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Financial Management Series: Inventory
Last month, we covered all the ins and outs of accounts receivable on a balance sheet. And as we know, properly balancing your assets and liabilities is crucial to your business' success. Businesses of all types, sizes, and ages use balance sheets to ensure that there is more money coming in than out, and ultimately determine profitability.
"Inventories can be managed, but people must be led."
Ross Perot
As we continue down each line item, we next run into "inventory". Inventory is most simply defined as the goods and materials that a business holds as an asset for the purpose of selling. Inventory is unique in that it can be further broken down into three types: raw materials, work-in-progress, and finished goods. Since inventory is classified as an asset, it should be accurately reported to meet the ever-changing demands of consumers, minimize costs, and avoid disruption in order fulfillment.
This month, we'll cover the types of inventory, how inventory can be valued, and examples of inventory.
Types of Inventory
1.Raw materials are unprocessed materials used to produce a good. Examples include steel for a car manufacturer, cotton for a clothing designer, or flour for a bakery.
2.Work-in-progress inventory is defined as partially completed goods waiting to be finished and sold. This type is also known as WIP and can be calculated in a few different ways depending on the business. An example of WIP inventory is an aircraft that's been built halfway to completion.
3.Finished goods are products that have been through the production process, are complete, and ready to sell. This type of inventory is also known as merchandise. As an example, imagine walking into your favorite clothing store; the merchandise you see around the store is considered finished goods.
How is inventory valued?
FIFO, LIFO, and the weighted average method are all different ways to assign values to your inventory. All values must comply with SEC requirements.
1.First- in, first-out (FIFO) method says that the cost of goods sold is based on the cost of the earliest purchased materials. The remaining inventory's cost is valued based on the latest purchased materials.
2.Last-in, first-out (LIFO) method is the inverse of FIFO. This method says that the cost of goods sold is valued using the cost of the latest purchased materials, and the remaining inventory is based on the cost of the earliest purchased materials.
3.Weighted average method requires valuing the inventory AND the cost of goods sold (COGS) based on the average cost of all materials purchased during a specific period.
Example of inventory
Think of a large automotive company, like Ford. The cars at the Ford dealership would be considered finished goods. This inventory is what is sold to the public and pushed by their salespeople. The steel, aluminum, and leather used to build the cars are considered raw material inventory. A car that has been built but is waiting on the interior features to be installed could be considered work-in-progress inventory.
Inventory can be a complicated process, that's why we're here to help! Lamont Accounting Services can help streamline your services and offer expert advice.
