Chapter 1

What is Inventory?

Inventory represents one of the most important assets for a company because its turnover represents revenue for the company.


In layman terms, “inventory” stands for a complete list of goods owned or stored either to resell or as a raw material for producing the final product and then, in turn, sell the final product. 


However, to understand it in a more formal way, let’s look at some of the widely accepted standard definitions of inventory.




As per the APICS (American Production and Inventory Control Society) Dictionary,


“Inventory is defined as those stocks used to support production, such as raw material and work in Process, supporting activities, such as maintenance, repair, and operating supplies, and finally Customer Service in the form of finished goods and spare parts.”


According to the Author of Operations Management, Lee J. Krajewski,


“Inventory is created when the receipt of materials, parts, or finished goods exceeds their disbursement; it is depleted when their disbursement exceeds their receipt.”




What are the basic functions of inventory?

There are 4 main basic functions that inventory serves in a business.


1.  To meet the anticipated demand of the products

2.  To safeguard against stock-outs

3.  To facilitate production requirements

4.  To segment operations



Types of Inventory

Inventory can be classified into three main categories, namely,



1.  Raw Materials


Raw materials or purchased parts are the raw products that are going to be used for making finished products. However, there are many other facets to raw materials such as different types of raw materials, why are they important, how to calculate how much raw material you need. To know all about this follow the link below.


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2.  ‘Work in Process’ Goods


‘Work in process’ goods are the goods that are partially completed are in the process of becoming finished goods.


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3.  Finished Goods


The final product manufactured by the industries or companies that is ready to be sold by wholesalers, retailers, etc.


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However, when you take a closer look, there are various other kinds of inventory (goods) as well that need our attention too. These are:



4.  Transit Inventory, aka Pipeline Inventory


The inventory that is in the transit from the manufacturer’s place to the retailer/wholesaler shop is called Transit inventory. At times, the transportation of inventory takes days or even weeks in transit.


It is the inventory that is continuously moving from one point into another in the supply chain. It consists of the orders that have been placed but have not been received yet, and therefore, it is also to be counted as an inventory.


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5.  Buffer Inventory, aka Safety Stock


Safety stock is used to avoid customer service problems and the cost associated with this. It protects against uncertainties in demand, in lead time and supply variations. The higher the service level you want to provide, the higher the safety stock will be. In the same way, the higher the lead time and the higher the demand variations are, the higher the safety stock will be.


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6.  Anticipation Inventory


It is inventory used to absorb uneven consumer demand during a certain period of time. Some companies that have a predictable seasonal demand, build up inventory during low demand periods so that when high demand periods come production rate is not affected.


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7.  Decoupling Inventory


This is the inventory kept in the manufacturing units, wherein the stock of one part of the product is kept in some quantity so that it doesn’t hinder in processing the other part of the product. It is something like safety stock, but the only difference is that this is safety stock for internal purposes so that the demand for a particular spare part is fulfilled while making the finished product.


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8.  Cycle Inventory


Cycle inventory is also called a lot sized inventory. It varies directly with the lot size. The quantity varies with the elapsed time between orders, the longer the time, the larger the cycle stock. For example, if you order every two weeks, your cycle stock will be equivalent to two weeks’ demand.


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9.  Maintenance, Repair, and Operating Supplies (MRO) Inventory


These are the products that support the production process of the finished goods such as lubricants, screws and ball-bearings, gloves, packing materials, etc.


Office stationery items like staples, pens, and pencils, papers, etc. are also part of the operating supplies.


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What is Inventory Management?

The term “Inventory management” stands for efficient managing of inventory by counting, storing, tracking of all your existing/future inventory systematically. 


In other words, it is ordering the right quantity of products and keeping track of all the company’s goods and storing them in an appropriate facility for easy retrieval while selling it.


“Inventory management is a well-developed science, not a simple common sense.” says the author Tony Wild in his book ‘Best Practice in Inventory Management.’




