Anyone who has ever worked in retail has heard the term inventory. For businesses, inventory is not only how stores keep customers happy, but it’s also how they keep supply chains moving (and ensure that supply is available to meet demand).
Beyond the borders of a brick-and-mortar store, what is inventory? More importantly, how does inventory management keep commerce moving? Here’s everything you ever wanted to know about this critical business concept.
What Is Inventory?
Based on where you are in the supply chain, there are multiple meanings to inventory. For producers, inventory is the raw materials required to produce goods that will be sold to intermediate or end consumers. Once they’re turned into commodities, these products are shipped to an intermediate consumer, retail outlet, or end consumer.
Intermediate consumers (like warehouses) often store inventory for shipment to fulfillment centers (like retail stores) or to the end consumer. These intermediate locations often rely on just-in-time inventory management to ensure that products are continually moving to their final destination. This strategy reduces liabilities and allows commodities to turn a profit faster.
At retail locations, inventory is the quantity of any product on hand at any given time. The goal of the retailer is to sell the available inventory to multiple end consumers. The longer inventory stays on the shelf or “in the back”, it inherits storage costs, a higher risk of damage, and may even become obsolete.
What Are the Types of Inventory?
There are three key types of inventory used throughout the supply chain. Each describes the condition of the products throughout the inventory management process – and where it stands between production and delivery.
1. Raw Material Inventory
The raw material inventory is at the beginning of the supply chain. This is the matter the products will be created from and ultimately moved down the line. For example, steel and rubber are used to produce vehicles. Similarly, textiles and wood are the raw material inventory used to produce furniture.
2. Inventory Management
As the raw materials are used, they move to the next step in the inventory management process (designated as a work-in-progress). Anything identified as work-in-progress not only takes the cost of raw materials into consideration, but also adds labor and overhead costs into the process. This concept allows companies to determine necessary costs of producing any given item – and then to employ cost management strategies to reduce their cost per unit.
3. Finished Goods
Once the final goods are produced, they become finished goods. At this state in the inventory management process, the product is ready to be shipped to its next destination and sold to the consumer. From here, merchandise can either be sent to retailers or shipped directly to the consumer through online sales.
Examples of Inventory
Depending on where they fall in the supply chain, inventory examples can take many different shapes. At its most basic level, however, inventory is the physical count of the commodities at any point in the process.
As an example of inventory, a large manufacturer may have their products in various stages of production. To report their total inventory to stakeholders, they will present it on their balance sheet as raw materials, work-in-progress, and finished goods. This informs their leadership as to where their inventory stands and what they are doing to maximize their resources.
In the retail world, inventory is a simple count of all items in stock and their value. Taking regular inventory counts informs management what is selling well, what isn’t, and what may be used to predict consumer or seasonal trends.
How Taking Inventory Works
The physical process of taking inventory (or taking inventory stock) is the accounting for resources throughout the manufacturing process. Instead of simply counting the finished goods available, taking inventory counts raw materials, works-in-progress, and finished products.
Example of Taking Inventory
Let’s assume that Bike Company XYZ makes one type of bicycle. To produce it, they need four materials: frames, suspensions, wheels, and tires. Their inventory process includes the materials in their possession and their value, the number of works-in-progress (and their value), and the number of finished products on hand.
Each of these factors provide different business insights: understanding the price of acquiring materials (plus labor) for works-in-progress helps a company determine their average cost of goods sold (COGS for short). In turn, knowing how much finished inventory is available allows the company to set expectations for their sales partners, ultimately driving their sales and keeping the supply chain moving.
What Is Inventory Management?
Regular accounting of raw materials, works-in-progress, and finished goods is just one aspect of inventory. Inventory management ensures that both ends of the supply chain are in harmony. That is, the company has enough raw materials on hand to produce goods while balancing the amount of finished products ready to be sold later.
Through the process of inventory management, employees in procurement and supply ensure that a company has enough of any given raw material to create their products. They also make certain the inventory is stored to minimize the risk of theft or damage, and there is a sufficient number of finished goods to avoid backlog.
Inventory Management Examples
Two of the most common inventory management models are the ABC inventory classification model or the economic order quantity model (EOQ). Both take a different approach in ensuring that companies have enough inventory to manufacture goods and prepare them for sale.
Economic Order Quantity Inventory Management
Using the economic order quantity (EOQ) inventory management process, managers balance the cost of having a surplus of items and then storing inventory with the cost of a “stockout” or shortage of an item. This balance should minimize storage costs and reduce the chance of production overruns. Analysts will look at which products sell best, and measure their order and carry costs to determine peak performance.
