What It Is:
How It Works/Example:
Inventory is commonly thought of as the finished goods a company accumulates before selling them to end users. But inventory can also describe the raw materials used to produce the finished goods, goods as they go through the production process (referred to as "work-in-progress" or WIP), or goods that are "in transit."
There are generally five reasons companies maintain inventories:
- To meet an anticipated increase in demand;
- To protect against unanticipated increases in demand;
- To take advantage of price breaks for ordering raw materials in bulk;
- To prevent the idling of a whole factory if one part of the process breaks down; and,
- To keep a steady stream of material flowing to retailers rather than making a single shipment of goods to retailers.
Inventory can also be used as collateral to obtain financing in some cases.
The basic requirement for counting an item in inventory is economic control rather than physical possession. Therefore, when a company purchases inventory, the item is included in the purchaser's inventory even if the purchaser does not have physical possession of those items.
Inventory is usually classified in its own category as an asset on the balance sheet, following receivables. It is important to note that the balance sheet's inventory account should also reflect costs directly or indirectly incurred in making an item ready for sale, including the purchase price of the item as well as the freight, receiving, unpacking, inspecting, storage, maintenance, insurance, taxes, and other costs associated with it.
Why It Matters:
Inventory is a key component of calculating cost of goods sold (COGS) and 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, it is important to understand how a company accounts for its inventory. 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.
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, and changes in inventory levels can send mixed messages to investors. Increases in inventory may signal that a company is not selling effectively, is anticipating increased sales in the near future (such as during the holidays), or has an inefficient purchasing department.
Declining inventories may signal that the company is selling more than it expected, has a backlog, is experiencing a blockage in its supply chain, is expecting lower sales, or is becoming more efficient in its purchasing activity.
Because there are several ways to account for inventory and because some industries require more inventory than others, comparison of inventories is generally most meaningful among companies within the same industry using the same inventory accounting methods, and the definition of a "high" or "low" inventory level should be made within this context.