Inventory is usually a business’s most valuable asset.
Can you imagine any successful business not doing everything possible to successfully manage their most valuable asset?
A wildly profitable hedge fund that’s okay with mediocre money management? A michelin-starred restaurant that’s satisfied with stale ingredients?
It doesn’t compute.
The inventory management process is the key to not only determining the quality of your company’s output, but to the financial health of your entire business. It’s how you form a clear picture of your organizational liquidity, cash flow, and value.
Successful inventory management begins with understanding the different types of inventory. So here they are. And while each section is an adequate introduction, they all link out to more detailed information.
You have the key. The magical key of inventory. Open the door and enter.
Manufacturing inventory is all the items kept on hand to produce products. And these supplies and materials are usually broken up into three groups based on the stage of production. Raw materials, works in process, and finished goods.
The Three Types
- Raw materials. These are the base components or totally raw materials used at the very first stage of production.
- Work-in-process. After raw materials are combined with human labor, the result is work-in-process inventory.
- Finished goods. The culmination of everyone’s hard work. When the product is ready to move up the supply chain or be sold, it’s finished goods inventory.
Managing Inventory: Manufacturing Edition
Like all inventory pipelines, manufacturing inventory must be smartly managed to maximize revenue. Some tips to profitably manage raw materials, WIP, and finished goods inventory are:
- Choose the inventory process that’s right for you. Look into and test perpetual, just-in-time, and ABC inventorying.
- Enlist help. It could be that a VMI or consignment inventory setup is optimal for your business model.
- Set and stick to reorder points. Don’t reorder on gut feelings. Set a minimum and play the numbers.
- Use automated demand forecasting when setting your safety stock.
Wait a minute, automated demand forecasting? Yeah! You’ll need manufacturing inventory software. Look for manufacturing inventory software that allows you to:
Work In Multiples
Get software that lets you add multiple production stages to bills of materials and include numerous work orders in a manufacturing order. Then you can add the right bill of materials or work orders to specific orders.
Tighten Up Ordering
Any good inventory software allows manufacturers to convert sales orders to manufacture orders automatically. Along with being able to create purchase orders for raw materials that are out of stock and work orders for repair and maintenance.
Make Pricing and Accounting Easy
The platform you choose should also give accurate estimates on the final cost of finished goods so pricing strategies are most effective. And those finished goods should all be accompanied with invoices and packing slips generated automatically from your platform’s accounting functionality.
Let’s look into the different types of manufacturing inventory a little deeper.
Raw Materials Inventory
Raw materials inventory is inventory that has not yet been used in the manufacturing process. Once a raw material is used in any way during production, it’s no longer a raw material. There are two kinds of raw material inventory.
These are the raw materials that make up the thing being manufactured. Think of the wax in a candle or the coffee beans in ground coffee.
These are the raw materials that are used during production but aren’t a part of the finished product. Think of cleaning supplies, batteries, lubricants, etc.
Why is this all important? Because calculating raw materials inventory not only gives you an accurate picture of your current assets. It also allows you to calculate your raw materials turnover rate. That’s a ratio which represents how quickly raw inventory is used and replaced. It’s an indicator of how accurate the current demand forecasting and resulting purchasing strategies are.
Managing Inventory: Raw Materials Edition
Wanna get the most out of your raw materials?
- Automate as much strategy as possible. Use a material resource planning (MRP) platform. They analyze historical data of all sorts—like consumption, lead time, production, stock levels, and purchasing cadence. And they suggest optimal management strategies. Get software that forecasts demand and includes costing and supply chain tracking features.
- Pay special attention to understock and overstock. The consistent presence of one or the other is a signal that your raw materials management isn’t ideal.
- Don’t cut costs on raw materials. More often than not, the extra labor and production stoppages are far more expensive than any savings.
- Leave WIP analysis for the more advanced levels of your inventory control operation, for now. You’ll get a better feel for your raw materials management if you focus your analysis on raw and finished goods inventory.
- You don’t have to account for every little thing. Some high-volume, low-cost raw materials can’t be reasonably tracked and accounted for. Things like screws or nails, for example. Cost those when they’re acquired so you don’t have to worry about them during production.
