Finished Goods Inventory

Finished goods inventory is the cost of products a manufacturer has completed and is holding ready for sale, but has not yet sold. It is the last of the three inventory stages in a manufacturing business, following raw materials and work in process. When a finished unit is shipped to a customer, its cost moves out of finished goods and into cost of goods sold on the income statement.

Finished goods are reported among current assets on the balance sheet, either as a separate line or within total inventories, with the breakdown by stage given in the notes. A retailer or wholesaler, which buys goods ready for resale, does not usually use the term; its equivalent account is called merchandise inventory.

Under absorption costing, which US GAAP and IFRS require for external reporting, the cost of each finished unit includes three elements: direct materials, direct labor and an allocated share of factory overhead. Labor and overhead together are known as conversion costs. Costs incurred after production, such as storage, selling and delivery to customers, are generally not added to finished goods; they are expensed as incurred. Abnormal amounts of wasted materials, labor or overhead are also expensed rather than included in inventory.

Completed units are transferred out of work in process at their accumulated cost. The total of these transfers for a period is called the cost of goods manufactured. The finished goods account then works much like merchandise inventory:

Here $\text{Beginning finished goods}$ is the opening balance, $\text{Cost of goods manufactured}$ is the cost of units completed during the period, and $\text{Ending finished goods}$ is the cost of completed units still unsold at period end. The first two together equal the cost of goods available for sale.

A bicycle maker starts the quarter with finished goods of $120,000. During the quarter it completes bicycles costing $900,000, so the journal entry debits finished goods inventory and credits work-in-process inventory for $900,000. A physical count at quarter end shows unsold bicycles costing $150,000. Cost of goods sold is therefore $120,000 plus $900,000 minus $150,000, which equals $870,000. Under a perpetual system, the company would also record each sale as it happened, debiting cost of goods sold and crediting finished goods.

Companies assign costs to units sold and units remaining using a cost flow assumption such as FIFO, weighted average or, under US GAAP only, LIFO. Finished goods must also be tested for declines in value. Under IFRS and for most US companies using FIFO or average cost, inventory is carried at the lower of cost and net realizable value, the expected selling price less costs to complete and sell. If a model of bicycle becomes outdated and can now be sold only for less than it cost, the shortfall is written off, often through an allowance to reduce inventory to net realizable value.

Holding finished goods ties up cash and creates storage, insurance and obsolescence costs, known together as the carrying cost of inventory. Holding too little risks lost sales and unhappy customers. Managers track the balance with measures such as inventory turnover and days sales in inventory, and many manufacturers have reduced finished goods through make-to-order production and just-in-time manufacturing. A rising finished goods balance with flat sales can be an early warning sign that demand is weakening or that a company is building stock to absorb fixed overhead and flatter profit, a practice auditors and analysts watch for closely.