Inventory management for retail & ecommerce businesses differs from manufacturing businesses. This is because retailers only deal with finished goods, while manufacturers also deal with raw materials and work in progress inventory.
That’s why the process of managing inventory and the metrics related to it is completely different in retail.
In this guide for merchants we are going to explain the entire inventory management process for retail & ecommerce businesses from start to finish. We will share best practices from the industry and answer the most frequently asked questions.
The Objective of Inventory Management?
With inventory being one of the biggest assets on a retailer’s balance sheet, the objective of inventory management is to maximize the return on this asset by buying right in the first place, storing it efficiently, selling it at the highest possible margins, and minimizing stock losses along the entire process.
Effect of Inventory Management on Your Retail or Ecommerce Business
A lot of retail & ecommerce businesses struggle financially due to issues related to inventory. This is because the effect of mismanaging inventory cascades down to other aspects of the business from sales to cash flow.
Effect on Sales
Failing to have the right amount of inventory at the right place at the right time will result in missing sales opportunities for the business.
However, this is not the only problem..
When customers come to your store and don’t find what they need and this starts to become a trend, they will start shifting to the competition. This will lead to loss of marketshare and the effect on sales will no longer be a temporary issue that the business is facing.
Bringing those customers back to your business will be a long and costly process in itself. It will involve a lot of marketing spend and some concessions and offers given to attract customers back and regain their loyalty.
Read also our article on 4 reasons why buying is the most important retail function
Effect on Margins
This effect can also be extended later on, as customers will start to put a reference price for your products in their mind and later on refuse to buy them at higher price levels.
Effect on Financials
Since inventory management affects sales & margins, it automatically affects the final financial situation of the business.
But this is not the only reason..
Failing to manage the inventory properly will result in higher stock obsolescence, i.e stock that has no value anymore because it has become very old or has been damaged. This usually happens when inventory aging goes out of control because inventory is not being cleared efficiently or because inventory is not being allocated properly to the stores and sales are being missed while the stock is lying at the warehouse to age and become obsolete.
Effect on Cash Flow
Inventory = Cash
When inventory is mismanaged, this results in cash either being lost, or remaining idle at the warehouse and not being pumped back into the business or used to buy new merchandise.
When you look at a retail or ecommerce business’ cash flow spreadsheet, you will find that the highest amount of outgoing cash is the payment to suppliers, i.e the cost of goods sold. When your inventory is not selling as planned and not managed accordingly you will have to still pay suppliers for new inventory that is coming, but you are not getting the cash out of the old inventory that is still sitting there waiting to get sold.
This will lead to liquidation events that will reduce your margins to generate cash quickly to be able to pay your suppliers and get newness into your stores.
That’s why we always recommend syncing your monthly open to buy plan to your cash flow management sheet, so that you will always be aware of how much inventory is coming and how this will affect your cash.
Read Also: Cash Flow Management for Retail & Ecommerce
Inventory Management Process
Buying the right amount of inventory is the first step in the inventory management process. For retailers this is done through the Open to Buy process. We explain this process in details in our free Open to Buy guide, please read it.
This process starts with a realistic retail budget where sales & margin will be forecasted for the next period and then based on that the buying plan will be set to support those sales figures.
Mastering this planning process is the key to preventing a lot of inventory management issues down the line.
2. Receiving & Movement
After the products have been bought and as they start to arrive at your warehouse or store, a proper receiving process should be followed.
The receiving usually starts with telling your retail merchandising system what exactly you are receiving, by creating a purchase order on the system (PO). This purchase order specifies the supplier name, the exact quantity of the items ordered and their cost.
Doing this sets the initial base for the inventory, ie the initial quantity and cost, and records it on your system and your books.
This purchase order then gets received at the warehouse and then the initial allocation is created to be sent to stores.
The allocation process specifies what is exactly going where.
Each store gets a location number that is specified on the system, and as the inventory gets allocated it will show which item has gone to which store and in which quantity.
As stocks get sold at the stores and replenishment is needed, every time an item gets replenished it will change its location on the system from warehouse location to the respective store location it has gone to. Same applies to any transfer between store locations or back to warehouse. Every movement needs to be recorded on the system.
