A small business—really, everyone in business—lives and dies on inventory management. But before we look at managing it, we need to ask, "What is inventory, anyway?"
Types of Inventory
Before we get ahead of ourselves, let's establish a working definition of inventory. We’ll actually need more than one because broadly speaking there are four types, which means things can get a bit confusing if we're not careful.
These are the raw materials you're going to use to make your final, finished products. Let's say you're running a pizza joint. The dough, sauce, and individual toppings are the feedstock. If you're running a canoe paddle factory, it's the wood and stain. Clothing? Bolts of fabric.
The term "raw" can be a bit misleading because it too can have more than one meaning. In the end, the level of "rawness" of your materials will depend on your industry. So, if you're a mill, your raw material is trees. But, if you're a skateboard company, your raw material is going to be sheets of plywood (that come from a mill).
Work in progress
Let's jump back to the pizza joint. You take the ingredients, the feedstock, put them all together and throw them in the oven. While everything is baking, it's halfway between being feedstock and something you can sell. This type, the stuff sitting on your production line, is work-in-progress inventory.
How much you have at any given time depends on your industry. With our pizza joint, we're never going to have all that much. Our oven's just not big enough. There will always be more cheese sitting in the fridge than baking in the oven. But if we were building airliners, we might have inventory on the line for months. And as the plane gets closer and closer to completion, there will be a lot more work-in-progress inventory than feedstock.
The next one is easy to understand as soon as we call it by its more common name, merchandise. This is inventory that's ready to be sold. But remember, finished goods can also be feedstock for another industry. We could be selling our finished product to the public or another company. Think back to that skateboard company buying sheets of plywood from the mill. The mill's finished product is the skateboard company's feedstock.
Industry dictates ratio
Before moving on to the fourth type of inventory, we can spend a bit more time thinking about the first three. Specifically, we can look at how different industries have different relative amounts of each type.
So, once again, back to our pizza joint. There's going to be mostly feedstock, a little bit of work-in-progress inventory, but almost no finished goods. Because it takes very little time to put together the ingredients and then bake them, you can wait for orders to come in before you get started. You'll never have a lot of finished product around because as soon as a pie is finished, it's out the door.
We already talked about building airliners. A lot of your inventory is going to be stuck in the production line because your product involves slowly and carefully assembling an astronomically large number of parts. What about the local dress shop? The retail industry has lots of finished goods but basically none of the other two types of inventory.
Spare parts and materials
The fourth type of inventory is the one every business in every industry has, spare parts and materials. It's all the stuff you keep around for when something breaks. At the pizza joint, it's the replacement bulb for the light in the oven. At the mill, it's the extra saw blade.
Now that we have some idea of what inventory is, let's dive a bit deeper.
Inventory: key concepts
FIFO vs LIFO
Imagine you've just come home from the store with some milk. When you open the fridge, you see a nearly empty carton already in there. Where do you put the new milk, in front of the old carton or behind it? Or imagine that you're standing in line waiting for the bus. When the bus arrives, how do people get on, based on who got there first or who got there last?
In both situations, you're following the FIFO principle, which stands for first in, first out. The old milk gets used first. The first person at the bus stop is the first person on the bus. Whatever (or whoever) arrives first gets used (or goes) first.
OK, two more situations. You're grabbing a plate at a buffet restaurant. Do you get one from the top of the stack or the bottom? You load up your plate and start walking back to your table when you see someone has gone and stolen your chair, but it's no problem because you see a stack of them in the corner. When you get yourself a new chair, do you take one from the top of the stack or the bottom?
In these situations, you're going to grab your plate and chair off the top of the stacks. Now you're following the LIFO principle, which stands for last in, first out. The last plate added is the first one used. The last chair added is the first one removed.
You'll need to be a bit careful with these two principles because there are related-but-different accounting terms with the same names. We don't have time to go into them now, but it's important for you to know they exist and are related to how your accountant thinks about inventory.
A, B, and C analysis
One last time let's think about our imaginary pizza joint, specifically the toppings. So you have your basic, inexpensive cheese, some fancier, pricier cheese, and then truffles, those super expensive underground mushrooms.They're all feedstock, but because of the differences in values, it makes sense to divide them into categories. Commonly, people go with three, A, B, and C, and try to balance them by looking at percentage of the cost to the company and percentage of overall inventory.
So, truffles are A. Buying them take 70% of your annual budget for inventory but they're only 20% of your total inventory.
Fancier cheese is B. Buying it takes 25% of your annual budget for inventory but it’s only 30% of your total inventory.
Basic cheese is C. Buying it takes only 5% of your annual budget for inventory but it’s a full 50% of your total inventory.
The advantage of A, B, C analysis is that now you can start to think about how much effort you're going to put into controlling—just another way of saying tracking and protecting—each category. You can keep stacks of basic cheese in the main cooler, the fancier stuff tucked away on a back shelf, and the truffles maybe locked in your office. You can also set up different schedules for ordering. You're always going to go through a lot of basic cheese, so you can set up a delivery of a few boxes once a week. But for the expensive truffles, you closely monitor your levels and order only exactly what you need. Another advantage to splitting your inventory into A, B, and C comes when you do physical counts. For the truffles, because they're A, you know you're going to go in and count every single one. But for the basic cheese, the C, you can do a much looser count, maybe only adding up the number of boxes on hand, instead of counting every small bag, which is going to save you a lot of time and effort.
Carry costs and loss, aka shrinkage
Bored with the pizza joint, you're back at the store to buy more milk. When you see milk’s on sale, do you load up your car with as much as you can carry or do you buy the same amount you always do?
It's great to save money, but you know there's only so much room in your fridge, and it's not like you can store the extra cartons in your backyard shed. You could always buy an extra fridge, but are the long-term costs of getting one and then running it going to be covered by the money you save on milk today? Even if you could get a very cheap fridge and run it on solar power, could you drink all that extra milk before it spoils or someone else gets their hands on it? Probably not.
In the end, it makes the most sense to have the smallest amount of milk possible without ever running out. That way, your carry costs are low, and you avoid losing any of it to spoilage or theft. This is where we get the JIT system, where inventory is delivered just in time, which means just before it's needed. Instead of you paying to carry the milk, you push those costs back onto the store. Don't worry about the store. They've got all kinds of economies of scale that make it much easier and cheaper for them.
Tracking brings it together
Putting these concepts into practice all come down to effective tracking. You need a system that can tell you in real-time how much inventory you have. Over time, you can then use this historical data to find trends and use them to fine-tune your inventory control.
Once you have accurate records of when inventory came in, you can establish a FIFO or LIFO system.
Keeping a close eye on your A inventory is a breeze when your count is always accurate and up to date.
Reducing carrying costs and loss is only possible once you can look at past use. If you look at how much you have now, how much you usually use, and lead time, which is how long it takes to order more inventory, you can then set a par level, which is your reorder threshold. Once your inventory goes below this threshold, you know it's time to get more.
There are a bunch of ways to track inventory, but the traditional ones are prone to error and take a lot of time. So, instead of trying to get everything done with paper and pen or spreadsheets, it's worth your time to look into inventory tracking software. There are dedicated inventory management software's. Your specific situation and needs will dictate what's best for you.
If you're concerned about keeping your data up to date in real-time and secure—and you should be—but don't have the time or IT expertise to set something up, look for a subscription, cloud-based solution. A good provider updates the software and backs up the data for you, seamlessly behind the scenes. And the data remains your property. They're just keeping it safe for you.