What is Inventory
Inventory is the term for the goods available for sale and raw materials used to produce goods available 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 is the array of finished goods or goods used in production held by a company. Inventory is classified as a current asset on a company's balance sheet, and it serves as a buffer between manufacturing and order fulfillment. When an inventory item is sold, its carrying cost transfers to the cost of goods sold (COGS) category on the income statement.
Types of Inventory
Inventory is generally categorized as raw materials, work-in-progress, and finished goods. Raw materials are unprocessed materials used to produce a good. Examples of raw materials include aluminum and steel for the manufacture of cars, flour for bakeries production of bread, and crude oil held by refineries.
Work-in-progress inventory is the partially finished goods waiting for completion and resale; work-in-progress inventory is otherwise known as inventory on the production floor. For example, a half-assembled airliner or a partially completed yacht would be work-in-process.
Finished goods are products that have completed production and are ready for sale. Retailers typically refer to this inventory as "merchandise". Common examples of merchandise include electronics, clothes, and cars held by retailers.
Many producers partner with retailers to consign their inventory. Consignment inventory is the inventory owned by the supplier/producer but held by a customer. The customer purchases the inventory once it has resold or once they consume it (e.g. to produce their own products). The benefit to the supplier is that their product is promoted by the customer and readily accessible to end-users. The benefit to the customer is that they do not expend capital until it proves profitable to them, meaning they only purchase it when the end-user purchases it from them or until they consume the inventory for their operations.
Inventory can be valued in three ways. The first-in, first-out (FIFO) method says that the cost of goods sold is based on the cost of the earliest purchased materials, while the carrying cost of remaining inventory is based on the cost of the latest purchased materials. The last-in, first-out (LIFO) method states that the cost of goods sold is valued using the cost of the latest purchased materials, while the value of the remaining inventory is based on the earliest purchased materials. 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 storage costs, spoilage costs, and the threat of obsolescence. However, possessing too little inventory also has its disadvantages; for example, the business runs the risk of market share erosion and losing profit from potential sales. 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.