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.