Inventory

What is 'Inventory'

Inventory is the raw materials, work-in-process products and finished goods that are considered to be the portion of a business's assets that are ready or will be ready for sale. Inventory represents one of the most important assets of a business because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company's shareholders.

BREAKING DOWN 'Inventory'

Inventory represents finished goods or goods in different stages of production that a company keeps at its premises. Inventory can also be on consignment, which is an arrangement when a company has its goods at third-party locations with ownership interest retained until goods are sold. Inventory is reported on a company's balance sheet under the current assets category, and it serves as a buffer between manufacturing and order fulfillment. When an inventory is sold, its carrying cost goes into the cost of goods sold on the income statement.

Types of Inventory

There are three components typically classified under the inventory account: raw materials, work in progress and finished goods. Raw materials represent goods that are used in the production as a source material. Examples of raw materials are metal bought by car manufacturers, food ingredients held by food preparation companies and crude oil held by refineries.

Work in progress includes goods that are in the process of being transformed during manufacturing and are about to be converted into finished goods. For example, a half-assembled airliner or a ship that is being built would be work in process.

Finished goods are products that have gone through the production and ready for sale, such as completed airliners, ready-to-ship cars and electronics. Retailers who buy and resell goods typically call inventory "merchandise," which includes finished goods bought from producers and can be resold immediately. Examples of merchandise include electronics, clothes and cars held by retailers.

Valuing Inventory

Accountants value inventory using one of the three methods. The first-in, first-out (FIFO) method says that the cost of goods sold is based on the cost of materials purchased the earliest, while the carrying cost of remaining inventory is based on the cost of materials bought the latest. The last-in, first-out (LIFO) method states that the cost of goods sold is valued using cost of materials bought latest, while the value of remaining inventory is based on materials purchased earliest. The weighted average method requires valuing both inventory and the cost of goods sold based on the average cost of all materials bought during the period.

Importance of Inventory Management

Possessing a high amount of inventory for a long time is usually not advantageous for a business because of costly storage, the possibility of obsolescence and spoilage costs. However, possessing too little inventory isn't beneficial either, since the business runs the risk of losing out on potential sales and potential market share as well. Inventory management forecasts and strategies, such as a just-in-time (JIT) inventory system, can help minimize inventory costs because goods are created or received only when needed.

RELATED TERMS
  1. Ending Inventory

    The value of goods available for sale at the end of the accounting ...
  2. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors ...
  3. Average Inventory

    A calculation comparing the value or number of a particular good ...
  4. Carrying Cost Of Inventory

    This is the cost a business incurs over a certain period of time, ...
  5. Perpetual Inventory

    A method of accounting for inventory that records the sale or ...
  6. Inventory Turnover

    Inventory Turnover is a ratio showing how many times a company's ...
Related Articles
  1. Investing

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  2. Investing

    What is Involved in Inventory Management?

    Inventory management refers to the theories, functions and management skills involved in controlling an inventory.
  3. Investing

    Days Sales of Inventory

    Days Sales of Inventory, also called Days Inventory Outstanding, is a key financial measurement of a company's performance pertaining to inventory management. In simple terms, it tells how many ...
  4. Investing

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  5. Investing

    Inventory Valuation For Investors: FIFO And LIFO

    We go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line.
  6. Investing

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  7. Investing

    Reading The Inventory Turnover

    Inventory turnover is a ratio that shows how quickly a company uses up its supply of goods over a given time frame. Inventory turnover may be calculated as the market value of sales divided by ...
  8. Investing

    Understanding Periodic Vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
  9. Investing

    How Does a Perpetual Inventory System Work?

    Perpetual inventory is a system that continually tracks inventory items for quantity and availability.
  10. Investing

    Understanding Activity Ratios

    Activity ratios measure how effectively a business uses its assets.
RELATED FAQS
  1. Does working capital include inventory?

    Learn about inventory that is part of current assets and working capital, which is the difference between current assets ... Read Answer >>
  2. How do you analyze inventory on the balance sheet?

    Learn how to analyze inventory using financial statements and footnotes by doing ratio analysis and performing qualitative ... Read Answer >>
  3. Why should investors care about the Days Sales of Inventory (DSI)?

    Learn about days sales of inventory and what it measures; understand why an investor would want to know a company's days ... Read Answer >>
  4. What is the difference between work in progress (WIP) and finished goods in accounting?

    Learn about the key features and differences between work in progress (WIP) and finished goods in terms of financial accounting ... Read Answer >>
  5. What is the formula for calculating inventory turnover?

    Learn about the inventory turnover ratio, how it is calculated and what this efficiency metric tells businesses about their ... Read Answer >>
  6. Why is it sometimes better to use an average inventory figure when calculating the ...

    For a couple of key reasons, average inventory can be a better and more accurate measure when calculating the inventory turnover ... Read Answer >>
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center