Businesses that deal with physical products will have inventory at some point during their operations if not always. Inventory is a term used to describe all tangible materials that businesses use to manufacture products for sale.
For businesses, it is one of the most important assets as it is the main reason for the revenues and profits that they generate, which also translates to an increase in the wealth of owners.
There are different methods to value inventory. The first method that businesses use is known as the First-In, First-Out (FIFO) method. In this method, they value inventory based on the cost of the earliest purchases.
Businesses can also value inventory using the weighted average method using the average cost of purchases. Finally, they can also use the Last-In, First-Out (LIFO) method of inventory valuation, where they value inventory based on the cost of the latest purchase. However, using the LIFO method may be prohibited under some accounting laws.
Types of Inventory
Businesses can categorize inventory into three main types. The first type is raw material. The raw material of a business consists of unprocessed material. These are materials that it further uses in the production process to make finished goods.
Examples of raw material include wood for furniture makers, crude oil for refineries, chemicals for pharmaceutical companies, etc.
The next categorization of inventory is work-in-progress. Work-in-progress is a term used to describe inventory that has entered the production process of business but has not left it.
In other words, work-in-progress is the inventory that is partially finished and still needs work to convert into finished goods. Examples of work-in-progress include molten aluminum for steel manufacturers, which still needs further work to become sellable.
The last categorization of inventory is finished goods. Finished goods consist of goods that are in their finished form and readily available for sale. These are goods obtained after raw materials go through the work-in-progress phase. Examples of finished goods include any products that consumers buy from a business.
The types of inventories that businesses use will depend on their nature. All businesses that deal with physical products will have finished goods but may not have raw materials or work-in-progress inventory. For instance, retailers purchase products and do not need to process them further to sell them.
Therefore, for them, raw material and work-in-progress inventory may not exist. Similarly, the type of inventory will also be different for different types of businesses. For example, the finished goods of one business may be raw materials for another.
A concept that applies to inventory is inventory profit. Inventory profit is the increase or appreciation in the value of an item classified in inventory for some time. Regardless of which type of inventory it is or the inventory valuation method used, inventory may be subject to an appreciation in value.
For example, a business holds inventory that cost $50, the market value of which has risen to $75. The $25 difference in the cost of the inventory and its market value is known as inventory profit.
Inventory profit can generate due to two main reasons. The first reason for it is inflation. Inflation occurs when the value of the currency in a country decreases, thus, decreasing the purchasing power of the currency.
When the purchasing power of currency declines, the prices of products in the country goes up. Inventory profit due to inflation mainly occurs when a business uses the FIFO valuation of inventory. In FIFO valuation, the cost of the oldest inventory will be the lowest and will encounter a higher profit due to inflation.
The second reason for inventory profit is appreciation in the value of inventory. Appreciation mainly occurs due to factors other than inflation, for example, market speculation. Businesses that hold a high amount of inventory commonly experience appreciation of inventory.
Some businesses base their operations around inventory profit due to appreciation in value, buying inventory when it is at a lower price, and selling it when its value appreciates.
For a well-managed inventory system, inventory profit is rare because inventory turnover should be fairly regular. When a business can regularly turn over its inventory, it will not experience any inventory profit. Inventory profit mostly occurs for businesses with lower inventory turnover.
However, as mentioned above, some businesses can still profit due to it. Similarly, for businesses that face the risk of obsolescence of inventory, inventory loss due to impairment will be more common, the longer they hold on to it. Overall, inventory profit is very rare, and only specific industries may experience it.
Businesses do not record inventory profit in their books of accounts when it occurs. That is because accounting rules do not permit businesses to record inventory profit. Instead, when a business sells its inventory, its gross profit increases due to inventory profit.
Therefore, businesses do not adjust the accounts at the time of profit. That is different from inventory loss due to impairment, where a business has to record it straight away.
Inventory consists of physical stock that a business holds and uses in its daily operations to generate revenues and profits. The business can use different valuation methods for its inventory and can also classify the inventory into different categories based on the completion level.
Sometimes, the value of inventory can increase when held in a business, known as inventory profit. Inventory profit can occur due to inflation or appreciation in value. There is no accounting treatment of inventory profit.
Inventory management is the efficient mechanism of ordering, storing, and use of the company’s inventory. The process includes the management of raw materials, components as well as finished goods. Further, the management of warehoused products and work in process items also fall under efficient inventory management.
Inventory management helps to know when to re-stock inventory, what amounts to purchase or produce, what price the products can be sold as well as the timing of sales to be made.
How to organize Inventory for small businesses?
