This article outlines the many types of inventory, provides real-world examples and covers inventory management. Understanding inventory best practices and analysis techniques will help you get the best return on investment (ROI) for your business.
Video: What is Inventory?
What Is Inventory?
Inventory is the accounting of items, component parts and raw materials a company 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 refers to all stock in the various production stages and is a current asset. By keeping stock, both retailers and manufacturers can continue to sell or build items. Inventory is a major asset for most companies. However, while inventory is an asset on the balance sheet, too much inventory can become a practical liability.
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.
A company that makes T-shirts has components that include fabric, thread, dyes and print designs.
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 (COGS) of the finished good includes the packaging it comes in as well as the labor 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.
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.
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.
A veterinarian in an isolated community stocks up on disinfectant and dog and cat treats in case the highway floods during spring thaw, delaying delivery trucks. The veterinarian stocks up on these items to meet customer demand.
An event planner buys discounted spools of ribbon and floral tablecloths in anticipation of the June wedding season.
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. The flowers are part of the cake’s design. If the baker ran out of them, they couldn’t deliver a finished cake.
As a restaurant uses its last 500 paper napkins, the new refill order arrives. The napkins fit easily in the dedicated storage space.
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.
The theoretical inventory of stock in the inventory record or system, which may differ from the actual inventory when you perform a count.
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.
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.
What Are the Four Different Inventory Type?
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.
12 Types of Inventory
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 are similar to 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 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. The tertiary type of 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 raw materials or finished items 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 is the term used for extra items or WIP kept at each production line station to prevent work stoppages. Decoupling inventory is useful if parts of the line work at different speeds and only applies to companies that manufacture goods. Whereas all companies may have safety stock.
Companies order cycle inventory in lots to get the right amount of stock for the lowest storage cost. Learn more about cycle inventory formulas in the “Essential Guide to Inventory Planning.”
A management accounting concept, service inventory 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 a given week.
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.
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.
Also known as obsolete inventory, excess inventory is unsold or unused goods or raw materials. A company doesn’t expect to use or sell this stock but must pay to store it.
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. Paper on which to print legal documents is the firm’s MRO.
The Importance of Inventory Control
Inventory control helps companies buy the right amount of inventory at the right time. Also called stock control, the process helps optimize inventory levels, reduces storage costs and prevents stockouts.
Find out more in the “Essential Guide to Inventory Control.”
Inventory Best Practices
Inventory best practices include careful inventory management. The business saying “If you can’t measure it, you can’t manage it” applies here. The first best practice is to track 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 globally. This data helps an organization be more responsive, up-to-date, and flexible.
Start a Cycle Count Program:
Save time, money and customers. Cycle counting benefits extend well past the warehouse by keeping stock reconciled and customers happy.
Use Batch/Lot Tracking:
Record information associated with each batch or lot of a product. 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.
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.
See a diagram of the inventory process flow and learn more by reading “The Essential Guide to Inventory Planning.”
What Is Inventory Count?
An inventory count is the physical act of counting 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. Inventory managers can use that information to forecast stock needs and manage budgets. To learn more about inventory counting, read the articles on “Taking Physical Inventory” and “Cycle Counting 101.”
Methods of Recording of Inventory
The two methods of recording inventory are periodic and perpetual. In periodic inventory, you count stock at specific times and add the totals to the general ledger. In the perpetual method, you record changes in stock as they occur.
Although any type of business can use periodic inventory, small organizations frequently use it, especially when there are no plans to scale the business. The periodic method requires no special software or equipment. Organizations often use scanner and point-of-sale (POS) devices to do the real-time counting required for perpetual inventory. To learn more about each method, read “The Periodic System: Is It the Right Choice?” and “The Definitive Guide to Perpetual Inventory.”
What Is Inventory Turnover?
Inventory turnover is the number of times a company sells or uses an item in a specific timeframe. The number 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
To learn more about inventory turnover, read “Inventory Turnover Primer: Calculations, Rates and Analyses.”
What Is Inventory Analysis?
Inventory analysis is the study of how product demand changes over time. This analysis 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. For more information on inventory analysis and control, see the “Essential Guide to Inventory Control.”
Benefits of Inventory Analysis
Inventory analysis raises profits by lowering costs and supporting turnover. Inventory analysis also offers these other benefits:
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, vs. 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.
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.
Learn more about demand forecasting in our “Essential Guide to Inventory Planning.”
Benefits of Inventory Management and Accurate Inventory
A good inventory management strategy and accurate inventory counts can help save companies money because they’ll spend only on items customers buy and simplify their operations. Read about more benefits in the article “Top Inventory Management Benefits.”
Accounting for Inventory
Accounting for inventory is the system that counts and records changes in the value of stock. Raw materials, WIP and finished goods are all assets. Financial accounting for inventory provides an accurate valuation of those stock assets.
Inventory accounting determines the value for stock items and the correct item count. These figures establish the costs of goods sold and the ending inventory value, which factor into the company’s overall value.
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. Learn more about average inventory cost in the article “The Key to Using Inventory Cost Accounting Methods in Your 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 so they can 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 from startups to small businesses to the Fortune 100. Learn more about how you can use NetSuite to help plan and manage inventory to reduce handling costs and increase cash flow.