Work In Process
Next up, work in process inventory. Otherwise known as WIP inventory. It’s all the goods in between raw materials and finished goods. The unfinished goods currently in the manufacturing process that have yet to be completed. Work in process goods also usually include overhead costs and labor associated with manufacturing. Work in process inventory is generally described as a company’s unfinished goods waiting to be completed and sold.
Any raw material that has been manipulated by human labor but is not yet a finished product is a work in process.
Figuring Out Work In Process
Most of the time, WIP goods are basically raw materials added to the production labor and overhead. You can click into the above post about WIP inventory to get the formula and some more details about calculating it.
Suffice it to say, using a formula to calculate WIP goods produces an estimate. There are a lot of things it can’t consider, like expired products, scrap, waste, spoilage, and production slow-downs or stoppage.
The Importance of WIP
Getting a handle on WIP is important for monitoring and optimizing manufacturing capacity and inventory control. It’s not great to let WIP inventory grow over time, unless of course it’s part of a larger safety stock or buffer inventory strategy. In general, it should be kept streamlined and consistent.
Why? Because reliable WIP numbers are an important valuation signal for businesses. They affect investments, loan approval, and future strategy. WIP isn’t liquid like raw materials or finished goods. Companies with bloated works in progress have lots of cash tied up in inventory that few people are willing to consider collateral.
And, finally, finished goods inventory. These are all the items that manufacturers sell to upstream vendors or to retail businesses. Keep in mind that “finished” is relative, though. One company’s finished product may be another company’s base manufacturing component. It all depends on where the finished product goes after its completion.
End-Period Finished Goods
Using finished goods numbers from the end of an accounting period is how businesses tally up their finished inventory. Click the post above to learn how to do all the necessary calculations to sort out your finished product inventory.
Ultimately, finished goods are reported as a current asset on the balance sheet. That balance sheet is how leadership and investors gauge cash flow and inventory liquidity. Both important signals of a business’s financial wellbeing.
Another benefit of knowing finished goods numbers is calculating turnover rate. That measures how quickly a business’s finished products are sold and replaced (turned over) over a specified time period.
Why Is Knowing Finished Goods Inventory Numbers Important?
Three primary reasons:
- It shines a light on current assets and gross profit. Inventory is often a production company’s biggest driver of profits. Its accuracy has ripple effects on the accuracy of all sorts of other accounting your business does. Accurately representing it on your balance sheet makes operating budgets and financial budgets far more accurate.
- It minimizes waste. Any business that knows precisely what they’re able to produce makes better raw material purchases and safety stock calculations. That frees up cash and lowers storage cost.
- It makes production more efficient. Finished product numbers let you analyze different stages of the production pipeline. This analysis helps you iterate on processes, roll out automated solutions where needed, and generally build toward smarter inventory management.
What’s the Right Inventory Level for Finished Goods?
It varies, to be honest. In general it should be minimized to keep storage costs down. But “minimal” is different for every business. The important part is being familiar with your process and balance sheet. Then you draw meaningful conclusions from your finished product numbers. And you can tweak your inventory control strategy because of it.
After inventory goes through the manufacturing stage, often it’s merchandised and sold.
Merchandise inventory is everything acquired from a manufacturer that’s intended for sale. Usually retailers and resellers like wholesalers are the companies with merchandise inventory. And that’s because merchandise inventory is intended to be resold at a higher price than for which they were purchased. That includes the goods in storage facilities, on displays, and in consignment.
Reporting Merchandise Inventory
It’s considered a current asset because it can reasonably be expected to be sold within the next accounting cycle or fiscal year.
On the balance sheet, it reflects the amount paid for all products yet to be sold. It’s essentially a holding account for inventory that’s ready for sale. And it’s always the ending inventory numbers for that accounting period reflected on the balance sheet.
The revenue from merchandise sold during an accounting period is an expenditure on an income statement for the period during which it was sold. Any merchandise not sold in that accounting period is counted as a current asset, as stated above.
Inventory Management: Merchandising Edition
There are two main ways to handle merchandising inventory:
- Perpetual inventory. This is an ongoing count of merchandise value. Every time a sale is made or product added, the inventory numbers change. Beverage inventory software platforms like BinWise do this, for example. They deplete items sold as they’re sold to maintain an ongoing count of inventory.
- Periodic inventory. This is inventory taken at specified intervals. It doesn’t provide real-time insights and it tends to be error-prone.