This way, when you generate your stock on hand (SOH) report at any given time, you will be able to see exactly where each piece hypothetically is.
We say “hypothetically” because, as we will discuss later errors happen along the way and will be rectified.
Read Also: Merchandising 101
Your inventory is now at the stores and sales are happening everyday.
Every time a piece is sold it is being deducted from the SOH for this particular store, and every time it gets replenished from the warehouse it is being transferred on the system from this location to the store location.
However; this process of tracking is not perfect and some errors can happen due to the following:
- Receiving was not scanned or counted right by the store
- Item was lost during the transfer process
- Item was stolen from the store
- Item was refunded but transaction was not recorded on the POS
- Item was sold but another item was scanned at the POS
All this leads to the stock on hand as per the report being slightly different from the actual state. Sometimes you might even see some items recorded as -1 pieces, which is not possible but this is due to one or more of those errors.
This is why retailers conduct stocktakes (Stock counts) or perpetual counts on a regular basis.
When a stock count takes place, all the existing items get scanned and this will form the new SOH for that location and any discrepancy will be reported as inventory shrinkage and the book value of the inventory on the balance sheet will be adjusted accordingly.
If this process is followed correctly, we will always have a mostly accurate view on our inventory and what is exactly where.
After the inventory has been in the business for some time it will start to age. Depending on its age, at some point this inventory needs to be cleared, so that new merchandise can be bought.
Retailers never expect to sell all their merchandise at full price, and they factor a certain level of markdown for each product category. The objective of the inventory management process here is to clear this merchandise at the highest possible margins and in the most efficient way.
The clearance process should be a gradual process, where stock is subjected to rising level of discount the longer it stays and until it is cleared. Sometimes certain items will not be cleared completely, and they will instead be written off the books and discarded.
Inventory Management Best Practices
Some practices can make your inventory management process easier and more efficient. Here we will list the most practical ones that we have used over the years.
Setting Merchandise Hierarchy
You will never be able to manage your inventory properly if you don’t have complete visibility over it.
Setting the proper merchandise hierarchy from the start will help you drill down to each SKU and what it actually is and what is the best way to clear it or the best place to allocate it to.
If the categorization of your merchandise is all over the place, or if you set vague class or sub-class names it will be very hard to read your reports or make any use out of them.
For example as you go through your sell through report to see what is not selling, you might find that a certain class has a low sell thru rate. If you have the right categorization you can then single out which sub-classes exactly are slow sellers and apply discount or offer on those sub-classes alone, rather than having a wider markdown.
This will result in lower discounts, higher margins, and hence better inventory management.
Proper Merchandising & Planning
Just as much as buying was an important step for inventory management, so is merchandising.
Allocating the right stock in the right amount to your stores and setting up a proper replenishment system will maximize your return on your inventory and allow you to sell more of it at full price.
Read Also: Inventory Allocation
This does not only include initial allocation based on store grades, but also moving your stocks between stores and consolidating inventory to certain locations that are able to sell it faster and at higher margins.
Creative Visual Merchandising
Proper merchandising also includes visual display on the floor and using the store windows to your advantage.
I can’t tell you how many times an item sold out after we put it in the window or highlight it on a floor mannequin. I also can’t tell you how many times we find an item in the zero sellers report, just to discover that it was not displayed on the floor and was buried down somewhere in the stock room.
When the sale time comes, these items would have lost their chance to be sold at full price and will now have to be discounted.
So proper visual merchandising will help you make the most out of your inventory.
VM practices that can help your inventory management can include:
- Changing your windows frequently (every 3-4 weeks)
- Changing the front display frequently
- Creating outfits out of your best sellers with slow sellers & utilizing mannequins
- Creating gifting ideas and displaying them
- Utilizing the cash desk for add-on display
Monitoring Sell Through Rates
An item might need to start being marked down even if it did’t reach and advanced age.
This can be assessed by regularly monitoring your sell through report and taking action on slow sellers early on. When you start acting early this will reduce the need for higher discounts down the line.
