What is Inventory?

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Definition: Inventory is regularly referred to as goods. Inventory consists of all raw material, work-in-process and finished goods that a company would sell or would need to make their products.

Inventory is a very important business asset. Business assets are broken down into current assets and non-current assets. A current asset is an asset that can be converted into cash or a cash equivalent quickly, it should not take longer than a year to convert. Non-current assets are assets that take more than a year to convert into cash.

Characteristics of Inventory

Taking the business opportunities and market conditions into account, inventory will be sold in less than one year. Inventory then qualifies as a current asset and will be presented as such in the balance sheet.

Types of Inventory

Retailers and manufacturers stock inventory. Retailers refer to their goods as merchandise, they buy finished products from manufactures or wholesalers and sell those products to their clients. Accounting for retail inventory is easy because they only must account for one kind of good.

Manufactures account for each step in the production process this makes the accounting a bit more complex.

There are three types of inventory in the production process:

Raw materials

Raw materials is the basic components needed to create the finished good. For example, in a company that manufactures chips, the raw materials will be the potatoes and oil.

Work in process (WIP)

Work in process inventory is products that have not been finished, they are still on the production floor. For example, the chips have already been baked a spiced, but it hasn’t been bagged yet the product is thus partly completed and cannot be sold yet.

Finished goods

Finished goods are products that are 100% completed and are ready to be sold. In the case of the chips example, the chips will be in the bags, boxed together and ready to be sold to retailers or wholesalers.

Each of the product categories is important when managing your business. Inventory control is a critical concept in business management a company must make sure that they have the right goods at the right time.

Recording Inventory in Accounting

Businesses account for the cost of inventory differently. Retailers will record the total amount that they paid for their goods. The cost of goods will include all charges linked to the purchase of the product for example, tax and delivery costs. Manufacturers will include the entire cost of completing the product to a point where it is ready to be sold.

Companies track their goods by means of either a periodic or perpetual inventory system. Using the periodic system is considered easy, companies will basically count all the stock at different times throughout the year to understand what stock was traded and what stock are left over. On the other hand, the perpetual inventory system is a very intricate system that tracks goods in real time using bar code scanners and sophisticated computer system. This system would be considered more accurate but also expensive.

Financial Statement Presentation

Mentioned above inventory is measured as a current asset and thus reported in the balance sheet as such. Retailers usually only list one type of merchandise but manufacturer tend to list the three different categories of inventory (raw materials, work-in-process, finished goods).

Businesses can assign the cost of inventory by using the FIFO (first-in, first-out), LIFO (last-in, first-out) or the weighted average costing method. The FIFO assumes that a company will use the goods that they brought first, first. The remaining stock at the end of the month will then be considered at the latest price.

The LIFO method assumes that the business will use the latest stock first and the remaining inventory will be based on the cost of the oldest goods. The weighted average method looks at both the inventory and the period.

Inventory Management

Inventory management is of utmost importance and is usually one of the main assets on a company’s balance sheet. Inventory management will separate successful businesses from unsuccessful businesses. Managers can make use of inventory turnover and other ratios to measure the exact what the value per piece of stock will be to the company. Retailers should have low inventory turns and high margins, they should, however, be concerned when they have low inventory turns and low margins.

It is costly to keep high volumes of inventory because of storage costs, possible product spoilage and the threat of becoming too old to use. Keeping to little inventory could also be a disadvantage if a company doesn’t have enough inventory they can lose out on potential sales. Managing inventory forecasts and inventory strategies will help managers eliminate unnecessary costs.

Conclusion

  • Inventory is made up of the raw materials, work-in-process and the final products that will be traded to the clients
  • Inventory is classified as a current asset
  • Retailers account for one product named merchandise where manufacturing companies will account for the multiple inventory categories
  • The different types of inventory are:
    • Raw materials
    • Work-in-progress
    • Final product
  • Business record inventory differently:
    • Retailers will record it at the cost of purchase.
    • Manufacturers will record all the costs involved in getting the product finalized.
  • Companies can assign the cost of inventory using:
    • FIFO
    • LIFO or
    • Weighted Average method
  • Inventory management is crucial and can cause the success or failure of a company.