Why is Inventory Management important?

“The motto of inventory management is to minimize holding costs while optimizing inventory.”


In other words, to reduce the stock levels while achieving higher availability of the products at the same time. This motive can be achieved only when inventory is managed systematically.


Here are some other salient reasons for the importance of inventory management



1.  Enables you to do the planning and forecasting accurately


Managing your inventory brings sense to all those data around you. Inventory management can help you analyze and distinguish the products between well-performers and shelf-eaters. This improves revenue generation and frees up cash flows.


Also, it would be great if you can forecast your customer’s purchasing pattern and restock your inventory based on that data. Inventory management grants you access to do stuff like this too.


For example, based on previous inventory statistics, your forecasted product “x” is going to be in massive demand during the sales season. You stockpiled product “x” in your inventory, and it paid off. You will not only generate revenue but can also stockpile your stocks again based on the daily sales pattern of your customers.



2.  Improves your delivery time


Nowadays, customers demand no less than the best in the market, whether it may be regarding the quality of the product delivered or the time taken to ship the product to its end customer.


Late delivery due to out-of-stock or inventory mismanagement cannot once be the cause of one sales loss because it affects your brand reputation.


Properly arranged and tracked inventory helps to locate when the order arrives and hence enables you to deliver the product quickly.


Opting for inventory management can protect you from mismanagement of inventory and also enables you to increase customer satisfaction by a speedy delivery.



3.  Controls your inventory costs


Inventory management is all about managing the flow of inventory through your organization. Inventory management helps you better understand which stocks are doing well and which stocks are just eating up your shelf space. The key is to order the inventory as much as needed, not too little and not too much.


Due to accurate forecasting done with the help of inventory management systems, you can order the products in the right amount and hence save the costs involved in purchasing extra products and storing them.


This also protects you from keeping a less demanding inventory, backorders, excessive inventory, etc. Also, better inventory management helps you understand which products need to be reordered and how frequently from your suppliers. This can help you crack deals with your supplier, thus saving money.



4.  Increases your business efficiency and productivity


If you are spending a lot of time searching for the products your customers order, then maybe it’s time to invest time into inventory management. Inventory management includes allocating specific locations to specific products, and therefore, you can track the products and their quantities in no time!


Systematically managing products not only saves time and efforts but also lets you divert your human resources towards more pressing matters regarding your business, hence, improving overall productivity.


In short, companies need inventories to operate, and having the right products available at the right time in the right quantities to meet customer requirements is the key to achieving the company’s objectives. And inventory management and control helps in doing just that; that’s why it is crucial.



Inventory / Product Tracking

Identifiers for efficient product tracking…


As we have already mentioned earlier that inventory management’s basic function is to track your inventory, some key identifiers enable a retailer/wholesaler to track the inventory. Let’s take a look at it in detail:




Important Inventory Management Terms

Cost of Goods Sold (COGS) is a direct cost of the production of the goods or products sold from an inventory. This amount includes the additional material charges as well which are used for the delivery and packaging of the goods.

COGS = Beginning Inventory + Purchases during the period - Ending Inventory

As inventory is an asset, till the time the product remains a part of that inventory, the amount of that product remains in the asset account. As soon as the product is sold, that amount (along with all the additional charges) goes into the expense account which is also called 'cost of goods sold.'

COGS always appears on the profit and loss statement and is also used for inventory measurements.

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The Bullwhip Effect is a phenomenon in the supply chain and distribution channels in which forecasts reveal supply chain inefficiencies. This mostly occurs when retailers become highly reactive to consumer demand, and in turn, intensify expectations around it, causing a domino effect along the chain.

The bullwhip effect was named for the way the amplitude of a whip increases down its length. Here, the end customers have the whip handle, and as they create a little movement, whip amplifies traveling up, increasing the buffer between the customer and the manufacturer. On average, there are 6 to 7 inventory points between the end customer and raw material supplier.

