Inventory management is a crucial asset for businesses as it enables them to minimize thecost of inventory on a company’s balance sheet when they receive these goods.Inventory can be classified in three ways, including materials, work-in-progress, andfinished goods.
What Is Inventory?
Inventory is the accounting of items, component parts and raw materials that a company eitheruses in production or sells. As a business leader, you practice inventory managementin order to ensure that you have enough stock on hand and to identify when there’s ashortage.
The verb “inventory” refers to the act of counting or listing items. As anaccounting term, inventory is a current asset and refers to all stock in the variousproduction stages. By keeping stock, both retailers and manufacturers can continue to sellor build items. Inventory is a major asset on the balance sheet for most companies, however,too muchinventory can become a practical liability.
Video: What Is Inventory?
Key Takeaways
- Inventory, which describes any goods that are ready for purchase, directly affects anorganization’s financial health and prosperity.
- While there are many types of inventory, the four major ones are raw materials andcomponents, work in progress, finished goods and maintenance, repair and operatingsupplies.
- While there are many ways to count and value your inventory, the importance lies inaccurately tracking, analyzing and managing it. Insights gained from inventoryevaluations are necessary for success as they help companies make smarter and morecost-efficient business decisions.
Inventory Explained
An organization’s inventory, which is often described as the step between manufacturingand order fulfillment, is central to all its business operations as it often serves as aprimary source of revenue generation. Although inventory can be described and classified innumerous ways, it’s ultimately its management that directly affects anorganization’s order fulfillment capabilities.
For example, in keeping track of raw materials, safety stock, finished goods or even packingmaterials, businesses are collecting crucial data that influences their future purchasingand fulfillment operations. Understanding purchasingtrends and the rates at which items sell determines how often companies need torestock inventory and which items are prioritized for re-purchase. Having this informationon hand can improve customer relations, cash flow and profitability while also decreasingthe amount of money lost to wasted inventory, stockouts and re-stocking delays.
13 Types of Inventory
There are four different top-level inventory types: raw materials, work-in-progress (WIP),merchandise and supplies, and finished goods. These four main categories help businessesclassify and track items that are in stock or that they might need in the future. However,the main categories can be broken down even further to help companies manage their inventorymore accurately and efficiently.
Raw Materials:Raw materials are the materials a company uses to create and finish products. Whenthe product is completed, the raw materials are typically unrecognizable from theiroriginal form, such as oil used to create shampoo.
Components:Components are like raw materials in that they are the materials acompany uses to create and finish products, except that they remainrecognizable when the product is completed, such as a screw.
Work In Progress (WIP):WIP inventory refers to items in production and includes raw materials orcomponents, labor, overhead and even packing materials.
Finished Goods:Finishedgoods are items that are ready to sell.
Maintenance, Repair and Operations (MRO) Goods:MRO is inventory — often in the form of supplies — that supports makinga product or the maintenance of a business.
Packing and Packaging Materials:There are three types of packing materials. Primary packing protects the product andmakes it usable. Secondary packing is the packaging of the finished good and caninclude labels or SKU information. Tertiary packing is bulk packaging for transport.
Safety Stock and Anticipation Stock:Safety stock is theextra inventory a company buys and stores to cover unexpectedevents. Safety stock has carrying costs, but it supports customer satisfaction.Similarly, anticipation stock comprises of raw materials or finished items that abusiness purchases based on sales and production trends. If a raw material’sprice is rising or peak sales time is approaching, a business may purchase safetystock.
Decoupling Inventory:Decoupling inventory is the term used for extra items or WIP kept at each productionline station to prevent work stoppages. Whereas all companies may have safety stock,decoupling inventory is useful if parts of the line work at different speeds andonly applies to companies that manufacture goods.
Cycle Inventory:Companies order cycleinventory in lots to get the right amount of stock for the lowest storagecost.
Service Inventory:Service inventory is a management accounting concept that refers to how much servicea business can provide in a given period. A hotel with 10 rooms, for example, has aservice inventory of 70 one-night stays in each week.
Transit Inventory:Also known as pipeline inventory, transit inventory is stock that’s movingbetween the manufacturer, warehouses and distribution centers. Transit inventory maytake weeks to move between facilities.
Theoretical Inventory:Also called book inventory, theoretical inventory is the least amount of stock acompany needs to complete a process without waiting. Theoretical inventory is usedmostly in production and the food industry. It’s measured using the actual versus theoretical formula.
Excess Inventory:Also known as obsolete inventory, excess inventory is unsold or unused goods or rawmaterials that a company doesn’t expect to use or sell but must still pay tostore.
Inventory is known as being a company’s goods and products that can be sold. It islabeled as being the current asset on a company’s balance sheet. The intermediarybetween manufacturing and order fulfillment.
Inventory Examples
Real-world examples can make inventory models easier to understand. The following examplesdemonstrate how the different types of inventory work in retail and manufacturingbusinesses.
Raw Materials/Components: A company that makes T-shirts hascomponents that include fabric, thread, dyes and print designs.
