What’s it: An inventory is a list of all the items that a company maintains as production inputs and items to fulfill sales. They include raw materials, work in progress, and finished goods.
They are essential for two reasons. First, by converting them into sales, the company earns money. Second, holding them for a while comes with costs, and it ties the company money.
Also known as stock.
What are the types of inventory
The company divides an inventory into three main categories, based on the type of item at their stage in the production process.
- Raw materials – consisting of goods that the company procures from suppliers. They haven’t undergone any further processing. An example is iron ore if the company is a steel producer or flour if it is a bread producer.
- Work-in-process – covering goods that are still in production systems and still require further processing to become finished goods. Say, a company is a carmaker, car frames fall into this category.
- Finished goods – consisting of the final output in the warehouse and waiting to be sold. Companies can immediately sell them to meet customer demand.
In operations management, inventory classification usually consists of five main categories, namely:
- Anticipation inventory, goods with low demand, and manufactured for the anticipated surge in demand can not be predicted precisely.
- Decoupling inventory or raw materials move within the system.
- Buffer inventory or raw materials are kept as a reserve for their supply variations.
- Pipeline inventory or materials in transit or confined in the system.
- Cyclical inventory or economic order quantity is calculated based on the principles of just-in-time.
Why inventories are important
Inventory is a source of revenue. The company will convert this into sales and collect money from customers. So, the higher the company’s inventory turnover, the faster they will sell and raise money. Therefore, analysts often use the inventory turnover indicator to assess the company’s inventory management effectiveness.
Maintaining inventory comes with costs. The company must incur storage costs and pay for unsold materials, components, and goods. Additionally, keeping inventory for long periods poses a threat of obsolescence. And, of course, it is a cost.
Inventories tie up working capital. Companies have to sell goods in warehouses to get money for operations. If sales are slow, goods pile up. The more the inventory piles up, the more cash is tied up in goods in the warehouse.
The company cannot use cash to make inventory for anything else until it is sold. For this reason, many analysts are interested in seeing how quickly a company can sell its inventory.
Inventory management has implications for selling prices. For example, if sales are growing slower than inventory level growth, goods are piling up in the warehouse. It happened because a purchase was too large or because sales fell.
Stacking goods in warehouses incurs higher costs. Firms may have to lower prices to stimulate demand. Of course, such a situation will result in lower profits for each item sold.
Maintaining inventory ensures the production system works. Running out of one stock item can bring the entire production system to a halt. Even if the production process stops, the company still has to pay staff, even those who are not continuing production.
Because of this, the company will usually implement stock control. It aims to ensure sufficient and available items on location when needed. Thus, the production system can run more smoothly, and the company can minimize stock storage costs.
Inventory effect on GDP
In gross domestic product (GDP), the investment component includes not only investment in capital goods but also changes in inventories. More specifically, the economists call it “inventory investment.” Typically, economists look at inventory ratio to total sales to gauge whether a business is holding too much or too little inventory.
When demand falls, supply increases. Businesses sell fewer items, encouraging the accumulation of goods. The business will then reduce production. If it lasts long enough, then layoffs are the next impact.
The change in inventory component makes business investment the most volatile component of GDP. It can jump or fall suddenly as demand grows.
Typically, businesses are slow to cut production when the economy starts to slow down. As a result, unintentional supplies build up. Combined with a drop in sales, that resulted in a sharp increase in the inventory-sales ratio.
To liquidate this unwanted inventory, businesses began to reduce production levels. In fact, they lowered it below the rate of decline in sales. They try to maximize sales from a combination of new output with finished goods in the warehouse. This drastic reduction in production ultimately exacerbated the economic slowdown.
Furthermore, during expansion, businesses saw demand rise. They struggle to keep production at the same pace as sales growth. However, to do so, they take longer to use resources optimally.
Finally, the inventory-sales ratio drops rapidly because of the depletion of inventory. This situation stimulated businesses to immediately increase production. They started recruiting additional workers.
How to present inventory in financial statements
You can find an inventory account in the current assets section of the financial statements. The company expects to convert these to sales within one operating cycle (usually one year).
When goods are sold, the cost of switching to an account associated cost of sales (cost of goods sold or COGS) in the income statement and ending inventory is reduced.
On the other hand, when a company buys raw materials, it will add to the current inventory. Therefore, the ending inventory figure in current assets will equal the beginning inventory plus purchases minus the cost of goods sold. Here is the formula:
Ending inventory = Beginning inventory + Purchases – Cost of goods sold
The higher the sales, the greater the cost of goods sold, and the less ending inventory. High sales mean the company successfully converted most of its raw materials, work in progress, and finished goods into revenue. The related costs are presented in the income statement as cost of goods sold.
