What is inventory?
Inventory (also called stock) is any type of good held by a company for the purpose of sales. Since inventory items have value and is expected to bring in a profit after sales, it is counted as a current asset on a company’s balance sheet.
Depending on the business, inventory can include raw materials, component parts, work in progress, finished goods, or any packaging.
1. Raw materials inventory
Raw materials inventory involves items used to make finished products. Raw materials can be commodities or components that businesses buy or extract themselves. In sum, they’re all the stock that hasn’t been used for manufacturing yet. For your accounting, raw materials are considered an inventory asset, with a debit to raw materials and credit to accounts payable. There are two different categories of raw materials — direct and indirect.
The formula to calculate the total cost of your raw materials inventory is:
Total Raw Materials = Beginning inventory + Purchases added – Ending inventory
Let’s say you own a scooter manufacturing company. For this quarter, your starting inventory was worth $20,000. During this period, you bought $34,000 worth of raw materials. At the end of this quarter, your raw materials on hand were $18,000.
Total = $20,000 + $34,000 – $18,000 = $36,000
As you’ll see, these inventory types follow the manufacturing process, from raw materials to works in progress to the finished products. Accounting for each stage of the production process helps portray an accurate picture of a manufacturer’s Cost of Goods Sold. For the raw materials stage, there are two categories of inventory, direct and indirect raw materials.
Direct raw materials
Direct raw materials are all the materials that make up the finished product. For example, all the parts used to make a bed would be considered direct raw materials, from the wood to the metal frame and components like screws. Direct materials are considered a part of the cost of goods produced, which is then divided into the cost of goods sold and ending inventory.
Indirect raw materials
Indirect raw materials are materials that are consumed during the manufacturing process but aren’t a part of the final product. Things like cleaning and office supplies, disposable tools, lubricants, and tape are examples of items that could be considered indirect raw materials.
Indirect raw materials typically fall under manufacturing overhead and are added to the cost of goods sold. If only a small amount of an indirect material is used, they are sometimes reported to an expense as incurred.
2. Maintenance, Repair, and Operating (MRO) inventory
MRO inventory consists of items used to keep a manufacturing company running smoothly. MRO inventory can include employee uniforms, industrial equipment, cleaning or operating supplies, safety equipment, and any materials you use to repair or maintain manufacturing equipment.
MRO goods are vital to keeping operations running and make up a large percentage of the total purchase for factories. But, as a category, it’s often overlooked when it comes to inventory control. Every hour a factory line downtime because of a defective part costs them thousands of dollars. Many times that part isn’t in stock, so the cost to get it shipped and installed is prohibitive, or it’s not properly labored or stored — and the part takes hours to find.
When it comes to MRO purchasing, it isn’t prioritized with the same scrutiny like other inventory, such as raw materials. Manufacturers often have numerous suppliers with no coherent procurement strategy among their sites. With so many moving parts, the costs add up, and MRO costs quickly make up a significant percentage of total manufacturing costs.
To fight back against MRO cost creep, there are few best practices to consider:
- Create an efficient MRO procurement policy with approved vendors to purchase from.
- Create a central location for MRO inventory that is tracked with the same rigor as all other inventory levels.
- Renegotiate terms and prices with supply chain partners annually in an effort to prevent cost creep.
3. Decoupling inventory
Decoupling inventory includes any extra components or raw materials that enable a manufacturer to continue with production, even in the case of unforeseen supply stockouts. Inventory is typically composed of several parts that are needed before the finished product can be sold. By breaking down, or decoupling, their inventory, a manufacturer can reduce any bottlenecks and decrease the odds of production stopping completely.
Decoupling inventory is most beneficial for larger manufacturers that produce items on a mass scale. In these cases, unavailable materials can lead to a significant loss. But having stores of decoupling inventory can provide enough buffer time to damage control and find new supplies to continue production.
4. Work In Progress (WIP) inventory
All the materials used to create a finished product are considered WIP inventory. If you manufacture bicycles, all of the unfinished bikes in your shop could be considered WIP inventory.
You can also think of all the materials in use on a factory floor as WIP inventory. WIP inventory does not include raw materials sitting on the shelf or finished goods ready for sale; they’re somewhere in between, thus getting the WIP designation.
