Inventory can be fast moving and large in scale. In addition, inventory passes through numerous stages throughout its lifespan. In order to gain an accurate picture of a business’ financial situation, it is necessary to properly account for inventory. Depending on how a business calculates their inventory, it can reflect in different ways on their cash flow statements, income statements and balance sheets. Therefore deciding the most applicable way to track and value your inventory an integral exercise. Tracking and valuing inventory throughout production and once it is complete is important to understand.
From Raw Materials to Finished Goods
Inventory accounts for raw materials, works-in-progress products, and finished goods. In a business, inventory is comprised of a business’ assets that are ready to be sold or will be sold soon. Raw materials are the materials used in the production of goods. Often, raw materials come from a variety of different suppliers and the cost of having raw materials is recognised at the point of acquisition. Raw materials will sit in inventory until they are ready to be used for production. Until then, they sit as a current asset on a company's balance sheet.
The next stage of inventory is considered works-in-progress. When a company utilises both direct and indirect materials in the production of goods, it must acknowledge that inventory stock has changed. Now the raw materials have shifted to works-in- progress. Since the raw materials are now being implemented into production, it is necessary to account for this. Effectively, there has been a decrease in the raw materials inventory stock. The current asset account needs to be credited and the works-in- progress inventory stock needs to be debited. In addition, indirect materials need to be removed. This is done by crediting raw material inventory stock, but a debit is applied to the factory overhead account.
Finished goods are the end-products that a business produces and can sell on to retailers to make a profit. The transition of the finished goods from manufacturers to retailers needs to be accounted for properly. When production of a good is complete, the works-in-progress account should receive a credit. In turn, the finished goods inventory account receives a debit.
Inventory Management Methods
Accounting for a business’ inventory is sensitive to a variety of factors. It can depend on the type of goods a business produces. For example, perishable goods and non-perishable goods are looked at differently from an accounting perspective. The type of industry can also influence the type of accounting method used.
Last-In, First-Out (LIFO) and First-In, First-Out (FIFO), are two standard ways of calculating inventory. LIFO is appropriate for goods that are not perishable. The principle behind LIFO is the goods put last on the shelf are the first to move out of the warehouse. Conversely, with FIFO, goods that are put on the shelf first, are the first ones to move out of the warehouse. In addition, it can give an accurate representation of everything purchased so replacement costs can be considered.
Keeping track of inventory and staying on top its financial performance can seem like a big task. By looking closer at accounting practices and valuation for inventory, the most applicable options for your business will become clearer.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.