A Small Business Guide to Inventory

While brands like Supreme are known for selling out new fashion lines in mere minutes, that’s not the path to maximum profitability for most businesses. Selling out can be frustrating because it means there are customers who would, but can’t, buy your products.

That’s why it’s essential to have a firm grip on your inventory. Let’s dive in.

Overview: What is inventory?

Inventory comprises the assets your business sells as part of its ordinary course of business. A shoe company’s inventory comprises shoes, and a balloon maker’s, balloons.

Not all assets your business sells may be considered inventory. Say you own a company that manufactures blankets, and you’re selling an old knitting machine to make room for a new one. The machine isn’t an asset your business usually sells, so it’s not considered inventory. Blankets make up your inventory.

Many service businesses, like consulting firms, have little to no inventory. Not-for-profits can have inventory, but they risk triggering the unrelated business activity income tax when they sell goods and services.

The 3 types of inventory your business can have

Inventory comes in three flavors: raw materials, work-in-progress, and finished goods. You can think of each inventory type as a stage in the manufacturing process, flowing from the raw materials to the finished goods.

Manufacturing businesses have all three inventory types, while retail companies that resell unaltered products only have the final stage, finished goods.

1. Raw materials

Raw materials are the building blocks of your inventory. A business that manufactures and sells furniture has wood, metal, fabric, batting, and nails in its raw materials inventory. Through the manufacturing process, raw materials are put together to create finished goods.

Raw materials inventory is valued at their cost to your business, including duties, taxes, and shipping from the supplier to your factory.

2. Work-in-process

Work-in-process (WIP, pronounced “whip”) inventory, as the name suggests, is where your company puts its raw materials together to create the saleable product. Manufacturing a product requires labor, machinery and other equipment, and raw materials.

Once your raw materials are put into the manufacturing process, they’re considered part of work-in-process inventory.

WIP inventory is the hardest to value because it requires the estimated completeness of each product. Accountants refer to this figure as the completion percentage regarding conversion.

You need to know the completion percentage to value WIP inventory properly: a unit 60% complete costs more than a unit that’s only 10% complete because of the labor and other manufacturing costs invested in it.

3. Finished goods

Finished goods inventory includes the final-form products your business sells to customers. Merchandise inventory purchased from wholesalers are finished goods. Once your WIP inventory is 100% complete, it joins finished goods inventory.

Finished goods purchased from wholesalers are valued at their cost, including duties, taxes, and shipping.

Goods your business manufactures are valued at their product costs: direct material, direct labor, and manufacturing overhead. Overhead costs include indirect costs, such as marketing and warehouse maintenance.

How does inventory management work?

Inventory management involves the sourcing, ordering, manufacturing, tracking, and selling of inventory. Small businesses, which often run on lean margins with little room for hiccups, need to monitor inventory so they have something to sell but not too much to where there’s a burdensome surplus.

Diligent inventory management can score your business some major efficiency points: Practicing effective inventory management ensures that you are sufficiently stocked and know when to adjust your manufacturing or purchasing cadence for changes in projected inventory needs.

A major goal of inventory management is to minimize carrying costs -- the cost of storing inventory -- without losing out on sales due to lack of inventory. The outcome of exemplary inventory management is a healthy inventory turnover ratio.

Consider a local bakery renowned for its buttery, flaky, perfect-with-an-espresso croissants. Before you ask, yes, food is inventory, whether it’s in a grocery store, deli, restaurant, bakery, or dive bar.

The bakery needs an inventory management system that looks at sales data and tells its owners the optimal number of croissants to make each day. From there, the owners can time the purchase of their raw materials -- eggs, butter, flour, and the best part, those little sliced almonds -- to optimize their freshness.

Small businesses also need to establish an inventory control method that matches the inventory they have. To limit waste, called deadstock, a bakery should go for a first-in, first-out (FIFO) control method, where the first croissants baked are the first sold. Other businesses may opt for its opposite, last-in, first-out (LIFO).

Check out our guide to inventory management to learn the central tenets of the practice. Also consider investing in inventory management software to track, evaluate, and improve your inventory control effectiveness.

3 benefits to successfully managing your business’ inventory

When your inventory control is, well, under control, you stand to reap serious benefits.

1. You don’t have excessive surplus inventory

The ideal inventory management system leaves you with the right amount of inventory: not too much that you can’t comfortably store it and not too little that you regularly sell out.

Think of investing in inventory like investing in a house: You don’t want to spend so much on a home that you can’t afford to grow your wealth in other ways. Being house-poor limits your ability to pursue other opportunities.

Successful inventory management prevents you from spending so much on inventory that it limits your business’s growth in other areas. By accurately predicting future demand for your products, you’ll reduce being inventory-poor.

2. You know what’s in stock

It’s essential to have a precise inventory count, especially for e-commerce businesses where customers place orders online. Nothing’s worse than having to cancel customers’ orders due to a lack of stock.

Inventory management software can keep track of your inventory checklist, a register of each product in your inventory. Many software solutions integrate with e-commerce platforms to act as the central inventory tracking system for your books and online shops.

3. Inventory counts are confirmatory, not determinative

Businesses shouldn’t rely on physical counts to know how many products are in their inventory. When you manage your inventory effectively, the regular physical inventory counts confirm the quantities on your inventory checklist.

There might be discrepancies in your ending inventory amounts, but that’s why you do inventory counts. Your software can’t possibly know about stolen, damaged, or otherwise unsaleable inventory. Proper inventory management takes a small burden off physical inventory counts.

Inventory your inventory management system

There is always room for improvement for managing your inventory. If you don’t use software, consider it. If you don’t regularly count your inventory by hand, do it once a month. The more time you spend analyzing your inventory, the more likely you are to keep the perfect amount of stock that maximizes business profit.