Inventory management: what it is, methods and tools

Published Friday 17 April 2026

Table of contents

• What is inventory management?
• How inventory management works
• Why efficient inventory management matters for your business
• Understand the inventory types your business has
• Inventory management methods every small business should know
• Steps to implement your inventory management system
• Improve your forecasts
• Track your inventory
• Use the best tools
• Efficient inventory management means better cash flow
• FAQs on inventory management

Key takeaways

• Implement a continuous five-stage inventory cycle that includes planning demand forecasts, purchasing at optimal times, receiving and storing goods properly, tracking stock levels in real time, and fulfilling customer orders efficiently.
• Use dedicated inventory management software instead of spreadsheets to gain real-time visibility, integrate with your accounting system, and avoid costly errors that can tie up cash flow and create compliance issues.
• Apply demand forecasting by analysing your historical sales data to identify seasonal trends and popular products, then adjust your stock levels accordingly to prevent both overstocking and stockouts.
• Focus on the 80/20 rule by prioritising the management of your top 20% of products that generate 80% of your sales, as this approach maximises efficiency and profitability while reducing time spent on slow-moving inventory.

What is inventory management?

Managing inventory involves ordering, storing, tracking, and selling your business's stock. It covers everything from raw materials to finished goods.

The goal is simple: have the right products in the right place at the right time. This helps you avoid running out of popular items or tying up too much money in stock that isn't selling.

How inventory management works

Managing inventory follows a continuous cycle that keeps stock flowing smoothly through your business. Understanding this workflow helps you see how all the pieces fit together.

The process works in five connected stages:

1. Plan: Forecast demand based on sales history and market trends.
2. Purchase: Order stock from suppliers at the right time and quantity.
3. Receive: Check incoming goods for accuracy and quality, then store them properly.
4. Track: Monitor stock levels, locations, and movements in real time.
5. Sell: Fulfil customer orders and record what leaves your inventory.

After each sale, the cycle begins again. Your sales data feeds back into planning, helping you refine future forecasts and purchasing decisions.

This continuous loop means managing inventory isn't a one-time setup. It's an ongoing process that improves as you gather more data about your business patterns.

Why efficient inventory management matters for your business

Efficiently managing inventory directly impacts your profitability and cash flow. Poor inventory control ties up money in unsold stock and creates compliance challenges, with the FMA having issued two infringement notices and a warning letter to entities and directors in 2020 for reporting failures.

Accurate inventory valuation is critical for financial reporting, as regulations require many entities to file audited financial statements within four months of their balance date. In 2020, 12% of certain New Zealand entities were referred for non-filing of financial statements.

Here's how inefficient inventory management affects your business:

• Lost revenue: Unsold items don't generate income
• Increased costs: Warehousing and inventory accounting add ongoing expenses
• Wasted space: Stored items occupy space that could serve other purposes
• Depreciation risk: Stock may deteriorate or become obsolete
• Security concerns: Items could be damaged or stolen

When you reduce excess inventory, you free up money to invest in other areas of your business. Keeping the right amount of stock means you can meet demand, fill large orders, and stay ahead of competitors.

Efficient inventory management helps you save money and grow your business.

Understand the inventory types your business has

Inventory types are the different categories of stock at various stages in your business cycle. Understanding these categories helps you track costs, plan purchases, and manage cash flow more effectively.

Most businesses work with three main types:

Raw materials

Raw materials are the basic components used to create your final product. Examples include fabric for a clothing manufacturer or timber for a furniture maker. Depending on your business, raw materials can take up significant storage space.

Work in progress (WIP)

Work in progress (WIP) refers to goods currently being manufactured but not yet complete. Examples include toys waiting to be painted or ceramics that haven't been fired. WIP inventory requires careful tracking as it moves through production stages.

Finished goods

Finished goods are products ready to be sold to your customers. You might sell them directly to clients or send them to distributors. Tracking finished goods helps you understand what's available to sell and when to reorder.

Each category has different storage needs, and each depends on the others. When you have enough raw materials, you can produce finished goods. If demand for finished goods falls, adjust your raw material orders to avoid excess stock.

Depending on your business, you may also track safety stock (buffer inventory for unexpected demand), dead stock (unsold items), or MRO inventory (maintenance, repair, and operations supplies).

Inventory management methods every small business should know

Inventory management methods are systematic approaches for controlling stock levels, ordering, and turnover. The best method depends on your business type, size, and goals.

Here are four methods commonly used by small businesses:

Just-in-time (JIT)

Just-in-time (JIT) means ordering stock from suppliers only as you need it for production or customer orders. This approach reduces storage costs, lowers insurance expenses, and minimises waste from unsold inventory.

Materials requirement planning (MRP)

Materials requirement planning (MRP) is a system that uses sales forecasts to plan your raw material needs. It calculates what materials you'll need, how much, and when to order them. MRP is most useful for manufacturing businesses with complex production schedules.

Economic order quantity (EOQ)

Economic order quantity (EOQ) is a formula that calculates the ideal amount of stock to order at one time. It balances ordering costs against holding costs, helping you minimise both and optimise your purchasing decisions.

