What is Inventory?
Definition: Inventory, often called merchandise, refers to goods and materials that a business holds for sale to customers in the near future.
In other words, these goods and materials serve no other purpose in the business except to be sold to customers for a profit. They are not used in the produce things or promote the business. The sole purpose of these current assets is to sell them to customers for a profit, but just because an asset is for sale doesn’t mean that it’s considered inventory. We need to look at three main characteristics of inventory to determine whether an asset should be accounted for as merchandise.
What Does Inventory Mean?
What is the definition of inventory? First, the assets must be part of the company’s primary business. For instance, a sandwich shop’s delivery truck is not considered inventory because it has nothing to do with the primary business of making and selling sandwiches. This is considered a fixed asset for the sandwich shop. To a car dealership, on the other hand, this truck would be considered inventory because they are in the business of selling vehicles.
Second, the assets must be available for sale or will soon be ready to sell. If some business assets could be sold but are never actually made available for sale, they aren’t inventory. These are just assets or investments of the company.
Third, the purpose of owning the assets must be to sell them to customers. Going back to our sandwich shop example, the truck was never meant to be sold to a customer. It was purchased to deliver sandwiches and was sold when it couldn’t perform that job. The car dealership, on the other hand, purchases vehicles for the sole purpose of reselling them. Thus, the truck is considered inventory to them.
These characteristics can be applied to all businesses in all industries, so if you ever unsure what should be included or not just remember this inventory template.
Types of Inventory
According to our inventory definition, there are many different types of inventory and each is accounted for slightly differently. Retailers are the easiest to account for because they typically only have one kind of goods called merchandise. They purchase it from wholesalers or manufacturers as finished products to sell to their customers.
Manufacturers, on the other hand, define inventory a little bit differently because they produce their own products to sell to customers. Thus, they need to account for the inventory at every stage of production. The three categories are raw materials, work-in-process, and finished goods. Let’s take a look at each of these categories in the Ford car plant.
Raw materials – Raw materials are the building blocks to make finished goods. Ford purchases sheet metal, steel bars, and tubing to manufacture car frames and other parts. When they put these materials into produce and start cutting the bars and shaping the metal, the raw materials become work in process inventories.
Work in process – Work in process inventory consists of all partially finished products that a manufacturer produces. As the unfinished cars make their way down the assembly line, they are considered a work-in-progress until they are finished.
Finished goods – Finished goods are exactly what they sound like. These are the finished products that can be sold to wholesalers, retailers, or even the end users. In Ford’s case, they are finished cars that are ready to be sent to dealers.
Each of these different categories is important and managing them is key to any business’ survival. Inventory control is one of the most important concepts for any business especially retailers. Since they purchase goods from manufacturers and resell them to consumers at small margins, they have to manage their purchasing and control the amount of cash that is tied up in merchandise.
Recording Inventory in Accounting
There are many different methods that can be used to record the cost of inventory, but first let’s take a look at what each business attributes to the cost.
When retailers purchase goods from wholesalers or manufacturers, they record the price that they paid for the goods. This includes sales tax, delivery fees, and any other fees associated with receiving the goods.
Manufacturers, however, must include all the of the production costs and any other cost like packaging that is necessary to make the inventory ready for sale.
Businesses typically use one of two different accounting systems to keep track of their goods: periodic and perpetual.
The periodic inventory system is simple and only requires an inventory spreadsheet to keep track of sales and goods remaining in stock. Basically, a count is performed periodically throughout the year to see what was sold and what was left. Although this is a very simple way to keep track of merchandise, it has many downsides.
The perpetual inventory system is a highly sophisticated system that keeps tracks of goods as they are purchased and sold in real time using a bar code scanner and computer system. This is far more accurate than a period system and far more costly.
Financial Statement Presentation Example
Inventory is reported on the balance sheet as a current asset. It’s typically presented right after cash and accounts receivable. Retailers typically only list one type of merchandise on their balance sheet where as manufacturers tend to list the three different categories of inventory separately.
Using the FIFO, LIFO, or the weighted average costing method, cost is assigned to the inventory that was sold during the year and is reported as cost of goods sold on the income statement.
Inventory Management Example
Good inventory management is what sets successful retailers apart from unsuccessful ones. Controlling purchasing and evaluating turns helps management understand what they need to stock and what they need to get rid of. It also helps them become more profitable.
Management uses the inventory turnover and the margin ratios to measure the earnings from each piece of merchandise and stock items that will produce more profits for the company. Investors and creditors also look at these ratios as a health indicator of the company.
For instance, a retailer with low turns and high margins is a normal. A retailer with low turns and low margins might indicate the company isn’t doing well.
Inventory is typically one of the largest assets on a retailer’s balance sheet and there are plenty of accounting oddities with it. Here’s more information about how it is valued and accounted for.
Summary Definition
What is inventory? Inventory consists of the goods that a company creates to sell to customers in the future or stocks to sell to them today. This includes raw materials used to manufacture products for customers as well as merchandise stocked to sell to cusomter today.
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