Inventory management is a crucial asset for businesses as it enables them to minimize the cost 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, and finished goods.
What Is Inventory?
Inventory is the accounting of items, component parts and raw materials that a company either uses in production or sells. As a business leader, you practice inventory management in order to ensure that you have enough stock on hand and to identify when there’s a shortage.
The verb “inventory” refers to the act of counting or listing items. As an accounting term, inventory is a current asset and refers to all stock in the various production stages. By keeping stock, both retailers and manufacturers can continue to sell or build items. Inventory is a major asset on the balance sheet for most companies, however, too much inventory can become a practical liability.
Video: What Is Inventory?
- Inventory, which describes any goods that are ready for purchase, directly affects an organization’s financial health and prosperity.
- While there are many types of inventory, the four major ones are raw materials and components, work in progress, finished goods and maintenance, repair and operating supplies.
- While there are many ways to count and value your inventory, the importance lies in accurately tracking, analyzing and managing it. Insights gained from inventory evaluations are necessary for success as they help companies make smarter and more cost-efficient business decisions.
An organization’s inventory, which is often described as the step between manufacturing and order fulfillment, is central to all its business operations as it often serves as a primary source of revenue generation. Although inventory can be described and classified in numerous ways, it’s ultimately its management that directly affects an organization’s order fulfillment capabilities.
For example, in keeping track of raw materials, safety stock, finished goods or even packing materials, businesses are collecting crucial data that influences their future purchasing and fulfillment operations. Understanding purchasing trends and the rates at which items sell determines how often companies need to restock inventory and which items are prioritized for re-purchase. Having this information on hand can improve customer relations, cash flow and profitability while also decreasing the 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 businesses classify 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 inventory more accurately and efficiently.
Raw Materials: Raw materials are the materials a company uses to create and finish products. When the product is completed, the raw materials are typically unrecognizable from their original form, such as oil used to create shampoo.
Components: Components are like raw materials in that they are the materials a company uses to create and finish products, except that they remain recognizable when the product is completed, such as a screw.
Work In Progress (WIP): WIP inventory refers to items in production and includes raw materials or components, labor, overhead and even packing materials.
Finished Goods: Finished goods are items that are ready to sell.
Maintenance, Repair and Operations (MRO) Goods: MRO is inventory — often in the form of supplies — that supports making a product or the maintenance of a business.
Packing and Packaging Materials: There are three types of packing materials. Primary packing protects the product and makes it usable. Secondary packing is the packaging of the finished good and can include labels or SKU information. Tertiary packing is bulk packaging for transport.
Safety Stock and Anticipation Stock: Safety stock is the extra inventory a company buys and stores to cover unexpected events. Safety stock has carrying costs, but it supports customer satisfaction. Similarly, anticipation stock comprises of raw materials or finished items that a business purchases based on sales and production trends. If a raw material’s price is rising or peak sales time is approaching, a business may purchase safety stock.
Decoupling Inventory: Decoupling inventory is the term used for extra items or WIP kept at each production line 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 and only applies to companies that manufacture goods.
Cycle Inventory: Companies order cycle inventory in lots to get the right amount of stock for the lowest storage cost.
Service Inventory: Service inventory is a management accounting concept that refers to how much service a business can provide in a given period. A hotel with 10 rooms, for example, has a service inventory of 70 one-night stays in each week.
Transit Inventory: Also known as pipeline inventory, transit inventory is stock that’s moving between the manufacturer, warehouses and distribution centers. Transit inventory may take weeks to move between facilities.
Theoretical Inventory: Also called book inventory, theoretical inventory is the least amount of stock a company needs to complete a process without waiting. Theoretical inventory is used mostly 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 raw materials that a company doesn’t expect to use or sell but must still pay to store.
Inventory is known as being a company’s goods and products that can be sold. It is labeled as being the current asset on a company’s balance sheet. The intermediary between manufacturing and order fulfillment.
Real-world examples can make inventory models easier to understand. The following examples demonstrate how the different types of inventory work in retail and manufacturing businesses.
