Inventory - What is inventory?
Inventory is an asset that is sold throughout the ordinary course of business. It is often one of the main sources of a company's revenue.
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Inventory includes goods ready for sale as well as any physical resources used in the production of the finished products. It is reported as a short-term or current asset as it is usually liquidated (turned into cash) within a year.
Sometimes referred to as stock, inventory represents tied-up capital. It is therefore important to implement effective stock management in order to free-up capital.
Businesses need to closely monitor inventory to achieve the right levels of stock. Too much inventory can lead to disruptions in production, additional expenses (such as storage and insurance costs), issues with cash flow, and financial losses – for example, if the inventory items expire or become obsolete.
On the other hand, too little inventory can cause a business to miss sales opportunities and lose customers.
Categories of inventory
Although inventory is usually recorded on the balance sheet under one single line called 'Inventory', stock takes various forms. Inventory can be broken down into sub-categories depending on the business’s supply chain and the nature of the goods or services sold.
Inventory for manufacturers
Manufacturers usually have three categories of inventory that reflect the various stages of the production process:
- Raw materials: items used by a company in the production of goods.
- Work in process: partially completed goods.
- Finished goods: completed products that are ready to be sold to customers.
These categories can vary between manufacturers. For example, a seller’s finished goods may become a buyer’s raw materials, and while many manufacturers address work in process, it might not be necessary for businesses with short production processes.
Inventory for retailers
For businesses without a production process, it is not necessary to categorise inventory. This typically includes retailers, wholesalers, or distributors that purchase finished goods to sell to third parties at a higher price. Inventory that consists solely of finished goods is known as merchandise.
The main difference between manufacturing inventory and merchandise inventory is that merchandise inventory has already completed the manufacturing process before reaching the merchant or retailer, whereas manufacturing inventory requires additional processing.
While merchants may handle minor assembly, packaging, shipping, or delivery, these activities are not classified as 'manufacturing'.
It is important to consistently and accurately assign costs to inventory. Valuing inventory helps companies manage cost flow assumptions associated with stock and stock repurchases.
The costs that go into creating or acquiring inventory are known as cost of goods sold (COGS). COGS includes all costs associated with the purchase or manufacturing of a product, including material, labour, overheads, shipping, and delivery. However, these costs can change over time meaning that a company can have many of the same items in stock, but with different units costing more than others.
To effectively value stock, companies need to find a way to accurately account for these variations. There are three main ways to value inventory:
- FIFO, first-in, first-out method: under the FIFO method, it is assumed that the first items to be purchased will also be the first to be used or sold (regardless of whether this actually happens in practice). COGS is therefore calculated based on the price of the goods with the oldest value, not the current value.
- LIFO, last-in, first-out method: under the LIFO method, it is assumed that the items purchased most recently will be the first to be used or sold. Goods are therefore accounted for using the most recent value.
- Average cost method: under this method, the cost of goods available for sale is divided by the number of units available for sale.
Inventory in Debitoor
For any small business, inventory is an important company asset. Debitoor invoicing software lets you process business assets in an intuitive and easy way.
Whenever you enter a new expense, you have the option to treat it as an asset. Debitoor even tracks depreciation and amortisation of assets that lose value over time.