Small businesses need to be cost-effective in the selection of various methods of inventory management. Here are the ways small businesses can use to organize their inventory:
1) Managing purchase orders
Small businesses shall start with creating and submitting accurate purchase orders. Purchase orders are used for the requisition of raw materials or goods to make resale. Managing purchase orders helps in tracking the movement of stock purchase efficiently to placement and payment of bills.
Purchase orders management helps the owners to estimate the cash flows of the business and also the need to re-stock the inventory levels. The stock re-order alerts can also tell which items are sold fast and slow and which needs refilling or restocking early.
2) Organizing vendor data
Small businesses need to set up stock and vendor information in their software or daily books. They can use excel sheets however they need to manually organize their spreadsheet. They need to organize data using point of sale mechanism.
They need to record each product’s information along with subsequent vendor details. The various details that need to depicted are product name, a short description of the product, product category, sizes, regular selling price, reorder quantities, details of the package, etc.
Using Point of sale mechanism helps to keep product details organized and in real-time. Further, it helps to track various post sales aspects such as vendor billing information, payment terms and contact of vendor.
3) Tagging and Labelling inventory
This is the step when the inventory comes in the hands of small businesses. This means managing the products on your hand. Tagging means allocating the prices and affixing price tags while product label displays mean using bar code labels, tracking the inventory to speed checking out i.e. selling the product.
The use of good allocation of time to tag and labeling of inventory helps in making quick checkout of the product. The point of sale mechanism emphasizes the use of bar code scanners. These scanners also come with the function of effective labeling and scanning.
ted, labels can be affixed directly to product packaging or attached to hang tags. Some inventory might even arrive prelabeled with manufacturer’s bar codes, which you can also track in your POS. In that case, your job is easy. You can just add a price label.
4) Physically counting inventory levels
This is a very time-consuming task and excessively mundane. However, this process is a must for small businesses. All the irregularities and reconciliations can be easily solved through physical verification and counting of inventories. For tax purchases, annual counting is a must and done at the end of the fiscal year.
Doing physical counts helps to reduce shortages, displacement, and errors in receipt of stocks. To catch these mistakes, counts should be done in a smaller time period. This can include spot counts at the time of receipt of the product from the vendor.
While stock count should be started with inventory in hand, spot counts should be matched to invoice or purchase orders.
POS mechanism can used by scanning the items and it can be nearly as useful as physical counting. However, when shortages are found, one should resort to physical counting.
5) Reconciliation of differences in inventory
After the physical counting of stocks, the differences if any shall be reconciled. This can be done by following the procedure of reconciliation. The first step would be to identify the discrepancy in counting. This can be due to inventory missing due to theft, damaged, and not reported and stock recorded as received but not actually received.
In a few cases, it can be just due to reasons owing to wrong labeling. If reasons cannot be known, the stock sheet needs to be adjusted to reflect physical balance in hand. After the adjustment in the books, the difference in any shall be accounted for loss in inventory as inventory shrinkage.
The small businesses shall carefully look if any human error has occurred intentionally or unintentionally. Further, small businesses can use various security features like access policy to stock and locking systems in order to reduce theft of stocks done intentionally.
Inventory is a current asset appearing in the balance sheet under the head current asset as well as a major item of the income statement.
Inventories are goods held for sale in the ordinary course of business that can help the management of the company to control and improve the business profitability and operate efficiently.
By nature, the cost of goods sold is an expense and the main component of the income statement.
Cost of goods sold can be calculated using the following formula;
COST OF SALE:
Opening Stock XXX
Add: Purchases XXX
Less: Closing Stock (XXX)
There are several impacts of inventory on the cost of goods sold including Purchase and production cost of inventory plays an important role in recognizing gross profit for the period.
The figure for gross profit is achieved by deducting the cost of sale from net sales during the year.
An increase in closing inventory decreases the amount of cost of goods sold and subsequently increases gross profit.
Similarly, another impact is the difference in valuation. Inventories are measured using these three methods i.e. FIFO (first in first out) LIFO (last in first out) or weighted average cost method.
Based on these methods closing stock for the period is determined which gives different results.
Because when costs of inventories are not uniform either due to price fluctuation or inflation the choice of inventory method may either increase or decrease the value of the closing stock which increases or decreases the cost of goods sold during the year.
directly affects the cost of goods sold during the year in a number of ways
either opening inventory of the current period belongs to last year closing
inventory or closing inventory of the current period.
But the main
causes of the cost of goods sold the account to increase or decrease is as
inventory for the current period is the stock leftover from last year means
items of goods that are not sold during the previous year.
Every organization wants to sell its opening inventory as soon as possible because there is a risk of obsolescence or deterioration that’s why the first items of every cost of sale account show opening stock.
