Corporate Finance & Accounting

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What is inventory?

The term inventory refers to the raw materials used in production as well as goods available for sale. A company’s inventory is one of the most important assets it owns, as inventory turnover is one of the main sources of revenue and subsequent earnings for the company’s shareholders. Inventory is divided into three types, including raw materials, work-in-progress, and finished goods. It is classified as a current asset on a company’s balance sheet.

key takeaways

  • Inventory is the raw materials used to produce goods and goods that are available for sale.
  • It is classified as a current asset on a company’s balance sheet.
  • The three types of inventory include raw materials, work in process, and finished goods.
  • Inventory is valued in one of three ways, including the first-in, first-out method; the last-in, first-out method; and the weighted average method.
  • Inventory management allows businesses to minimize inventory costs when creating or receiving goods as needed.

Learn about inventory

Inventory is a very important asset for any company. It is defined as a range of goods held by a company in the normal course of its business for production or finished goods. Inventory is divided into three categories, including raw materials (any supplies used to produce finished goods), work in process (WIP), and finished goods or products ready for sale.

As mentioned above, inventory is classified as a current asset on a company’s balance sheet, and it acts as a buffer between manufacturing and order fulfillment. When an inventory item is sold, its carrying cost is transferred to the Cost of Goods Sold (COGS) category on the income statement.

Inventory can be assessed in three ways. These methods are:

  • First-in, first-out (FIFO) method, where the cost of goods sold is based on the cost of the earliest purchased material.On the other hand, the carrying cost of remaining inventory is based on the cost of recently purchased materials
  • Last-in, first-out (LIFO) method, where the cost of goods sold is denominated at the cost of the most recently purchased material, while the value of the remaining inventory is denominated at the oldest purchased material.
  • The weighted average method requires valuation of inventories and cost of goods sold based on the average cost of all materials purchased during the period.

Company management, analysts, and investors can use a company’s inventory turnover ratio to determine how many times it has sold its products in a given period. Inventory turns can indicate that a company has too much or too little inventory on hand.

special attention items

Many producers work with retailers to consign their inventory. Consignment inventory is inventory owned by a supplier/producer (usually a wholesaler) but held by a customer (usually a retailer). Customers buy inventory once it has been sold to end customers or once they have consumed it (for example, producing their own product).

The benefit to suppliers is that their products are promoted by customers and easily available to end users. The benefit to the client is that they don’t spend until the capital is in their favor. This means they will only buy it if the end user buys from them or until they consume inventory for their operations.

Inventory management

It’s usually not a good idea for a business to have a lot of inventory for a long time. This is because of the challenges it presents, including storage costs, damage costs and the threat of obsolescence.

Having too little inventory also has its downsides. For example, a company risks market share erosion and potential loss of sales profits.

Inventory management forecasts and strategies, such as just-in-time (JIT) inventory systems (with backflush costing), can help companies minimize inventory costs because goods are only created or received when needed.

Inventory Type

Remember that inventory is usually divided into raw materials, work in process, and finished goods. The IRS also classifies goods and supplies into additional inventory categories.

Raw materials are unprocessed materials used to produce goods. Examples of raw materials include:

  • Aluminum and steel used to make cars
  • Flour from a bakery that produces bread
  • Crude oil held by refineries

Work-in-progress inventory is partially finished goods awaiting completion and resale. WIP inventory is also known as production floor inventory. Semi-assembled airliners or partially completed yachts are generally considered work-in-progress inventory.

A finished product is a product that has gone through the production process, is completed, and is ready for sale. Retailers often refer to this inventory as merchandise. Common examples of merchandise include electronics, clothing, and cars held by retailers.

How do you define inventory?

Inventory refers to the goods and products a company is ready to sell, as well as the raw materials used to produce them. Inventory can be classified in three different ways, including raw materials, work-in-progress, and finished goods.

In accounting, inventories are considered current assets because companies typically plan to sell finished goods within a year.

Methods for evaluating inventory include last-in, first-out (LIFO); first-in, first-out (FIFO); and weighted average methods.

What is an inventory example?

Consider a fashion retailer like Zara, which operates on a seasonal schedule. Due to the fast-fashion nature of turnover, Zara, like other fashion retailers, is under pressure to sell inventory quickly. Zara’s merchandise is an example of a finished product stage inventory. On the other hand, fabrics and other production materials are considered as raw material forms of inventory.

What can inventory tell you about your business?

One way to track the performance of a business is its inventory turnover rate. When a business sells inventory faster than its competitors, it reduces carrying costs and lowers opportunity costs. As a result, they often perform well because it helps improve the efficiency of merchandising.

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