Raw Materials/Components: A company that makes T-shirts has components that include fabric, thread, dyes and print designs.
Finished Goods: A jewelry manufacturer makes charm necklaces. Staff attaches a necklace to a preprinted card and slips it into cellophane envelopes to create a finished good ready for sale. The cost of goods sold (COGS) of the finished good includes both its packaging and the labor exerted to make the item.
Work In Progress: A cell phone consists of a case, a printed circuit board, and components. The process of assembling the pieces at a dedicated workstation is WIP.
MRO Goods: Maintenance, repair and operating supplies for a condominium community include copy paper, folders, printer toner, gloves, glass cleaner and brooms for sweeping up the grounds.
Packing Materials: At a seed company, the primary packing material is the sealed bag that contains, for example, flax seeds. Placing the flax seed bags into a box for transportation and storage is the secondary packing. Tertiary packing is the shrink wrap required to ship pallets of product cases.
Safety Stock: A veterinarian in an isolated community stocks up on disinfectant and dog and cat treats to meet customer demand in case the highway floods during spring thaw and delays delivery trucks.
Anticipated/Smoothing Inventory: An event planner buys discounted spools of ribbon and floral tablecloths in anticipation of the June wedding season.
Decoupled Inventory: In a bakery, the decorators keep a store of sugar roses with which to adorn wedding cakes – so even when the ornament team’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 of them, 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 10 tables at which diners spend an average of one hour eating a meal. Its service inventory, therefore, is 120 meals per day.
Theoretical Inventory Cost: A restaurant aims to spend 30% of its budget on food but discovers the actual spend is 34%. The “theoretical inventory” is the 4% of food that was lost or wasted.
Book Inventory: The theoretical inventory of stock in the inventory record or system, which may differ from the actual inventory when you perform a count.
Transit Inventory: An art store orders and pays for 40 tins of a popular pencil set. The tins are en route from the supplier and, therefore, in transit.
Excess Inventory: A shampoo company produces 50,000 special shampoo bottles that are branded for the summer Olympics, but it only sells 45,000 and the Olympics are over — no one wants to buy them, so they’re forced to discount or discard them.
The Importance of Inventory Control
Inventory control helps companies buy the right amount of inventory at the right time. Also known as stock control, this process helps optimize inventory levels, reduces storage costs and prevents stockouts.
Inventory control empowers companies to collect the maximum amount of profit. It enables them to minimize the investment made in stock, allowing companies to best evaluate their ongoing assets, account balances, and financial reports. It is important because it prevents exuberant costs because of purchasing too much or inessential inventory, rather prioritizing the obligatory inventory.
With the appropriate internal and production controls, the practice ensures the company can meet customer demand and delivers financial elasticity. Inventory control enables the maximum amount of profit from the least amount of investment in stock without affecting customer satisfaction. Done right, it allows companies to assess their current state concerning 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 keeping track of your inventory, others include:
Carry Safety Stock:
Also known as buffer stock, these products help keep companies from running out of materials or high-demand items. Once companies deplete their calculated supply, safety stock serves as a backup should the level of demand increase unexpectedly.
Invest in a Cloud-based Inventory Management Program:
Cloud-based inventory management systems let companies know in real-time where every product and SKU are located globally. This data helps an organization be more responsive, up-to-date, and flexible.
Start a Cycle Count Program:
Cycle counting benefits extend well past the warehouse by keeping stock reconciled and customers happy while also saving businesses time and money.
Use Batch/Lot Tracking:
Record information associated with each batch or lot of a product. While some businesses log precise details, such as expiration dates that provide information about their products’ sellable dates, companies that do not have perishable goods use batch/lot tracking to understand their products’ landing costs or shelf lives.
Inventory management is critical in strengthening companies supply chain because it helps to stabilize 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 specific timeframe, which can reveal whether a company has too much inventory on hand. To determine inventory 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 over time and it helps businesses stock the right amount of goods and project how much customers will want in the future.
