What is inventory? Types, utility, accounting, and valuation

What is inventory? Types, utility, accounting, and valuation

What is inventory?

Inventory is a set of goods in existence destined to carry out an operation, be it purchase, rental, sale, use, or transformation and in this way ensure the service to internal and external customers. It must appear, accounting, within the asset as a current asset.

At the end of reading you will be able to define what an inventory is, you will understand how it affects the financial objectives of a company, you will recognize its different types, you will understand its usefulness, in addition to knowing its accounting systems and its valuation methods. This information is complemented by a video course that presents essential concepts of accounting management of a company’s inventories.

A company’s inventories are made up of its raw materials, its products in process, the supplies it uses in its operations, and finished products. An inventory can be something as basic as a bottle of glass cleaner used as part of a building’s maintenance program, or something more complex, such as a combination of raw materials and subassemblies that are part of a manufacturing process. (Müller, p.1)

Set of corporeal, tangible, and in-stock goods, owned and immediately available for consumption (raw material), transformation (products in the process), and sale (goods and finished products). (Perdomo, p.72)

Inventory is defined as the accumulation of materials (raw materials, work-in-progress, finished goods, or items in maintenance) that will later be used to meet future demand. (Moya, p.19)

The stock is the set of products stored awaiting their subsequent use, more or less close, which allows regular supply to those who consume them, without imposing on them the discontinuities that manufacturing entails or possible delays in deliveries by suppliers. (Ferrin, p.47)

Inventories are defined as idle goods stored waiting to be used. (Eppan, p.364)

The financial impact of inventory

The constitution of inventories involves two types of factors: Positive, since it provides the company with operational flexibility, allowing it to produce at a different rate than the acquisition rate and offering the possibility of issuing larger volume orders; and Negative since a series of financial and management costs appear that are harmful to the economy of the organization. (Cruelles, p.78)

When performing financial analysis, the impact of inventory on three of the basic financial ratios is observed :

  1. It affects Net Profit by contributing expenses ( inventory costs ) such as leasing or purchasing warehouses, depreciation, materials management systems, and labor costs associated with their maintenance, conservation, and administration, among others.
  2. In cash flow, it impacts the well-known acid test [(Current Assets – Inventories) ÷ Current Liabilities], which shows the firm’s ability to meet its short-term obligations. A high inventory will show less ability of the company to respond on this front.
  3. The Return on Investment (ROI) [Net Profit ÷ Total Assets], impacts both Net Profit, through expenses as already explained, and Total Assets (Fixed Assets + Current Assets) since it makes up current assets along with bank accounts and accounts receivable.
See also  Accounts and items in the Financial statements

Types of Inventories

There are different classifications, some of them are listed below.

According to its shape

  • Raw Materials Inventory:  It is made up of all the materials with which the products are made, but which have not yet received processing.
  • Inventory of Products in Manufacturing Process:  It is made up of all those goods acquired by manufacturing or industrial companies, which are in the manufacturing process. Its quantification is done by the amount of materials, labor, and manufacturing expenses, applicable to the closing date.
  • Inventory of Finished Products:  These are all those goods acquired by manufacturing or industrial companies, which are transformed to be sold as finished products.

There is a type of complementary inventory, depending on its form, that is not commonly cited in the literature:

  • Factory Supplies Inventory:  These are the materials with which the products are made, but which cannot be accurately quantified (Paint, sandpaper, nails, lubricants, etc.).

Additionally, in commercial companies, there are:

  • Merchandise Inventory:  It is made up of all those assets that belong to the company, whether commercial or commercial, which are bought and then sold without being modified. This Account will show all the merchandise available for Sale. Those that have other characteristics and are subject to particular conditions must be shown in separate accounts, such as merchandise on the way (those that have been purchased and not yet received), merchandise given on consignment, or pledged merchandise (those that are owned by of the company but that have been given to third parties in the guarantee of value that has already been received in cash or other goods).

According to its function

According to Castillo (p.5):

  • Safety or reserve inventory is that which is maintained to offset the risks of unplanned stoppages of production or unexpected increases in customer demand.
  • Decoupling inventory is the one that is required between two adjacent processes or operations whose production rates cannot be synchronized; this allows each process to work as planned.
  • Inventory in transit is made up of materials that advance in the value chain. These materials are items that have been ordered but not yet received.
  • Cycle inventory results when the number of units purchased (or produced) to reduce costs per unit purchase (or increase production efficiency) is greater than the immediate needs of the company.
  • Forecast or seasonal inventory accumulates when a company produces more than immediate requirements during periods of low demand to meet those of high demand. Frequently, this accumulates when the demand is seasonal.

From the logistics point of view

For Ballou (p.330, 331) they can be classified as follows:

  • In pipelines: these are the inventories in transit between the levels of the supply channel. Work-in-process inventories in manufacturing operations can be considered pipeline inventory.
  • Speculative Stocks – Commodities such as copper, gold, and silver are purchased both to speculate on price and to meet operating requirements and when inventories are established in advance of seasonal or seasonal sales.
  • Inventories of a regular or cyclical nature: These are the inventories necessary to satisfy the average demand during the time between successive replenishments.
  • Safety Stock – The inventory that can be built to protect against variability in stock demand and total replenishment time.
  • Obsolete, Dead, or Lost Stock – When held for a long time, it deteriorates, expires, is lost, or is stolen.
See also  Just-in-time Production Philosophy

Why is it useful to keep inventories?

