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.

Transparency is an essential value for Appvizer. As a media, we strive to provide readers with useful quality content while allowing Appvizer to earn revenue from this content. Thus, we invite you to discover our compensation system.   Learn more
Definition backgroundA simple definition of what you should know about pay in slip
Definition
last month
A simple definition of what you should know about pay in slip
Bank deposits is a job in itself and pay in slip is even more difficult. This article is for you as it has the solution you need to know how, when and what to do with a pay in slip. You won't need to ask the bank teller.
Template backgroundA free cash flow statement template Excel to download
Template
last month
A free cash flow statement template Excel to download
You're eager to know what a cash flow statement template Excel is and how to use one, then you've found the right article. Plus, you've lucked out as we've decided to include a free template for you to download.
Definition backgroundHow to control over fixed assets? [Guide and tips]
Definition
last month
How to control over fixed assets? [Guide and tips]
Good control over fixed assets can significantly improve the profitability of the business. Discover what control over fixed assets is, their importance, key internal risks, and how to control it in this article.
Definition backgroundDebit Note Definition- Why You Should Care
Definition
last month
Debit Note Definition- Why You Should Care
Debit notes are an important part of any business that deals with transactions. Therefore, it's even more important to have a good grasp on them. Click here to find out more about them!
Definition backgroundInternal vs External Audit- Difference and Specificities
Definition
last month
Internal vs External Audit- Differences and Specificities
Is something wrong in your business, but you're not quite sure what it is? Looking to do an audit, but you're not sure which one to do? Read our article on the differences between internal and external audits to find out.
Definition backgroundBookkeeping Tasks to Run Your Small Business
Definition
last month
Bookkeeping Tasks to Run Your Small Business
Is your business a bit disorganized? Do you sometimes miss pay dates? Better organize your business by applying a couple of these basic bookkeeping tasks.
Definition backgroundWork in Progress Inventory- Manage the Middle
Definition
last month
Work in Progress Inventory - Manage the Middle
Do you deal with a lot of inventory? Does it some times feel a bit too overwhelming? Well we've got you covered, this article covers one of the most important inventory phases, Work in Progress, click here!