The effect of inventory on the income statement
In general, two approaches are for calculating inventory value. A company can use the specific identification method if it can identify the units of inventory that have been sold and that have remained in stock for a year. It was more likely for large items like cars.
However, suppose identification is difficult to do because it involves high volume. In that case, companies can use three methods to measure it: first-in, first-out (FIFO), last-in, first-out (LIFO), and the weighted average. Each method results in a different ending inventory value, cost of goods sold, profit, and taxes.
- FIFO: earliest item purchased is first sold.
- LIFO: the lastest item bought is first sold.
- Weighted average cost: allocates costs evenly across all units.
In the FIFO method, the ending inventory consists of the most recent purchased items. Meanwhile, sales consisted of items that were earliest purchased. Therefore, when prices rise (inflation), the value of the ending inventory will be higher. Meanwhile, the COGS value will be lower. This means that the gross profit, tax expense, and net income will be higher when it uses FIFO.
For example, suppose a company buys for Rp50. Then, the company buys again, and the price goes up to Rp60. Under the FIFO method, the company will use the final price, Rp60, to calculate the ending inventory. Meanwhile, because an item that costs Rp50 is sold the first time, the company will use that figure in the COGS calculation.
Meanwhile, under the LIFO method, because the lastest item purchased is first sold, the inventory will consist of the first purchased item. Meanwhile, COGS consists of the most recently purchased items.
When the price goes up, as in the example above, it will result in lower inventory value. Meanwhile, COGS will be higher. Gross profit, taxes, and net income will be lower. The company uses the final price, Rp60, to calculate the ending inventory in the above case. Meanwhile, for COGS, the company uses the initial price, RP50.
Meanwhile, under the weighted average cost, the company will allocate inventory costs evenly across all units. Therefore, the ending inventory value, COGS, gross profit, tax expense, and net income will be between the FIFO and LIFO values.
Well, I’ll summarize the effects of all three methods:
|Ending inventory||COGS||Gross profit||Tax expense||Net profit|
|Price increase (inflation)||FIFO > LIFO||FIFO < LIFO||FIFO > LIFO||FIFO > LIFO||FIFO > LIFO|
|Price decline (deflation)||FIFO < LIFO||FIFO > LIFO||FIFO < LIFO||FIFO < LIFO||FIFO < LIFO|
How to analyze inventory
The inventory turnover ratio is a financial ratio you can use to measure the effectiveness of inventory management. The calculations are easy. You simply divide the cost of goods sold on the income statement by the average inventory in current assets. The following is the inventory turnover ratio formula:
Inventory turnover = Cost of goods sold / Average inventory
Alternatively, you can use the purchase number as the numerator. But, you have to calculate it first because the company doesn’t report it on the income statement.
Purchases = Ending inventory – Beginning inventory + Cost of goods sold
To conclude, you can compare the inventory turnover rate from year to year and compare it with the industry average. A high ratio relative to the industry average may indicate management is relatively effective at managing inventory. That shows companies can quickly convert stock into sales.
But, high ratios can also occur due to too little inventory. And, it hurts the company because deficiencies arise. Inadequate inventory makes the company unable to optimize sales, especially when demand is increasing.
Is it due to insufficient inventory or effective management? You can compare the growth in industry sales to the growth in sales of the company. If the industrial sales growth is high, it may indicate the company is experiencing a shortage of inventory.
Furthermore, you can use the inventory turnover figure to calculate another ratio, days of inventory on hand (DOH). The DOH shows you the number of days the company can convert inventory into sales. To calculate this, you divide the number of days in a year (365) by the inventory turnover.
DOH = 365 / Inventory turnover
The lower the DOH, the more desirable. That means companies are converting inventory faster. For example, DOH 30 indicates that it takes an average company 30 days to convert inventory into sales.
How businesses manage inventory
Inventory management is essential to avoid the adverse effects of understock and overstock. If the inventory is insufficient, the company loses sales potential and can erode market share. Conversely, if the overstock lasts long enough, it comes at a higher cost.
For that reason, companies should have systems in place to ensure they have sufficient supplies at the right time. The two common approaches companies adopt are:
Just-in-time (JIT) – the company does not store any raw materials and does not require buffer stock. The company relies on regular, effective delivery, so items are available before raw materials run out. The main advantage of JIT is that it reduces the effects of overstock. But, companies can also run out of stock if the delivery is late.
Just-in-case (JIC) – the company uses buffer stocks to anticipate shortages. They will buy a little more as a stand. JIC excels when the demand for a particular product suddenly increases. But, because it buys more, JIC also comes at a cost.