The Ultimate Guide To Inventory Management for Multichannel Retailers
Chapter 2: Principles of Inventory Management
Now that you have the terminology down, let’s move on to the principles of managing your online inventory. In this chapter, we’ll discuss inventory management tips, various accounting methods for tracking costs, advanced methods to further streamline your supply chain, and various pricing strategies to increase profits. After reading this, you’ll feel more confident selling your products online.
Section 1: Inventory Management Basics
One wrong shipment can undo the best of business plans. To help you avoid that, let’s review the basics of inventory management.
A labyrinthian warehouse can intimidate even the most seasoned retailer, with all those boxes, numbers, and barcodes. But for anyone hoping to master ecommerce, the first step is understanding inventory. After all, your customers aren’t buying your cool website or superior shipping methods, they’re buying products.
1. Keep Organized with SKUs
We’ll begin where we left off in the last chapter: SKUs. Stock Keeping Units are unique numbers assigned to each of your products to streamline all aspects of inventory management and shipping fulfillment. That’s the primary benefit of using them, and it’s a good one.
SKUs can be customized however is most natural for your company — you can organize products primarily by brand, category, popularity, etc. if that’s what’s useful for you — and can get as detailed as color and size varieties. We explained more about how to create your own SKUs in the previous chapter, but as one of the vital inventory management principles, SKUs are worth mentioning again.
2. Pay Attention to Product Types
Another useful organization tip is knowing your product types. Understanding what kind of products you’re dealing with — and their individual needs — allows you to optimize your workflow and eliminate wasted time.
Here are four product types that are handled differently as inventory:
- Item: A single product that requires no special attention; the standard for product types.
- Case pack: Individual items bundled together, usually the same product, but not always. Sometimes it doesn’t affect how you store your inventory, but other times it does, so it’s worth noting.
- Assembly: Items that need to be put together. Individual parts may be scattered throughout your warehouses, so depending on your sales cycles, you have to choose to organize them by parts or by the end product.
- Family: Products that have variations, usually color and size. Again, your sales cycles should determine how to group them.
It’s best to rely on past sales data when sorting your product types, so you know which methods to prioritize for slotting them.
3. Predict Demand
Another benefit of keeping eyes on your past data is predicting demand in the future so that you don’t run out of stock. As they say, “an ounce of prevention is worth a pound of cure.”
Pay attention to sales analytics to know which products sell most, and when. Keep in mind seasonal variations and holidays, as well as other incidents that change shopping behavior, such as weather.
4. Keep Backups
No matter how good you are at predicting demand, no one is perfect. At some point or another, some random occurrence is going to throw a wrench in your plans, and you’ll likely be left out of stock or without a supplier.
The only reliable solution is to keep backups. By this, we mean either physical items of your bestsellers or else a backup supplier in case something sudden happens with your current one. That’s not an excuse to neglect your predictive planning, it’s just better to have a safety net.
5. Maintain Accuracy
Inventory management is all about accuracy. That’s the name of the game when your goal is to keep track of hundreds of different products, and even a single error could lose you a customer.
The right inventory management software can handle most of this for you. Its automation of inventory processes can handle any number of sales across multiple platforms, removing much of the human error (to say nothing of how much time it saves).
But with or without software help, you should still watch out for some of the most common inventory mistakes:
- More than one SKU item per slot. That’s just asking for a mix-up.
- Similar items slotted next to each other. This is unfortunately hard to avoid since organizing similar products together has its own advantages.
- Incorrectly identify quantity. Usually results from case packs, i.e., counting the packs instead of the items within.
- Environmental conditions. Beware of problems in the actual warehouse, such as poor lighting or ineffectual stacking methods.
Another tip for maintaining accuracy is conducting periodic audits to make sure all your information is correct. We all need check-ups every now and then.
Takeaway: From the Ground Up
From here, the series is going to start diving into more advanced topics on inventory management, but just remember that none of them will work unless you’ve covered the basics. What that means is, you could calculate the perfect prices, shipping schedules, and slotting locations, but it won’t matter if you accidentally used the same SKU on two different products. Inventory management works from the ground up, so make sure you get the fundamentals down before tackling those expert techniques.
Section 2: Inventory Accounting Methods
FIFO, LIFO, HIFO, Specific ID, Weighted Averages…What’s the difference between these inventory accounting methods, and which one is best for your company?