Following Muller (pp. 3 and 4), in a just-in-time manufacturing environment, inventory is considered waste. However, if the organization is experiencing cash flow difficulties or lacks strong control over (i) the transfer of electronic information between major departments and vendors, (ii) delivery times, and (iii) the quality of materials you receive, keeping inventory plays an important role. Among the most important reasons for establishing and maintaining an inventory are:

  • Predictability: To plan capacity and establish a production schedule, it is necessary to control how much raw material, how many parts, and how many sub-assemblies are being processed at any given time. Inventory must maintain a balance between what is needed and what is processed.
  • Fluctuations in demand: A reserve of inventory on hand provides protection; You don’t always know how much is going to be needed at any given time, but customer or production demand still has to be met on time. If you can see how customers act in the supply chain, surprises in demand fluctuations are kept to a minimum.
  • Supply instability: Inventory protects against unreliable suppliers or when an item is in short supply and it is difficult to ensure a constant supply.
  • Price Protection: The wise purchase of inventory at the right times helps avoid the impact of cost inflation.
  • Lower ordering costs: If you buy a larger quantity of an item, but less frequently, your ordering costs are less than if you buy small quantities over and over again (however, the costs of holding an item for some time longer time will be higher). To control ordering costs and ensure favorable pricing, many organizations issue global purchase orders coupled with periodic shipping and receiving dates for units of stock ordered.

The need to have inventories is given by the difficulty of coordinating and managing over time the needs and requirements of customers with the production system and the production needs with the ability of suppliers to supply materials within the agreed period. (Cruelles, p.77)

Inventory accounting systems

There are two basic inventory control methods or systems:

1. Periodic inventory system

With this method, the company does not keep a continuous record of its stock, instead, it counts stocks at the end of the period or fiscal year, and the results are reflected in the financial reports.

González (p.88)  mentions the following as the main characteristics of this system:

  • It is expensive as it becomes necessary to stop the activity of the company to carry out the physical count of the merchandise, which implies a significant waste of resources.
  • The volume of stocks at any given time is not known exactly and therefore does not allow for adequate monitoring or a correct product policy (shrinkage, breakage, turnover, profitability, etc.)

The basic scheme of the periodic inventory system is presented below (Cruelles, p.113)

cost-flow-assumption

 

See also  What is Direct costs?

 

2. Perpetual or perpetual inventory system

With this method, the company keeps a continuous record of its inventories and the costs of the products or merchandise that it has sold.

González (p.89)  also points out the following advantages of this method over the newspaper:

  • It allows better control of the article and the application of production techniques by having information in real-time on inventory levels, rotations, price evolution, etc. Therefore, decision-making is improved.
  • It facilitates the physical count if this is necessary to carry out an inventory verification.
  • It allows us to reduce costs and offer a better service to customers, etc.

The basic scheme of the perpetual inventory system is presented below (Cruelles, p.108)

cost-flow-assumption

 

 

Inventory valuation methods

Among the most important methods to value inventories, we have:

  • FIFO or FIFO method. This method is based on first-in-first-out. His appreciation is more in line with the reality of the market since it uses a valuation based on more recent costs.
  • LIFO or LIFO method. Contemplate that all that merchandise that enters last is the one that leaves first. Its advantage is based on the fact that the inventory maintains its stable value when there is a rise in prices.
  • Arithmetic Average Cost Method. The result will be given by the arithmetic mean of the unit prices of the articles.
  • Harmonic or Weighted Average Method. This average will be calculated by weighting the prices with the units purchased and then dividing the total amounts by the total number of units.
  • Moving Average Cost or Balance Method. Calculates the value of the merchandise, according to the variations produced by the inputs and outputs (purchases or sales), obtaining successive averages.
  • Basic Cost Method. Through this method, fixed values ​​are attributed to the minimum stock, this method is quite similar to LIFO with the difference that it is applied only to the minimum inventory quantity.
  • Retail Price Method. Allows inventory estimation as often as desired. The physical inventory will be carried out, based on the sale prices marked on the articles.
  • Market Cost or Lowest. The lower price of stocks is taken as the basis, maintaining the accounting principle of conservatism, which does not anticipate benefits and foresees possible losses.

To learn more about inventory accounting systems and inventory valuation methods:  Inventory valuation systems

 

Bibliography

  • Ballou, Ronald H. Logistics: Supply Chain Management, Pearson Education, 2004.
  • Castillo Gomez, Karla Alicia. Inventory policy proposal for product “A” of the company REFA Mexicana SA de CV, Thesis. University of the Americas Puebla, 2005.
  • Cruelles, Jose Agustin. Stocks, processes, and operations management: Get to know and manage your factory. Marcombo-Zadecon, 2012.
  • Eppan GD et al. Operations Research in Management Science, Pearson Education, 2000.
  • Ferrin Gutierrez, Arturo. Stock management in warehouse logistics, FC Editorial, 2007.
  • González Gómez, José Ignacio, Morini Marrero Sandra and Do Nascimento, Eduardo. Control and management of the commercial and production area of ​​the SME, Netbiblo, 2002.
  • Moya Navarro, Marcos Javier. Inventory control and queue theory, EUNED, 1999.
  • Muller, Max. Fundamentals of inventory management, Editorial Norma, 2005.
  • Perdomo Moreno, Abraham. Fundamentals of Internal Control, Cengage Learning Publishers, 2004.

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