Inventory: Definition, Types, Valuation, and Management

Key takeaways
* Inventory includes raw materials, work‑in‑progress (WIP), and finished goods used for production or held for sale.
* Common valuation methods are FIFO, LIFO, and the weighted average method; the choice affects cost of goods sold (COGS), taxes, and reported profits.
* Effective inventory management (for example, just‑in‑time systems and modern inventory software) reduces holding costs, spoilage, and obsolescence.
* Inventory turnover—COGS divided by average inventory—measures how quickly inventory is sold and replaced and is a key indicator of operational efficiency.

What is inventory?
* Inventory represents the goods and materials a company holds for production or sale.
On the balance sheet, inventory is a current asset because it is typically expected to be sold or consumed within a year.
When inventory is sold, its carrying cost moves from the balance sheet into cost of goods sold (COGS) on the income statement.

Types of inventory
* Raw materials: Unprocessed inputs used in production (e.g., metals for auto manufacturing, flour for bakeries, crude oil for refineries).
Work‑in‑progress (WIP): Partially completed goods on the production floor (e.g., a half‑assembled aircraft).
Finished goods: Completed products ready for sale (retail merchandise such as electronics, clothing, or cars).
* Additional classifications used by tax authorities can include merchandise and supplies.

Valuation methods
How inventory and COGS are valued affects financial reporting and taxes. Common methods:
* First‑in, first‑out (FIFO): Assumes the oldest purchases are sold first; COGS reflect earlier costs, remaining inventory reflects recent costs.
Last‑in, first‑out (LIFO): Assumes the newest purchases are sold first; COGS reflect recent costs, remaining inventory reflects older costs.
Weighted average: Values inventory and COGS using the average cost of goods purchased during the period.

Consignment inventory
* Consignment inventory is owned by the supplier but held by a retailer until sold or consumed.
Benefits to suppliers: greater shelf presence and access to end customers without immediate sale.
Benefits to retailers: no capital outlay until items sell or are consumed.
* Accounting and logistics must be managed carefully to track ownership and revenue recognition.

Inventory management strategies
Challenges of holding inventory include storage costs, spoilage, theft, and obsolescence. Risks of too little inventory include lost sales and market share. Common strategies:
* Just‑in‑time (JIT): Minimizes on‑hand inventory by producing or ordering goods only as needed, reducing holding costs and waste.
Backflush costing: Often used with JIT to simplify accounting by assigning costs after production.
Inventory management systems: Software that tracks stock across channels and locations, highlights low turnover items, and helps detect waste or fraud.
* Forecasting and demand planning: Align stock levels with expected customer demand to balance service levels and carrying costs.

Inventory turnover and performance
* Inventory turnover (stock turnover) measures how many times inventory is sold and replaced over a period.
Formula: Inventory turnover = COGS ÷ Average inventory.
– Average inventory is commonly calculated as (beginning inventory + ending inventory) ÷ 2.
Interpretation: High turnover generally indicates strong sales and efficient management; low turnover suggests overstocking or weak demand and can depress profitability.
* Managers use turnover trends to inform production, purchasing, and pricing decisions.

Example: Fast fashion
* Retailers like Zara illustrate responsive inventory systems: rapid design‑to‑shelf cycles reduce excess stock, lower markdowns, and keep assortments aligned with current trends. High responsiveness supports quick turnover and better margins.

Bottom line
Inventory is a fundamental operating asset that links production and sales. Correct classification, valuation, and active management are essential for controlling costs, meeting customer demand, and maximizing profitability. Metrics such as inventory turnover help companies diagnose performance and guide operational and financial decisions.