In a perfect world, we’d all know how much each item is sold for, but the world of business is far from perfect. The reality is that kind of meticulous record-keeping comes at a high cost. Several cost-effective methods of inventory accounting have gone out of business, and those that are left allow companies to influence their balance sheets (all legally, of course).
Since different companies have different goals, a variety of inventory methods arose to suit everyone’s needs. Below is a reference list of the most practical and most common inventory accounting methods, along with the kinds of businesses they work best for. Take a look to see which suits you best.
FIFO (First In, First Out)
FIFO is the most common inventory method, partly because it’s the most sensical. It assumes the products acquired first are sold first, regardless of the actual physical flow of goods.
Thanks to inflation, FIFO tends to mark profits high and the cost of goods sold (COGS) low. It allows products bought and stocked years ago to be listed on your balance sheet as sold at the most recent market value.
Best for: Companies that need to puff out their chests a little. FIFO delivers the most impressive balance sheet, so it’s a smart choice if your priorities are attracting/appeasing investors, qualifying for loans, or impressing analysts. It also makes sense if your supplier costs are steadily decreasing, although that only applies to a minority of businesses.
LIFO (Last In, First Out)
The opposite of FIFO and the second most common inventory method is LIFO. It assumes that sold products are those acquired most recently.
In contrast to FIFO, LIFO tends to offer conservative profits and a higher COGS. The most recent acquisitions are usually the most costly, so margins are lowest with LIFO accounting.
Best for: Income tax benefits. A lower recorded income means a lower tax bill, and so LIFO can be used strategically to underplay your own profits. This fits industries where the cost of supplies and products remains level or steadily increases.
Right in the middle of FIFO’s optimism and LIFO’s pessimism is the Weighted Average approach. This simply averages out all the products sold, regardless of when they were acquired. The total COGS for all items is divided by the total number of items, and the resulting average is used for all products.
Best for: The Weighted Average method really only applies to companies that sell similarly priced products, mainly commodities. The higher the disparity between product prices, the more inaccurate your final figures will be. For that reason, the Weighted Average method is only used by a few select companies.
HIFO (Highest In, First Out)
More specialized than the above methods, HIFO offers the lowest profits and highest COGs, taking LIFO’s strategy to the extreme. Products with the highest cost are marked first to match the most recent (presumably highest) prices; the balance sheet reflects the minimum potential profits and maximum potential COGS.
HIFO is unconventional and not recognized by the GAAP (Generally Acceptable Accounting Principles). As such, it may draw greater scrutiny by auditors.
Best for: Companies that want to double-down on income tax benefits where LIFO isn’t enough. Its volatility leads it to be an uncommon choice, although it’s more frequently used for a temporary period to smooth over financial blemishes.
Specific Identification (Specific ID)
Maybe the above methods seem convoluted, and you’d prefer to just record each product for the price it was actually sold. That’s Specific Identification, the most accurate inventory accounting method, but also the most involved. The larger your inventory, the more manpower required to count it physically.
The downside is that Specific ID allows management to manipulate balance sheets directly. For example, they can report that cheaper goods were sold first, lowering the COGS and raising profits, or that the highest priced products were sold first for the opposite effect. It allows management to pick and choose between the advantages of FIFO and LIFO.
Best for: With the costs of manually counting each item, Specific ID becomes impractical once your inventory reaches a certain size. It’s most often used with luxury and expensive goods (jewelry, cars, etc.), where there are fewer items to manage as a whole, and each is unique.
Takeaway: Ask a Professional About Which Method is Right For You
Explaining each of these methods may give the impression that it’s easy to falsify official documents, but that’s not the case at all. There are plenty of laws in place to ensure each method is used permissibly. For example, LIFO is prohibited under the International Financial Reporting Standards, making it illegal in most non-U.S.A. countries — and even in the U.S.A., its use is regulated (Internal Revenue Code § 472). For many reasons, including legal compliance, it’s best to consult a certified accountant before committing to any one method.
Section 3: Inventory Management Strategies
Want to take your inventory management to the next level? Read about advanced tactics like Just In Time (JIT), ABC analysis, and continuous/periodic tracking.
Choosing the best accounting method for your ecommerce business is just the first step to better and more hands-on inventory management. There are also some more advanced tactics to improve efficiency, and luckily these don’t involve so much tax law.
In this section of our inventory guide, we’re going to cover several next-level strategies for streamlining your inventory management and making it as efficient — and profitable — as possible. We’ll discuss the popular JIT strategy and ABC analysis, and then compare perpetual and periodic accounting systems.
