Money Matters

What is inventory?

Explore the essentials of inventory - its definition, valuation methods, types, tracking systems, and effective management strategies for businesses.

people in office

When you hear the term “inventory,” images of crowded warehouses or neat supermarket shelves may spring to mind. At its core, the inventory definition encompasses all the goods and materials a business holds to support production, facilitate operations, and ultimately, create sales.

Whether you’re running a bustling e-commerce business or a small-town bakery, a fundamental understanding of inventory is key to ensuring smooth operations and financial stability.

Understanding business inventory

Business inventory can be considered the lifeblood of a retail or manufacturing company. It represents the array of goods currently for sale (finished goods), those being used in the creation of products to be sold (work in process), or the items required to facilitate this process (raw materials).

These assets must be meticulously tracked to gauge product demand, identify best-selling items, manage costs, and optimize cash flow. The inventory accounting process is a fundamental component of business management.

Imagine you run a clothing store. Your inventory includes the clothes you’re selling. If you make the clothes yourself, then the threads and fabrics used to produce more clothes form a different part of your inventory.

The different types of inventory in accounting

Inventory accounting is far from a one-size-fits-all concept. Rather, it involves distinguishing between various types of inventory (depending on where they are used in the production process), each with unique characteristics and implications for your financial statements and tax obligations. The most common types of inventory in accounting include:

  • Raw materials: These are the base ingredients or components that will eventually become a part of the final product. In a bakery, for example, flour, sugar, and yeast would be raw materials.

  • Work in Progress (WIP): This inventory type encompasses products that are in the production process but are not yet complete. For our bakery, this could include dough that’s being prepared or bread that’s currently baking.

  • Finished goods: These are the products that are ready for sale. Continuing our bakery example, a fresh loaf of bread on the shelf would be a finished good.

  • MRO (Maintenance, Repair, and Operations) supplies: These are not for sale, therefore they are not inventory, but these items support the production process or maintain the operations and can sometimes be confused as being part of inventory when they are supplies. Examples are cleaning supplies, factory equipment, or even office supplies. These items are recorded as expenses rather than assets like inventory.

Deciphering inventory models

Inventory models are mathematical equations or formulas that help businesses control their inventory, anticipate demand, manage reorder points, and minimize costs. The two most popular inventory models are the Economic Order Quantity (EOQ) model and the Just-in-Time (JIT) model. They are used in businesses such as grocery and other retail stores whose inventory consists of finished goods.

Economic Order Quantity (EOQ): This model aims to find the optimal order quantity that minimizes total inventory costs. These costs include purchase cost, holding cost, and shortage cost. The EOQ model is beneficial for businesses with consistent demand and steady production.

Just-in-Time (JIT): The JIT inventory model is designed to order inventory as needed for production or sales, effectively reducing inventory holding costs and waste. This model requires accurate forecasting and reliable suppliers to prevent stock outs.

Understanding and applying these models can significantly enhance inventory management, contributing to the efficiency and profitability of your business.

Tracking inventory

One key to determining inventory reorder levels is efficient inventory tracking. This prevents stock outs (which can result in lost sales and damage to your brand’s reputation) and overstocking (which can tie up your capital and increase storage costs). By maintaining the right amount of stock, you can ensure smoother operations, better cash flow management, and improved customer satisfaction.

Manual vs. automated inventory tracking

Inventory tracking can be as simple as maintaining a spreadsheet with product details and quantities or as sophisticated as using a dedicated inventory management software.

Manual Tracking: This is a traditional method where you manually count your inventory and update a record, usually a spreadsheet. While this method might work for a small business with limited items, it can be time-consuming and prone to human error, especially as the business grows and inventory expands.

Automated Tracking: This involves using inventory management software that automatically updates stock levels as products are bought and sold. Automated tracking systems can also provide real-time inventory updates, track products across multiple locations, generate sales forecasts, and send reorder alerts when stock levels are low. Although there’s an upfront investment involved, the increase in efficiency and accuracy can deliver significant long-term benefits.

Barcode scanning and RFID systems

Modern inventory tracking has evolved beyond simple spreadsheet updates or automated software entries. Today, many businesses use technologies such as barcode scanning and Radio Frequency Identification (RFID) systems to track their inventory.

  • Barcode Scanning: Each product is assigned a unique barcode that contains information about the item. When the barcode is scanned at the point of sale, the system automatically updates the quantities.
  • RFID Systems: Unlike barcodes, which need to be manually scanned, RFID tags can be automatically detected and tracked by RFID readers. This allows for real-time inventory tracking and can significantly reduce manual labor and errors.

Regular inventory audits

Regardless of the tracking method you choose, regular inventory audits—where you physically count all your inventory—are a crucial part of an effective inventory tracking system. They help ensure the accuracy of your inventory records and identify any discrepancies due to theft, damage, or administrative errors.

Inventory audits can be time-consuming, so many businesses opt for cycle counting, where a small subset of inventory is counted on a specific day without interrupting daily operations.

The bottom line on inventory tracking

Inventory tracking, when done effectively, can provide a comprehensive overview of your business’s stock levels. By choosing the right method for your business and performing regular audits, you can streamline your operations, optimize stock levels, and create a foundation for growth and success.

