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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Inventory Management

What it is:

Inventory management is the process of ensuring that a company always has the products it needs on hand and that it keeps costs as low as possible.

How it works (Example):

Inventories are company assets that are intended for use in the production of goods or services made for sale, are currently in the production process, or are finished products held for sale in the ordinary course of business. Inventory also includes goods or services that are on consignment (subject to return by a retailer) or in transit.

There are three types of inventory: raw materials, work-in-progress, and finished goods. Given the significant costs and benefits associated with inventory, companies spend considerable amounts of time calculating what the optimal level of inventory should be at any given time. Because maximizing profits means minimizing inventory expenses, several inventory-control models, such as the ABC inventory classification method, the economic order quantity (EOQ) model, and just-in-time management are intended to answer the question of how much to order or produce.

Inventory management also means maintaining effective internal controls over inventory, including safeguarding the inventory from damage or theft, using purchase orders to track inventory movement, maintaining an inventory ledger, and frequently comparing physical inventory counts with recorded amounts.

Common inventory accounting methods include "first in, first out" (FIFO), "last in, first out" (LIFO), and lower of cost or market (LCM). Some industries, such as the retail industry, tailor these methods to fit their specific circumstances. Public companies must disclose their inventory accounting methods in the notes accompanying their financial statements.

Inventory management makes its biggest mark on the inventory line item of the balance sheet. That line item doesn't just reflect the cost of the inventory; it also reflects costs directly or indirectly incurred in readying an item for sale, including not only the purchase price of that item but the freight, receiving, unpacking, inspecting, storage, maintenance, insurance, taxes, and other costs associated with it.

Why it Matters:

Inventory management is a key component of cost of goods sold and thus is a key driver of profit, total assets, and tax liability. Many financial ratios, such as inventory turnover, incorporate inventory values to measure certain aspects of the health of a business. For these reasons, and because changes in commodity and other materials prices affect the value of a company’s inventory, inventory management is important.

Inventory management is also a key part of managing a company's supply chain. Buy too much stuff, and a company can end up paying more for warehousing, insurance, shipping, and other services related to obtaining and maintaining inventory. All of these affect the bottom line. Finding the best way to buy, store and move inventory can make the difference between profits and losses for many companies.

Because there are several ways to account for inventory and because some industries require more inventory than others, comparison of inventory management is generally most meaningful among companies within the same industry using the same inventory accounting methods. The definition of a "good" or "bad" inventory management should be made within this context.

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