Finished Goods: A jewelry manufacturer makes charm necklaces. Staffattaches a necklace to a preprinted card and slips it into cellophane envelopes tocreate a finished good ready for sale. The cost of goods sold(COGS) of the finishedgood includes both its packaging and the labor exerted to make the item.
Work In Progress: A cell phone consists of a case, a printed circuitboard, and components. The process of assembling the pieces at a dedicatedworkstation is WIP.
MRO Goods: Maintenance, repair and operating supplies for acondominium community include copy paper, folders, printer toner, gloves, glasscleaner and brooms for sweeping up the grounds.
Packing Materials: At a seed company, the primary packing materialis the sealed bag that contains, for example, flax seeds. Placing the flax seed bagsinto a box for transportation and storage is the secondary packing. Tertiary packingis the shrink wrap required to ship pallets of product cases.
Safety Stock: A veterinarian in an isolated community stocks up ondisinfectant and dog and cat treats to meet customer demand in case the highwayfloods during spring thaw and delays delivery trucks.
Anticipated/Smoothing Inventory: An event planner buys discountedspools of ribbon and floral tablecloths in anticipation of the June wedding season.
Decoupled Inventory: In a bakery, the decorators keep a store ofsugar roses with which to adorn wedding cakes – so even when the ornamentteam’s supply of frosting mix is late, the decorators can keep working.Because the flowers are part of the cake’s design, if the baker ran out ofthem, they couldn’t deliver a finished cake.
Cycle Inventory: As a restaurant uses its last 500 paper napkins,the new refill order arrives. The napkins fit easily in the dedicated storage space.
Service Inventory: A café is open for 12 hours per day, with 10tables at which diners spend an average of one hour eating a meal. Its serviceinventory, therefore, is 120 meals per day.
Theoretical Inventory Cost: A restaurant aims to spend 30% of itsbudget on food but discovers the actual spend is 34%. The “theoreticalinventory” is the 4% of food that was lost or wasted.
Book Inventory: The theoretical inventory of stock in the inventoryrecord or system, which may differ from the actual inventory when you perform acount.
Transit Inventory: An art store orders and pays for 40 tins of apopular pencil set. The tins are en route from the supplier and, therefore, intransit.
Excess Inventory: A shampoo company produces 50,000 special shampoobottles that are branded for the summer Olympics, but it only sells 45,000 and theOlympics are over — no one wants to buy them, so they’re forced todiscount or discard them.
The Importance of Inventory Control
Inventory control helps companies buy the right amount of inventory at the right time. Alsoknown as stock control, this process helps optimize inventory levels, reduces storage costsand prevents stockouts.
Inventory controlempowers companies to collect the maximum amount of profit. It enables them to minimize theinvestment made in stock, allowing companies to best evaluate their ongoing assets, accountbalances, and financial reports. It is important because it prevents exuberant costs becauseof purchasing too much or inessential inventory, rather prioritizing the obligatoryinventory.
With the appropriate internal and production controls, the practice ensures the company canmeet customer demand and delivers financial elasticity. Inventory control enables themaximum amount of profit from the least amount of investment in stock without affectingcustomer satisfaction. Done right, it allows companies to assess their current stateconcerning assets, account balances and financial reports.
Inventory Best Practices
The business saying “if you can’t measure it, you can’t manage it”applies to inventory management and best practices. While the first best practice is keepingtrack of your inventory, others include:
Carry Safety Stock:
Also known as buffer stock, these productshelp keep companies from running out of materials or high-demand items. Oncecompanies deplete their calculated supply, safety stock serves as a backup shouldthe level of demand increase unexpectedly.Invest in a Cloud-based Inventory Management Program:
Cloud-based inventorymanagement systems let companies know in real-time whereevery product and SKU are located globally. This data helps an organization be moreresponsive, up-to-date, and flexible.Start a Cycle Count Program:
Cycle counting benefits extend wellpast the warehouse by keeping stock reconciled and customers happy while also savingbusinesses time and money.Use Batch/Lot Tracking:
Record information associated with eachbatch or lot of a product. While some businesses log precise details, such asexpiration dates that provide information about their products’ sellabledates, companies that do not have perishable goods use batch/lot tracking tounderstand their products’ landing costs or shelf lives.
Inventory management is critical in strengthening companies supply chain because it helps tostabilize the dynamics between customer demand, storage space, and cash restraints.
What Is Inventory Turnover?
Inventory turnover is the number of times a company sells or uses an item in a specifictimeframe, which can reveal whether a company has too much inventory on hand. To determineinventory turnover,use the following equations:
Average inventory =(Beginning Inventory + Ending Inventory) / 2
Inventory turnover =Sales + Average Inventory
What Is Inventory Analysis?
Inventory analysis is the study of how product demand changes overtime and it helps businesses stock the right amount of goods and project how muchcustomers will want in the future.
A well-known method for performing inventory analysis is ABC analysis. Toperform an ABC analysis, group goods into three categories:
A inventory: A inventory includes the best-selling products thatrequire the least space and cost to store. Many experts say this represents about20% of your inventory.
B inventory: B items move at a similar rate to A items but cost moreto store. Generally, this represents about 40% of your inventory.