When accounting for WIP inventory, it typically gets its own inventory account entry on the general ledger and is a current asset. Costs include the raw material costs, labor cost, and factory overhead.
Calculating the WIP inventory formula can be time-consuming and tricky, so most businesses try to minimize it before a specific reporting period. Businesses that follow a Just In Time (JIT) inventory philosophy typically have very little WIP inventory.
5. Finished goods inventory
Finished goods are items that are ready for showtime. They’ve been manufactured from raw materials or purchased from a supplier, and are ready to be sold to customers. Finished goods that are purchased as completed for sale are considered merchandise by retailers.
For a given accounting period, finished goods are short-term assets because of the expectation they will be sold as soon as possible. The finished goods inventory formula is a straightforward inventory ratio that can be used to calculate the value of your goods:
Finished Goods = (Cost of Goods Manufactured – Cost of Goods Sold) + Previous Finished Goods Inventory Value
Finished goods are combined with raw materials and WIP inventory to make up the total inventory line item on a balance sheet. (Note: safety stock and cycle stock are just two alternative ways finished inventory can be classified.)
6. Safety stock and other types of stock
Safety stock is any extra buffer inventory held to protect against going out of stock. Even after calculating average inventory turnover and seasonal trends, there’s always a chance of experiencing unforeseen surges in demand or supply shortages.
In addition to safety stock, there are related types of inventory a company should hold to better meet customer demand:
- Cycle stock (also called working stock): The amount of inventory a business uses to fulfill customer orders for a given period of time. Cycle stock is the first inventory to sell and immediately converts into cash flow.
- Anticipatory stock: Inventory purchased by a business in preparation for increased demand or fluctuations in the market. Examples of anticipatory stock are stocking more inventory of swimsuits and sandals right before summer, or increasing the number of turkeys before Thanksgiving.
- Psychic stock: Rather than being sold, this type of inventory is intended to stimulate demand in the market. Psychic stock is typically used in a retail business, with the most popular example being products displayed on mannequins or in window displays.
7. Packing materials inventory
Packing materials inventory includes any items your business used 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.
8. Pipeline (or in-transit) stock
Pipeline inventory (also called in-transit stock or transit inventory) is any stock currently moving between manufacturers, distributors, retailers, or another destination. In most cases, the bigger a company’s operations, the more pipeline stock it has to manage.
Take, for example, an electronics company that sources its components from Taiwan, manufactures its products in the US, and then distributes them to various retailers around the world. The company has a significant portion of its inventory as pipeline stock.
Not only does pipeline inventory require additional inventory management systems and tracking, it also incurs significantly more overhead, transportation, and carrying costs. The longer it takes before inventory can be sold, the more that inventory ties up a company’s cash flow.
The formula to calculate pipeline stock is:
Pipeline inventory = Lead time x Demand rate
Continuing our previous electronics company example, say the lead time for motherboards is four weeks and it orders 1,000 motherboard units every week. The pipeline inventory would be 4,000 units.
Another formula used alongside pipeline inventory is economic order quantity (EOQ). EOQ calculates the optimal amount of inventor a business should order to minimize overhead and storage costs. The formula to calculate EOQ is:
EOQ = √ (2 x demand x ordering costs / carrying costs)
Say the electronics company has a ordering cost of $300 for each motherboard and it sees a demand of 10,000 units per year. It also incurs a carrying cost of $10 for every motherboard in its inventory. The formula shows an EOQ of 774 units for the motherboard.
9. Excess inventory
Excess inventory is any unsold or unused stock a company has left over after a projected sales period. It’s inventory that is unlikely to sell anymore and has lost its projected market value.
The usual causes of excess inventory include inaccurate sales forecasts, mismanaged inventory, a large amount of returned or cancelled orders, or an unforeseen decrease in demand.
Large quantities of excess inventory not only mean a loss in revenue, it also ties up cash flow and incurs increased storage and overhead costs. The best thing for a business to do is to cut losses and put its excess inventory on sale, bundle them with other products, or offer them as a free gift with purchase.
Properly accounting for manufacturing inventory through every step of the process is essential to running a profitable business. In a business environment increasing in complexity and with little margin for error, inventory management software that brings order to chaos can mean the difference between ending the year in the red or black. The days of missing parts and runaway costs are over, turn your inventory into your company’s secret weapon.