This is inventory that consists of every item in the supply chain that’s in-transit. Think of manufacturing companies with complex overseas shipment or retailers that have numerous warehouses shipping them items. In both cases, there’s always a fair amount of items in no one’s physical possession—being transported—that need to be tracked.
And that’s just what pipeline inventory does.
Depending on the agreement between buyer and seller, who owns pipeline inventory changes.
If the legal possession transfers to the buyer when the inventory is packed into the transport vessel, it’s called freight-on-board shipping point. And if that ownership begins
Pipeline Stock: By the Numbers
Optimizing inventory depends on accurate calculations. This type of inventory is no different.
When your in transit inventory is represented accurately on your balance sheet, it further clarifies how much cash you have tied up in inventory. Along with overhead costs like transport and storage. It’s a particularly impactful number for businesses in complex
You can learn how to calculate your pipeline stock by clicking the above link to our detailed post on the topic. And once you do, it’ll allow you to start optimizing inventory management.
Inventory Management: Pipeline Edition
Here’s how to get the most out of your goods in transit:
- Make solid contingency plans. When something goes wrong in transit, the buyer or seller are sometimes helpless. Usually a third party must be contracted to solve the problem. That can take time and cost money. In the unfortunate event that your stock is lost, late, of low quality, or prohibitive for whatever reason, make a contingency plan. Decide when it’s worth it to cut your losses and discount or liquidate stock.
- Also decide how much decoupling inventory you should put away in the case of a supply chain hiccup.
- Calculate EOQ. Economic order quantity is a measure of the optimal purchasing levels based on demand, ordering costs, and carrying costs. Again, the post above will walk you through calculating it.
Speaking of inventory hiccups, it’s time to talk about safety stock.
It’s not easy to predict supply and demand. That’s why anyone managing inventory builds in their own little insurance.
Safety stock is additional inventory kept in stock in the case of unexpected delays from suppliers. It protects against stockouts or delays in raw material, finished foods, or packaging inventory. Stockouts are a direct sales loss. They also hurt brand engagement by degrading the customer experience. Safety stock is the solution to that.
There are a few other similar types of inventory, though.
This is the inventory a business must have on-hand to meet regular, foreseen supply and demand. That’s opposed to safety stock hedging against unforeseen fluctuation.
Buffer stock is the inventory needed to protect against spikes in demand from buyers. It’s meant to protect businesses from lost revenue and customers from poor experiences.
Unlike its brothers and sisters, anticipation inventory trafficks in the foreseen, the … anticipated! It refers to extra inventory kept on hand periodically or seasonally to account for known fluctuations in demand. The holidays are a great example of this, as many businesses factor in holiday shopping into extra inventory.
BlueCart, for example, provides historical sales data from all your buyers. That allows you to gauge how demand varies over the long term and put in place accurate anticipation stock.
Everything In Moderation
All of these types of inventory provide protection, but they’re not free. It costs money to hold stock because you’re not selling it and there are holding costs to store it. You also risk any held stock becoming expired or obsolete. Then you can kiss it goodbye.
So what’s worse, loss from inventory-related mismanagement or costs from holding or losing inventory?
That’s the million dollar question. And the answer depends on your business and the tools you use to drive your inventory management strategy. The key is being consistent and having a foundational understanding of your inventory. Then you’ll know what success looks like and how to chase it.
MRO inventory refers to all the inventory needed for maintenance, repair, and operation. It’s all the materials, equipment, and supplies used for manufacturing that don’t end up as part of the finished good.
What type of stuff makes up MRO inventory?
- PPE like masks, hardhats, and respirators
- Office supplies
- Lighting fixtures and furniture
- Industrial equipment
- Laboratory equipment
Inventory Management: MRO Edition
Strangely, as crucial as MRO items are, their inventory management is often neglected. They’re not the most exciting items. And they’re not tied directly to revenue. So they’re not subjected to the same rigorous analysis as other types of inventory. Why is this?
Mostly because the turnover rate is slow. And there’s a tradition of obtaining MRO goods on an as-needed basis. Also, businesses don’t want to distract maintenance employees with inventory management tasks. But also because lots of teams have hidden private inventories of MRO items.
It’s not uncommon for one team to put in a request for safety or repair equipment while another team has their own stockpile. It shouldn’t be ignored, though. And those who don’t ignore it do so in two primary ways:
- Internal management is when the manufacturing company monitors, replenishes, and optimizes their MRO inventory in-house. They do it all on their own.
