Developing an Inventory Management Strategy

In any thriving retail business, inventory levels are continually changing. Stock intakes, sales, returns, as well as damage to stock and theft all affect inventory. Keeping track of all of these moving pieces is a challenge to any business.

Efficient inventory management is crucial to the success of any retailer. Bad inventory management leads to lost sales due to stockout issues, cancelled shipments, or items placed on backorder.

You need the right inventory management system to handle this critical part of your retail operations.  

Inventory Management Systems

What is an inventory management system? It is a specific configuration of technology, processes, and procedures working together to monitor and maintain stock levels.

This could, of course, be done manually. But in the modern retail environment, this gives too much room for human error. What you need is an automated system that  can streamline all of your routine inventory management tasks—thus boosting accuracy and limiting error.

With the right system in place, you will be able to fulfil orders accurately, efficiently, and consistently. This will keep your customers happy and avoid unnecessary lost sales.

An efficient inventory management strategy will help you take care of all inventory—whether finished products or raw materials—from the moment it enters your stores until delivered to customers or vendors.

Inventory Management Techniques

As more inventory flows through your supply chain, the management of inventory becomes increasingly complex. So as your business grows, it becomes more important to use the right techniques and tools to manage your inventory.

There are several systems which you can use for inventory management. The ultimate goal of these tools is to improve the efficiency of your inventory management—which will result in more satisfied customers.

What follows are some of the inventory management techniques that businesses have used with much success to run their inventory. Use this information as a guide to choose the right combination of inventory management strategies for your business.

1. Economic Order Quantity (EOQ)

The economic order quantity (EOQ) is the most ideal amount of merchandise a company should buy to keep inventory costs to the minimum.

The goal is to curb spending by figuring out the absolute maximum number of product items a company needs to buy to do business.

A benefit of this system is that it's customizable according to the needs of a business. For example, the EOQ model might suggest buying more of an item to earn a discount, or to save on increased shipping costs that would have resulted from multiple purchase orders.

2. ABC Analysis

The ABC analysis separates products into distinct groups based on their profit margins, earning potential, and inventory cost.

A typical application is to assign all the most profitable and valuable products to group A and all the least valuable products to  group C. Group B is reserved for products that fall somewhere in the middle between the most and least valuable product lines.

Since the products in group A are treated separately, the ABC analysis allows a company to have better oversight over their high-value product lines.

You have to sell a lot of group C products to turn a profit, so individual items of this product don't matter that much to the company.

Separating the two helps you make better decisions with regards to stock purchases in order to increase profits and lower costs.

3. Just-in-Time (JIT)

This well-known inventory management technique couples the purchase or raw materials to accurately timed production schedules. New products and raw materials are only ordered when they are truly needed. Which means they won't clog up warehouse space or turn into dead stock.

The JIT strategy is a surefire way to minimise waste and maximise efficiency. It will cut inventory costs, streamline your supply chain, and increase your overall business productivity.

There are risks involved with this technique. Your planning has to be excellent and you need healthy relationships with suppliers. This is because any bottlenecks in the supply chain will have serious consequences for your business.

4. Safety Stock

Safety stock is in some ways the opposite of the JIT strategy. Here, the company orders more stock than needed as a buffer against stockouts.

In the retail industry, anything can go wrong and it's not always possible to make accurate sales forecasts. The safety stock acts as an insurance policy against  disruptions in supply, customer demand, or manufacturing yield.

In this way, the business will always have enough stock on hand to sell regardless of circumstance. This will prevent loss of sales due to unforeseen demand or unexpected supplier difficulties.

5. Reorder Point (ROP)

The Reorder Point technique (ROP) is used to determine how much of a product you need in stock to prevent any possibility of a stockout occuring.

With this technique, you take  in more stock than the safety stock number, because it takes into account the lead time between when you order the stock and when it arrives at your warehouse. The reorder points this into account and allows enough time for shipping.

In this way, you will have an accurate basis to restock inventory based on your particular business.

This technique will also prevent unnecessary warehousing overhead from ordering products too early and having it sitting around unsold.

6. FIFO & LIFO

These two techniques are different ways of managing the storage life of your products. It represents a balance between keeping your shelves stocked with the latest products while preventing dead stock.

FIFO stands for "First-in, First-out". In other words, the oldest inventory is sold first— preventing old stock from turning into dead stock.

LIFO stands for "Last-in, First-out". Newer inventory is prioritised and sold first. This ensures that your product lines are always fresh. This approach isn't practical for all industries.

Creating an Inventory Management Strategy

With the six inventory management strategies in your pocket, you can now devise an inventory management strategy that will suit your particular business needs.

There are several steps that you should follow—which we will discuss one-by-one.  

1. Choose a Storage/Handling Facility

It's important to choose the right warehouse location for your business—especially if your business requires more than one storage and processing venue.

