What is Inventory?
As a business leader, you practice inventory management in order to ensure that you have enough stock on hand and to identify when there’s a shortage.
The verb “inventory” refers to the act of counting or listing items. As an accounting term, inventory is a current asset and refers to all stock in the various production stages. By keeping stock, both retailers and manufacturers can continue to sell or build items. Inventory is a major asset on the balance sheet for most companies, however, too much inventory can become a practical liability.
Inventory is a very important asset for any company. It is defined as the array of goods used in production or finished goods held by a company during its normal course of business. There are three general categories of inventory, including raw materials (any supplies that are used to produce finished goods), work-in-progress (WIP), and finished goods or those that are ready for sale.
As noted above, inventory is classified as a current asset on a company’s balance sheet, and it serves as a buffer between manufacturing and order fulfillment. When an inventory item is sold, its carrying cost transfers to the cost of goods sold (COGS) category on the income statement.
Inventory can be valued in three ways. These methods are the:
- First-in, first-out (FIFO) method, which says that the cost of goods sold is based on the cost of the earliest purchased materials. The carrying cost of remaining inventory, on the other hand, is based on the cost of the latest purchased materials
- Last-in, first-out (LIFO) method, which states that the cost of goods sold is valued using the cost of the latest purchased materials, while the value of the remaining inventory is based on the earliest purchased materials.
- Weighted average method, which requires valuing both inventory and the COGS based on the average cost of all materials bought during the period.
Types of Inventory
1. Raw Materials:
Raw materials are the materials a company uses to create and finish products. When the product is completed, the raw materials are typically unrecognizable from their original form, such as oil used to create shampoo.
Components are similar to raw materials in that they are the materials a company uses to create and finish products, except that they remain recognizable when the product is completed, such as a screw.
3. Work In Progress (WIP):
WIP inventory refers to items in production and includes raw materials or components, labor, overhead and even packing materials.
4. Finished Goods
Finished goods are items that are ready to sell.
Maintenance, Repair and Operations (MRO) Goods:
MRO is inventory — often in the form of supplies — that supports making a product or the maintenance of a business.
5. Packing and Packaging Materials:
There are three types of packing materials. Primary packing protects the product and makes it usable. Secondary packing is the packaging of the finished good and can include labels or SKU information. Tertiary packing is bulk packaging for transport.
6. Safety Stock and Anticipation Stock:
Safety stock is the extra inventory a company buys and stores to cover unexpected events. Safety stock has carrying costs, but it supports customer satisfaction. Similarly, anticipation stock comprises of raw materials or finished items that a business purchases based on sales and production trends. If a raw material’s price is rising or peak sales time is approaching, a business may purchase safety stock.
7. Decoupling Inventory:
Decoupling inventory is the term used for extra items or WIP kept at each production line station to prevent work stoppages. Whereas all companies may have safety stock, decoupling inventory is useful if parts of the line work at different speeds and only applies to companies that manufacture goods.
8. Cycle Inventory:
Companies order cycle inventory in lots to get the right amount of stock for the lowest storage cost. Learn more about cycle inventory formulas in the “Essential Guide to Inventory Planning.”
9. Service Inventory:
Service inventory is a management accounting concept that refers to how much service a business can provide in a given period. A hotel with 10 rooms, for example, has a service inventory of 70 one-night stays in a given week.
10. Transit Inventory:
Also known as pipeline inventory, transit inventory is stock that’s moving between the manufacturer, warehouses and distribution centers. Transit inventory may take weeks to move between facilities.
11. Theoretical Inventory:
Also called book inventory, theoretical inventory is the least amount of stock a company needs to complete a process without waiting. Theoretical inventory is used mostly in production and the food industry. It’s measured using the actual versus theoretical formula.
12. Excess Inventory:
Also known as obsolete inventory, excess inventory is unsold or unused goods or raw materials that a company doesn’t expect to use or sell, but must still pay to store.
Many producers partner with retailers to consign their inventory. Consignment inventory is the inventory owned by the supplier/producer (generally a wholesaler) but held by a customer (generally a retailer). The customer then purchases the inventory once it has been sold to the end customer or once they consume it (e.g., to produce their own products).
The benefit to the supplier is that their product is promoted by the customer and readily accessible to end users. The benefit to the customer is that they do not expend capital until it becomes profitable to them. This means they only purchase it when the end user purchases it from them or until they consume the inventory for their operations.
Possessing a high amount of inventory for a long time is usually not a good idea for a business. That’s because of the challenges it presents, including storage costs, spoilage costs, and the threat of obsolescence.
Possessing too little inventory also has its disadvantages. For instance, a company runs the risk of market share erosion and losing profit from potential sales.
Inventory management forecasts and strategies, such as a just-in-time (JIT) inventory system (with backflush costing), can help companies minimize inventory costs because goods are created or received only when needed.
What is the impact of inventory in businesses
Inventory is a major asset for any manufacturing or trading business, so it’s important for business owners to understand what it really means. In addition to the common definition, certain industries like manufacturing and service use specialized definitions that account for all of the assets relevant to that industry. Knowing the different types of inventory, including types that aren’t specifically used in accounting, can help business owners understand how their inventory is working for them. If you wish to learn more about the inventory management process, then check out this video to get a quick overview of that.
What Is an Example of Inventory?
Consider a fashion retailer such as Zara, which operates on a seasonal schedule.2 Because of the fast fashion nature of turnover, Zara, like other fashion retailers is under pressure to sell inventory rapidly. Zara’s merchandise is an example of inventory in the finished product stage. On the other hand, the fabric and other production materials are considered a raw material form of inventory.