Remember, the goal isn’t just to track inventory but to leverage that information to make informed business decisions.

Inventory valuation methods

Inventory valuation is a crucial aspect of inventory accounting. It determines the monetary value of the products sitting on your shelves or in your warehouse, shaping your financial statements and influencing your tax liability. The value of inventory directly affects the calculation of the Cost of Goods Sold (COGS) and gross profit, which are key figures for analyzing a company’s performance.

The three main methods for inventory valuation are: First-In, First-Out (FIFO); Last-In, First-Out (LIFO); and Weighted Average Cost (WAC). Each method has its own advantages and drawbacks, and the choice between them depends on various factors such as the nature of your inventory, business model, and the financial reporting standards in your region.

First-In, First-Out (FIFO)

FIFO is an inventory valuation method that assumes the oldest items (those purchased or produced first) are sold before the newer ones. This method reflects a logical flow of inventory, particularly for perishable goods where older items need to be sold first to prevent spoilage.

If you own a fruit stand, you would want to sell the oldest apples first. Using the FIFO method, the cost of these older apples is recorded in COGS when a sale occurs, leaving the cost of the newer apples in ending inventory.

FIFO can increase net income because it assumes that cheaper, older inventory is sold first. This leads to a lower COGS, higher profit, and potentially higher taxes, particularly during periods of inflation.

Last-In, First-Out (LIFO)

In contrast, the LIFO method assumes the most recently acquired or produced items are sold first, leaving the older stock in inventory. While this might seem counter-intuitive for a physical product flow, it can provide tax advantages during inflation.

Using the fruit stand example, if you were using LIFO, you would be selling the newest apples first. The cost of these new apples—likely higher due to inflation—is recorded in COGS, resulting in a higher COGS, lower profit, and consequently, lower taxes.

However, it’s important to note that LIFO is not an acceptable method of accounting for inventory under some accounting standards, so make sure you understand the principles applicable in your situation.

Weighted Average Cost method (WAC)

The WAC method strikes a middle ground. It calculates a new average cost after each inventory purchase by dividing the total cost of items in inventory by the total number of units available for sale. This average cost is then used to determine COGS and ending inventory value.

Imagine your fruit stand has apples bought at different prices. Under the weighted average cost method, you would calculate the average cost of all apples, regardless of when they were purchased. Every time an apple is sold, the COGS will be this average cost, and the same average cost is used to value the remaining apples.

This method smooths out price fluctuations, which can be beneficial in industries where inventory items are so intermingled that it becomes difficult to assign a specific cost to an individual unit.

Specific identification

In industries where inventory has a high value, and it is easy to identify individual products, such as jewelry, automobiles, and houses, the cost of individual items is tracked and used for COGS.

Choosing the right inventory valuation method is a strategic decision, which can significantly impact your business’s reported profit, taxable income, and inventory planning. It’s vital to consider your business context and consult with an accountant to make an informed decision.

An example of inventory tracking in action

Let’s consider an inventory tracking example featuring a fictional coffee shop, “Brewed Delights.”

Brewed Delights, a popular coffee shop in the heart of Boston, offers a range of coffee beans, snacks, and coffee-related merchandise. When they first opened, they used a simple manual tracking system to manage their inventory. But as their business grew, they started facing challenges.

Manual tracking became time-consuming and prone to human error, leading to occasional stock outs of popular items, like their signature house blend, and overstocking of slower-selling products. These inconsistencies started to affect customer satisfaction and the shop’s profitability.

Recognizing the need for better inventory management, the owner of Brewed Delights decided to transition from manual tracking to an automated inventory tracking system. Each product in their inventory was assigned a unique barcode that contained information about the product, including type, size, cost, and selling price.

When a customer bought a bag of the house blend coffee, the barcode was scanned at the point of sale, and the system automatically deducted the sold quantity from the inventory records.

The system also sent a notification when stock levels of any product, such as their signature blend, fell below a certain threshold. This alert gave Brewed Delights enough lead time to reorder and replenish their stock before running out, effectively preventing stock outs.

Moreover, the system provided valuable insights into sales trends, allowing Brewed Delights to identify their best-selling products and those that were not performing as well. These insights enabled them to optimize their stock levels, reducing the capital tied up in slow-moving inventory.

While introducing the automated system required an upfront investment, the benefits of accurate, real-time inventory tracking, reduced stock outs and overstocks, and actionable sales insights led to improved customer satisfaction and increased profitability, making the new system a worthwhile investment for Brewed Delights.

Effective inventory tracking can revolutionize inventory management, highlighting the tangible benefits it can bring to a business, irrespective of its size or industry.

Wrapping pp: The power of inventory

In conclusion, inventory—be it raw materials, WIP, or finished goods—plays a critical role in business operations. Understanding what inventory is, recognizing the different types of inventory in accounting, and employing effective inventory models can significantly enhance your business’s efficiency and profitability.

Whether you’re a seasoned business owner or an ambitious start-up, developing an intuitive understanding of inventory can streamline your operations, improve customer satisfaction, and give you an edge in the competitive business landscape. After all, the more effectively you manage your inventory, the better equipped you are to navigate the challenges and opportunities that come your way.