Inventory management is a discipline primarily about specifying the shape and placement of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials.
The concept of inventory, stock or work-in-process has been extended from manufacturing systems to service businesses and projects, by generalizing the definition to be “all work within the process of production- all work that is or has occurred prior to the completion of production.” In the context of a manufacturing production system, inventory refers to all work that has occurred – raw materials, partially finished products, finished products prior to sale and departure from the manufacturing system. In the context of services, inventory refers to all work done prior to sale, including partially process information.
TYPES OF INVENTORIES
The three types of inventories are direct material inventory, work in progress inventory and the finished goods inventory where the direct material inventory includes the stock of raw material which the company has purchased for its use in production; work in progress inventory is the cost accumulated to the goods that are partially completed and the finished goods inventory is the stock that has finished all stages of production and is now available for sale.
Inventory means those current assets, which have been or will be converted into the final products of a company for sale in the near future. In other words, inventory represents finished goods or goods in different stages of production that a company keeps at its premises or at third-party locations with ownership interest retained until goods are sold. The three most important types of inventory are the raw materials, the work in progress (WIP) inventory and the finished goods.
Following are the different types of inventory:
Raw Material Inventory:
Raw materials are the basic materials that a manufacturing company buys from its suppliers and that is used by the former to convert them into the final products by applying a set of manufacturing processes. For example, aluminum scrap is the raw material for a company that produces aluminum ingots. Flour is the raw material for a company that produces bread or pizza. Similarly, metal parts and ingots are the raw materials bought by a company that manufactures cars and crude oil is the raw material for an oil refinery.
It is very common and easy to observe that the final products of one company are bought as raw materials for some other company. For instance, many oil drilling companies produce crude oil as their final product. On the other hand, the same crude oil is bought by oil refining companies as raw materials in order to produce their final products i.e. gasoline, kerosene, paraffin, etc.
It is important to optimize raw material inventory. This is because if a company keeps too much of raw material inventory in stock, it will incur higher carrying costs and there is also the undesirable possibility of the inventory getting obsolete. For example, in the pharmaceutical or food industry, the raw materials may be perishable. If not used within a stipulated time limit, they can get expired and can’t be used in production. On the other hand, a company must have a certain minimum level of inventory at all times to cater to the production volumes, which mostly follow the trend of the market demand. Thus, the optimization of raw material inventory is important.
Work in Progress (WIP) Inventory
Work in progress inventory can also be called semi-finished goods. They are the raw materials that have been taken out of the raw materials store and are now undergoing the process of their conversion into the final products. These are the partly processed raw materials lying on the production floor. And they have also not reached the stage where they have been converted into the final product.
The extent of inventory locked-up as work in progress is lower the better. This is understandable as the inventory under process is of no use till it gets converted into the final product. It may be saleable at some price but it cannot be sold to generate any revenue for the company’s core business. In fact, in lean manufacturing systems, the work in progress inventory is considered as waste.
So it is most desirable that the volume of inventory that is lying in the form of work in progress be minimized and the time is taken to convert it into the final also be minimized so that the locked-up value can be released as quickly as possible. The idea is that this capital, which is locked-up in the form of work in progress inventory, can otherwise be invested somewhere else in order to achieve much better returns.
Finished Goods Inventory:
Finished goods are indeed the final products obtained after the application of the manufacturing processes on the raw materials and the semi-finished goods discussed above in the article. They are saleable and their sale contributes fully to the revenue from the core operations of the company.
Regarding the level of finished goods inventory, there are two types of industries that we need to look at. First, we would take the industries in which the finished goods are mass-produced and the sale happens after the production. Examples of such industries are the FMCG industry and the oil industry. For a company in such an industry, the correct approach is to maintain the finished goods inventory in a similar manner as the raw material inventory is maintained i.e. at an optimized level as per the demand in the market.
The other type of industry is one in which the goods are manufactured on demand i.e. the order is first received and then the production starts. An example of such industries is the capital goods industry and the customized goods industry. For a company in such an industry, it is neither necessary nor advisable to keep any inventory of finished goods because their finished goods kept ready in stock might never get sold even if they have the slightest deviation from the specifications of the new orders coming from the customers. So they may never get a return on their investment gone in making the finished goods ready.
The role and functions of the stock
Inventory management is a determining point in the strategic management of any organization.
The main function of inventory management is to determine the sufficient amount and type of input products, products in process and finished products, facilitating production and sales operations and minimizing costs by keeping them at an optimal level.
Efficient inventory management is essential to ensure that the business has enough products stored to meet consumer demand. If it is not handled correctly it can result in the business losing money on potential sales that cannot be satisfied or that you waste money taking care of too much inventory. An inventory management system can prevent these types of errors from occurring.
Inventory is included in all the important segments of one’s company and has important effects on all the main functions of the company – we mainly have inventories because that allows us to perform the functions of purchasing, production and sales at different levels.
Each function has to generate different inventory demands:
Sales: Costumer demand must be satisfied quickly and completely to avoid the buyer resorting to competition, so you not only must have sufficient inventory to meet market demand, but also, you should consider an additional amount for unexpected requests.
Production: Production and delivery do not usually occur instantaneously, so you must have stock of the product that can be used in a timely manner and that the actual sale does not wait until the completion of the production process.
Purchases: When a significant increase is expected in the prices of basic raw materials, a sufficient quantity must be stored at the lowest price prevailing at the moment. In the same way, if shortages of necessary raw materials are foreseen, it is essential to have a reserve to continue regularly with production operations.
Inventory Valuation — LIFO vs. FIFO
Understanding LIFO and FIFO
The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows. The U.S. generally accepted accounting principles (GAAP) allow businesses to use one of several inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost.
First-In, First-Out (FIFO)
The First-In, First-Out (FIFO) method assumes that the first unit making its way into inventory–or the oldest inventory–is the sold first. For example, let’s say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on the income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (on the balance sheet).
Last-In, First-Out (LIFO)
The Last-In, First-Out (LIFO) method assumes that the last or more unit to arrive in inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
TYPES AND PURPOSE