A well-known method for performing inventory analysis is ABC analysis. To perform an ABC analysis, group goods into three categories:
A inventory: A inventory includes the best-selling products that require the least space and cost to store. Many experts say this represents about 20% of your inventory.
B inventory: B items move at a similar rate to A items but cost more to store. Generally, this represents about 40% of your inventory.
C inventory: The remainder of your stock costs the most to store and returns 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 your inventory that garners 80% of your profits. A company will want to focus on these items to increase sales and net profit margins. Inventory analysis may influence the choice of inventory 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: Inventory analysis helps you identify and reorder items you sell often, so you don’t spend money on inventory that moves slowly.
Reduces Stockouts: When you understand which inventory customers want most, you can better anticipate demand and prevent stockouts.
Increases Customer Satisfaction: Analyzing inventory offers insight into what and how customers purchase goods.
Reduces Wasted Inventory: Understanding what, when and how much people buy minimizes the need to store obsolete products, as well as when products expire so you can have a strategy behind using them.
Reduces Project Delays: Learning about supplier lead times helps you understand when to reorder and how to avoid late shipments.
Improves Pricing From Suppliers and Vendors: Inventory analysis can lead you to order high volumes of products regularly rather than small volumes on a less reliable schedule. This regularity can put you in a stronger position to negotiate discounts with suppliers.
Expands Your Understanding of the Business: Reviewing inventory provides 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 at any given moment is critical to success. Decision makers know they need the right tools in place to be able to manage their inventory effectively. NetSuite offers a suite of native tools for tracking inventory in multiple locations, determining reorder points and managing safety stock and cycle counts. Find the right balance between demand and supply across your entire organization with the demand planning and distribution requirements planning features.
NetSuite provides cloud inventory management solutions that are the perfect fit for companies within the startup to small businesses to Fortune 100 range. Learn more about how you can use NetSuite to help plan and manage inventory, reduce handling costs and increase cash flow.
What is manufacturing inventory?
In manufacturing, inventory consists of in-stock items, raw materials and the components used to make goods. Manufacturers closely track inventory levels to ensure there isn’t a shortage that could stop work.
Accounting divides manufacturing stock into raw materials, WIP and finished goods because each type of inventory bears a different cost. Raw materials typically cost less per unit than do finished items.
What does inventory mean in the service industry?
Every company has stock that supports its regular business. For service companies, this inventory 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 or consume it as work in progress. Essentially, the inventory process is 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 and MRO. However, some people recognize only three types of inventory, leaving out MRO. Understanding the different types of inventory is essential for making sound financial and production planning choices.
How is inventory controlled?
Inventory control — or stock control — is making sure that your business has the right supply of inventory to meet customer demand. This usually requires inventory management software and 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’s on order, the product’s value, and where it’s stored. It’s important to keep accurate inventory records to assist with inventory control and keep accurate balance sheets.
What is demand forecasting?
Demand forecasting is the practice of predicting customer demand by looking at past buying trends, such as promotions and seasonality. Accurately predicting demand provides a better understanding of how much inventory you’ll need and reduces the need to store surplus stock.
Inventory forecasting relies on data to inform decisions, applying information and logic to guarantee you’ve got enough product on hand to meet demand while not tying up cash with unnecessary inventory. There are a number of advanced simulations used, but it typically comes in the form of trend forecasting, graphical forecasting, qualitative forecasting, or quantitative forecasting.
What is average inventory cost?
The average cost of inventory is a method for calculating the per-unit cost of goods sold. To calculate the average cost, get the sum of the cost of all stock for sale, and divide it by the number of items sold.
This method is also called weighted average cost, and is a valuable way to determine the value of your current inventory. It works best for brands that have high volumes of inventory and SKUs that are similar in cost. One of its benefits over other methods is that it makes it easier to track and consistently calculate inventory value by using a blended average.
What is inventory count?
An inventory count is the physical act of counting and checking the condition of items in storage or a warehouse. An inventory count also checks the condition of items. For accounting purposes, inventory counts help assess assets and debts.
Inventory counts help you understand which stock is moving well and inventory managers often use this information to forecast stock needs and manage budgets.