Popularized by Toyota in the 1970s, the Just In Time (JIT) strategy is a Japanese organization structure that offers a viable alternative to conventional inventory management. The central idea is to receive inventory as needed, which reduces storage costs and allows faster transitions from one product to another.
JIT opposes the more traditional “Just In Case” strategy, in which companies store abundant inventory “just in case” there’s an unexpected upswing of demand. Taiichi Ohno, founder of the JIT system and the Kanban Board (below) to manage it, theorized correctly that more intensive inventory management could cut the costs of storing superfluous inventory.
While the JIT strategy was designed for manufacturing, it has found new life in ecommerce. The dropshipping model, in which retailers never store products but instead transfer sales order directly to the supplier, is an ideal of the JIT strategy. One of JIT’s top goals is to maintain zero inventory.
To employ JIT successfully, one must meticulously manage product deliveries and shipments, relying on accurate predictions for meeting demands. It involves working closely with suppliers and benefits from flexible relationships to accommodate on-a-dime changes.
The JIT strategy works best for stable industries easy to forecast, but startups of all kinds find it useful for reducing inventory costs in the early years.
Inventory management can be hard to wrap your head around, so many managers use ABC analysis to categorize their products and make them easier to supervise. ABC analysis takes the Pareto Principle — the concept that 80% of effects come from 20% of the causes, also known as the 80-20 rule — and applies it to inventory management, helping companies focus more on the big-earners than the majority of products.
ABC analysis breaks products into three categories, A, B, and C, based on their annual sales:
- A items: The top 10-20% of items that account for 70-80% of the yearly consumption value.
- B items: Mid-range. Around 30% of items that account for 15-25% of the annual consumption value.
- C items: Least favorite. Most items, around 50%, that only account for about 5-10% of the annual consumption value.
The idea is that inventory managers should spend most of their time on A items: monitoring them, predicting their sales habits, giving them optimal warehouse space, etc. Bestsellers should never risk going out of stock and receive most of the analytics resources. Likewise, B and C items require less attention. In fact, C items should be considered for cancellation.
The larger your product range is, the more useful ABC analysis becomes. This organizational tactic is designed to help inventory managers better allocate their time according to what’s profitable. This is particularly true for businesses with large product catalogs.
Perpetual vs. Periodic Accounting Systems
No matter what accounting method you choose — FIFO, LIFO, HIFO, etc. — you still need to decide how frequently to check and track your inventory. Do you monitor items continuously for maximum accuracy at the cost of workforce availability and resources? Or do you check your inventory on a fixed schedule, which reduces accuracy but lowers management costs?
Let’s take a closer look at how these methods work:
- constantly changing balances
- fast, up-to-date analytics
- accurate COGS
- require more staff and/or advanced resources like digital systems
- typically costlier
- balances only change at the end of an accounting period
- lags in updating analytics
- less accurate COGS (final figures are lumped together at the end of a cycle; therefore, your accounting methods are more influential)
- require less staff and resources
- typically cheaper
For most companies, it’s just a matter of whether or not they can afford continuous tracking. Perpetual tracking offers more benefits, namely sales data that are both accurate and timely. However, the high price of constant monitoring — including the cost of implementing a new company-wide inventory management system — limits who can use it. If you choose a less expensive inventory management system, you can reap the benefits of a perpetual inventory system with no consequences to your budget.
Furthermore, some methods suit some industries more than others. For businesses with high sales volumes and multiple outlets, continuous tracking is more-or-less a necessity. Luxury industries or companies with low sales volume and inventories can get away with periodic monitoring without severe consequences.
Takeaway: Stacking Advanced Inventory Strategies
The strategies we talk about above aren’t exclusive — they can be stacked and used in conjunction with other strategies and accounting methods. For example, you can implement the FIFO method to bolster your quarterly balance, and take effect further with periodic tracking. If you’re more concerned with accuracy and current figures, try Specified ID accounting with continuous monitoring — that could give you data for predictions reliable enough to support JIT. As for ABC analysis, this strategy focuses on aligning time and resources spent on inventory management with products that typically produce the highest value (namely profits and revenues). Moreover, ABC analysis stacks well with other inventory management strategies so long as you aren’t a single-product seller.
Section 4: Pricing Strategies For Ecommerce Products
With the right pricing strategies, you can increase profits without necessarily increasing sales. Read about the most effective ecommerce pricing strategies here.
No matter how great your team is, your greatest sales promoter will always be your prices. The art of pricing your products combines psychological phenomena with more traditional business savvy and cold, hard calculations. There are a lot of small opportunities to maximize profits between the manufacturer’s price and the number you put on the price tag.
