A healthy inventory flow enables sale closings, customer shipments, and productive work for employees. Without this flow, the business dies. It should be no surprise to find that in many industries, a firm's financial performance and position depend heavily on the firm's ability to manage inventory effectively and efficiently.
In business, Inventory has several definitions:
- Firstly, inventoryrefers primarily to goods, raw materials, and other tangible items that a company holds, intended ultimately for sale. The rest of this article assumes that definition.
- Secondly, as a verb, inventory means to count or list units of a resource on hand. A hotel business, for instance, might inventory the contents of a hotel room when a guest departs as a check against loss.
- Thirdly, inventory also refers to a listing for a specific purpose. A hospital might create an "inventory" (list) of medical equipment and supplies that should always be on hand in an operating room.
The Inventory Challenge
Companies that hold and sell inventory face a double challenge.
- On the one hand, in-demand products must be available when customers are ready to buy.
- On the other hand, acquiring and managing stock to meet this objective can be very costly (see the section on costs below).
As a result, many firms give substantial and constant attention to finding ways to improve and optimize stock management. The goal is to do this while minimizing costs at the same time.
Explaining Inventory in Context
This article further defines, explains, and illustrates inventory in context with related terms and concepts from the fields of inventory management, accounting, and finance. These fields are rich in inventory-related terms, including the following:
- What is Inventory?
- What are the major categories of inventory?
- How do firms account for inventory assets?
- Three inventory performance measures.
- Example Income Statement with Inventory Metrics Data
- What are essential objectives in inventory management
- How do firms forecast and order inventory?
- How do firms minimize and avoid inventory costs?
Business inventory falls typically into two classes, merchandise inventory and manufacturing inventory. Note; however, several different kinds of stock fit neither of those categories.
Merchants who buy finished goods and then sell them in that form deal primarily with merchandise inventory. Retail shops and food stores, for instance, acquire, hold, and sell merchandise stock. Merchants earn margin on these goods by making them available when and where customers want them. The merchant's role may include packaging, shipping, delivery, or minor assembly, but these activities are not "manufacturing."
The term merchandise stock refers only to inventory the merchant owns. As such, it is a company asset, to be valued and accounted for at the end of each accounting period. Merchandise held for sale on consignment but belonging to someone else is not part of the merchant's inventory.
Companies that buy raw materials or necessary parts, and then manufacture finished goods from them usually classify inventory as either raw materials, work in progress, or "finished goods."
Raw materials inventory
Raw materials include assets in the same form suppliers provide them. For an oil production company, raw materials include natural crude oil. For a metal stamping company that produces automobile parts, raw materials include unworked sheet metal as acquired from the supplier.
Works In Progress Inventory
Work in progress includes goods that have been worked or partially assembled, but which are not yet finished goods. For an automobile manufacturer, vehicles halfway through the assembly line are work in progress inventory.
Finished Goods Inventory
Finished goods include goods the company produced from raw materials, now ready to sell and ship. For the automobile company, finished vehicles not yet sold or sent to dealers are finished goods stock.
Note that one firm's finished goods can be another firm's raw materials. Flat sheets of steel may be finished goods for the steel company, but raw materials for the metal stamping company.
Other Kinds of Inventory
The term inventory also applies to several different kinds of items that do not fit the descriptions for merchandise or manufacturing stock. For example:
Hotel Rooms and Airline Seat Inventory
Hotels refer to unsold guest rooms for a given night as inventory. Airlines identify unsold seats in each ticket class, for each flight, each day, as inventory.
These assets become worthless if they do not sell by their designated days. As a result, hotels and airlines sometimes offer last-minute price discounts, trying to recover at least some value instead of none.
Repair Shop Spare Parts Stock
Repair shops and other service firms maintain spare parts stock. Firms that repair automobiles, appliances, shoes, or watches, for instance, either carry parts stock themselves or else work closely with suppliers who can supply them quickly on short notice.
Repair shops typically make some margin on "parts" themselves, but these do not qualify as merchandise or finished goods. The customer may or may not receive a bill summarizing individual "parts" and "labor" charges.
Supplies Stock for Services
Medical clinics, hair salons, and cleaning services usually maintain a supplies stock. They do not sell these items directly to customers as merchandise, because they use them to deliver services.
Non-Physical Goods Inventories
Sellers of electronic books (ebooks) carry a product title inventory. They hold master copies of each title, from which they produce and ship any number of individual customer copies. For these vendors, the stock is not physical goods but instead a collection of intellectual property usage rights, which they sell to individual customers.
Non-physical inventories of this kind can also include other "electronic" products that ship by internet download. Examples include software, recorded music and videos, and documents in PDF format. Here also, the seller's "inventory" is not physical property, but instead, a set of intellectual property usage rights.
For non-physical goods of this kind, most of the other major cost areas with traditional physical stock are also absent, such as storage costs and handling costs. And, such inventory is never used up nor out of stock. It loses value, however, when it becomes obsolete, or when competitive market prices change.
"Inventories" appears on the Balance sheet as assets. As a result, they impact asset-related metrics such as Total asset turnover and Return on total assets. Note that inventories almost always appear under "Current assets" because firms consider them relatively liquid assets.