- Hybrid management is when the management of some MRO goods is outsourced to a third party. This often takes the shape of a VMI agreement and brings many of the same benefits to the manufacturer.
Looking to sharpen up your MRO practices, here’s a condensed version of the tips in the article we linked to above:
- Define all MRO items that are business critical
- Have a company-wide purchasing strategy to avoid redundancy
- Embrace VMI agreements
- Depend on analytics and demand forecasting
- Store all MRO in a central location (helps discourage that private inventory nonsense we mentioned)
- Educate staff on supply chain best practices
- Audit your MRO inventory regularly; stop neglecting it
We’ve mentioned VMI inventory a few times. Now’s as good a time as any to go a little deeper.
VMI, or vendor managed inventory, is an agreement between a buyer and a seller where the seller manages the buyer’s inventory for them. While it’s in possession of the buyer.
If you’re a buyer, sounds like a pretty sweet deal, huh? Why would a supplier do such a thing? To answer that question, let’s take a brief look at how VMI agreements work.
How Does It Work?
VMI inventory is owned by the vendor but stored at the buyer’s premises. In that sense, it’s a type of consignment inventory. The vendor and buyer then agree on the specifics and goals of the agreement. Then the vendor ships the inventory to the buyer and monitors inventory levels. The vendor then makes all the replenishing purchase orders based on their own forecasting.
This system obviously requires buyers openly sharing a lot of data with vendors so the latter can accurately forecast.
Inventory Management: VMI Edition
Here’s how buyers can get the most out of their VMI agreements:
- Be generous with your data, but protect it. Make sure you have a confidentiality agreement before that data is shared.
- Do research and choose the right vendor for you. Don’t rush into anything. It’s a pain to dissolve an established VMI relationship.
- Create a very detailed contract that specifies what items are being managed, min and max inventory levels, and how returns will be handled.
- Choose small-to-medium size vendors. Often huge national vendors that offer VMI services don’t have the incentive to provide stellar service.
- Make sure you share with your vendor anything that might affect buying behavior, like opening up a new sales channel. That’ll help them keep their finger on the pulse of demand forecasting.
And here’s how vendors can have a positive experience:
- Get creative with your buyers, and ask for value beyond storage. What can they do for you in terms of displays, staff education, demos, and upselling? Can they include your branding on their website or somewhere in their store? There are a lot of ways to integrate your product into your buyer’s sales strategy beyond consigning your product to them.
- Abide rigidly in any confidentiality agreement and you’ll find your buyers are quite forthcoming with their data. The more data, the better you can manage inventory, and the longer you’ll keep your clients.
- Get some boots on the ground. Send representatives to retail locations to oversee branding, display, and salesperson education.
Pros & Cons
Pros of using VMI for buyers:
- Reduced risk because buyers need not invest in the inventory up front
- Higher cash flow because money isn’t tied up in sitting inventory
- Inventory levels tend to be more optimized because vendors don’t want to lose clients.
- With lower inventory comes lower carrying costs and less shrinkage
- Stockouts are rare or non-existent on account of fluid, informed, and contractually-obligated inventory replenishment.
- Less bandwidth spent on inventory management, more bandwidth spent on core business responsibilities
- Sales and brand engagement increase because sales staff are educated by vendor representatives
Pros of using VMI for vendors:
- There is more control over product displays, branding, and in-store organization
- Just as salespeople get better with vendor expertise, vendors can count on more sales because of salespeople’s expertise
- Carrying costs go down for you, too, because you’ll have a better understanding of your product’s demand. That’ll make it possible to purchase more strategically and streamline your own inventory.
So, Those Are the Types of Inventory, Eh?
Sure as heck are! What’s important to note about all these types of inventory is that they’re not mutually exclusive. Many businesses have almost all of these types of inventory simultaneously. And good inventory management is able to handle it all smoothly.
That’s because smooth inventory management is all about consistent tracking and iterative decision making. If you establish a baseline in any type of inventory, you’re able to start measuring against it. That’s how businesses tweak their way to success.
One way to get a head start is using an ecommerce platform that streamlines all your communication with suppliers and vendors. While also easily tracking inventory and smoothing out purchasing and invoicing. BlueCart does that for thousands of wholesalers across the country. Book a demo and we’ll show you exactly how we can help.