In this article, we’re going to explain everything you need to know about pricing your products, starting with some basics and working up to more advanced techniques.
Pricing Basics: Margin, Markup, and COGS
There’s a lot of math involved in product pricing, so let’s review some basic terminology to explain what you’re calculating.
- Cost of Goods Sold (COGS): This is the total cost for acquiring a product, starting with the wholesale price and adding storage, shipping, and other operating expenses. Usually used for tax purposes, this figure also helps to establish a starting value for the product. The trouble is this number can vary depending on which accounting method you use. To calculate the COGS, read this in-depth guide.
- Gross Profit: The amount of profit you make on a sale. [sales price] – [COGS] = [gross profit]
- Profit Margin: The gross profit cited as a percentage. [gross profit] ÷ [sales price] = [margin %]
- Markup: The percentage amount showing how much more your selling price is than the cost to acquire the item. [gross profit] ÷ [COGS] = [markup %]
These terms can be confusing, especially mixing up markups and margins. But each will play a different role depending on your pricing strategy, so take some time to learn their differences.
Ecommerce Pricing Strategies
Despite the math involved, pricing products isn’t a black-and-white calculation. It utilizes a degree of business know-how and strategic thinking to land on the perfect price for maximizing profits. Here are some of the most effective pricing strategies for ecommerce:
Manufacturer’s Suggested Retail Price (MSRP)
Let’s start with the most basic, no-brainer pricing strategy. The MSRP is predetermined by the manufacturer, usually through the Keystone Pricing strategy (below).
- No calculating involved
- Fast & easy
- Because it’s not personal to you, the MSRP is usually not optimized
- Same price as many of your competitors
Another basic strategy, Keystone Pricing simply doubles the wholesale price. This is usually enough to yield a healthy profit after operating costs but is too simplistic for hands-on managers.
- Easy to calculate
- Usually viable
- Suitable for base pricing before adding your own markups
- Not optimized
You can factor in some psychological phenomena into your prices to encourage more sales. The best example is ending prices in 99 cents instead of an even dollar; prices ending in “99” have been proven to sell better in test environments. There are tons of psychological studies on shopping behavior, so the more you read, the better you can price your products.
Another application of psychological pricing is perceived value. The fashion industry does this well, which is why luxury brands can get away with a nearly 400% markup.
- Scientifically proven to be successful
- Can be applied to various degrees, depending on your needs and knowledge
- Requires research
Companies like thrift stores rely on their low prices to attract customers. To them, undercutting competitor prices is more profitable than increasing their margins. Discount pricing can be permanent as with dollar stores, or temporary as with sales/clearances/deals to earn a quick boost in sales. Chain stores can afford this strategy more efficiently since they have more sources of income at their disposal to balance the loss.
- Increases loyalty with competitive shoppers
- Temporary discount campaigns give small sales boosts and increase publicity
- Gives you an edge in competitive markets
- Good for unloading unpopular stock
- By the numbers, it’s not as profitable as other strategies
One of the most laborious pricing strategies to apply, loss-leader pricing sells products at a loss (negative profits) to achieve a secondary purpose, such as customer satisfaction or publicity. Loss leaders are often used to get customers “in the door” before encouraging more profitable sales or an upsell. The key to this strategy is to make up the loss elsewhere, which is why this is a more advanced technique.
- Raises customer appreciation and loyalty
- Undercuts competitors
- Great for unloading unpopular stock.
- Costs you money to apply. Treat this tactic more like advertising than sales.
Takeaway: Different Pricing Strategies for Different Products
While other inventory management principles are uniform across all your operations, you can (and should) vary your pricing strategy product by product. This is where ABC analysis comes in handy, by helping you categorize your products by their salability.
For example, increasing the markups on A items (best sellers) can compensate for lowering the cost of C items (infrequent sellers). That would help you unload C item stock faster and therefore reduce your inventory management costs. Product pricing can get as intricate as you want, and the right business minds can increase profits without necessarily growing sales.
Section 5: Advanced Pricing Techniques
Why do most prices end in 9? There are tons of psychological strategies for pinpointing the perfect price to appeal to customers. In this section, we share 7 advanced pricing techniques to give you an edge.
In our last installment, we talked about the basics of pricing your inventory, including the most common pricing strategies. But what if you want to be uncommon? What if you want your prices to be better than good? Then, you need some advanced pricing techniques.
