that moved quicker. That being said, ordering costs need to be taken into account, too, because typically, the more you order, the better the price per piece.

Your EOQ can be found by calculating two times your setup order costs (S) and the demand rate, or number of units (D) and dividing it by the production costs. 

(2x Setup order costs x Demand rate) / Production Costs = EOQ 

While the EOQ inventory control method is popular, it doesn’t work for every company. It’s assuming that the rate of demand, unit price of inventory, and ordering costs are all constant, but that typically isn’t the case forever. If any of these factors fluctuate, you need to recalculate. 

Hospitals, for example, can use the EOQ inventory for some of their products, but not others. The demand for fresh hospital gowns, scrubs, and standard medications like anti-nausea meds will all be consistent; the standard costs of the product and the ordering fees will be steady, too. 

That being said, hospitals and pharmacies wouldn’t be able to use the EOQ control method for certain medications. If there’s a spike in flu cases or a new virus that hits an epidemic level, hospitals may see a dramatically increased demand for vaccines.

Inventory Production Quantity 

Formula for inventory production quantity.

This method is also known as Economic Production Quantity (EPQ). It tells you the number of products that your business should order in a single batch to reduce both holding and setup costs. It’s working off the assumption that each order is delivered by your supplier in parts to your business, as opposed to a full product. 

If this sounds similar to the EOQ model, that’s because it is… it’s essentially an extension of it. The key difference here is that the EOQ model assumes suppliers are delivering your inventory in full instead of in parts. 

Businesses in the auto industry, for example, typically receive orders from suppliers in parts. These parts may or may not come from different manufacturers.  

This model should also only be used if the demand for product is relatively consistent over time. If you’re running an auto repair shop, for example, this would likely work well, as most car maintenance requirements stay pretty consistent over time. 

This calculation is complicated to explain through text, so we’ll let the formula speaks for itself.

Take the square root of (2 x Setup costs x Demand rate) / Yearly housing cost per product (1- [Yearly demand rate / Yearly Production Rate])

ABC Analysis Using the Pareto Principle 

ABC analysis allows you to sort your inventory based on the value of specific inventory, where the value is all about how much money each specific product brings you. 

Using this method, your entire inventory will be broken down into groups A, B, or C. These groupings will help you determine the number of specific products you should have in store at any one point. 

You can categorize your inventory using the Pareto Principle, which is also known as the “80/20 rule.”

 It dictates that the highest-value, slowest-moving products should only make up a small percentage of your inventory and that it should have the most attention to ensure it’s never out of stock. Meanwhile, the lower-profit products that sell consistently should make up a bigger chunk of your inventory, especially since they don’t require careful attention for ordering. 

You can see the breakdown here:

  • Category A. This inventory brings in the most money but is only a small amount of your total inventory. It should ideally only make up 20% of your in-stock inventory because it may not sell as frequently or consistently. Despite only making up around ⅕ of your inventory, it accounts for around 70% of your total revenue.
    Though it’s only a small portion of your stock, pay these products the most attention and ensure that you’re never close to running out. 
  • Category B. This inventory isn’t vital for your business, but it does matter. It sells well, and with good profit margins. It should make up about 30% of your supply and account for around 25% of your revenue.   
  • Category C. You might think that category C matters least, but it does still matter. These products aren’t the most high-value, but they are consistent sellers, and can help bring people to the store.
    Ordering controls are more relaxed here, as these items will make up 50% of your stock and yield 5% of total revenue.  

ABC analysis is a great inventory control method to use because it helps you identify and prioritize the inventory that yields the highest profit.

 A jewelry store, for example, will have a range of products at different price points. They can sell a $10,000 diamond ring and see $1000 in profit, but these may only sell once every few days. They also have sterling silver charms for charm bracelets that cost $50 and earn $5 in direct profit, but they might average 15 sales a day. 

The only downside to ABC analysis is that the inventory must be categorized correctly for the method to work. If it doesn’t, you’ll put your inventory control attention on products that aren’t yielding the most profit. 

Just In Time vs. Just In Case Inventory 

Just In Time and Just In Case are two different inventory control methods that determine when you should order more inventory. Let’s take a look at the difference between the two. 

Just In Time Inventory

Just In Time inventory management prioritizes keeping your inventory as low as possible, only ordering when there’s a buyer ready. It’s designed to increase efficiency, minimize holding times, and reduce waste. 