Slow sellers found through the sell through report don’t necessarily need a discount straight away. Sometimes all what they need is a better visual display and highlight. (actually most of the time this is the case)
This is why monitoring your inventory reports can save your margins.
Monitoring Inventory Aging
Since age is the primary factor in our decision to start discounting, the aging report should be generated and monitored on a regular basis.
Failing to clear merchandise as it ages will result in reduced freshness, as your OTB will be locked for new purchases and this will affect your future sales.
Ideally you want to have an inventory mix, where the majority is between 0 to 3 months and the following buckets get lower as the age gets higher
Controlling Stock Loss
Strictly following a set schedule of stock takes and perpetual counts will lead to higher accuracy of inventory reporting, as well as rectifying any high-risk causes related to stock loss.
Shrinkage eats at the retailer’s profits and controlling it is an easy way to maximize returns on inventory. After each stock count is conducted a stock loss action plan should be created and followed.
Tracking & Optimizing Inventory Metrics
There are a number of inventory metrics that can guide on the efficiency of the inventory management process of a company.
These Metrics Include:
Based on the results of the inventory metrics, you can judge which products are better for your profitability, and start to take this feedback and use it in your buying.
Over time, you will start to have better returns and also your inventory cycle will start to function more smoothly.
If every time you analyze reports and metrics thoroughly and start excluding certain SKUs and replacing with better ones, you will have less stock to clear at the end of the cycle and your cash will start turning fast.
By optimizing this process you will also pay lower inventory storage fees, because now you are buying the right amount of stock and it is turning faster.
This is the beauty of planning and acting on your numbers…
Inventory Management for Ecommerce
Most of the process we have described in this guide applies also to ecommerce, except for the physical store locations.
However, a lot of ecommerce businesses nowadays sell through multiple warehouse locations. The same will apply here, by creating different locations for each warehouse and ensuring that all items are scanned and updated on the system to reflect the right quantity physically present at that location.
Warehouses also conduct stock counts on a regular basis and have the same reporting norm for shrinkage.
If a business is having both online and offline locations, the stock for the online location can be separated at the warehouse in bins and only this stock will be updated on the online store. This is to avoid having this stock being replenished to stores and moving out of the warehouse while still being offered for sale online.
A lot of new cloud-based POS systems, offer the option of syncing your inventory online and offline as it sells from the store. They are worth checking out, if you will be selling online and offline at the same time from the same inventory pool at your store, which we actually recommend for small brick & mortar retailers.
Frequently Asked Questions About Inventory Management
Retailers use a barcode system connected to their retail merchandising system to scan items when they are received, sold or moved between stores.
Your minimum amount of inventory is based on the stock cover you want to maintain.
For example, if your target stock cover is 6 months, then the minimum amount of inventory is the amount to cover the sales of the next 6 months. This is usually calculated through the Open to Buy process.
Inventory is considered a current asset because it can be liquidated and converted into cash in less than a year.
Retail stores write off and damage obsolete stock that cannot be sold anymore due to defects or high age on the sales floor. They do this to take this inventory off their books.
A Stock loss action plan is a plan that is created after a stock count to address the reasons that lead to stock loss and the high risk areas on the floor that need attention, in order to reduce shrinkage in the future.
When you calculate GMROI (Gross Margin Return on Inventory Investment) you will be able to know how much return on every dollar invested in inventory you are getting. This will depend on your gross margins and how much inventory you carry on average.
We have complied a list of benchmarks that show GMROI by retail category here.
Inventory management involves many different functions in the retail business, and when done right will improve the returns of the businesses over time.
a lot of retailers report inventory management as their biggest issue, but as we have seen here, this can be avoided by having a system in place and using technology to help up us in the process.
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Retailer & Founder of Retail Dogma, Inc.
Rasha has 12 years of retail & ecommerce experience. She has started an ecommerce business in 2008, and later worked at H&M, Bath & Body Works, Victoria’s Secret and Landmark Group. She’s currently working with an omni-channel retail start-up, and scaling its retail operations in UAE.
She has lived in 4 different countries, speaks 3 different languages and holds a master’s degree in Strategic Management & Marketing.