What is Inventory?

Inventory is like everything you bring to a yard sale…

All the furniture, old records, and used books sitting on your lawn, waiting for someone to buy them, are part of your inventory. Once someone purchases an item, it’s no longer part of your inventory. Let’s say you realize that lots of people are buying your handmade hats. If you decide to knit more hats for future yard sales, the yarn you use becomes part of your inventory, too. Furniture you use to display your wares, like tables, aren’t for sale, so they aren’t included in your inventory.

Inventory consists of all the goods a company has available to sell, in stores or warehouses, plus the raw materials it has on hand to make those products. Inventory includes both products that are finished and ready for purchase and those that are still being made. Things that the company does not plan to sell, even if they reside in a store, are not part of its inventory. For example, a clothing company might have dresses that are part of its inventory, but the mannequins used to display them are not. Inventory is considered a current asset because companies are constantly selling through their inventory, so it generally converts to cash within a year.

Companies can have many different types of inventory, but there are three main categories:

1. Raw materials are the things a company will use to build the products it will later sell. To return to our example of Apple, the silicon that goes into making computer chips is a raw material.
2. Work-in-process includes anything that isn’t a raw material but also isn’t ready to be sold to consumers. When Apple turns silicon into computer chips but hasn’t yet built those chips into a computer, the computer chips are a work-in-process.
3. Finished goods are anything a company has that is ready for sale to customers. This would include laptops, phones, accessories, and everything else you can buy in an Apple Store.

Inventory turnover is a popular ratio that measures how often a company sells all of its goods and replaces them with new products to be sold. The higher a company’s inventory turnover, the more often it replaces its inventory of goods for sale. Investors use this ratio, alongside others, as one quick way to look at an enterprise’s financial situation.

However, this number provides a somewhat imperfect look at a company’s inventory. A business may have some goods that have been waiting to sell for years, along with other products that sell quickly enough to compensate. Still, this ratio gives investors a sense of how swiftly a company can sell what it produces.

There are two formulas for calculating inventory turnover:

Inventory Turnover = Cost of Goods Sold / Average Inventory Inventory Turnover = Sales / Average Inventory

Cost of goods sold refers to the direct expenses associated with creating goods for sale, including labor and materials. To come up with average inventory, you subtract the inventory at the end of the period from the inventory at the beginning and divide by two (the average is used to account for the fact that inventory levels can vary with the seasons).

Both ratios can show you the number of times that a company sells through its inventory and replaces it in a certain period of time, such as one year. Low turnover can mean a company is producing too many goods or not selling enough of them, while high turnover suggests that sales are strong or the company doesn’t have enough products in stock.

Investors care about inventory turnover for a few reasons. One is that it can be expensive to hold a lot of inventory for extended periods. Companies have to build or rent warehouses to house their work-in-process or finished goods. There is a higher potential for loss through spoilage or theft. Some products, like electronics, might become obsolete if a new model is released. This risk varies with the type of business. Grocers have to worry more about spoilage than hardware stores, while tech companies are more likely to have their goods become obsolete than bookstores.

On the flip side, high inventory turnover can indicate that there is a significant demand for a company’s goods. That’s a good thing for any business that sells products to consumers. But it can also mean that a company isn’t making enough products to meet that demand.

To increase turnover, companies can study the amount of inventory each store has or the amount of inventory in transit (moving from warehouses to stores or from production to warehouses). These numbers can be useful when designing a supply chain or deciding what goods to send to specific stores.

Inventory balance is the total value of all of a company’s inventory, including raw materials, work-in-process, and finished goods. This number usually appears on a company’s balance sheet, the financial document that lists all of a company’s assets and liabilities.

Companies can use a few different strategies for calculating inventory value:

• First In, First Out (FIFO): Companies assume that items are sold in the order they’re made or bought. If a company made 100 DVDs that it sold for $10 each and 100 DVDs that it sold for $20 each, it would subtract $10 from its inventory for each of the first 100 DVDs sold, regardless of which disc actually sold. It would deduct $20 for the next 100 DVDs sold.
• Last In, First Out (LIFO): Companies make the opposite assumption — The last item purchased or made is sold first. In the example above, the first 100 sales would reduce the company’s inventory by $20 each. The next 100 sales would reduce its inventory by $10 each.
• Weighted Average Cost (WAC): The average cost of a good is used. In the previous example, the company would deduct the average cost of a DVD ($15) from its inventory value each time it makes a sale.

Inventory management is all about controlling a company’s inventory, from purchases of raw materials to the production and sale of finished goods. The job of inventory managers is two-fold: First, they aim to make sure there are always goods available when customers want to buy them. No Apple Store should run out of iPhones, or it could lose out on sales. Second, inventory managers try to keep the least inventory on hand while meeting demand. The less inventory a company carries, the lower its associated costs will be.

There are many inventory management strategies a company can use. Some companies use just-in-time (JIT) inventory systems, in which raw materials arrive at production facilities exactly when the facility is ready to use them. Similarly, finished goods ship to stores based on forecasted sales to minimize the amount of inventory that is in stock waiting to be sold. This type of system can reduce inventory holding costs but can cause production slowdowns or lost sales if goods don’t arrive at the right time.

Another inventory management strategy is called dropshipping. Instead of stores keeping products in stock, a manufacturer or wholesaler ships goods directly to customers when they make a purchase. Home goods retailer Wayfair is one example of a company that uses a dropshipping model.

Good inventory management can make a company more efficient, reducing the costs of holding inventory and increasing turnover. That results in a company that is more flexible and may produce greater profits. Poor inventory management can increase a company’s costs by increasing shrinkage (theft of goods by employees or customers), spoilage, or obsolescence. It can also result in lost sales when products go out of stock.