Better communication among supply chain partners, better forecasting methods, and a highly demand-driven approach can help reduce inventory waste or over-stocking that result out of the bullwhip effect.

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The 'reorder point' or 'replenishment order quantity' is the inventory level used to determine the need for stock replenishment. As stock reaches the reorder point, the seller can release fresh purchase orders to the supplier for replenishment. The total time between PO creation and receipt of stock ready to be sold is called as 'lead time'. Anything below the reorder point is safety stock.

Reorder Point = Lead Time Demand + Safety Stock

It is always advisable for sellers to set a re-order point considering lead times, sales forecasts, and safety stock quantity at any given point of time; hence avoiding any low-stock or out-of-stock situations; an expert seller approach!

ABC / Pareto analysis is an inventory control technique based on the Pareto principle named after an Italian economist Vilfredo Pareto. Also called 80 / 20 rule, this principle suggests that 80% of the total output is generated only by 20% of valuable efforts. ABC analysis typically segregates inventory into three categories based on its value and control measures required: 'A' is 20% of inventory with 15% value; 'B' is 30% inventory with 15% value; whereas 'C' is 50% inventory with 5% value and hence treated as most liberal.

These are only suggestive numbers and vary from company to company but tend to follow a similar pattern. This analysis helps business managers to draw more attention to the critical few (A) and less on the trivial many (C) and focusing inventory control efforts where it will have the greatest effect.

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The time taken by the supplier to supply the required order after the purchase order is placed is called Lead Time. Also called as the time between the placing of a purchase order and the receiving of the goods ordered.

If the supplier is not able to supply the required ordered goods on time, the seller must keep a backup stock to avoid any sort of hamper to the business reputation. The longer the lead time, the larger the number of goods must be kept as a backup from the very beginning.

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Big Data represents massive amounts of human-generated data, in structured or unstructured form, as a result from a variety of sources - social media, online transactions, enterprise content, emails, mobile devices, applications, databases, servers, and other means.

The importance of big data doesn't revolve around how much data you have, but what you do with it. Big Data, when captured, formatted, manipulated, and analyzed, can help a company gain useful insights and take critical and better organizational decisions.

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Bundling or Kitting is a sales technique of grouping separate but related products / SKUs into sets that can be sold, packed or shipped as a single unit or order, hence helping sellers to increase the total order value.

Say, for example, kitting of shampoo and conditioner, or PC with drives or software, or a pack of t-shirts. Sometimes, sellers also use kitting / bundling to introduce a new product along with existing products for promotions or soft-launch.

This technique is highly used by brick & mortar stores, malls, as well as online sellers for its benefits in abundance.

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Last-in-First-out (LIFO) is a method used to account for inventory where the most recently produced products are considered as sold first. It is a cost flow assumption technique used only by the U.S. Companies in moving the cost of products most recently purchased, from inventory to cost of goods sold (COGS). This means that the cost of the oldest products will be reported as inventory.

The LIFO inventory control method has gained popularity in the U.S. because due to inflation and the fact that companies can associate their most recent inflated costs with sales, thereby reporting less taxable income.

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Inventory which is required to meet an immediate expected demand is called Current Demand Inventory. The only difference between future demand and current demand is, in current demand you need to apply a period for which you require the inventory. Future demand doesn't require a specific timeline. For example, if you have a requirement of inventory for tomorrow specifically, then that can be termed as Current Demand Inventory.

Demand Override is a fixed quantity adjustment that is used to replace or supersede the existing demand or even the existing demand history. It can also be a factor that can be taken into consideration to change or adjust the demand.

'Days of inventory on hand' is a ratio measuring the average number of days an item is held in the inventory. Since inventory cost represents the opportunity cost of funds, this ratio indicates how well inventory is being managed, and is one of the elements in determining the operating cycle of a company.