Usually it's best to choose a warehouse that's closer to your suppliers or manufacturers. This decreases lead times between ordering goods and taking it into inventory.

Consider using third-party logistics (3PL) for your warehousing and distribution processes, since it makes it a lot easier to grow and scale your business. You will be able to coordinate activity between your e different warehouses and 3PL partners with the right inventory management software.

2. Choose the Right Inventory Software

It's important to take the time to choose the right software for your business. The right software can make a big difference to the success of your inventory management.

The right system will help you make accurate demand forecasting, process orders and returns, and manage all your warehouse locations.

The goal is to streamline your inventory management activities while  automating the most time-consuming and error-prone parts of the process. The system will also update inventory levels automatically in real time.

Choosing the right software isn't always easy. There are several competing interests, including cost, the specific needs and challenges of your business and industry, as well as the question of integration with your existing systems and software.

3. Negotiate Vendor Agreements

It's always a good idea to iron out the particulars of the relationship you have with your distributors.

You have decided on the details with regards to shipping and payment schedules. For example, how soon after you placed an order with a distributor can you expect the products to arrive at your warehouse? If products  sit on your shelves unsold, will your suppliers accept returns?

4. Decide on Dead Stock

You have to decide on a procedure to handle stock that doesn't sell. Of course, you could have a returns agreement in place with your supplier. But what if you've already exceeded the return terms?

One possibility is to donate dead stock to charities or nonprofits. This would be a tax write-off and prevent competitors from buying up the stock and using it to undercut you in the market.  

5. Update your Business Plan

All the stakeholders in your business need to be kept up to date with your inventory management strategy.

Communicate this information with everyone, especially the members of your team. As your strategy evolves, keep updating your business plan and keep everyone informed of the changes.

6. Pick a Stock Replenishment Strategy

You need to decide on the reorder point for each of your product lines. Nothing is worse than having to turn willing customers away because of stockout problems.

On the other hand, if you take in too much stock of a particular product, you will experience higher storage costs and  inventory losses due to spoilage—which will negatively affect your bottom line.

The right reorder point is a balance between market demand, stock turnaround time, and reorder lead times—while also taking safety stock into account.

Metrics for Inventory Forecasts

Most retailers have most of their cash flow tied up in their stock. That is why accurate inventory demand forecasts are crucial to the long-term success of any business.

Here are a couple metrics that you can use to make accurate inventory demand forecasts.

1. Inventory Turnover

When looking at a specific month, quarter, or year of business, how many times does the company completely sell out all inventory—replacing it with new stock? This is the company's inventory turnover.

Calculating the inventory turnover is quite simple. The cost of goods is divided by the average inventory. This number gives a measure of the efficiency of a company's operations. Higher inventory turnover is better.

2. Gross Margin %

What is the gross margin of your operations, calculated as a percentage?

It's a simple calculation: Gross Margin % = (Total Revenue - Cost of Goods Sold)/Total Revenue x 100%.

This will not only give an indication of business profitability, but it is a clear indication of the productivity of your inventory outlay.

This number is especially important to track as you grow your company. A higher sales volume will instantly translate into a more efficient operation.

3. Order Fill Rate %

The order fill rate is a measure of how well you are able to meet customer demand—regardless of fluctuations in the market or supply issues.

To calculate the order fill rate, work out the ratio of orders you were able to fulfil successfully as a percentage.

A low number shows that your inventory management strategy needs some work as it can lead to low customer satisfaction and lost sales. It will also be detrimental to your brand perception in the market.  

4. Cost of Carry

What is the cost of holding inventory over a period of time? This would include costs associated with warehousing, insurance, as well as financial costs.

Since lowering this number is essential for boosting the profitability and efficiency of your operations, you should evaluate the cost of carry on a continuous basis.

5. Days Sales of Inventory (DSI)

What is the average number of days it takes your company to turn inventory into sales?

The number of days it takes  for your monthly inventory to sell is a strong indicator of the efficiency of your inventory management strategy.

If you sell out a month's inventory in less than five days, you are continually at risk of running out of stock. But if this number is too high, you risk turning inventory into dead stock. The goal is to find the optimal number for your company, market, and particular operations.

Conclusion

In this article we discussed a number of factors that you should consider in putting together an inventory management strategy.

Effective inventory management is no easy task. It requires a combination of good management and accurate oversight.

If you have the wrong data with regards to tracking and counting stock, your demand forecasting will be off. Which leads to wrong purchasing decisions. You will overstock on some items and understock on others, leading to lost sales, shipping delays, and increased warehousing costs.

When you have the right inventory management strategy in place, you will always have enough stock on hand to cover demand while keeping inventory costs down.

Creating an effective inventory management strategy will take  time. You will have to go through several iterations, taking into account the particular needs of your business, as well as carefully evaluating the benefits and disadvantages of each setup.

This is well worth the investment in time and resources. Making the best use of your inventory resources is crucial to your success.