What Is Inventory?

What Is Inventory?

Let me tell you directly: inventory refers to the raw materials you use in production and the goods you've produced that are ready for sale. As a company owner or manager, you should know that your inventory is one of your most important assets because turning it over generates primary revenue and earnings for shareholders. You'll find three types here—raw materials, work-in-progress, and finished goods—and it's listed as a current asset on your balance sheet.

Key Takeaways

Inventory includes raw materials for production and goods available for sale, and you classify it as a current asset on the balance sheet. The three types are raw materials, work-in-progress, and finished goods. You can value it using first-in first-out, last-in first-out, or weighted average methods. Through inventory management, you minimize costs by creating or receiving goods only as needed.

Understanding Inventory

Inventory is a crucial asset for any company, defined as the goods used in production or finished goods you hold during normal business operations. You have three categories: raw materials for producing finished goods, work-in-progress, and ready-for-sale finished goods. As I mentioned, it's a current asset on your balance sheet, acting as a buffer between manufacturing and fulfilling orders. When you sell an item, its carrying cost moves to cost of goods sold on your income statement.

Under U.S. GAAP, you value inventory in three ways. The first-in first-out method bases cost of goods sold on the earliest purchased materials, with remaining inventory costed at the latest purchases. The last-in first-out method does the opposite, using latest purchases for cost of goods sold and earliest for remaining inventory. The weighted average method values both based on the average cost of all materials bought in the period.

Important Considerations

You, along with analysts and investors, can use inventory turnover to see how many times a company sells its products in a period. This metric tells you if there's too much or too little inventory on hand.

Special Considerations

Many producers consign inventory to retailers, where the supplier owns it but the retailer holds it. The retailer buys it only after selling to the end customer or consuming it. This setup promotes the supplier's product and makes it accessible to users, while the retailer avoids spending capital until it's profitable.

Types of Inventory

Inventory falls into raw materials, work-in-progress, and finished goods, with the IRS adding merchandise and supplies. Raw materials are unprocessed, like aluminum for cars, flour for bread, or crude oil for refineries. Work-in-progress includes partially finished goods on the production floor, such as a half-assembled airliner or yacht. Finished goods are complete and ready for sale, like electronics, clothes, or cars that retailers call merchandise.

Inventory Management

Holding too much inventory long-term isn't advisable due to storage, spoilage, and obsolescence risks. Too little means you risk losing market share and profits from missed sales. Use forecasts and strategies like just-in-time inventory, where goods arrive only when needed, to cut costs. Invest in a good management system, especially if you have multiple locations, to spot waste, low turnover, and fraud.

Inventory Turnover

Inventory turnover measures how often you sell, replace, or use inventory, giving insight into profitability and inefficiencies. Consumer demand drives it—high demand means quick turnover, low demand slows it. Calculate the ratio as cost of goods sold divided by average inventory value. Use this to decide on manufacturing continuance or fix issues.

How Do You Define Inventory?

Inventory is your company's goods ready for sale plus raw materials to produce them, categorized as raw materials, work-in-progress, and finished goods. In accounting, it's a current asset you plan to sell within a year, valued by last-in first-out, first-in first-out, or weighted average methods.

What Is an Example of Inventory?

Take Zara, a fashion retailer on a seasonal schedule. Their fast fashion pushes rapid inventory sales, with merchandise as finished goods. Fabric and materials are raw inventory.

What Can Inventory Tell You About a Business?

Track business performance via inventory turnover speed. Faster turnover than competitors means lower holding and opportunity costs, leading to better efficiency and outperforming in sales.

The Bottom Line

Inventory supplies materials to run operations, including raw materials for production and finished goods for sale. Manage it and track turnover to gauge success and identify improvements when profits drop.