Number of units in inventory × 365 ÷ Annual usage in number of units

A forecasting system that automatically analyses and makes forecasting decisions without any human input is called Black Box Forecasting. As the name says, 'the black box forecasting' keeps a track of the ongoings and the sales of a particular product.

It's more like turning your inventory management system to 'auto-pilot' mode.

Backflush is an accounting approach, used in a Just-in-Time (JIT) environment, in which costing is delayed until goods are finished. Costs are then 'flushed' back at the end of the production process and assigned to the goods. This approach helps in eliminating all work-in-process accounts and manual assignments of costs to products during the various production stages.

Backflush accounting is entirely automated, with a computer handling all transactions. Backflush costing may not always conform to generally accepted accounting principles (GAAP) and also lacks consideration of sequential audit trail.

Backflushing is not suitable for long production processes, neither for the production of customized products.

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Inventory shrinkage is excess inventory which is listed in the inventory accounting records, but in actual no longer exists because of some of the other reasons.

Inventory shrinkage can be because of damage of goods during shipping, spoilage, if in less quantity can be ignored. If the shrinkage happens in excess, mismanagement, theft by employees, incorrect record-keeping, evaporation or similar issues can be the cause.

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Moving average is a demand forecasting method that uses most recent actual past data to calculate the average demand over a fixed time period. It removes the effect of random fluctuations and is most useful when demand has pronounced trends or seasonal fluctuations.

Moving average = Demand in previous 'n' periods ÷ 'n'

It's called 'moving' because as a new demand number is calculated; the oldest number in the set falls off, keeping the time period locked. For example, if you want to calculate a three-month moving average on 1st August, you will calculate the average demand of May, June, and July. Subsequently, on 1st September, you would use May, June, and July demand for the calculation.

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Economic Order Quantity is a methods of calculating the quantity of the stock that needs to be re-ordered, considering the demand of that particular item / product and your inventory holding costs.

EOQ is a term that answers to the question,
"What quantity of stock should I re-order to replenish my inventory?"

It's basically an ideal quantity a company should purchase for its inventory.

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Kanban ('visual signal' or 'card' in Japanese) is a visual scheduling system related to Just-in-Time (JIT) production that tells you 'what - when - how much' to produce. The first Kanban system was developed by Taiichi Ohno of Toyota Automotive, the aim of which was to tackle inadequate & inefficient production; and to control inventory optimally.

Kanban system visualizes both - the workflow and the actual work passing through the flow. In this way, it helps avoid supply disruption and overstocking of stock or raw materials at any stage in value chain. So there is no incoming of the stock unless & until there is space for it.

Kanban gradually improves existing process - whether it is software development, recruitment, sales, procurement, etc., rather than changing everything from the core.

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Cycle count is an efficient and cost-effective inventory auditing practice where a small subset of inventory, in a specific location, is counted on a specified day. This is to ensure accuracy of inventory without having to count entire inventory, and the result of which can be used to infer results of total inventory. So, any accuracy or error found could be assumed to be occurring for whole inventory.

Cycle count is usually conducted on an ongoing basis, often weekly or monthly, hence is less unsettling than a full physical count which requires shutdown of day-to-day functioning. Fast-moving and more expensive items typically are counted more often then slower moving and less expensive ones.

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A consignment inventory is a quantity of stock that is in possession of the customer, yet owned by the supplier. In this scenario, the supplier allocates some of his inventory to the seller, which remains in the supplier's warehouse only. The seller has the rights to sell those products on his behalf to his end-customer, either through a physical store or an online marketplace. Only when the seller sells or consumes that part of the inventory, its considered to be purchased from the supplier.

A gym and a supplier of protein supplements. There is no inventory in the gym, but with the supplier. As soon as the customer purchases from the gym, the item from the consignment inventory with the supplier is considered to be sold. Till there is no purchase, the owner of that inventory is the supplier, and not the gym.

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Next Chapter
Chapter 2
Inventory Management Techniques