Near the close of the 20th century, Hewlett Packard overtook IBM as the world’s third-largest PC manufacturer in the world. Yet not all was well at HP. Cutthroat competition and rapid advances in technology forced constant price cuts, making profit margins razor thin — by 1997, some HP product lines hadn’t made a profit since 1993.
Executives at HP had been looking under the hood for ways to wring more profit from their rapidly growing business. Their analysis found the main driver of PC costs was excess inventory. Not only that, their study found their total operating profit equaled inventory-related costs. As a result, HP reinvented their supply chains by changing the way they organized inventory and giving their product divisions more autonomy in managing inventory. After the reinvention, their laptop division broke even, and by 1999 was profitable.
As HP found, a business can feel the effects of inventory costs, but it’s not immediately clear where they come from. The fundamental problem is you don’t know you’re leaking money until you’re able to analyze it properly. But in order to effectively manage inventory, it needs to be classified so you can prioritize your most essential items, find inefficiencies, and track costs throughout your supply chain.
What Is Inventory?
Inventory is just another name for the stock a business keeps. Conventional examples include the raw materials a manufacturing company holds, as well as the merchandise retailers sell. Classifying inventory allows a business to have the right items at the right time in the right quantity.
Understanding the different types of inventory and classifying them efficiently allows a business to reduce costs by not holding too much inventory, while maximizing sales by reducing stockouts. Classification enables you to be laser-focused on the 20% of your inventory that generates 80% of your revenue.
Why Classifying Inventory Puts You Ahead
Some manufacturing businesses have thousands of items they need to keep track of and forecast demand for. If a business doesn’t know what items are essential for turning a profit, they could be wasting precious time with inessential inventory instead of their most profitable products, or burning time and cash with other inefficient operations.
Accurate classification also saves employees time by simplifying inventory audits and spot checks, freeing them up for higher level tasks. With optimized inventory operations, stockouts are reduced, which is essential for earning customer loyalty. A study by GT Nexus found 63% of shoppers buy from a competitor or don’t buy at all when faced with a stockout.
On the other side of the coin, classification helps businesses identify essential inventory and enables a business to go leaner with less important items, which frees up working capital for other needs.
Accounting Benefits of Inventory Classification
Classifying inventory can be a lifesaver during tax time when accounting for Cost of Goods Sold (COGS), which ultimately tells you if your business was profitable. COGS is simply the total cost of buying or manufacturing your inventory. Classification also aids in smooth accounts payable/receivable operations and a general ledger that balances out.
Throughout the fiscal year, properly classifying inventory enables a business to do spot checks and create reports for more efficient operations. Inventory audits are never fun, whether you do it monthly, quarterly, or yearly, but classification definitely makes them less painful.
Putting your inventory into the right buckets can make your accounting life much easier, but the types of inventory you hold can often depend on your inventory management philosophy.
How Inventory Management Affects Inventory Types
With small factories, little capital, and facing uncertain demand, Japanese manufacturers had to learn to be as efficient as possible, producing what they needed on demand. Toyota famously perfected manufacturing inventory management in the decades after World War II, and their philosophy spread to the US in the 1980s, which is now known as Just In Time (JIT) inventory management, or lean manufacturing.
JIT inventory management strives for maximum efficiency in manufacturing, acquiring inventory as needed to be available just in time for production. A business that runs on a JIT methodology rarely holds safety stock and generally has low inventory levels, which reduces holding costs.
JIT inventory management has a sister philosophy called Just In Case Inventory (JIC). With JIC, businesses store large stocks to hedge against the risk of stockouts and uncertain demand. This helps prevent backorders, stockouts, and unhappy customers, but requires high inventory costs.
Most companies lie somewhere in between the JIT and JIC extremes, depending on the industry they operate in. If you deal in raw materials and commodities, it might make more sense to use JIC, while a retailer or drop shipper would be wise to lean towards JIT.
Wherever you land on the inventory management spectrum, all manufacturing businesses use five common inventory types to identify their stocks. Manufacturing inventory follows the manufacturing process, starting with raw materials, then moving to work in progress, and finished goods.
