Inventories (Financial Accounting)

Inventory is a list for goods and materials, or those goods and materials themselves, held available in stock by a business. It is also used for a list of the contents of a household and for a list for testamentary purposes of the possessions of someone who has died. In accounting inventory is considered an asset.

The word inventory was first recorded in 1601. The french term inventaire, or "detailed list of goods," dates back to 1415.
Business inventory
The reasons for keeping stock
There are three basic reasons for keeping an inventory:

1. Time - The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amount of inventory to use in this "lead time"
   
2. Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods.
   
3. Economies of scale - Ideal condition of "one unit at a time at a place where user needs it, when he needs it" principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory.
   

All these stock reasons can apply to any owner or product stage.

• Buffer stock is held in individual workstations against the possibility that the upstream workstation may be a little delayed in long setup or change-over time. This stock is then used while that change-over is happening. This stock can be eliminated by tools like SMED.
  

Special terms used in dealing with inventory

• Stock Keeping Unit (SKU) is a unique combination of all the components that are assembled into the purchasable item. Therefore any change in the packaging or product is a new SKU. This level of detailed specification assists in managing inventory.
  
• Stockout means running out of the inventory of an SKU.
  
• "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.
  

Typology

1. Buffer/safety stock
   
2. Cycle stock (Used in batch processes, it is the available inventory excluding buffer stock)
   
3. De-coupling (Buffer stock that is held by both the supplier and the user)
   
4. Anticipation stock (building up extra stock for periods of increased demand - e.g. ice cream for summer)
   
5. Pipeline stock (goods still in transit or in the process of distribution - have left the factory but not arrived at the customer yet).
   

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 ties up cash and if uncontrolled it will be impossible to know the actual level of stocks and therefore impossible to control them. Whilst the reasons for holding stock are covered earlier, most 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 - returned goods that are salable.
  
• Spare parts
  

For example
Manufacturing
A canned food manufacturer's materials inventory includes the ingredients to form 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. This may be vats of prepared food, filled cans not yet labelled or sub-assemblies of food components. It may also include finished cans that are not yet packaged into cartons or pallets. Its finished good inventory consists of all the filled and labelled 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:

1. 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.
   
2. 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 goods.
   
3. 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.
   
4. 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.
   

It is a key observation in "Lean Manufacturing" that it is often the case that more than 90% of a product's life prior to end user sale is spent in distribution of one form or another. On the assumption that the time is not itself valuable to the customer this adds enormously to the working capital tied up in the business as well as the complexity of the supply chain. Reduction and elimination of these inventory 'wait' states is a key concept in Lean.
High level inventory management
It seems that around about 1880 there was a change in manufacturing practice from companies with relatively homogeneous lines of products to vertically integrated companies with unprecedented diversity in processes and products. Those companies (especially in metalworking) attempted to achieve success through economies of scope - the gains of jointly producing two or more products in one facility. The managers now needed information on the effect of product mix decisions on overall profits and therefore needed accurate product cost information. A variety of attempts to achieve this were unsuccessful due to the huge overhead of the information processing of the time. However, the burgeoning need for financial reporting after 1900 created unavoidable pressure for financial accounting of stock and the management need to cost manage products became overshadowed. In particular it
was the need for audited accounts that sealed the fate of managerial cost accounting. The dominance of financial reporting accounting over management accounting remains to this day
with few exceptions and the financial reporting definitions of 'cost' have distorted effective management 'cost' accounting since that time. This is particularly true of inventory. Hence high level financial inventory has these two basic formulas which relate to the accounting period:

1. Cost of Beginning Inventory at the start of the period + inventory purchases within the period + cost of production within the period = cost of goods
   
2. Cost of goods − cost of ending inventory at the end of the period = cost of goods sold
   

The benefit of these formulae is that the first absorbs all overheads of production and raw material costs in to a value of inventory for reporting. The second formula then creates the new start point for the next period and gives a figure to be subtracted from sales price to determine some form of sales margin figure. Manufacturing management is more interested in inventory turnover ratio or average days to sell inventory since it tells them something about
relative inventory levels.
Inventory turn over ratio (also known as inventory turns) = cost of goods sold / Average Inventory = Cost of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)
and its inverse
Average Days to Sell Inventory =
Number of Days a Year / Inventory Turn Over Ratio = 365 days a year / Inventory Turn Over Ratio
This ratio estimates how many times the inventory turns over a year. This number tells us how much cash/goods are tied up waiting for the process and is a critical measure of process reliability and effectiveness. So a factory with two inventory turns has six months stock on hand which generally not a good figure (depending upon industry) whereas a factory that moves from six turns to twelve turns has probably improved effectiveness by 100%. This improvement will have some negative results in the financial reporting since the 'value' now
stored in the factory as inventory is reduced. Whilst the simplicity of these accounting measures of inventory are very useful they are in the end fraught with the danger of their own assumptions. There are in fact so many things which can vary hidden under this appearance of simplicity that a variety of 'adjusting' assumptions may be used. These include:

• Specific Identification
  
• Weighted Average Cost
  
• Moving-Average Cost
  
• FIFO and LIFO.
  

