Inventory is tangible goods and materials that a business holds for sale or uses in the production of products or services.
It includes raw materials, work-in-progress goods, and finished products.
Inventory can be classified into different categories based on the stage of completion, usage, and the time it takes to sell.
Inventory is important because it acts as a barrier between the manufacturing process and the demand of customers, making sure that products are accessible whenever needed.
Proper inventory management is vital for maintaining smooth operations, fulfilling customer demands, and maximizing profit.
Implementing efficient inventory management practices is essential for achieving operational efficiency, cost savings, and increased profit margins.
Effective inventory management requires a deep understanding of the various types of inventory that a company holds.
By analyzing data and trends, businesses can determine the optimal levels of inventory to hold, which can help them avoid backorders, overstocks, and obsolete products.
How is Inventory Recorded in Accounting Books?
The inventory held by a company is an invaluable asset, as it directly contributes to generating revenue and profits for shareholders.
It serves as a primary source of income generation through sales.
In terms of financial reporting, inventory is categorized as a current asset on a company’s balance sheet, reflecting its short-term nature.
Inventory is recorded in accounting books using two primary methods: periodic inventory systems and perpetual inventory systems.
- Perpetual Inventory System: The perpetual inventory system operates by constantly monitoring inventory levels in real-time, ensuring that records are promptly updated with each sale or purchase. This system delivers immediate and accurate information regarding stock availability, the cost of goods sold, and the remaining inventory. Alternatively, perpetual inventory systems utilize modern technologies such as bar-codes and sensors to maintain a continuous and up-to-date tracking of inventory levels in real time.
- Periodic Inventory System: Under the periodic inventory system, inventory counting takes place at specific intervals, usually at the end of an accounting period. The determination of the cost of goods sold and the ending inventory relies on the physical count conducted periodically, as well as the opening inventory balance. In periodic inventory systems, businesses must conduct physical counts of their inventory at regular intervals and make necessary adjustments to their records based on the results of the count.
Methods to Value Inventory
Valuing inventory is necessary for accurate financial reporting and determining the cost of goods sold. The most common methods for valuing inventory are:
- FIFO (First-In, First-Out): FIFO assumes that the oldest inventory items are sold first. It values the inventory based on the cost of the earliest purchased items. This method is commonly used when the goods’ physical flow aligns with their cost flow.
- LIFO (Last-In, First-Out): Contrary to FIFO, LIFO assumes that the most recently acquired inventory items are sold first. It values the inventory based on the cost of the latest purchased items. LIFO can be beneficial during inflationary periods, as it matches the current cost of goods sold with the current higher prices.
- Weighted Average: The weighted average method calculates the average cost of all units of inventory, considering both the opening inventory and the purchases. It is calculated by dividing the total cost of goods available for sale by the total number of units available.
Types of Inventory
- Raw Materials: These are the basic materials and components used in the production process. Examples include wood for furniture manufacturing or steel for construction.
- Work-in-Progress (WIP): WIP inventory comprises goods that are in the production process but not yet completed. It includes partially assembled products or items undergoing various stages of manufacturing.
- Finished Goods: Finished goods are the end products ready for sale to customers. These can be electronics, clothing, automobiles, or any other goods manufactured by the company.
- MRO Inventory: Maintenance, Repair, and Operations (MRO) inventory consists of items necessary for supporting day-to-day operations, such as tools, spare parts, or office supplies.
Why Is It Important to Keep Track of Inventory?
Effective inventory management can help businesses avoid stock shortages, minimize waste, and optimize cash flow.
By accurately tracking inventory levels, businesses can make informed decisions about when to reorder products, which products to promote, and which products to discontinue.
This can ultimately lead to improved profitability and customer satisfaction.