Why Inventory Management Is Essential in Business
Although inventory management is a critical business procedure to ensure costs are kept in control and consumer demand is met, it has many more implications for business operations. Understanding and controlling inventory helps leaders determine their business health while keeping the supply chain moving appropriately.
Inventory management also helps businesses understand their inventory turnover (how fast a company can replenish its inventory). By maximizing turnover, a company can reduce their storage costs and ensure they produce what customers want to purchase. This directly affects profits and assets on hand which has implications for tax liabilities at the end of a company’s fiscal year.
Inventory management also affects ancillary costs. For instance, if a company has too many raw materials, they may be forced to pay for additional warehousing, security, and transportation. If a company has too many finished goods, they have to store them and protect them from warehouse damage. Good inventory management practices ensure that companies produce the right products and continue the supply chain moving from factory to end consumer.
What Are Common Inventory Accounting Methods?
Based on business practices and financial goals, there are three primary inventory accounting methods companies use to value their raw materials: Last-In, First-Out (LIFO), First-In, First-Out (FIFO), and the weighted average cost method.
As the name suggests, the “last-in, first-out” (LIFO) inventory accounting method assumes that the most recent units to come in are the first to be sold, regardless of their cost. Companies tend to use the newest and most expensive materials to create finished goods. Businesses that tend to hold onto inventory over longer periods of time benefit from LIFO inventory accounting because it reduces their reported net income, which in turn can minimize the tax liability on their inventory reserve.
Contrary to LIFO inventory accounting, the first-in, first-out (FIFO) method assumes that all items are sold in the order they are acquired, regardless of the cost. If a company produces 50 units at one price and then 70 at a higher price (and then sells 50 units), it would expense (as Cost of Goods Sold) the cost of the first 50 units. .
Companies who utilize FIFO for their inventory accounting often try to gain savings by managing higher costs of first-in inventory.
Weighted Average Cost Method (WAC)
The third method of inventory management is the weighted average cost method (WAC). Under this inventory management process, inventory managers use a simple formula to average the cost of goods available for sale over the number of units available. Under a periodic inventory system (which is the most common among businesses), the cost of goods sold (COGS) is determined by counting the ending inventory and their cost, which then plays into the weighted average cost. But when applied to a perpetual inventory system, the regular count provides a continual count of inventory and COGS, which then creates a “moving” average cost.
The Lower of Cost or Market rule (LCM) is not an inventory management process, but rather a rule that determines which method should be used to report inventory value. Because goods and commodities can shift price over time, companies report their inventory at whichever is lower: its actual cost or its current market value. That way, if inventory has become obsolete or its value has diminished over time, its reported value will not be exaggerated. LCM inventory accounting minimizes the cost of a product based on the cost to produce or acquire it (historic cost), or the price of selling it to the customer (market value). In instances when a product could have a negative net realizable value (NRV), this method allows companies to record the inventory as a loss, thus reducing their liabilities.
What Is Inventory’s Primary Driver in Business?
For businesses producing a finished good, inventory’s primary driver is consumer demand. If their production is aligned with the law of supply, then they will continually derive increased profits from customers. By optimizing for demand, businesses can create enough products to fulfill market needs without maintaining excessive storage or security costs.
Conversely, companies can also face inventory drivers that negatively affect their business. If a product is no longer in demand – or if the work-in-progress time falls out of alignment with market cycles – the amount of inventory held can hurt a company’s bottom line. In an ideal world, a company will produce enough finished goods to align with consumer demand, which ultimately acts as a business driver.
Ask An Expert About Inventory
InvestingAnswers is on a mission to help consumers build and protect their wealth through education. That is why we have experts answering your pertinent questions at the end of each article.
What Is a Good Inventory Management Method?
There is no one universal inventory management method. Rather, inventory management depends on a company’s goals and production cycles. Companies that produce many different products (or have high levels of SKU-level proliferation) may benefit from the ABC inventory management solution. Companies that produce fewer specialized products could prefer using the EOQ method.
What Is Inventory Turnover?
Inventory turnover is the rate that a company purchases (or creates) and resells inventory to customers. Inventory turnover helps producers understand how fast they need to produce in order to fulfill customer sales demands. At a retail level, inventory turnover measures sales relative to available stock, allowing management to determine how often to reorder goods (and at what volume).
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
Mutual funds are one of the great success stories in the history of financial services. In 1970, just 360 funds existed in the United States, with assets under...Read More →
Chances are you've seen this curious designation on a few business cards: CFA. It stands for...Read More →
Every year in January, I do a big portfolio review. I rebalance my portfolio and make sure that I still like my current mutual funds and ETFs. And I get to know the...Read More →
Over the past century, the United States has generated billions in wealth for the select few who came up with a brilliant business idea (or had the good fortune to...Read More →