Inventory

Inventory is the stock of goods a business holds for sale in the ordinary course of business, together with the materials and partly finished goods it uses to produce them. For a retailer, inventory is the merchandise on its shelves and in its warehouses. For a manufacturer, it includes raw materials, work in process and finished goods. Inventory is reported on the balance sheet among current assets, and when it is sold, its cost moves to the income statement as cost of goods sold.

For many companies inventory is one of the largest assets and a major use of working capital. Managing it well means balancing the cost of holding stock against the risk of running out. Accounting for it is governed by ASC 330 in US GAAP and IAS 2 under IFRS.

Inventory is usually classified by its stage in the business:

• Merchandise inventory is goods bought ready for resale by retailers and wholesalers.
• Raw materials are inputs that a manufacturer has bought but not yet used in production.
• Work in process is goods that have started production but are not yet complete.
• Finished goods are completed products awaiting sale.
• Supplies, such as packaging and maintenance items, may be included in inventory if they will be used in production.

Goods a business holds on behalf of others, such as consigned goods, are not its inventory, while goods it owns that are in transit or held by others are.

Inventory is first recorded at cost, which includes the purchase price, freight-in, import duties and, for manufacturers, direct labor and an allocation of production overhead. Because identical items are often bought at different prices, businesses use a cost flow assumption such as first in, first out, weighted average or, in the United States only, last in, first out, to assign costs to items sold and items remaining. Unique, high-value items may be tracked by specific identification.

Inventory must then be checked for declines in value. Under IFRS, and under US GAAP for companies not using LIFO or the retail method, it is carried at the lower of cost and net realizable value, the estimated selling price less costs to complete and sell. A write-down is recorded directly or through an allowance to reduce inventory to net realizable value.

For example, an electronics retailer holds 500 tablets that cost $300 each, or $150,000. A newer model has been launched and the old tablets can now be sold for only $280 each, with $15 of selling costs per unit, giving a net realizable value of $265. The retailer writes the inventory down by $35 per tablet, a total of $17,500, recognizing the loss in cost of goods sold for the period.

Businesses track inventory using one of two systems. A perpetual system updates inventory records with every purchase and sale, so the balance and cost of goods sold are always known; barcode and point-of-sale technology have made this the norm for most businesses. A periodic system updates inventory only when a physical count is made, and calculates cost of goods sold as beginning inventory plus purchases minus ending inventory. Even with a perpetual system, businesses carry out physical counts to detect shrinkage from theft, damage and errors.

Holding inventory has costs, including storage, insurance, financing and obsolescence, summarized as the carrying cost of inventory. Techniques such as the economic order quantity model, ABC inventory classification and just-in-time manufacturing help reduce these costs. Analysts measure efficiency with inventory turnover and days inventory outstanding. A build-up of inventory relative to sales can signal weak demand, poor purchasing or obsolete stock, and inflated inventory is a well-known route to overstating profit, which is why auditors observe year-end counts. Businesses short of cash can also borrow against stock through inventory financing.