Small Business Inventory Management 101: How to Manage Inventory

Missed sales, tied-up money, and an under-stocked inventory got you worried? You’re not alone. At least 46% of all businesses have inventory-related issues because they either don’t track or track manually. This less-than-ideal inventory management approach costs U.S. retailers 53% of unplanned markdown costs. Adopting a good inventory management strategy can help you reduce all such losses.

In this article, we’ll cover a range of solutions, some of which might change the way you manage your business inventory.


What Is Inventory Management?

You have been an entrepreneur for a while, so you would be familiar with activities such as ordering, stocking, and selling products. Other aspects of inventory management include MRO (maintenance, repair, and operating supplies), warehousing and processing, packaging, sorting, and stock rotation. Considering everything involved, inventory management can be a tricky task, especially for small businesses.

If you’ve been struggling with manual inventory management, process documentation and compliance, it’s time to consider getting some help.



Useful Techniques of Inventory Management for Small Businesses

The challenges most small businesses face include over-stocking or under-stocking, poor processing, spoilage, rise and fall in customer demand, and optimal use of warehouse space. To help you circumvent these, we’ve put together several simple tips and tricks.


1. Organize and Track

Getting organized is the first important step. Organize the information related to your stock, supplier, and shipping details into an accessible system. To organize your inventory, you need data such as product name and quantity, name of vendor or manufacturer, universal product code or article number, retail, wholesale and selling price, payment terms, reorder quantity, shipping information (weight, size), colors, expiration date, and pictures.

You will find most of this information on your order sheets or get them from the vendor. Often the vendor will use their own methods to record this data, which can be manual or software-based.

Once you have the details, you can assign a unique SKU (stock-keeping unit) to your products. Keeping this data updated at all times can help you locate products faster and identify damaged goods, customer returns, and late deliveries.

Using a spreadsheet is a popular method, but it also has its flaws. Spreadsheets are vulnerable to human errors, time-consuming, difficult to sync, and can get big enough to produce errors while loading. They’re a hassle if your team has more than one member.

Instead, you could try cloud-based software. They allow multiple users to access data remotely, are easy to update, and sync immediately.

Another aspect of being organized includes tagging or labeling products to track them. This helps to prevent running out of stock when a consumer’s favorite item is high in demand. Surveys show that tagging options like RFID (Radio Frequency Identification) can increase inventory accuracy up to 95%.


2. Group Inventory Items

Categorizing inventory items into groups according to the value helps inventory tracking and control. This technique is also known as ABC analysis.

Here’s how it works.

  • Group ‘A’ items include high-demand items that give you the highest profits.
  • Group ‘B’ items include products with a normal demand and drive a portion of the profits.
  • Group ‘C’ items include products that do not affect the profits or demand individually but are important for the business.

With the priority of orders sorted, inventory managers can redirect their focus to the delivery, storage, and sale of group A.

ABC analysis helps you negotiate with vendors better and hike prices to drive profits when demand for a product is high.

The biggest benefit is that you can optimize your inventory for maximum profit.


3. Choose an Inventory Accounting Method

You can simplify managing inventory once you identify which accounting method works for you.

Here’s a closer look at the four most common ones:

First In First Out (FIFO)

FIFO is a strategy that works around clearing first-acquired items first. If your business works with stock perishables or export goods, FIFO will drastically lower the chance of damage to inventory items. Other benefits of FIFO include a reduction in total net income and, subsequently, the total taxable income for the year when the prices are falling. It allows businesses to report lower taxable income on profits from selling newer goods later.


Last In First Out (LIFO)

LIFO is the opposite of FIFO, wherein you begin by selling the inventory items you purchased last. LIFO accounting reduces the total profit and taxable income of a business when prices are rising. LIFO is most beneficial for automobile or retail businesses.

Here’s a study to help you understand the full effects of LIFO and FIFO on profits and cash flow during inflation and deflation.

LIFO is accepted in the United States under the GAAP (Generally Accepted Accounting Principles) rules. However, the IFRS (International Financing Reporting Standards) rules which are followed in most other countries in the world prohibit usage of LIFO due to potential net income distortions. It may be worth pointing that some inventory reversal write-downs are permitted under IFRS but not permissible under GAAP.


Weighted Average Costing (WAC)

Weighted average costing involves dividing the cost of units on sale by the cost of units on the shelf. This gives you an estimate of the cost of every unit sold and every unit in the inventory.

Weighted average costing is useful when inventory costs are not assigned to specific units. However, this method can also result in huge losses if some of your units are more expensive than others.