The designation means these assets will, or could, convert to cash in the near term. As current assets, they also contribute to liquidity metrics such as Working capital and Current Ratio. And, their impact on these metrics can be substantial where they account for a large part of the firm's asset base. In some manufacturing firms, such as Cummins Engine, for example, inventories account for 18%-25% of the asset structure.
What Determines Original Inventory Value?
What value does inventory initially take on the Balance sheet? Tax authorities and local GAAP usually require original inventory value to represent either:
- Historical cost
Historical cost is the total of all initial direct and indirect costs of acquiring the stock and bringing it in-house. Most assets including inventories are at first valued at historical prices.
- Cost or Market Value,
Firms may sometimes apply the lower of cost or market ruleto value inventories. Under this rule, in principle, inventory value is taken as the lower these two values: Firstly, historical cost, and secondly, market price. And, the market value in this case usually means the current replacement cost. Note, however, the following constraints on market price:
- Market price cannot be higher than the estimated selling price, minus selling expenses. Selling price less selling costs is net realizable value. This value is the ceiling of permissible market values.
- Market price cannot be lower than net realizable value minus an average profit margin. This price is the floor of permissible market values.
- In other words, the stock value is the historical cost if that is lower than the market value "floor." Otherwise, its value is whichever is lower: market value ceiling or replacement cost.
How Do Firms Update Inventory Values?
Total inventory value typically changes more or less continuously, as firms stock new items and either sell or lose existing stock. The market value of individual items in stock also changes over time, for instance, when inventory items spoil or become obsolete.
In any case, total inventory value must appear on the Balance sheet as it stands at the end of the reporting period after changes for the period are complete. Firms usually apply this equation:
Ending value = Beginning value + Net purchases – Cost of Goods Sold
Note that cost of goods sold (COGS) sometimes appears as a stand-in for stock used up during an accounting period (see the inventory turns metric, below, for instance). This value is appropriate especially when a company turns raw materials into work in progress and then finished goods. "Cost of goods sold" reflects the direct and indirect labor costs and materials costs used to bring stock from one stage to the next. As a result, COGS represents the total historical "cost" of these assets.
LIFO and FIFO Conventions: How Do They Differ?
When the historical costs (or COGS) of each specific stock unit is known, the above instructions for reaching the total current inventory value are sufficient. However, the firm must refer to additional valuing rules when both of two conditions apply:
- Firstly, units in stock are interchangeable.
One barrel of crude oil as raw materials is probably interchangeable with any other barrel of the same kind. One sealed can of peas in finished goods may be interchangeable with thousands of others in stock.
- Secondly, the costs of acquiring units in stock are changing over time.
A firm may purchase oil as raw materials in January at $85 / barrel. In June, the same barrel may cost $90, and another barrel may cost $98 in December. Similarly, a can of peas may have a COGS of $1.00 in January, $1.10 in February, and $1.50 in March.
Choose any method when units are interchangeable
Referring to the example above, suppose the firm adds cans of peas to inventory as follows:
January, 75 cans added, @ $1.00.
February, 125 cans added, @$1.10.
March, 100 cans added, @$1.50.
Suppose that a total of 60 cans sell from inventory during these three months. The accounting question in such cases then is this: What was COGS for the 60 units that left stock? Would that be January's COGS or another month's COGS?
With interchangeable units and changing price conditions, companies can choose any one of three approaches to value inventory. After selecting a method for the first reporting period, however, tax authorities do not make it easy to change the plan in subsequent periods.
In any case, three acceptable approaches to valuing under these conditions include:
1. First In First Out (FIFO)
Under FIFO, as items leave inventory, the accountant proceeds as though the single unit in stock for the longest time goes first. And, the next to move has the value of the item on hand second-longest, and so on.
Under FIFO, when 60 cans leave inventory, the firm reports them as 60 of the 75 "January" cans. As a result, COGS becomes the following:
COGS = 60 x $1.00
2 Last in First Out (LIFO)
Under LIFO, the accountant precedes as though the first to leave is the item that has been there the shortest time. And, the next to move has the value of the item on hand for the next longest time, and so on--in this case, the value of the100 "March" cans. As a result, for a COGS becomes the following::
COGS = 60 x $1.50
3. Average Cost
Under the average cost method, the accountant computes a weighted average cost of goods sold per unit. For the peas example:
Weighted Average COGS per Unit
= (75 x $1.00 + 125 x $1.10 + 100 x $1.50) / ( 75 +125 + 100)
= $362.50 / 300
= $1.21 / unit
Under the weighted average COGS approach:
COGS = 60 x $1.21
Choosing a Costing Approach
Which costing approach should a company choose? Remember that once a firm chooses a costing method, tax authorities do not make it easy to change.
- When costs are rising, LIFO maximizes COGS and therefore minimizes the total value of the remaining items. A higher COGS under LIFO leads to lower reported income and lower taxes.
- When costs are rising, FIFO minimizes COGS and thus maximizes the total value of remaining items. A lower COGS under FIFO leads to higher reported income and higher taxes.
Note that International Financial Reporting Standards (IFRS) do not allow the use of LIFO in many countries.
Regardless of which accounting convention is in use, FIFO, in fact, describes the actual flow of inventory in most companies. Few companies sell newer items before selling older stock they are holding. Many companies choose the Average cost method instead of either LIFO or FIFO, believing the average provides a more accurate measure of true stock costs during the period.