In business management, inventory consists of a list of goods and materials held available in stock. An inventory can also be a self examination, a moral inventory.


Business inventory

Each country has its own rules about accounting for inventory; this article concentrates on economic theory, United States financial accounting rules, and Eliyahu M. Goldratt's throughput accounting. National boundaries do not limit economics, and throughput accounting functions independently of national regulations because it affects public financial reports only indirectly.

Organizations in the U.S. define inventory to suit their needs within Generally Accepted Accounting Practices (GAAP), the rules defined by the Financial Accounting Standards Board (FASB) (and others) and enforced by the Securities and Exchange Commission (SEC) and other federal and state agencies. Inventory management affects organizations' internal operations through their cost accounting methods. Nearly all goods feature printed bar codes -- known as Stock Keeping Units or SKUs -- for their role in managing inventory.

While financial accounting uses standards that allow the public to compare firms, cost accounting functions internally to an organization and with much greater flexibility. A discussion of inventory from standard and theory of constraints-based (throughput) cost accounting perspective follows some examples and a discussion of inventory from a financial accounting perspective.

Inventory examples

While inventory is usually discussed in terms of goods for sale, manufacturing, service, and not-for-profit organizations also have inventories of fixtures, furniture, supplies, ... that they do not intend to sell. Manufacturers', distributers', and wholesalers' inventory is kept in warehouses. Retailers' inventory may be kept in a warehouse or in a shop or store accessible to customers. Inventories that are not intended for sale to customers or clients may be kept in any premises an organization uses.

Manufacturing organizations usually divide their "goods for sale" inventory into:

  • materials and components scheduled for use in making a product (Materials and Components or Raw Materials)
  • materials and components that have begun their transformation to finished goods (Work in Process, or WIP)
  • finished goods that are ready for sale to customers.

For example:

  • Manufacturing: A canned food manufacturer's materials inventory includes the foods to be canned, empty cans and their lids (or coils of steel or aluminum for constructing those components), labels, and anything else (solder, glue, ...) that will form part of a finished can. The firm's work in process includes those materials from the time of release to the work floor until they become complete and ready for sale to wholesale or retail customers. Its finished good inventory consists of all the cans of food in its warehouse that it has manufactured and wishes to sell to food distributors (wholesalers), to grocery stores (retailers), and even perhaps to consumers through arrangements like factory stores and outlet centers.
  • Logistics or distribution includes the owners (wholesalers and retailers), manufacturer's agents, and transportation channels an item passes through between manufacture and purchase by a final consumer. At each stage, goods belong (are assets) to the seller until the buyer accepts them. Distribution includes four components:
    • Manufacturers' agents: Distributors who hold and transport finished goods for manufacturers without ever owning it. Manufacturers' agents' inventory is called matériel to differentiate it from goods for sale.
    • Transportation: The movement of goods between owners. Goods in transit are owned by the seller until the buyer accepts them. Sellers or buyers may transport goods but most transportation providers act as the seller's agents.
    • Wholesaling: Distributors who buy goods from manufacturers and other suppliers (farmers, fishermen, etc.) for resale work in the wholesale industry. A wholesaler's inventory consists of all the products in its warehouse that it has purchased from manufacturers or other suppliers. A produce wholesaler (or distributor) may buy from distributors in other parts of the world or from local farmers. Food distributors wish to sell their inventory to grocery stores, other distributors, or possibly to consumers.
    • Retailing: A retailer's inventory of goods for sale consists of all the products on its shelves that it has purchased from manufacturers or wholesalers. The store attempts to sell its inventory of soup, bolts, sweaters, or other goods to consumers.

Accounting perspectives

Financial accounting

An organization's inventory can appear a mixed blessing, since it counts as an asset on the balance sheet, but it also ties up money that might serve for other purposes and requires additional expense for its protection. Inventory may also cause significant tax expenses, depending on particular countries' laws regarding depreciation of inventory. (See Thor Power Tools Decision.)