An overstated amount of opening stock increases the amount of cost of sales significantly and vice versa.
Similarly closing stock represents the items that are not yet sold at the end of the period.
When a closing stock is wrongly calculated say overstated it lowers the cost of goods sold and increases gross profit for the year.
On the other hand for an understated amount of closing stock when adjustment entry is made to remove the effect of extra stock it increases the cost of sale directly which increases the amount of cost of goods sold significantly and ultimately decreases the profitability of the company.
Another impact of inventory on the cost of sale is their physical obsolescence, deterioration, theft, shortage or decline in prices.
These items may not be able to sell at their original selling price that’s why they are carried at net realizable value ( NRV) in this case a reduction in price is charged to the cost of goods sold thus reducing the value of closing stock and increases the gross profit.
to the international accounting standards and generally accepted accounting
principles, every entity is supposed to prepare annual financial statements
including the following:
statements or reports are made in order to provide a clear understanding of how
the business is performing financially so far.
includes and reports each and every transaction that has occurred throughout
the preparation of financial statements by the financial department, an audit
firm is hired that audits all the statements and makes sure it shows the true
and fair view of the business. One of the major line items of financial
statements is the inventory.
What is inventory?
which is also known as stock are the goods or commodities that is sold by the
company for trading purposes. Inventory is held by the entity in the warehouses
with the ultimate goal of reselling them.
are current assets since inventories have a useful life of less than a year,
the owner holds the risks and rewards of the goods and has a right to transfer
these goods to anyone he wants.
the end of each year an inventory count is done at the warehouse to calculate
the amount of closing inventory i.e. how much inventory is still left at the
warehouse and is not sold.
is treated as a current asset on the financial statements and also makes a part
of cost of goods sold.
Inventory on income statement:
The formula to calculate profit is Revenue – Cost and similar is the format of income statement.
reports the annual turnover first, the amount of which is extracted from the sales
per IAS 01, the gross profit and net profit shall be distinctly reported. Hence
the cost of goods sold is deducted from the sales in order to calculate the
Revenue – Cost of Goods Sold = Gross Profit
operating expenses are then deducted from the gross profit with the aim of
arriving at the net profit.
this article, since we are talking about the inventory, we will discuss the
cost of goods sold only. The formula to calculate cost of sales is as follows:
Opening Inventory + Purchases – Closing Inventory
opening inventory is the closing inventory of the preceding year and the amount
can be extracted from previous financial statements.
purchases amount is taken from the purchase ledger while the closing inventory
is calculated at the year end.
example, if the accounting period ends at 31st December, the
inventory count is done at 31st December each year. These are valued
at lower of cost or NRV as per IAS 2.
realizable value is the difference between the selling price at which the
damaged goods can be sold and any costs incurred in order to sell the good. The
cost of goods sold is then deducted from the revenue amount.
means that the closing inventory is indirectly added to the revenue in order to
calculate the net profit.
Inventory on Balance Sheet:
inventory is classified as a current asset since it has a useful life of less
than a year and is a tangible good from which future economic benefits are
The assets are reported in the order of liquidity on the balance sheet. The least-liquid item is reported the foremost which is the inventory whereas cash and bank are reported as the last current asset.
closing inventory is reported at its cost or net realizable value, whichever is
Inventory on statement of cash flow:
in closing inventory is adjusted in the operating activities section of the
cash flow statement.
capital changes are reported under the operating profit for the year with the
aim of achieving net cash flow from operating activities.
increase in closing inventory is deducted from the cash flow statement since
cash is paid for purchases but no cash has been received against such purchases
which results in a decrease in cash flow.
a decrease in closing inventory is added to the operating profit in operating
activities section of the cash flow statement.Inventory on statement of changes in equity:
There is no impact of inventory on statement of retained earnings.
Periodic Inventory System Vs Perpetual Inventory System is a distinctive technique used to follow the number of goods on hand. The more refined of the two is the perpetual system, however, it requires substantially more record-keeping to keep up.
The periodic system depends upon a physical count of the stock to decide the ending inventory, balance and the cost of the things sold, while the perpetual system monitors stock balances.
There are various differences between the two systems, which are as follows:
Periodic Inventory System Vs Perpetual Inventory System:
- Computer systems: It is difficult to physically keep up the records for a perpetual inventory system since there might be a huge number of transactions at the unit level in each financial period. On the other hand, the simplicity of a periodic inventory system takes into consideration the utilization of manual record-keeping for extremely little inventories. On the other hand, the simplicity of a periodic inventory system takes into consideration the utilization of manual record-keeping for extremely little inventories.
