What Is Inventory? Categories, Importance, Cost Of Holding Inventory

Excessive inventory, or dead stock, can use up a lot of capital, as well as storage space. Inventory accounting refers to the accounting that deals with the accounting and valuation changes that can be introduced in the inventoried assets. The inventory of a company generally deals with goods that involve three stages of production.

A business can face difficulties in its supply chain and order management in events like natural disasters, price hikes and many more. To fulfill customer orders in such situations, inventory teams prepares a contingency plan according an adequate level of safety stock is maintained. MRO items are not accounted as inventory items in books of accounts; however, they play a cardinal role in the day-to-day operations of an organisation. MRO supplies are utilised in maintenance, repair and maintenance of the machines, tools and other equipment used in the production process.

Raw materials

Understocking is the opposite of overstocking, where a business doesn’t have enough inventory to meet customer demand. This could lead to lost sales, damaging of the business reputation, or even complete loss of customers in severe cases. The last category is finished goods which are the end products ready for sale to customers. These goods have passed through the production process, starting as raw materials, passing through the WIP stage, and finally becoming a finished product. The four main types of inventory management are just-in-time management (JIT), materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).

To meet this surge in demand, the company must keep sufficient inventory at its distribution centers and retail outlets. Not having enough inventory could lead to lost sales opportunities and disappointed customers. Inventory plays a crucial role in the efficient operation of supply chain management, often being referred to as the ‘lifeblood’. It is typically stored in warehouses and is moved along the supply chain from suppliers to manufacturers, and then ultimately to the end customer.

What is Inventory? Definition, Types, and Challenges

But beyond that inventory meaning, there are a host of other related concepts whose definition will provide useful context to an understanding of inventory. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, inventory definition economics Adam is an expert in economics and behavioral finance.

Properly managed inventory reduces such risks and helps maintain a steady flow of goods along the supply chain. If the company experiences a higher demand for its products, it needs to ensure that its raw materials and components inventory is sufficient to increase production. Efficiently managed inventory can also impact a company’s cash flow positively. With a well-managed inventory system, companies can better predict when they will need to restock certain items. This allows them to coordinate with suppliers and plan their spending accordingly.

• Delays in order fulfillment can occur if companies do not have the right products in the right quantities at the right time.
• Shortages and excesses can indicate problems in inventory forecasting, production efficiency, and raw material acquisition.
• Each category has a distinct role in the supply chain and contributes differently to business operations and financial health.

What is the impact of inventory in businesses

• Fluctuation in the ratio of inventory to sales is known as inventory investment or disinvestment.
• They are ready for selling purposes and can be used by the consumers who purchase them.
• For example, leather can be the raw materials to make belts and bags; cotton can be the raw materials for a garment manufacturer.
• Live inventory helps an individual to easily handle all the multiple channels by checking that they are up-to-date as well as accurate.

In recent years, there have been changes to inventory accounting rules under ASC 330, including updates aimed at simplifying the measurement of inventory. For example, businesses can now use the lower of cost or market method with fewer restrictions, helping to streamline inventory valuation. FIFO assumes that the first items purchased or produced are the first ones sold or used. This method works well when the prices of inventory are rising because it assigns the lower, earlier costs to the cost of goods sold (COGS), leaving the higher-priced inventory on the balance sheet. FIFO is an inventory valuation method that assumes the oldest items (those purchased or produced first) are sold before the newer ones.

This approach reduces storage and insurance costs, as well as the cost of liquidating or discarding excess inventory. For companies with complex supply chains and manufacturing processes, balancing the risks of inventory glut and shortages is especially difficult. To achieve these balances, they may call on several methods for inventory management, including just-in-time (JIT) and materials requirement planning (MRP).

Under ASC 330, market value refers to the replacement cost of the inventory, but with limits based on net realizable value and normal profit margins. IFRS, on the other hand, places greater emphasis on net realizable value alone. To ensure transparency and maintain compliance with ASC 330, businesses are required to disclose specific details about their inventory in their financial statements. Learn differences between FIFO vs. LIFO, and how to calculate FIFO and LIFO step by step. Optimize inventory valuation, cut costs, and improve your business’s financial accuracy. Effective inventory tracking can revolutionize inventory management, highlighting the tangible benefits it can bring to a business, irrespective of its size or industry.

Inventory affects all operating activities like manufacturing, warehousing, sales, etc. The amount of opening and closing inventory should be sufficient enough so that other business activities are not adversely affected. Inventory is an asset that is owned by a business and has the express purpose of being sold to a customer.

Can inventories impact a company’s financial statements?

In the context of procurement, economies of scale refer to buying raw materials in larger lots from suppliers and holding inventory. It is considered to be cheaper for the company than buying frequent small lots. In such cases, the organisation buys in bulk and holds inventories at the plant warehouse. Seasonal products refer to items that attract sharp demand only in their season and no demand outside of their season. For example, the demand for gift items rises before festivals like Diwali and Christmas, but slows down soon after. If seasonal demand is not considered early in the ordering cycle, it can affect the entire supply chain.

For businesses transitioning to new inventory standards, it’s essential to review current accounting methods and practices. Companies may need to revise their inventory accounting policies, update their software systems, and train their accounting teams to apply new methods correctly. Companies must disclose their inventory valuation method (e.g., FIFO, LIFO, or weighted average) and any changes in accounting methods. If a write-down occurs, it must be disclosed, along with the reasons for the reduction and the amount of the write-down. Inventory is classified as a current asset, and it must be reported at the lower of cost or market value. When the cost of inventory exceeds its market value, the business must recognize a loss by writing down the inventory to its market value.

These products have limited shelf lives and maintaining too much inventory can lead to more instances of spoilage, waste, and unnecessary expenses. Efficient inventory management helps monitor product expiry dates and ensures optimal order quantities, which can prevent overstocking and understocking. As a result, profitability can be improved due to fewer products being wasted. Ensuring continuity of services and operations is the primary goal of supply chain management. Inventory helps achieve this objective by acting as a buffer that counterbalances the variations in supply and demand.

Create a process of accountability

Companies often maintain sophisticated inventory management systems capable of tracking inventory levels in real time. Inventories are a crucial part of a company’s strategic planning and financial health. By effectively managing inventories, companies can significantly reduce their operational costs, improve cash flow, and enhance customer satisfaction through timely product availability.