By minimizing inventory, you’re preventing buying inventory that never sells, resulting in lost profit. You’ve also got more of your working capital freed up for other needs. 

For big-ticket items like engagement rings, for example, some jewelry stores will order in specific settings in an individual buyer’s size along with diamonds that meet what the customer is looking for. This prevents waste because they don’t order in every setting in every size (some of which will inevitably go unpurchased), and it allows for more customization in the long run. 

For some auto repair shops, Just In Time inventory will be most useful for specific parts. There might be airbags that are only compatible with a car that’s ten years old, and it’s unlikely that anyone would come in needing them. Ordering them when needed is likely the preferable solution to having something on hand you’ll likely never use. 

Here, your suppliers must be reliable, and you need steady production. If you have a customer place an order and you tell them two weeks to get their product in, the last thing you want is to call the supplier and find out you’ll have to wait four months to receive what you need now.

If you opt for Just In Time Inventory management for some or all of your inventory, remember that you need an inventory management system that’s flexible. 

Just In Case Inventory 

The opposite of Just In Time Inventory, of course, is the Just In Case approach. Here, businesses will order inventory preemptively, keeping larger inventories on hand. The goal here is to minimize the chance that you’ll run out of stock and risk losing a sale.

A computer repair store, for example, knows that they’ll almost certainly need a few key parts on a regular basis, including laptop batteries, hard drives, and equipment for screen repairs. If they keep all of these items in stock, they’ll be able to potentially do same-day or next-day repairs, as they won’t have to order in the needed inventory. 

While you’re at low risk for running out of your supply, the higher storage costs can be a downside here. 

Just In Time management is a popular method, but plenty of businesses prefer using the Just In Case method instead. It all comes down to your business and what works best for you. 

Different Inventory Tracking Methods to Consider 

There’s one last major part of inventory management that we need to talk about, and that’s how you’re actually going to track the inventory that you have in stock. 

Some businesses, for example, prefer to use a manual excel sheet, while others use RFID scanners hooked up to complicated inventory management programs, or opt for mobile systems that are more flexible.

Here are the more popular inventory tracking methods to choose from: 

Manual Data Entry with Excel Sheets 

Some small businesses don’t want to go through the hassle of learning a traditionally-complicated inventory management tool (or to pay for one). As a result, they stick to using manual excel sheets. This system is simple and it’s undeniably cost-effective. That being said, it’s prone to human error and doesn’t work well once your inventory starts to scale. 

Manual Daily Audits

If you prefer sticking to a manual approach but want to double-check your inventory regularly, daily audits may be a good option. 

During daily audits, you’ll go through your entire inventory and review what you currently have, ensure it’s in place, and assess whether you need to order more.

Unfortunately, any manual method is prone to human error; even with daily audits, things get missed, which can risk you running low on stock. It’s also worth pointing out that daily audits take up an enormous amount of time that could be better put to other tasks.

Daily audits can be used to monitor high-value inventory and ensure that everything is as it should be, but it works best with other systems.

Using Specialized Inventory Management Tools 

 There are plenty of inventory management tools and apps available.
Some businesses will opt for systems using RFID scanners, which will physically scan products during a check-in or checkout process to track your current inventory. These systems can be complicated to use and expensive to set up.

An increasing number of businesses are opting for more
intuitive, user-friendly mobile apps. These tools keep track of your current inventory, where you can quickly view product images, details, pricing, and more. You can easily process sales manually or by using a camera on your mobile device to scan barcodes, so there’s plenty of flexibility with how you want to use it. And if you’re worried about something getting missed in terms of inventory control, you don’t need to; you’ll get low stock alerts that you can customize for each product. 

No matter how much inventory you have on hand or how big your business is, keep in mind that almost all businesses will benefit immensely from using a flexible inventory management tool. You absolutely want to reduce human error and improve efficiency during this process. Sortly’s got you covered there; learn more about what we can do for you here

Conclusion 

Sortly inventory management software is displayed on a computer, tablet and smartphone.

A well-managed inventory is much more likely to be a profitable inventory, and having the right strategies and tools in place will be essential to helping your business thrive.

That means you want to invest the time and energy into inventory management, even though it can be a giant pain. Trust us, we know. We created Sortly specifically with the goal of making inventory management easier, more effective, and less maddening.

Looking for a better way to manage your inventory? Start your free trial of Sortly now.

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