Inventory appears as a current asset on an organization's balance sheet because the organization can turn it into cash by selling it. Some organizations hold larger inventories than their operations require in order to inflate their apparent asset value and their perceived profitability.

In addition to the money tied up by acquiring inventory, inventory also brings associated costs for space, for utilities, and for insurance to cover staff to handle and protect it, fire and other disasters, obsolescence, shrinkage (theft and errors), and others. Such holding costs can mount up: between a third and a half of its acquisition value per year.

Businesses that stock too little inventory cannot take advantage of large orders from customers if they cannot deliver. The conflicting objectives of cost control and customer service often pit an organization's financial and operating managers against its sales and marketing departments. Sales people, in particular, often receive commission payments, so unavailable goods may reduce their potential personal income.

FIFO vs. LIFO accounting

When goods are sold from inventory, the value of the inventory is reduced by the cost of goods sold. For commodity items which cannot be tracked individually, a method must be chosen to identify which item was sold. Two popular methods are FIFO and LIFO. Using FIFO, the first unit which arrived in inventory is considered to be the first one sold. Using LIFO, the last unit arriving in inventory is considered the first one sold. Which method is chosen can have a significant effect on net income and book value, and in turn on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation. Due to its potential to skew inventory value LIFO inventory accounting is effectively banned under UK GAAP and IAS.

Standard cost accounting

Standard cost accounting uses ratios called efficiencies that compare the labor and materials actually used to produce a good with those that the same goods would have required under "standard" conditions. As long as similar actual and standard conditions obtain, few problems arise. Unfortunately, standard cost accounting methods developed about 100 years ago, when labor comprised the most important cost in manufactured goods. Standard methods continue to emphasize labor efficiency even though that resource now constitutes a (very) small part of cost in most cases.

Standard cost accounting can hurt managers, workers, and firms in several ways. For example, a policy decision to increase inventory can harm a manufacturing managers' performance evaluation. Increasing inventory requires increased production, which means that processes must operate at higher rates. When (not if) something goes wrong, the process takes longer and uses more than the standard labor time. The manager appears responsible for the excess, even though s/he has no control over the production requirement or the problem.

In adverse economic times, firms use the same efficiencies to downsize, rightsize, or otherwise reduce their labor force. Workers laid off under those circumstances have even less control over excess inventory and cost efficiencies than their managers.

Many financial and cost accountants have agreed for many years on the desirability of replacing standard cost accounting. They have not, however, found a successor.

Theory of constraints cost accounting

Eliyahu M. Goldratt developed the theory of constraints in part to address the cost accounting problems in what he calls the "cost world". He offers a substitute, called throughput accounting, that uses throughput (money for goods sold to customers) in place of output (goods produced that may sell or may boost inventory) and considers labor as a fixed rather than as a variable cost. He defines inventory simply as everything the organization owns that it plans to sell, including buildings, machinery, and many other things in addition to the categories listed here. The only variable costs in throughput accounting are the operating expenses like materials and components that vary directly with the quantity produced.

Finished goods inventories remain balance sheet assets, but labor efficiency ratios no longer evaluate managers and workers. Instead of an incentive to reduce labor cost, throughput accounting focuses attention on the relationships between throughput (revenue or income) on one hand and controllable operating expenses and changes in[inventory on the other. Those relationships direct attention to the constraints or bottlenecks that prevent the system from producing more throughput rather than people who have little or no control over their situations.

See also

Manufacturing, Distribution, Logistics, Transportation, Wholsaling, Retailing, Accounting, Cost accounting, Throughput accounting, Eliyahu M. Goldratt, List of theory of constraints topics, Vendor Managed Inventory, Economic order quantity, Operations research

Moral inventory

Often in the course of 12 step programs, members say they are taking an inventory. Much like an inventory of goods and services detailed here, it is a balance sheet of attributes. It might list such things as thankfullness, humility, acceptance, trust, forgiveness and restitution. Addicts use these inventories as a moral compass and guide for where they are in recovery.

Other uses of inventory


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