Inventory Management

Inventory management refers to the process of ordering, storage, using, and selling a company’s inventory. This includes the management of raw materials, components, and finished products, as well as warehousing and processing of such items.

The 4 Types of Inventory Management

The types of inventory management are Raw Materials, Works-In-Process, Maintenance, Repair and Operations or MRO and Finished Goods.

Inventory management is a process for controlling, storing, and keeping track of your inventory items. Inventory management is an essential component of supply chain management, as it regulates all the operations that are involved from the time an item enters your warehouse until it has been utilized or sold.

Accounting for Inventory
Inventory represents a current asset since a company typically intends to sell its finished goods within a limited amount of time, typically a year. Inventory has to be physically counted or measured before it can be put on a balance sheet. Companies may maintain sophisticated inventory management systems capable of tracking real-time inventory levels.

Inventory is accounted for using one of three methods: first-in-first-out (FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing. An inventory account typically consists of four separate categories:

Raw materials — represent various materials a company purchases for its production process. These materials may undergo significant work before a company can transform them into a finished good ready for sale.
Work in process — represents raw materials and /or component parts in the process of being transformed into a finished product.
Finished goods — are completed products available for sale to a company’s customers.
Merchandise — represents finished goods a company buys from a supplier for future resale.

Inventory Management Methods

Depending on the type of business or product being analyzed, a company will use various inventory management methods. Some of these management methods include just-in-time (JIT) manufacturing, materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).

Just-in-Time Management (JIT) — This manufacturing model originated in Japan in the 1960s and 1970s. Toyota Motor (TM) contributed the most to its development.  The method allows companies to save significant amounts of money and reduce waste by keeping only the inventory they need to produce and sell products. This approach reduces storage and insurance costs, as well as the cost of liquidating or discarding excess inventory. JIT inventory management can be risky. If demand unexpectedly spikes, the manufacturer may not be able to source the inventory it needs to meet that demand, damaging its reputation with customers and driving business toward competitors. Even the smallest delays can be problematic; if a key input does not arrive “just in time,” a bottleneck can result.

Materials requirement planning (MRP) — This inventory management method is sales-forecast dependent, meaning that manufacturers must have accurate sales records to enable accurate planning of inventory needs and to communicate those needs with materials suppliers in a timely manner.  For example, a ski manufacturer using an MRP inventory system might ensure that materials such as plastic, fiberglass, wood, and aluminum are in stock based on forecasted orders. Inability to accurately forecast sales and plan inventory acquisitions results in a manufacturer’s inability to fulfill orders.

Economic Order Quantity (EOQ) — This model is used in inventory management by calculating the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory while assuming constant consumer demand. The costs of inventory in the model include holding and setup costs. The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand. It assumes that there is a trade-off between inventory holding costs and inventory setup costs, and total inventory costs are minimized when both setup costs and holding costs are minimized. 

Days sales of inventory (DSI) — is a financial ratio that indicates the average time in days that a company takes to turn its inventory, including goods that are a work in progress, into sales. DSI is also known as the average age of inventory, days inventory outstanding (DIO), days in inventory (DII), days sales in inventory or days inventory and is interpreted in multiple ways. Indicating the liquidity of the inventory, the figure represents how many days a company’s current stock of inventory will last. Generally, a lower DSI is preferred as it indicates a shorter duration to clear off the inventory, though the average DSI varies from one industry to another.

There are other methods to analyze inventory. If a company frequently switches its method of inventory accounting without reasonable justification, it is likely its management is trying to paint a brighter picture of its business than what is true. The SEC requires public companies to disclose LIFO reserve that can make inventories under LIFO costing comparable to FIFO costing. 

Frequent inventory write-offs can indicate a company’s issues with selling its finished goods or inventory obsolescence. This can also raise red flags with a company’s ability to stay competitive and manufacture products that appeal to consumers going forward.