C inventory: The remainder of your stock costs the most to store andreturns the lowest profits. C inventory represents the other 40% of your inventory.
ABC analysis leverages the Pareto, or 80/20, principle and should reveal the 20% of yourinventory that garners 80% of your profits. A company will want to focus on these items toincrease sales and net profit margins. Inventory analysis may influence the choice ofinventory control methods, whether just-in-time or just-in-case.
Benefits of Inventory Analysis
Inventory analysis raises profits by lowering costs and supporting turnover. It also:
Improves Cash Flow: Inventoryanalysis helps you identify andreorder items you sell often, so you don’t spend money on inventory that movesslowly.
Reduces Stockouts: When you understand which inventory customerswant most, you can better anticipate demand and prevent stockouts.
Increases Customer Satisfaction: Analyzing inventory offers insightinto what and how customers purchase goods.
Reduces Wasted Inventory: Understanding what, when and how muchpeople buy minimizes the need to store obsolete products, as well as when productsexpire so you can have a strategy behind using them.
Reduces Project Delays: Learning about supplier lead times helps youunderstand when to reorder and how to avoid late shipments.
Improves Pricing From Suppliers and Vendors: Inventory analysis canlead you to order high volumes of products regularly rather than small volumes on aless reliable schedule. This regularity can put you in a stronger position tonegotiate discounts with suppliers.
Expands Your Understanding of the Business: Reviewing inventoryprovides insights into your stock, customers and business.
NetSuite Software for Managing All Your Inventory Needs
Properly managing inventory can make or break a business. Having insight into your stock atany given moment is critical to success. Decision makers know they need the right tools inplace to be able to manage their inventory effectively. NetSuite offers a suite of nativetools for tracking inventory in multiple locations, determining reorder points and managingsafety stock and cycle counts. Find the right balance between demand and supply across yourentire organization with the demand planning and distribution requirements planningfeatures.
NetSuite provides cloud inventory management solutions that are the perfect fit for companieswithin the startup to small businesses to Fortune 100 range. Learn more about how you can use NetSuite to help planand manage inventory, reduce handling costs and increase cash flow.
Inventory FAQs
What is manufacturing inventory?
In manufacturing, inventory consists of in-stock items, raw materials and the components usedto make goods. Manufacturers closely track inventory levels to ensure there isn’t ashortage that could stop work.
Accounting divides manufacturing stock into raw materials, WIP and finished goods becauseeach type of inventory bears a different cost. Raw materials typically cost less per unitthan do finished items.
What does inventory mean in the service industry?
Every company has stock that supports its regular business. For service companies, thisinventory is intangible. A law firm’s inventory, for example, includes its files,while paper on which to print legal documents is the firm’s MRO.
What is inventory process?
An inventory process tracks inventory as companies receive, store, manage and withdraw orconsume it as work in progress. Essentially, the inventory processis the lifecycle of goods and raw materials.
What are the four different inventory types?
There are four main types of inventory: raw materials/components, WIP, finished goods andMRO. However, some people recognize only three types of inventory, leaving out MRO.Understanding the different types of inventory is essential for making sound financial andproduction planning choices.
How is inventory controlled?
Inventory control — or stock control — is making sure that your business has theright supplyof inventory to meet customer demand. This usually requires inventory management softwareand supply chain management (SCM) software that brings in data from purchases, shipping,warehousing, reorders, receiving, storage, loss prevention, and even customer satisfaction.
What is an inventory record?
An inventory record, or stock record, contains data about the items a company has in stock,such as the amount of inventory on hand, what’s been sold and reordered, what’son order, the product’s value, and where it’s stored. It’s important tokeep accurate inventory records to assist with inventory control and keep accurate balancesheets.
What is demand forecasting?
Demand forecasting is the practice of predicting customer demand by looking at past buyingtrends, such as promotions and seasonality. Accurately predicting demand provides a betterunderstanding of how much inventory you’ll need and reduces the need to store surplusstock.
Inventory forecasting relies on data to inform decisions, applying information and logic toguarantee you’ve got enough product on hand to meet demand while not tying up cashwith unnecessary inventory. There are a number of advanced simulations used, but ittypically comes in the form of trend forecasting, graphical forecasting, qualitativeforecasting, or quantitative forecasting.
What is average inventory cost?
The average cost ofinventory is a method for calculating the per-unit cost of goods sold. To calculatethe average cost, get the sum of the cost of all stock for sale, and divide it by the numberof items sold.
This method is also called weighted average cost, and is a valuable way to determine thevalue of your current inventory. It works best for brands that have high volumes ofinventory and SKUs that are similar in cost. One of its benefits over other methods is thatit makes it easier to track and consistently calculate inventory value by using a blendedaverage.
What is inventory count?
An inventory count is the physical act ofcounting and checking the condition of items in storage or a warehouse. An inventorycount also checks the condition of items. For accounting purposes, inventory counts helpassess assets and debts.
Inventory countshelp you understand which stock is moving well and inventory managers often use thisinformation to forecast stock needs and manage budgets.
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