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.
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.