Inventory
A guide to understanding the goods and materials a company holds for sale, how they are valued, and their critical role in operations and liquidity.
Inventory refers to the goods and materials a company holds for the ultimate purpose of resale or for use in its production process. In accounting terms, this includes raw materials waiting to be used, work-in-progress goods on the factory floor, and finished goods ready to be sold. Because companies expect to sell or use these items within their normal operating cycle (typically one year), inventory is recorded on the balance sheet as a current asset.
The Three Types of Inventory
Inventory is typically broken down into three main categories, which helps companies track resources at different stages of the production cycle:
- 1. Raw Materials: These are the basic inputs purchased from suppliers that will be used to create the final product. Examples include steel for a car manufacturer, flour for a bakery, or silicon for a chip maker.
- 2. Work-in-Progress (WIP): This category includes goods that are currently in the process of being manufactured but are not yet complete. Examples are partially assembled cars on an assembly line or unfinished furniture.
- 3. Finished Goods: These are completed products that are ready for sale to customers. For a retailer, this would be the merchandise on its shelves. For a manufacturer, it would be the packaged goods in its warehouse.
How Inventory is Valued
Accounting rules require companies to assign a cost to their inventory. The choice of method, known as a cost flow assumption, directly impacts reported profits and the inventory value on the balance sheet.
Common Valuation Methods:
- FIFO (First-In, First-Out): This method assumes that the first units purchased are the first ones sold. Ending inventory is therefore valued at the cost of the most recent purchases.
- LIFO (Last-In, First-Out): This method assumes that the most recently purchased items are the first ones sold. This leaves the older, often cheaper, costs in the ending inventory balance.
- Weighted-Average Cost: This method uses the weighted-average cost of all goods available for sale during the period to value both ending inventory and the cost of goods sold.
LIFO is Not Permitted Under IFRS
A key difference in global accounting standards is that IFRS (International Financial Reporting Standards) forbids the use of the LIFO method. U.S. GAAP, however, still permits it. This can lead to significant differences in reported profits for US companies compared to their international peers, especially during periods of high inflation.
Why Inventory Matters for a Business
Inventory is a critical asset that sits at the intersection of a company's operations and its financial health.
Operations and Liquidity
Operations: Inventory is the lifeblood of a retail or manufacturing business. Managing inventory levels effectively is essential to meet customer demand without interruption. Too little inventory can lead to stockouts and lost sales, while too much can lead to storage costs and the risk of obsolescence. Liquidity: While inventory is a current asset, it is less liquid than cash or accounts receivable. The cash used to purchase or produce inventory is tied up until the goods are sold. Therefore, high inventory levels can strain a company's working capital and reduce its ability to invest in other opportunities.
The valuation of inventory also directly influences a company's profitability. The cost of inventory sold during a period is recorded as the Cost of Goods Sold (COGS) on the income statement, which is a major determinant of a company's gross profit.
Key Takeaways
Inventory includes a company's raw materials, work-in-progress, and finished goods.
It is classified as a current asset on the balance sheet, but it is generally less liquid than cash or accounts receivable.
The value of inventory is determined using a cost flow assumption, most commonly FIFO, LIFO, or weighted-average cost. IFRS prohibits the use of LIFO.
Effective inventory management is critical; excess inventory ties up cash and risks obsolescence, while too little inventory can lead to lost sales.
The cost of inventory sold is recognized on the income statement as Cost of Goods Sold (COGS), which directly impacts a company's gross profit.
Inventory
A guide to understanding the goods and materials a company holds for sale, how they are valued, and their critical role in operations and liquidity.
Inventory refers to the goods and materials a company holds for the ultimate purpose of resale or for use in its production process. In accounting terms, this includes raw materials waiting to be used, work-in-progress goods on the factory floor, and finished goods ready to be sold. Because companies expect to sell or use these items within their normal operating cycle (typically one year), inventory is recorded on the balance sheet as a current asset.
Table of Contents
The Three Types of Inventory
Inventory is typically broken down into three main categories, which helps companies track resources at different stages of the production cycle:
- 1. Raw Materials: These are the basic inputs purchased from suppliers that will be used to create the final product. Examples include steel for a car manufacturer, flour for a bakery, or silicon for a chip maker.
- 2. Work-in-Progress (WIP): This category includes goods that are currently in the process of being manufactured but are not yet complete. Examples are partially assembled cars on an assembly line or unfinished furniture.
- 3. Finished Goods: These are completed products that are ready for sale to customers. For a retailer, this would be the merchandise on its shelves. For a manufacturer, it would be the packaged goods in its warehouse.
How Inventory is Valued
Accounting rules require companies to assign a cost to their inventory. The choice of method, known as a cost flow assumption, directly impacts reported profits and the inventory value on the balance sheet.
Common Valuation Methods:
- FIFO (First-In, First-Out): This method assumes that the first units purchased are the first ones sold. Ending inventory is therefore valued at the cost of the most recent purchases.
- LIFO (Last-In, First-Out): This method assumes that the most recently purchased items are the first ones sold. This leaves the older, often cheaper, costs in the ending inventory balance.
- Weighted-Average Cost: This method uses the weighted-average cost of all goods available for sale during the period to value both ending inventory and the cost of goods sold.
LIFO is Not Permitted Under IFRS
A key difference in global accounting standards is that IFRS (International Financial Reporting Standards) forbids the use of the LIFO method. U.S. GAAP, however, still permits it. This can lead to significant differences in reported profits for US companies compared to their international peers, especially during periods of high inflation.
Why Inventory Matters for a Business
Inventory is a critical asset that sits at the intersection of a company's operations and its financial health.
Operations and Liquidity
Operations: Inventory is the lifeblood of a retail or manufacturing business. Managing inventory levels effectively is essential to meet customer demand without interruption. Too little inventory can lead to stockouts and lost sales, while too much can lead to storage costs and the risk of obsolescence. Liquidity: While inventory is a current asset, it is less liquid than cash or accounts receivable. The cash used to purchase or produce inventory is tied up until the goods are sold. Therefore, high inventory levels can strain a company's working capital and reduce its ability to invest in other opportunities.
The valuation of inventory also directly influences a company's profitability. The cost of inventory sold during a period is recorded as the Cost of Goods Sold (COGS) on the income statement, which is a major determinant of a company's gross profit.
Key Takeaways
Inventory includes a company's raw materials, work-in-progress, and finished goods.
It is classified as a current asset on the balance sheet, but it is generally less liquid than cash or accounts receivable.
The value of inventory is determined using a cost flow assumption, most commonly FIFO, LIFO, or weighted-average cost. IFRS prohibits the use of LIFO.
Effective inventory management is critical; excess inventory ties up cash and risks obsolescence, while too little inventory can lead to lost sales.
The cost of inventory sold is recognized on the income statement as Cost of Goods Sold (COGS), which directly impacts a company's gross profit.
Related Terms
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