Inventory

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This article is about business inventory. For other uses, see Inventory (disambiguation).

Inventory is a list of goods and materials held available in stock by a business.

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 U.S. Securities and Exchange Commission (SEC) and other federal and state agencies. Inventory management affects organizations' internal operations through their cost accounting methods. Identification of goods using Stock Keeping Units (SKUs) assists in managing inventory. The term stockout means running out of inventory.^[1]

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 accountants often discuss inventory in terms of goods for sale, organizations - manufacturers, service-providers and not-for-profits - also have inventories (fixtures, furniture, supplies, ...) that they do not intend to sell. Manufacturers', distributors', and wholesalers' inventory tends to cluster in warehouses. Retailers' inventory may exist in a warehouse or in a shop or store accessible to customers. Inventories not intended for sale to customers or to clients may be held in any premises an organization uses. Stock is simply cash in disguise. If stocks are uncontrolled, you are encouraging theft. Moreover it will be impossible to know the actual level of stocks and therefore impossible to control them.

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

Raw Materials - materials and components scheduled for use in making a product.
Work in Process, WIP - materials and components that have begun their transformation to finished goods.
Finished goods - goods ready for sale to customers.
Goods for resale.

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

The logistics chain includes the owners (wholesalers and retailers), manufacturers' agents, and transportation channels that an item passes through between initial manufacture and final purchase by a consumer. At each stage, goods belong (as assets) to the seller until the buyer accepts them. Distribution includes four components:

Manufacturers' agents: Distributors who hold and transport a consignment of finished goods for manufacturers without ever owning it. Accountants refer to manufacturers' agents' inventory as "matériel" in order to differentiate it from goods for sale.
Transportation: The movement of goods between owners, or between locations of a given owner. The seller owns goods in transit until the buyer accepts them. Sellers or buyers may transport goods but most transportation providers act as the agent of the owner of the goodss.
Wholesaling: Distributors who buy goods from manufacturers and other suppliers (farmers, fishermen, etc.) for re-sale 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 (soup, bolts, sweaters, or other goods) to consumers.

New old stock

New old stock (sometimes abbreviated NOS) is a term used in business to refer to merchandise being offered for sale which was manufactured long ago but that has never been used. Such merchandise may not be produced any more, and the new old stock may represent the only market source of a particular item at the present time.

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 Tool Company v. Commissioner.)

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.

The Role of a Cost Accounting on the 21st Century in a Manufacturing Organization

By helping the organisation to make better decisions, the accountants can help the public sector to change in a very positive way that delivers increased value for the taxpayer’s investment. It can also help to incentivise progress and to ensure that reforms are sustainable and effective in the long term, by ensuring that success is appropriately recognised in both the formal and informal reward systems of the organisation.

To say that they have a key role to play is an understatement. Finance is connected to most, if not all, of the key business processes within the organisation. It should be steering the stewardship and accountability systems that ensure that the organisation is conducting its business in an appropriate, ethical manner. It is critical that these foundations are firmly laid. So often they are the litmus test by which public confidence in the institution is either won or lost.

Finance should also be providing the information, analysis and advice to enable the organisations’ service managers to operate effectively. This goes beyond the traditional preoccupation with budgets – how much have we spent so far, how much have we left to spend? It is about helping the organisation to better understand its own performance. That means making the connections and understanding the relationships between given inputs – the resources brought to bear – and the outputs and outcomes that they achieve. It is also about understanding and actively managing risks within the organisation and its activities.

FIFO vs. LIFO accounting

Main article: FIFO and LIFO accounting

When a dealer sells goods from inventory, the value of the inventory reduces by the cost of goods sold. For commodity items that one cannot track individually, accountants must choose a method to identify the nature of the sale. Two popular methods exist: FIFO and LIFO accounting (first in - first out, last in - first out). FIFO regards the first unit that arrived in inventory the first one sold. LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects 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 LIFO's potential to skew inventory value, UK GAAP and IAS have effectively banned LIFO inventory accounting.

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. Throughput accounting recognizes only one class of variable costs: 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 to people - who have little or no control over their situations.

National accounts

Inventories also play an important role in national accounts and the analysis of the business cycle. Some short-term macroeconomic fluctuations are attributed to the inventory cycle.

References

^ "Financial dictionary", Special Investor

External links

Inventory Operations
Academic Papers on RFID & inventory problems

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