What is inventory?

What is inventory?

Inventory refers to the goods and materials that a business holds for resale or production. It includes raw materials, work-in-progress, and finished goods that are held in stock for a certain period of time. Inventory is a crucial aspect of accounting as it directly impacts a company’s financial statements, such as the balance sheet and income statement.

In different industries, inventory can vary significantly. For example, in the retail industry, inventory may include clothing, electronics, and household items. In the manufacturing industry, inventory may consist of materials like steel, plastic, and chemicals, as well as components and finished products. In the food industry, inventory can include perishable items such as fruits, vegetables, and dairy products.

The importance of inventory in accounting

Inventory is a crucial component of the matching principle, a core accounting concept. Inventory represents a cost (when purchased or manufactured) that hasn’t been matched with its corresponding revenue (when sold). Assigning an accurate value to inventory is important to properly reporting a business’s profits and assets.

Inventory is a key component of the balance sheet, listed under current assets. It reflects the money a business has invested in goods waiting to be sold since inventory levels and their valuation can also influence financial ratios used to assess financial health.

Common ways to manage inventory

Managing inventory effectively is a balancing act for businesses. You want to have enough stock to meet customer demand and avoid stockouts, but you also don’t want to tie up too much cash in unused inventory or end up with excess products that go to waste.

Demand forecasting

Predicting future customer demand is crucial for optimal inventory management. Analyse historical sales data, consider seasonal trends, and factor in any marketing or promotional campaigns that might influence demand.

ABC analysis

This method categorises inventory items based on their value and annual usage.

• A items: High-value, high-usage items requiring close monitoring and tight control (e.g., expensive electronics in a retail store).
• B items: Medium-value, medium-usage items requiring moderate control (e.g., clothing items in a clothing store).
• C items: Low-value, low-usage items requiring less stringent controls (e.g., office supplies).

Inventory control

There are a few ways to control inventory depending on your business:

• FIFO (First-In, First-Out): The assumption is that older inventory is sold first, so the cost of goods sold reflects older product costs.
• LIFO (Last-In, First-Out): The assumption is that newer inventory is sold first, so the cost of goods sold reflects more recent product costs. This can be beneficial during periods of inflation.
• Weighted Average Cost (Average Cost): An average cost per unit is calculated based on all purchases of an item during a specific period.

Overall, inventory plays a vital role in ensuring that a business can meet customer demand and ultimately generate revenue. Proper management and control of inventory are essential to avoid overstocking, stockouts, and potential losses. By accurately tracking and valuing inventory, businesses can make informed decisions to optimise their operations and financial performance.