How to create an efficient inventory management system

Inventory management can be hard for any business to do well. Here's how you can create an efficient system.

A small business owner managing inventory in the back of a van

Inventory is money

Inventory management can be difficult because it's hard to predict demand. If you stock up on a particular product line but demand drops, you'll have stock that you don't need. And if products are lying in your warehouse for too long, that will affect your cash flow because:

  • unsold items don't generate revenue
  • warehousing costs money, and so does inventory accounting
  • stored items take up space that could be used for something else
  • stock may deteriorate or become obsolete
  • items could be damaged or even stolen

So the money tied up in excess inventory could be put to better use elsewhere.

On the other hand, if you don't keep enough inventory and demand spikes, you'll miss out on sales – and maybe even lose customers. You won't be able to fill big orders and you'll have to scramble to catch up with your competitors.

Either way you could lose money. So it's important to manage your inventory as efficiently as possible.

Understand the inventory types your business has

Inventory usually falls into one of three main categories:

1. Raw materials

These are the basic materials from which your final product is made. Depending on your field of work, they can take up a lot of space.

2. Work in progress (WIP)

These are goods that are in the process of being manufactured but are not yet complete. Examples include toys to be painted and ceramics that haven't yet been fired.

3. Finished goods

These are products that are ready to be sold to your customers. They may be sent to distributors or you might sell them directly to your clients.

Each category has different storage requirements, but each one is dependent on the other. If you don't have enough raw materials, you can't make finished goods. And if demand for your finished goods drops, you could end up with too many raw materials.

Improve your forecasts

The first step to efficient inventory management is to understand the demand for your products. How does it vary over time? There may be seasonal fluctuations or other trends that can help you work out how demand will change.

Quality accounting software will generate reports into past sales. These can help you identify which products are popular at which times of year. Then you can adjust your stock accordingly.

Track your inventory

The next step is to find out what inventory you have and where it is. That might be easy if your business is small, but it can quickly become complex as you scale up.

Raw materials may be easy to track, but WIPs will move around a lot, and could be anywhere in the building. Finished goods need to be tracked right out of the door – and beyond. The best systems track products every step of the way – from raw materials to customer delivery of finished goods.

Barcode scanning is the traditional way to track stock, and it's still popular today. Other systems, such as radio-frequency identification (RFID) tags, are becoming more affordable and are often faster and more flexible.

Use the best tools

Whatever tracking system you use, make sure you have the software to support it. Avoid relying on Excel spreadsheets to manage your inventory, as:

  • spreadsheets can't easily be modified by several people at once
  • it's easy to make mistakes and delete entries – or even the whole file
  • you have to make regular backups to avoid data loss
  • spreadsheets weren't designed for stock management

It makes more sense to use inventory management software that was made for the job. Ideally this should tie into your accounting software – because inventory is money.

If the software is cloud-based, you won't have to worry about upgrades or backups, because it's all done for you. This will also let you check and manage your inventory from anywhere, at any time.

Efficient inventory management means better cash flow

A great inventory management system can help your business become more efficient. It will reduce waste, decrease the time that each item spends in your warehouse and help you predict future demand.

If you sell physical items, proper inventory management is key to your company’s well-being. With money invested up in every different type of item, even small efficiencies can make a big difference. Find out more in our Guide to inventory.

If this is tied into cloud-based accounting software, you can have the best of both worlds. You'll have an effective stock tracking solution coupled with clear financial reporting. And you'll be able to manage everything on-site and remotely.

The less money you have tied up in unproductive stock, the more you'll have for other areas of business. And that means greater cash flow, which is what your business needs to survive and thrive.


Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.

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