Days sales of inventory (DSI)

Days sales of inventory (DSI) is a ratio showing the average number of days it takes to sell your entire inventory. A lower DSI means you're selling stock quickly and efficiently. A higher DSI may signal overstocking or slow-moving products that tie up cash.

Steps to implement your inventory management system

Implementing an inventory management system involves five key stages, from planning through to fulfilling orders. Follow this process to get your inventory under control:

1. Plan and forecast: Use your sales history to predict future demand. This helps you order the right quantities at the right time.
2. Purchase and order: Create a clear process for buying stock from suppliers. Consistent ordering prevents both shortages and overstocking.
3. Receive and store: Check incoming stock for accuracy and damage. Store items in an organised way so they're easy to locate.
4. Track your inventory: Use barcodes or software to maintain a real-time record of what you have and where it's located.
5. Fulfil orders: Pick, pack, and ship customer orders accurately and on time. Fast, accurate fulfilment keeps customers coming back.

Improve your forecasts

Demand forecasting helps you predict how much stock you'll need and when you'll need it. Accurate forecasts prevent overstocking and stockouts, improving your cash flow and customer satisfaction.

To improve your forecasting:

• Analyse historical sales data: Look for patterns in your past sales to identify seasonal trends and popular products
• Use accounting software reports: Generate detailed sales reports that reveal which products sell best at different times
• Adjust stock levels accordingly: Plan your purchases based on these insights to match expected demand

Track your inventory

shows you exactly what stock you have, where it's located, and how it moves through your business. Real-time tracking prevents stockouts, reduces theft, and helps you make informed purchasing decisions.

As your business grows, tracking becomes more complex. You need visibility across all inventory types:

• Raw materials: Typically stationary and easier to count during stock takes
• Work in progress: Moves frequently through production and requires regular monitoring
• Finished goods: Must be tracked from completion through to customer delivery

Two common tracking methods work well for small businesses:

• Barcode scanning: A traditional, reliable method that's still widely used
• Radio-frequency identification (RFID) tags: A faster, more flexible option with decreasing costs making it accessible for small businesses

Use the best tools

Inventory management software automates tracking, reduces errors, and integrates with your accounting system for better financial visibility. The right tools save time and provide real-time insights into your stock levels.

Seeing your inventory in real time is critical when operations are disrupted. During the COVID-19 pandemic, 21% of regulated entities in New Zealand relied on an exemption to get more time to file financial reports, highlighting how many businesses' systems weren't prepared.

Why spreadsheets fall short for inventory:

• Limited collaboration: Multiple people can't easily work on the same file
• High error risk: Easy to accidentally delete entries or entire files
• No automatic backups: Risk of losing all your data
• Missing features: Lack of essential inventory management functionality

Benefits of dedicated inventory software:

• Accounting integration: Connects directly to your financial records
• Cloud-based access: Lets you check and manage inventory from anywhere
• Automatic updates: Eliminates manual upgrades and backup management
• Real-time reporting: Provides instant visibility into stock levels and trends

Efficient inventory management means better cash flow

Efficiently managing inventory improves cash flow by reducing money tied up in excess stock and preventing lost sales from stockouts. The right system frees up capital for other business investments.

Key cash flow benefits:

• Reduced waste: Lose less money to obsolete or damaged stock
• Faster turnover: Move items through your warehouse more quickly
• Better demand prediction: Prevent overstocking with more accurate purchasing
• Integrated reporting: Gain clear visibility into how inventory affects your finances

When your inventory system integrates with cloud-based accounting software, you get real-time financial insights alongside stock tracking. You can manage everything remotely while making informed decisions about purchasing, pricing, and cash flow.

Every dollar you free from unproductive stock is a dollar you can invest in growing your business. Get one month free and discover how Xero inventory management software can improve your cash flow and business efficiency.

FAQs on inventory management

Here are answers to common questions about inventory management.

What are the 4 types of inventory management methods?

The four main inventory management methods are:

• Just-in-time (JIT): Reduces holding costs by ordering only when needed
• Materials requirement planning (MRP): Plans raw material needs for manufacturing
• Economic order quantity (EOQ): Calculates the ideal order size
• Days sales of inventory (DSI): Measures how quickly you sell stock

What are the 5 stages of the inventory management process?

The five stages of inventory management are:

1. Planning and forecasting demand
2. Purchasing new stock
3. Receiving and storing goods
4. Tracking inventory levels
5. Fulfilling customer orders

How often should I review my inventory levels?

How often you review depends on your business. Fast-moving goods typically need daily or weekly checks, while slower items can be reviewed monthly or quarterly. Inventory software provides real-time updates so you always know your stock levels.

What's the difference between inventory management and stock control?

Controlling stock focuses on what you have in the warehouse right now. Managing inventory is broader, covering how you forecast, order, and manage stock from supplier to customer. Controlling stock is one part of how you manage inventory overall.

What is the 80/20 rule in inventory management?

The 80/20 rule (also called the Pareto Principle) states that roughly 80% of your sales typically come from 20% of your products. Focus on managing these high-value items to work more efficiently and become more profitable.