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What is Inventory?

Inventory encompasses both the raw materials employed in manufacturing and the finished products ready for sale. It stands as a crucial asset for a company since the flow and management of inventory serve as a fundamental driver for generating revenue and profits, thereby benefiting the shareholders. On a company’s balance sheet, inventory is classified as a current asset.

Types of Inventory

The three main categories of inventory comprise raw materials, work-in-progress, and finished goods.

Raw Materials

Raw materials form the foundation of inventory, comprising the basic materials used in the production process. In manufacturing, these could include raw metals, fabrics, or any component processed during production.

Work-in-Progress (WIP)

Work-in-progress inventory includes goods that are in the process of being manufactured but are not yet finished. This class of inventory is crucial in tracking the various stages of production and understanding where resources are allocated.

One example of this is the assembly of the controversial Airbus A380 airliner: factories in France, Germany, the UK, and Spain produce critical components, but other contractors around the world provide minor parts. Everything is shipped by land and sea to the Airbus plant in Toulouse, France for final assembly.

Finished Goods

Finished goods represent the end product ready for sale to customers. For retailers, this could be the stock on store shelves, while for manufacturers, it includes products awaiting shipment.

Inventory Valuation Methods

Inventory can be valued in different ways, each impacting financial statements and tax obligations.

First-in, first-out (FIFO)

The FIFO method is based on the notion that the first goods purchased or built are the first ones to be sold or used. Consequently, the cost of the oldest inventory items is matched against revenue, leaving the most recent purchases in the inventory.

During periods of inflation, FIFO tends to report lower costs of goods sold (COGS), resulting in higher profits, lower taxable income, and, consequently, reduced tax liabilities. It mirrors the current market value as the COGS includes older, lower-priced inventory.

FIFO generally mirrors current prices accurately, providing a realistic representation of the inventory’s value. In times of inflation, FIFO might overstate profits as it matches lower-cost older inventory against current higher selling prices.

Last-in, first-out (LIFO)

Contrary to FIFO, LIFO assumes that the most recently purchased or produced items are the first to be sold. Therefore, the cost of the most recent inventory items is matched against revenue, leaving the oldest purchases in inventory.

During inflation, LIFO reports higher costs of goods sold. This results in lower profits, higher taxable income, and increased tax liabilities. It reflects the most recent, higher-priced inventory against current revenues.

LIFO more closely aligns costs with revenues during inflationary periods, reflecting the current market value. It might understate the value of ending inventory as older, lower-cost items remain on the books.

Weighted Average Method

The weighted average method calculates the average cost of inventory items available for sale during the reporting period. This method averages out the costs of inventory, smoothing the impact of price fluctuations. It moderates the effects of both rising and falling prices on COGS.

The weighted average method provides a more stable and consistent valuation that can be useful when prices are volatile. However, it may not accurately reflect the current market conditions as it combines costs uniformly, potentially masking the real value of the inventory.

Inventory Management

Inventory management is the strategic orchestration of procurement, storage, and utilisation of inventory to meet customer demand while minimising excess stock. Effective inventory management involves the following.

Accurate Forecasting

Accurate forecasting forms the bedrock of efficient inventory management, through leveraging historical data, market trends, and insights from sales patterns to anticipate future demand. By analysing past sales, seasonal fluctuations, and market trends, businesses can make informed decisions regarding inventory levels. This proactive approach minimises the risk of overstocking or stockouts, allowing companies to align their inventory levels with anticipated demand, thereby optimising storage capacity and reducing carrying costs.

Just-in-Time (JIT) Inventory

The Just-in-Time (JIT) approach revolutionised inventory management by advocating for goods to be procured and delivered precisely when needed in the production process or for customer orders. By synchronising inventory arrival with demand, JIT minimises excess inventory storage and carrying costs. This method relies on close coordination with suppliers, ensuring that goods arrive exactly when required, thereby optimising space, reducing waste, and enhancing operational efficiency.

ABC Analysis

ABC Analysis categorises inventory based on its value and usage frequency, allowing businesses to prioritise their management efforts and resources. The categorisation typically consists of:

  • Category A. High-value items with high usage frequency. These items are critical for revenue generation and customer satisfaction.
  • Category B. Moderate-value items with moderate usage frequency.
  • Category C. Low-value items with low usage frequency.

By stratifying inventory into these categories, businesses can focus on managing and monitoring high-value items more closely, while optimising the handling and stocking of lower-value items. This prioritisation ensures that resources are allocated efficiently based on the strategic importance of each inventory category.

Inventory Turnover

Inventory turnover, also known as stock turnover, stands as a pivotal element within inventory management. It quantifies the frequency and extent to which a company’s inventory is sold, replenished, or utilised. This metric serves as a barometer for a company’s profitability and highlights any operational inefficiencies requiring attention.

The level of consumer demand acts as a critical gauge, influencing the pace at which inventory moves. Robust demand generally signifies swift movement of a company’s offerings from shelves to consumers, while tepid demand often results in a sluggish turnover rate.

The formula is simple:

Inventory Ratio = Cost of Goods Sold (COGS) ÷ Average Value of Inventory

  • ​COGS. The total cost of goods or services sold during a specific period.
  • Average Inventory. The average amount of inventory held during the same period, usually calculated by summing the beginning and ending inventory for the period and dividing it by two.

By leveraging this metric, business leaders can make pivotal decisions regarding the continuation of specific product lines or services, and also identify and rectify any underlying issues within the inventory management process.

Inventory facilitates the continuity of business operations by supplying necessary materials. This encompasses raw materials essential for producing goods and services, alongside finished products sold to consumers. Efficient inventory management and assessing turnover rates aid companies in gauging their success and identifying areas for improvement when profits start declining.

FAQs

What insights can inventory provide about a business?

Monitoring a business’s performance can be achieved by examining its inventory turnover rate. When a business sells its inventory more rapidly than its competitors, it reduces holding costs and opportunity costs. Consequently, such efficiency in selling goods often leads to outperformance in the market.

What is Consignment Inventory?

Consigned inventory refers to stock owned by the supplier/producer, usually a wholesaler, yet stored by a customer, typically a retailer. The customer later buys this inventory either upon selling it to the final customer or upon using it (e.g., in manufacturing their own goods).

This arrangement provides advantages for both parties involved. For the supplier, their product gains promotion through the customer and remains easily accessible to end-users. Meanwhile, the customer benefits by deferring capital expenditure until it becomes profitable. Consequently, they only make the purchase when the end-user buys it from them or when they utilise the inventory for their operational needs.

DISCLAIMER: This article is for informational purposes only. BARTERCARD is not affiliated with any company mentioned.

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