What is inventory?

Inventory is the goods that a business has on its premises or on consignment. The essential role of inventory is to act as a buffer, allowing for the smooth functioning of the production and order fulfillment processes. The four components of inventory are defined as:

  • Raw materials. This is the source material for a company's manufacturing process. It can literally be "raw" materials that require considerable reconfiguration to become a product (such as sheet metal) or it can be components purchased from a supplier, and which can simply be bolted onto a product that is being assembled.
  • Work in process. This is raw materials that are in the process of being transformed into finished products through a manufacturing process. This can be quite a small amount if the manufacturing process is short, or a massive amount if the item being created requires months of work (such as an airliner or a satellite).
  • Finished goods. This is products that have successfully completed the manufacturing process, and are ready for sale.
  • Merchandise. This is finished goods that have been purchased from a supplier, and which are ready for immediate resale. Examples of merchandise are clothes sold at a retailer, or tires sold at a local automobile repair shop.

Inventory does not include supplies, which are considered to be charged to expense in the period purchased. Also, customer-owned inventory should not be recorded as inventory owned by the company. Further, supplier-owned inventory located on the premises should also not be recorded as inventory by the company.

Inventory can be located in three places, which are:

  • In company storage. By far the most common of the inventory location types, this is inventory kept in any location that is under the direct control of the business. This may be anywhere at a company facility, in trailers in the company parking lot, in leased warehouse space, and so forth.
  • In transit. A business technically takes ownership of inventory if the delivery terms from the supplier are FOB shipping point, which means that ownership passes to the buyer as soon as the goods leave the shipping dock of the supplier. At the other end of the delivery pipeline, a business also owns inventory until it reaches the customer's receiving dock if it is shipping under FOB destination terms. However, from a practical perspective, a company does not usually attempt to account for inventory that is either in transit to it or from it.
  • On consignment. A company may retain ownership of inventory at a retailer or distributor location, with its ownership interest continuing until such time as the inventory is sold. This inventory is much more difficult to track, since it is off-site.

Inventory is considered an asset, and is recorded as such on a company's balance sheet. Creating a proper valuation to include on the balance sheet requires either a physical count of the inventory to establish the quantities on hand, or a perpetual inventory system that relies on accurate record keeping of every inventory-related transaction. A proper valuation also requires the assignment of a cost to the inventory, which usually involves a costing methodology, such as FIFO costing, LIFO costing, or weighted-average costing.

Related Courses

Accounting for Inventory 
How to Audit Inventory