Inventory represents a significant current asset for nearly every company involved in producing or selling physical goods. The value of inventory directly influences a company’s balance sheet and is directly tied to the calculation of the Cost of Goods Sold (COGS) on the income statement.
Defining Business Inventory
Business inventory is formally defined as the goods a company holds either for the purpose of resale to customers or for use in the manufacturing process to create products for sale. This collection of items represents a monetary investment that has not yet been converted into revenue through a sale. On the company’s balance sheet, inventory is classified as a current asset because it is expected to be converted into cash within one year or one operating cycle.
Accurate tracking of the quantity and cost of inventory is necessary for managers to determine the optimal production or purchasing levels. Misstating inventory levels can lead to incorrect profit margins, impacting tax calculations, investor confidence, and long-term strategic planning.
Categories of Inventory
The composition of inventory differs significantly depending on whether a business is a retailer, a wholesaler, or a manufacturer. Companies that produce their own products track inventory across various stages of completion, while those that only resell goods focus on a single category.
Raw Materials
Raw materials are the basic components or inputs purchased by a manufacturing firm that will be physically converted into a finished product. Examples include the steel used to build car frames, the flour purchased by a bakery, or the microchips acquired by a computer manufacturer. The cost of these materials remains in the inventory account until they are physically requisitioned and introduced into the production line.
Work-in-Process (WIP)
Work-in-process inventory consists of goods that have been started in the manufacturing process but are not yet complete or ready for sale to the customer. This category holds the cumulative costs of all resources expended on the product up to that point in time. The valuation of WIP includes the cost of the initial raw materials, the direct labor applied to the product, and an allocated portion of manufacturing overhead costs.
Finished Goods
Finished goods inventory represents the final products that have been entirely completed, packaged, and are now ready for immediate sale to end consumers or other businesses. For a manufacturer, the cost accumulated in the WIP stage is transferred to the finished goods category once production is finalized.
Merchandise Inventory
Merchandise inventory is the category used exclusively by retailers and wholesalers that purchase goods already in a final, sellable condition. Unlike manufacturers, these companies do not alter the physical form of the product they acquire before selling it to their own customers. A department store’s stock of clothing, a grocery store’s packaged food, or a distributor’s supply of electronics all fall under this classification. The cost of merchandise inventory includes the purchase price of the goods plus any freight-in costs necessary to get the items to the retailer’s location.
Inventory Valuation Methods
Assigning a monetary value to inventory is necessary because the cost of items purchased or produced often changes over time. When an item is sold, the cost assigned to it directly impacts the Cost of Goods Sold (COGS) on the income statement and the value of remaining inventory on the balance sheet. Companies utilize several accepted accounting methods to track this flow of costs, even if the physical movement of the goods does not align perfectly with the cost assumption.
The First-In, First-Out (FIFO) method assumes that the oldest inventory items acquired are the first ones sold, meaning the cost of the oldest unit is the first to be expensed as COGS. During periods of rising purchase costs, FIFO generally results in a lower COGS and a higher reported gross profit because the lower, older costs are matched against current revenue.
Conversely, the Last-In, First-Out (LIFO) method assumes the newest inventory costs are the first ones recognized as COGS. LIFO tends to result in a higher COGS and lower reported profit during periods of rising costs, as the higher, more recent costs are expensed first.
A third common approach is the Weighted-Average Cost method, which calculates a new average unit cost after every purchase or production run. This average cost is then applied to all units sold until the next purchase, providing a smoother representation of cost flow that mitigates the impact of short-term price fluctuations.
Determining Inventory Ownership
The legal determination of ownership is a significant factor in deciding whether certain goods should be included in a company’s inventory count, especially when the items are not physically present. A company must include all goods for which it holds legal title, even if those goods are temporarily stored off-site or are currently in transit between the seller and the buyer.
Goods in transit require careful attention, particularly with respect to the shipping terms agreed upon by the seller and the buyer. Under “FOB (Free On Board) Shipping Point” terms, ownership transfers to the buyer the moment the goods leave the seller’s dock, meaning the buyer must include the goods in their inventory count while they are still being transported. Conversely, under “FOB Destination” terms, ownership only transfers when the goods arrive at the buyer’s location, and the seller retains the inventory on their books until that final delivery.
Another common scenario involves consigned goods, where the owner (consignor) places the goods in the hands of an agent (consignee) who attempts to sell them. The consignee never takes legal title to the goods and should not include them in their inventory count.
Assets That Do Not Count as Inventory
Inventory is defined by its eventual purpose of being sold to generate revenue, which distinguishes it from long-term assets used to facilitate business operations. Property, Plant, and Equipment (PPE), also known as fixed assets, are one such exclusion.
Fixed assets include items such as factory buildings, machinery, office furniture, and vehicles, which are intended to be used over multiple years to produce or sell goods. These items are capitalized and depreciated over their useful lives, rather than being expensed as Cost of Goods Sold like inventory. A manufacturer’s production line machine is a fixed asset, while the goods it produces are the inventory.
Operating supplies are another category that must be separated from inventory, as they are consumed internally rather than sold to customers. This includes items like office supplies, janitorial cleaning products, or lubricants for machinery. These supplies are generally expensed immediately or classified as a prepaid asset, reflecting their role as administrative or maintenance costs rather than components of a sellable product.