Inventory Management 101: How to Manage Small Business Inventory

For most businesses, especially those in the manufacturing, distribution and trading space, inventory is an important revenue driver. Like every revenue drivers, how a business manages its inventory affects its cash flow, profit and automatically its financial position. This post focuses on understanding inventory; how to manage it and also the need to maintain appropriate stock levels.

Inventory is the goods or materials a business uses in production, produces or sells/trades with. For accounting purposes, Inventories are defined as assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c)in the form of materials or supplies to be consumed in the production process or in the rendering of services.

In a typical manufacturing company, your inventory is the raw materials, semi-finished goods and the finished goods. For a merchant, your inventory is the products you sell. Raw materials are the basic “inputs” of production — wheat, maize, wood, additives or chemicals and anything else that gets turned into the final product. Work in process or semi-finished goods represents goods that still require work before they are ready for sale to customers. Finished goods are those that have been all the way through the production process and are awaiting sale.

It is not advisable for a business to hold too much or too little inventory at any point in its operations. By holding a lot of inventory, the business will need to pay for warehousing or storage costs as well as other related costs such as insurance, security, rent and utilities. Other likely occurrences are theft and capital blockage; and moreover, in cases where the goods have short shelf life, they will go bad or become obsolete, so you will have to sell them at very low prices.

Holding very little inventory also limits your ability to meet customer demands and you thenlose goodwill from new and existing customers. All these will affect your profitability adversely.

As part of managing inventory, you must determine a re-order level, quantity to order,a minimum inventory (or safety stock) and maximum stock levels that is suitable to the business.

Reorder level is the inventory level at which a company would place a new order for inventory. It is calculated as:
Reorder Level = Lead Time in Days × Daily Average Usage.

For instance, ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily. Its supplier takes a week to deliver the order. The inventory manager should place an order before the inventories drop below 3,500 units (500 units of daily usage multiplied with 7 days of lead time) in order to avoid a stock-out.

Also, there is the need to set Safety inventory level (sometimes as the minimum inventory level), which is the emergency stock you need to endure unexpected occurrences. In cases where the company has safety inventory level, there is the need to add that to the Reorder Level.

For instance, if ABC Ltd. decides to hold a safety stock equivalent to average usage of 5 days, their Safety stock would equal 2,500 units (500 units of daily usage multiplied by 5 days).

Last but not the least, the company needs to set a maximum stock level above which more inventory is not allowed. This prevents the business from the various costs associated with overstocking.

It is worth noting that in recent times, the usage of technology tools such as Point of Sale (POS) applications has made it easier for businesses to manage their inventory. These applications alert the right person(s) in the business of what action needs to be undertaken to ensure optimal levels of stock at all times.

If your business is in need of stock management, contact Built Accounting on 0303974832 for latest technologies to manage your business’ inventory.