5 Common Inventory Types
1. Raw Materials
Raw materials are the items manufacturers use to make their finished products. Raw materials can be commodities they buy on the open market or extract themselves, or components that are used in manufacturing. For example, if you’re a bicycle manufacturer, you would consider processed steel — which you purchase from a steel fabricator — part of your raw materials inventory.
2. Work in progress (WIP)
Work in progress inventory (WIP) is all the material waiting to be completed as a finished product. If you’re a bicycle manufacturer, all of the unfinished bikes you have in your shop could be considered WIP inventory. WIP is not raw materials or finished goods, they’re somewhere in the middle and thus get the WIP designation. Think of all the materials being used on a factory floor as WIP inventory.
3. Finished Goods
Finished goods are items that are ready to be sold. They’ve been manufactured from your raw material, passed inspection and are waiting for your customers to purchase them. For accounting purposes, finished goods are combined with raw materials and WIP inventory to make up the total inventory line item on a balance sheet. If you were a bicycle manufacturer, the complete bikes would fit into finished goods.
Retail businesses use a different, but similar inventory type called finished goods ready to be sold. This inventory type is different from finished goods in manufacturing because they’re finished items purchased for sale for retail or wholesale. The clothes a fashion retailer acquires are always ready to be sold upon arrival, whereas finished goods by manufacturers were once raw materials and work in progress before being ready to be sold for wholesale and retail.
4. Packing Materials
This inventory type includes any materials your business uses to pack the products you sell. If you make toothpaste, the tube you put the toothpaste in could be classified as packing materials. Any boxes or packaging you use to ship or store your products are packing materials as well.
5. MRO Supplies
MRO is an acronym for maintenance, repair, and operating supplies. These are inventory items that you use to keep your factories running smoothly. MRO supplies can include things like employee uniforms, cleaning, and office supplies, as well as any materials you use to repair or maintain manufacturing equipment.
This inventory type is key to keeping operations running and make up a large percentage of total purchase for factories, but as a category, it’s often overlooked when it comes to inventory control.
In addition to inventory types, there are four stock usage classifications that are used to describe the status of the stock and it’s intended use.
The Four Classifications of Stock Usage
1. Safety Stock
Safety stock is inventory that is always held to reduce the risk of a stockout or manufacturing downtime. It’s also called buffer, hedge, or fluctuation stock. Think of safety stock as insurance for when demand spikes or when there’s a materials shortage.
Safety stock ensures in demand or hard to supply items are available to customers or your manufacturing operations. Of course, there are higher inventory costs when you hold safety stock, but customers are more satisfied with the lower stockout rates and manufacturing stoppages.
1. Pipeline Stock
Pipeline stock consists of items that are in transit, often by truck, rail, or air. Transit inventory is common for large manufacturing companies with complex supply chains like automakers. Some inventory can take up to a week or more to arrive and is counted as pipeline stock until the buyer receives the shipment. It’s useful for understanding how much cash the buyer has tied up in inventory their business can’t sell yet.
3. Anticipatory Stock
Anticipatory stock is inventory a business acquires in anticipation of a spike in demand or forecasted shortage. For example, a retailer might acquire anticipatory stock in advance of the holiday shopping season. Or an analyst for a manufacturer might order anticipatory stock of raw materials when forecasting a spike in a commodity’s price.
4. Decoupling Stock
Decoupling stock is inventory held by manufacturers to prevent production stoppages. Decoupling stock can be thought of as a type of safety stock specific to manufacturers in that it prevents a stock out of any one item from grinding operations to a halt.
By keeping stock for each segment of the manufacturing process in reserve, one part of the process won’t slow down or stop the others. In essence, you are decoupling each part of your manufacturing process from each other so they aren’t dependant on each other to operate.
Managing inventory can feel like a neverending slog for big and small businesses alike, but it doesn’t have to be that way. Proper inventory classification makes accounting for inventory less stressful with properly labeled stock that you can prioritize, instead of treating every last item the same way. With the right solution to meet inventory accounting challenges, you can make better reports, which leads to better business decisions. And with less time spent chasing down answers to inventory accounting mysteries, you can free yourself up to spend more time growing your business.