The first 5 affect the price itself, while the last 2 change how you present the price. All these strategies have been verified to increase sales and make customers more likely to buy — and we link to the studies to prove it.
1. Charm Pricing (The Magic Number “9”)
Ever wonder why prices often end in 99 cents? It’s not just a meaningless trend — ending prices with “9” actually increases sales. According to an MIT-University of Chicago study, prices that end in “9” sell better, explaining why they constituted 60% of all prices listed in advertising (around the turn of the century).
Although no one can quite explain the phenomenon, there are some prevailing theories. One is that customers focus on the left-most numbers more, so the difference between “$19.99” and “$20.00” seems more like a dollar than a cent. Another theory suggests customers ignore cents altogether, arriving at the same conclusion.
2. Precision Pricing
Consumers are usually on guard for stores pulling a fast one. That’s why even numbers on prices put people on edge — it seems like a price inflated by the seller, regardless of whether that’s true or not. Consequently, odd-numbered and irregular prices seem more accurate to the actual cost, and, therefore, are more trustworthy in the eyes of shoppers, according to a University of Florida study.
This concept has two primary applications:
- Use odd or irregular numbers.
- Use a cent value (i.e., don’t use “00”).
You can even use precision pricing to increase your margins. For example, $817.99 is a more attractive price than “$800,” even though it is more expensive.
3. Simplify Prices (Less Syllables, No Commas)
This technique goes a bit deeper than others and can be hard to apply in conjunction with precision pricing above. But, with little extra thought and effort, you can simplify your prices to make them seem more appealing than they actually are.
The Journal of Consumer Psychology revealed that customers prefer prices with fewer syllables. However, it’s not just in how they sound, but how they’re written: by removing the comma in numbers with 4+ digits, the consumer’s brain encodes the information differently. For example, “1,472” is read “one-thousand, four-hundred seventy-two,” but “1472” is read “fourteen seventy-two.” That distinction also comes in handy if you ever speak your prices out loud in videos.
A Yale-Singapore Management University study shows us that consumers trust prices more when they’re varied, likely for the same reasons that precision pricing works. What this means is consumers are more likely to buy a product if it’s priced differently than similar products.
The study uses packs of gum as examples. If two similar packs are both priced the same at 63¢, consumers only bought gum 46% of the time. However, when the prices were varied even a little — 62¢ and 64¢ — customers bought gum 77% of the time.
5. Weber’s Law and the 10% Price Increase
Let’s say you’re holding a gallon jug of water. Suddenly, and without you realizing it, someone sneaks an extra cup of water into the jug…You wouldn’t even notice, right? What about two cups? What about twenty cups?
At what point do you notice an increase? Weber’s Law states that it’s proportional to the original size, and in retail pricing that equates to 10%. That means that once a price is established as normal, an online seller can safely increase it up to 10% without too many customers noticing the difference.
6. Anchor Pricing
Sometimes it’s not in the price itself, but how the amount is presented. One of the most popular methods for influencing the interpretation of costs is to give it a complimentary reference point, what’s called an anchor price.
Imagine selling a pair of sunglasses for $100. That may seem expensive to some people, but what if you surrounded the $100 sunglasses with other sunglasses that cost $200, $250, or $500? Suddenly, the $100 sunglasses seem cheaper and more like a bargain — even though the price never changed.
If your strategy is to undercut prices and sell at a discount, you can take this technique even further. Try listing the MSRP or even competitor prices right next to yours so customers can see with their own eyes how much more they save buying with you.
7. Smaller Fonts
One last little tip: smaller fonts. A University of Connecticut-Clark University study showed that people process prices in part by how large or small they’re written. Through what’s known as the size-congruency effect, prices written in smaller fonts seem less expensive than prices written in larger fonts.
You can even amplify this effect by placing your small font next to a larger font to appear even cheaper. For example, have your price written in a smaller font size than the anchor price. Just make sure it’s still highly visible — try a brighter color to help it stand out amid larger text.
Takeaway: Where Head Meets Heart
The last article on pricing focused more on mathematics and how to calculate prices for optimal profitability. This article focuses on psychological pricing and how to increase profits and prices based on perceptions, sometimes even in direct opposition to logic. How can both work at the same time?
The trick is to incorporate both math and psychology, logic and perception, head and heart. Crunching the numbers will give you a good starting point and set the parameters you’re working in. It can even give you a working range for setting prices to keep you out of the red. From there, you can apply psychological tactics to get some extra nickels and dimes — which add up in a big way with enough sales.