Definition: Inventory is a business and accounting term that refers to raw materials, merchandise, and goods available for sale. It represents one of the most important assets for a business because it is a primary source for generating revenue and ongoing earnings. Inventory may be a bit different for each industry or business.
There are different types of inventory depending on the industry. Both manufacturers and retailers stock inventory. Retailers refer to their merchandise or goods as inventory. They purchase finished, ready-to-sell products from wholesalers. Then, they sell the products to customers or clients. Accounting for retail inventory is an easy task since they only account for one type of good.
Accounting for a manufacturer’s inventory is more complex due to the steps in the production process. The production process accounts for three types of inventory, including raw materials, work-in-process, and finished goods. Business management places importance on all of these types of inventory, and it is essential for a company to ensure they have the goods needed at the right time.
Companies choose from different inventory methods for their financial statements. Each method is a systematic approach to calculating and reporting inventory turnover. It does not matter which method a business chooses to use; however, regulators will expect them to continue using the same method each year. The three main inventory methods that GAAP covers include FIFO (first in, first out), LIFO (last in, first out), and WAC (weighted average cost).
Managing inventory is essential for controlling the costs of operation. When inventory is managed and reported appropriately on financial reports, it enables a business to make smarter decisions. The process provides real-time information about what is selling and what is not. It’s useful for helping know where to cut back and how to maximize profits.
What is Inventory?
Inventory is the stock a retailer or manufacturer has on hand. It may include customer-ready products or parts and raw materials that are to be used during the manufacturing process. Basically, inventory is composed of all the components used in production or sales in a business. Managing inventory is essential for ensuring a business runs smoothly. Additionally, managing inventory ensures the supply network continues to function without a hitch. Business leaders and managers must engage in proper inventory management strategies to ensure the right amount of stock is on hand at all times.
Why is Inventory so Important?
Inventory is crucial to day-to-day operations for most companies. How much product a company has on hand is on their balance sheet as an asset. Knowing how much inventory they have on hand helps a company plan efficiently, especially when it pertains to finances. Most companies, at least those that handle goods over services, need inventory. They cannot sell what they do not have. In short, inventory equals money. A business needs to make money to survive and most businesses make money by selling products. Inventory is essential to making sales, but it is also important for helping companies plan and budget their expenditures accurately and effectively.
What are the Inventory Methods?
There are many inventory methods, but three are most commonly used in accounting. Each company has to adopt its own inventory costing method and apply it consistently from year to year. These three inventory methods include FIFO, LIFO, and a weighted average. Each of these three methods involves specific cost-flow assumptions. The assumptions are not directly related to the actual physical flow of goods. The methods are just used to assign costs to each inventory unit.
- FIFO or first-in, first-out calculations are the oldest inventory method. It matches revenue against the assigned cost of each sold product. More recent purchases are assigned to units in the last or ending inventory.
- LIFO or last-in, first-out calculations are the opposite of FIFO. Recent costs are assigned to recent goods sold, with the older costs remaining in inventory.
- WAC or weighted average costs use a cost average to account for the cost per unit. Average cost divides the total cost of available goods for sale by the total units that are available for sale.
What are the Types of Inventory?
When a business has inventory on hand, it can be raw materials and parts needed to make products or goods, or it may be finished products that are housed waiting for purchase by customers. Sometimes, inventory is held on consignment by a third party who holds the products until they are sold. There are three basic types of inventory.
- Raw Inventory: This type of inventory includes the starting or raw materials needed for the manufacturing process. Examples include metals used by auto or steel companies or food and spices used in the food industry.
- Work in Progress: Anything that is partially processed but is not a finished good is a work in progress. A vehicle that is partially assembled and raw dough in a bakery are both examples of work-in-progress inventory.
- Finished Goods: These are products that have already progressed through manufacturing and are ready to be sold to consumers, distributors, or wholesalers. A finished vehicle, televisions, computers, and pre-packaged foods are examples.