The weighted average method is most commonly used in the gas and petroleum industries. It is also the method with the least amount of tracking required.


Specific Identification

Alternatively, specific identification is used to identify inventory costs based on single items sold. This method requires the highest amount of tracking since each product is identified.

These are commonly used when the product purchase is easier to separate for the business—for example, automobile dealers.


There is no one-size-fits-all when it comes to inventory costing. So, make sure that you review every process carefully with your accountant before settling on one.


4. Know Your Inventory Costs

Below are some of the inventory costs you should calculate.

Ordering Costs

Ordering costs will involve all your expenses on activities related to the ordering process. This accounts for the labor cost that handles delivery order processing, placement, and reception for businesses.


Carrying Costs

Carrying unsold goods is not a cheap one-time expense. Here’s everything that is included in the carrying cost.

  • Insurance cost
  • Taxes
  • Warehouse storage costs
  • Handling costs
  • Employee costs

According to Investopedia, the total carrying cost makes up about 20-30% of inventory costs.


Shortage Costs

Shortage costs are incurred when your inventory has insufficient goods. It can cause more than monetary damage to the brand. For instance, you’ll be paying quite a bit for expedited shipping costs to meet orders. You’ll also lose consumers and still have to pay idle employees.


In practice, these cost estimates can help you make wiser decisions around inventory stocking, ordering, and delivery planning. They also give you a clear estimate of the total cost of inventory ownership.


5. Consider Dropshipping

Dropshipping is a practice where retail businesses directly buy and ship items from the wholesaler or manufacturer. It takes out all the hard work involved in business inventory management, especially if you’re a small business with a low budget or inadequate warehouse capacity.

If you’re unsure whether dropshipping is suitable for your business type, consider the following:

Faster Product Launch: If you’re considering a new product line, then dropshipping will help lower your investment. For starters, you won’t be shoveling money into product development. Dropshipping will help you keep tabs on demand and selling costs, thereby allowing you to determine just how much you need. You’ll also save on expenses such as staff and warehousing. On the other hand, for branded dropshipping strategy, you may incur non-recurring engineering (NRE) costs and brand marketing costs.

Lower Shipping Expenses: If you cater to international clients, then you’ll understand just how cringe-worthy shipping fees can be. Dropshipping can save you the expenses of setting up a fulfillment center, warehousing/storage and shipping fees.

Lower Margin: You only get a “cut” of the sales since you’re selling another manufacturer’s products. Branded dropshipping could potentially improve this.

Competition: To stay competitive in a saturated industry, such as cosmetics, you may need to lower your sales price, which might lower your margin even more. To earn a sizeable profit, you may need to increase your sales volume with this price strategy.

Quality: While you’re not responsible for the manufacturing, your customers will hold you accountable for sub-standard products. Depending on the contract, you may need to handle returns and refunds while keeping an eye on Quality-of-Service metrics such as fulfillment speed of your dropship partner.

Knowing the cost savings and potential quality of service risks associated with dropshipping, you can make an informed decision around whether dropshipping is right for your business or product(s).


6. Plan Inventory Restocking

A standard way to manage inventory restocking of products is to use the concepts of Safety stock and reorder point.

Safety Stock

A safety stock does as its name suggests—it saves your business. This is the buffer stock you might want to order during a high-demand season.

Here’s the formula to calculate safety stock.

Safety Stock = (Maximum Daily Usage  X Maximum Lead Time in Days) – (Average Daily Usage  X Average Lead Time in Days)


Maximum Daily Usage = Maximum units sold in a day

Maximum Lead Time = Maximum days taken to replenish inventory for the unit sold

Average Daily Usage = Average units sold in a day

Average Lead Time = Average days taken to replenish inventory for the unit sold


It is crucial to note that while businesses need safety stock, too much of it can hurt you. Not only will your money be tied up in inventory that isn’t moving, but you’ll also be spending money to manage and safeguard that inventory.


Reorder Point

Reorder point is the point in the business cycle when it’s time to reorder inventory items.

Here’s the formula to calculate the reorder point for your business.

Reorder Point = (Average Daily Usage  X Average Lead Time in Days) + Safety Stock


Average Daily Usage = Average units sold in a day

Average Lead Time = Average days taken to replenish inventory for the unit sold


Here’s a guide to understand when to use the reorder point method.


An alternative to the reorder point method is Just in Time (JIT) business inventory management. JIT involves ordering inventories when they are needed. The products arrive right on time, leaving small business owners little need to store them, reducing inventory costs.