- Records: In Perpetual System, there are nonstop updates to either the general record or inventory record transactions happen. On the other hand, under a Periodic Inventory System, there is no expense of products sold record entry at all in a financial period until such time as there is a physical check, which is then used to determine the expense of goods sold.
- Purchases: In Perpetual System, Inventory purchases are recorded in either the crude materials stock record (based on the idea of the purchase), while there is additionally a unit count entry into the individual record that is kept for each stock item. On the contrary, in the Perpetual Inventory, all purchases are recorded into a purchase asset account, and there are no individual stock records to which any unit-count data could be included.
- Cost of merchandise sold: In the Perpetual system, there are persistent updates to the expense of products sold record as every deal is made. On the other hand, in the Periodic Inventory System, the expense of products sold is determined in a total amount toward the end of the bookkeeping period, by adding absolute buys to the starting stock and subtracting finishing stock. In the last case, this means it can be hard to get an exact expense of merchandise sold figures prior to the end of the bookkeeping period.
This list clarifies that
the Perpetual Inventory system is immensely better than the Periodic Inventory
The primary situation where a periodic system may make sense is the point at which the measure of the stock is exceptionally little, and where you can outwardly review it with no specific requirement for more definite inventory records.
The Periodic system
can also work admirably when the warehouse staff is inadequately prepared in
the uses of a Perpetual Inventory System, since they may accidentally record stock
transactions incorrectly in a Perpetual System.
Periodic Inventory bookkeeping systems are more suitable for private ventures because of the cost of getting the staff and technology to help a Perpetual System. A business, for example, a vehicle vendor or art display, maybe more suited to the Periodic System because of the low sales volume and the simplicity of the following stock physically.
However, the absence of exact data about
the expense of merchandise sold or stock balances during the periods when there
has been no ongoing physical inventory check could prevent business choices.
Organizations with high deals volume and different retail outlets (like markets or drug stores) need perpetual inventory systems.
The innovative part of the perpetual inventory system has numerous focal points, for example, the capacity to more effectively distinguish stock related mistakes.
The perpetual system can demonstrate all transactions thoroughly at the individual unit level. In the perpetual system, directors can make the proper planning of purchasing with reasonable information on the number of products on hand in different areas.
Having a progressively precise following of inventory dimensions additionally gives a better method for checking issues, for example, burglary.
Business is the asset of every businessman and businesswoman, and the assets of the business are the fixed assets and inventory. At the start of the business studies, most students are confused about fixed assets and inventories.
In actual business, there are clear differences in both of the terminologies. Here are the definitions and the differences between the inventories and fixed assets.
Assets have two big types in the business world, fixed assets, and current assets. Fixed assets are assets that cannot easily convert into cash. It is used for more than more years.
Fixed assets can be tangible and intangible. Fixed tangible assets are those assets that are touchable and seeable easily like building, furniture, etc. The non-tangible fixed assets are those which cannot be touched like brand and trademark.
Fixed assets can also be defined as those assets which can and cannot work in the day to day business activates. The items included in the fixed assets are buildings, machines, cars and trucks, furniture etc.
Inventory is also called stock which holds in business to sale in the one year period. Inventory is the current asset because it is expected to convert into cash within a year.
There is a different type of Inventories in different business. The raw material is the inventory of the manufacturing company. Work in progress is also included in the inventory.
Finished goods that are in stock and different components purchased for supplies are the parts of inventory or it is itself the inventories. Too little inventory is also not good because you will lose the profit when demand is so high, and you don’t have inventory or stock.
Inventory targets the profits of the company, the higher the inventory, the higher will be the profit. Inventory can manage the cash flow too because it is easily converted into cash.
Fixed assets Vs Inventories
There are few comparisons which differentiate inventories and fixed assets.
assets are for a long period of time while inventory is for a short period of
time. Because keeping inventory for a long period of time is risky and not
and Types of fixed assists and inventories
Assets and inventories have different items and types. Fixed assets are tangible
and non-tangible assets which can be touched or untouched like machinery, cars,
trucks, buildings, name of brand and trademark, etc. while inventories are
totally different. Inventories are the goods which are in stock ready for sale
and it can be a raw material, or the supplies used for goods.
is an important factor in business. Risk is always increasing when keeping
inventory for a long period of time or more than one year. Because it is
important to sell out all the stock in the years and make new and fresh
inventories. Hence, fixed assets are not profitable when it is kept for less
than a year. Fixed assets like building, machinery mostly used for the whole
life of the same business.
Depreciation is the
most important part of the fixed assets. Fixed assets are depreciated on annual
basis. The cost of deprecation is also calculated in every business. Buildings,
machinery, cars, and other fixed assets except land are depreciated annually. Hence, inventory is not depreciated, and it
also not have any depreciation cost.