What Type of Asset is Inventory?
Inventory includes raw materials, goods, or products. These are all ready to produce or sell. In accounting, inventory is classified as a current asset. The reason for this classification is because, in most cases, the company plans on selling the finished products within one year.
When is it Necessary to Record Inventory?
Inventory is a current asset and is recorded as such on the company’s balance sheet. Inventory includes physical property, merchandise, or other items for sale or resale. The intention is that the inventory will be sold later. Both internal and external departments receiving revenue for selling products must record inventory.
What Effect Does Inventory Have on Accounting?
Accurate reporting of inventory is necessary for businesses. Discrepancies in incorrectly valued inventory impact financial statements, such as statements of retained earnings, income statements, and balance sheets. Inventory on accounting needs to be calculated and reported correctly, since it often accounts for a large share of the current assets of a company. Ultimately, inventory determines how much profit or loss is generated by a business.
How is Inventory Classified in Financial Statements?
On a company’s financial statements, inventory is classified as a current asset. It serves as a buffer between order fulfillment and manufacturing. Inventory isn’t an income statement account. But changes in inventory are calculated with the Cost of Goods Sold. This calculation is included in most income statements.
Where does Inventory go on a Balance Sheet?
Since inventory is a current asset, it is reported in the section for current assets on the balance sheet. However, any change in inventory is part of the Cost of Goods Sold, which is included in a company’s income statement. Increases in inventory are subtracted from the company’s purchases of goods. Inventory decreases are added to the purchase of goods.
What Happens if an Inventory Item is Sold?
Inventory is recorded and reported on the balance sheet. When inventory items are sold, these costs are subtracted from the inventory and reported as a cost on the income statement as a Cost of Goods Sold. The cost of goods sold is usually the largest expense that is reported on income statements.
What is the Average Cost of Inventory?
The average cost of the inventory method assigns costs to inventory items. These costs are based on the total cost of goods produced or purchased in a period. The costs are divided by the total number of items that were produced or purchased in that period. Another term for the average cost method is the weighted-average method. To calculate the average cost of inventory for a year, the inventory counts are added at the end of each month, then divided by the number of months.
How Should Inventory be Managed?
Managing inventory is important to a business’s bottom line and profit margin. Each company may have its own method of managing inventory, but the strategies and techniques will be similar.
- Accurate Forecasting. Projecting sales calculations are based on historical sales, market trends, promotions, marketing efforts, and predicted growth in the current economy.
- FIFO Method. Goods should be sold in the same order as they were created or purchased. This is essential for perishable products such as makeup, flowers, or food.
- Identify Low-turn Stocks. Stock that hasn’t moved in six to 12 months should be reevaluated. Excess stock needs to be liquidated or removed.
- Audit Stock Regularly. Inventory is usually assessed or audited at least once a year. Even if inventory management software is used, it’s a good idea to make sure stock matches what the computer says.
- Inventory Management Software. When purchasing inventory management software, look for those that provide real-time analytics. Your stock levels should automatically adjust every time a sale is completed.
- Initiate Stock Tracking. Stock levels should be tracked at all times.
- Hire a Stock Controller. A stock controller processes purchase orders and receives deliveries. They should be able to show how much inventory is available at any point in time.
Effective inventory management is crucial to a company’s profitability. Businesses of all sizes benefit from following good management practices with their inventory. It can be costly to overstock items that require time and staff to track and store. On the other hand, it’s costly to not have the items on hand when customers come looking for them. Effective inventory management will help businesses land between the two extremes and have an adequate amount of products on hand when they are needed.
Is Inventory an Asset or Liability?
For accounting purposes, inventory is nearly always an asset. Why? Because an asset is something that is expected to provide economic benefit at some time in the future, usually in the next year. Liabilities are debts or financial deficits. Inventory production is correlated to consumer demand and is generally expected to sell once it is produced. Therefore, it is an asset vs. a liability.