While reorder point strategy works for industries where businesses must maintain adequate stocks, JIT works for industries where storage is an expensive process.

Here are a few examples of companies that have adopted the JIT model.


7. Audit Stocks

Stock auditing can help you confirm the numbers you see on your ledgers or POS systems (if you use them). For example, a physical inventory count and products’ order count tags can be checked against the ledgers as part of the audit process.

You can use the physical inventory counting or the ABC analysis method to do an audit. Not sure what’s the difference? While ABC analysis will help you track how your high-priority products are moving through the inventory, physical tracking can give you clear estimates on all your products.

Schedule inventory audits every once in a while, or when your accountant may need it. These can be year-end audits, spot checks, or cyclical audits.

You can do an audit once in 2-3 months, quarterly, or annually based on the type of inventory you have.


8. Measure and Monitor Inventory

Keep track of sales, market trends, and your business to understand your needs and better manage your inventory.

Here are four numbers to help you estimate inventory status.

Inventory Turnover

The inventory turnover ratio gives you an estimate of the number of times your business sells and replaces the inventory.

Calculate your inventory turnover by using the below-given formula.

Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory


Average Inventory = (Beginning Inventory + Ending Inventory) / 2


Sell-Through Rate (STR)

STR is used to calculate the amount of inventory sold in a given period compared to the stock received in the same period. The ideal STR is anywhere between 40-80%.

Here’s the formula to calculate your STR.

Sell-through Rate = (Number of Units Sold / Number of Units Received)  X 100


Economic Order Quantity (EOQ)

EOQ involves ordering the maximum number of inventory that meets demand. It helps businesses estimate orders accurately and reduce holding and storage costs.

Here’s the formula to measure your EOQ.

EOQ = square root of  (2 X Setup Costs  X Demand Rate  / Holding Costs)


Demand Rate = Annual demand cost (average products sold over a year)

Setup Costs = Costs of order per purchase (shipping + handling costs)

Holding Costs = Holding costs (also known as carrying costs) per unit per year


Days Inventory Outstanding (DIO)

DIO is a measure that tells you how many days the capital is tied up in your inventory before making a profit. A low DIO is typically a good sign for a business. It means the inventory is selling fast. However, it may also indicate that the business needs to keep a close watch on its inventory to avoid a shortage.

Measure your DIO using this formula.

Days Inventory Outstanding (Annual) = 365 X Cost of Goods Sold (COGS) / Average Inventory


Average Inventory = (Beginning Inventory + Ending Inventory) / 2


Here are some additional metrics for small businesses to assess inventory performance:

  • Sales Revenue (net income after subtracting the cost of undeliverables, refunds, and discounts)
  • Gross Margin (total sales revenue after deducting the COGS)
  • Inventory Accuracy (discrepancies between inventory and inventory data)
  • Item fill rate (difference between customer orders fulfilled and placed)
  • Cycle time (Total time spent on producing and fulfilling an order)


9. Improve Order Fulfillment Accuracy

An often-ignored process of business inventory management is order fulfillment. It is also referred to as receiving orders. This step is very important when managing inventory.

Here are a few ways to boost fulfillment accuracy:

  • Assigning an employee to order fulfillment
  • Checking all products received against the order list
  • Reporting inconsistency in the delivery/order (if any)
  • Proceed with the labeling/tagging processes if there are no issues with the products


Mistakes in fulfillment can lead to customer dissatisfaction, refund issuance, return shipping and other costs. So, standardizing on the pick and pack process and measuring fulfillment errors help reduce these avoidable costs to business.


10. Control Inventory Quality

There’s nothing quite as devastating as an inventory full of costly products that cannot be sold because of quality issues or potential malfunction in the field. Avoid this by pulling together your best quality control efforts. Here are a few methods that can help you control the quality of products in your inventory.

  • Statistical Quality Control – is needed in businesses where products are produced and sold in large quantities. The process involves inspecting the quality of products from a random sample.
  • Product Inspection – is used to check the quality of the final product that’s being sold to the consumers. It involves checking inventory items against specifications to identify defects and is useful for small businesses.

According to the American Society for Quality, quality-related costs can exceed 15-20% of sales revenue.


Final Thoughts

Inventory management isn’t easy, but we do hope our small business inventory management guide helped put you on the right path. And while we’ve given you a lot to explore and process, implementing a tip at a time will help you protect and nurture your inventory and investment. More importantly, as your business and inventory capacity grow, your inventory management skills will continue to hold you in good stead.


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