Types of Inventory in Accounting and How They Work

By Nicholas Barone
Published: 11/15/21
definition backgroundTypes of Inventory in Accounting and How They Work

Whether you’re a store with a lot of inventory sitting around, a shipping company or just a production company, inventory is a very important element in any business’s functioning. Inventory, especially in accounting can be a little complicated for businesses with no prior knowledge, however it can be extremely important to know. Keep reading to find out more!

Definition of Inventory in Accounting

In accounting terms, inventory is stock in various production stages and is a current asset. Inventory allows businesses, retailers and manufacturers, to build, sell and send products more efficiently. It also protects businesses from risks of shortages and shipping delays, more relevant today than ever, with all the supply chain issues today businesses that have extra stock are less affected by the crisis. Inventory is a major asset that should not be neglected.

Types of Inventory

Being able to use and understand the types and stages of inventory is crucial for making sound financial and business decisions. There are four main types of inventory in accounting:

Raw Materials

The first step of the manufacturing process, raw materials are the starting block for any production, in other words it’s stock that hasn’t yet been used for manufacturing. There are actually different types of raw materials, ones that are recognizable from their original form and ones that are unrecognizable. Take for example oil, if you’re making food, the oil won’t be identifiable in the finished product, as compared to a screw in a bike, which you directly see in the finished product.

Work in Progress (WIP)

This type of inventory describes partially finished goods that still have to be finished. The term “work in progress” actually refers to the raw materials, labor and overhead costs for products at different stages in the production process. To put it into more context, think about a bike, all the parts are done, rubber for the tires, inner wheels, chains for gears, etc., are all just waiting to be assembled to make the final product.

Finished Goods

Finished goods are products that have completed the manufacturing process, or purchased in its complete form by businesses, and not yet sold to customers. If a finished good is sold to a customer, it is no longer known as a finished good, it is merchandise. In accounting, the cost of finished goods are recorded in the short-term asset section of the balance sheet, because finished goods are expected to be sold fairly quickly. At the end of a financial reporting period, the total finished goods are combined with the costs of raw materials and work in progress in one “inventory” line on the balance sheet.

Function of Inventory

Inventory has four main functions: anticipate potential customer demand, and to protect businesses against fluctuations, separate the different steps of the production process, to take advantage of quantity discounts and shield the business from inflation, in case the price of raw materials or goods go up.

Inventory Management

What we laid out before may seem simple enough, but running and coordinating supply chains and controlling and overseeing purchases is anything but. Whoever’s in charge has to manage suppliers as well as customers, maintain stock levels, control the amount of product that’s for sale and fulfill orders. All of this is important because having good inventory management can help you reduce costs, fulfill orders, provide better customer service and prevent waste.

Obviously, the way you manage inventory depends on the kind of products you sell, and channels you sell them through. But what tools should you use to manage inventory?

Inventory Management Software

Small to medium sized businesses often rely on old methods to manage inventory, like Excel, Google Sheets or other spreadsheet applications. However, these days that’s not doesn’t cut it, you have to know when to reorder, what quantities to order, where to put the stock. Even more complicated, inventory management also includes steps like end-to-end production and business management, lead time and demand forecasting, metrics, reports and much more. All of this can be hard to manage if you’re just depending on old spreadsheet applications. If your business deals with a large quantity of inventory, you should think about investing in an inventory management software system.

Inventory in Accounting- How it Can Help Your Business

If your business deals with inventory, you need to know all of what we laid out in this article. Inventory is an integral part of businesses, and knowing how to deal with it is crucial. Moreover, managing a big inventory can be stressful, that’s why we’d recommend small and medium sized businesses with a considerable inventory to invest in an inventory management software program. To start to get an idea of what tools are out there and how they can help your business handle inventory click here.

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