Inventory Turn is a financial accounting tools for evaluating inventory and it is not necessarily a management tool. Inventory management should be forward looking. The methodology applied is based on historical cost of goods sold. The ratio may not be able to reflect the usability of future production demand as well as customer demand. Business models including Just in Time (JIT) Inventory, Vendor Managed Inventory (VMI) and Customer Managed Inventory (CMI) attempt to minimize on-hand inventory and increase inventory turns. VMI and CMI have gained considerable attention due to the success of third party vendors who offer added expertise and knowledge that organizations may not possess.
Accounting perspectives
The basis of Inventory accounting
Inventory needs to be accounted where it is held across accounting period boundaries since generally expenses should be matched against the results of that expense within the same period. When processes were simple and short then inventories were small but with more complex processes then inventories became larger and significant valued items on the balance sheet. This need to value unsold and incomplete goods has driven many new behaviours into management practise. Perhaps most significant of these are the complexities of fixed cost recovery, transfer pricing, and the separation of direct from indirect costs. This, supposedly, precluded "anticipating income" or "declaring dividends out of capital". It is one of the intangible benefits of Lean and the TPS that process times shorten and stock levels decline to the point where the importance of this activity is hugely reduced and therefore effort, especially managerial, to achieve it can be minimised.

Accounting for Inventory
Each country has its own rules about accounting for inventory that fit with their financial reporting rules. So for example, organizations in the U.S. define inventory to suit their needs within US 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. Other countries often have similar arrangements but with their own GAAP and national agencies instead. It is intentional that financial accounting uses standards that allow the public to compare firms' performance, cost accounting functions internally to an organization and potentially 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. The internal costing/valuation of inventory can be complex. Whereas in the past most enterprises ran simple one process factories, this is quite probably in the minority in the 21st century. Where 'one process' factories exist then there is a market for the goods created which establishes an independent market value for the good. Today with multi-stage process companies there is much inventory that would once have been finished goods which is now held as 'work-in-process' (WIP). This needs to be valued in the accounts but the valuation is a management decision since there is no market for the partiallyfinished product. This somewhat arbitrary 'valuation' of WIP combined with the allocation of overheads to it has led to some unintended and undesirable results.
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 could 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, as in Thor Power Tool Company v. Commissioner. Inventory appears as a current asset on an organization's balance sheet because the organization can, in principle, 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 warehouse 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 sales commission payments, so unavailable goods may reduce their
potential personal income. This conflict can be minimised by reducing production time to being near or less than customer expected delivery time. This effort, known as "Lean production" will significantly reduce working capital tied up in inventory and reduce manufacturing costs (See the Toyota Production System).
The role of a cost accountant on the 21st-century in a manufacturing organization
By helping the organization 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 recognized in both the formal and informal reward systems of the organization. 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 organization. It should be steering the stewardship and accountability systems that ensure that the organization 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 organizations’ 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 organization 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 organization and its activities.
FIFO vs. LIFO accounting
When a dealer sells goods from inventory, the value of the inventory is reduced by the cost of goods sold (CoG sold). This is simple where the CoG has not varied across those held in stock; but where it has, then an agreed method must be derived to evaluate it. For commodity items that one cannot track individually, accountants must choose a method that
fits the nature of the sale. Two popular methods which normally exist are: FIFO and LIFO accounting (first in - first out, last in - first out). FIFO regards the first unit that arrived in inventory as 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 labour 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 trully variable costs like materials andcomponents 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.
Distressed inventory
Also known as distressed or expired stock, distressed inventory is inventory whose potential to be sold at a normal cost has or will soon pass. In certain industries it could also mean that the stock is or will soon be impossible to sell. Examples of distressed inventory include products that have reached its expiry date, or has reached a date in advance of expiry at which the planned market will no longer purchase it (e.g. 3 months left to expiry), clothing that is defective or out of fashion, and old newspapers or magazines. It also includes computer or consumer-electronic equipment that is obsolescent or discontinued and whose manufacturer is unable to support it. One current example of distressed inventory is the VHS
format.
Inventory credit
Inventory credit refers to the use of stock or, inventory, as collateral to raise finance. Where banks may be reluctant to accept traditional collateral, for example in developing countries where land title may be lacking, inventory credit is a potentially important way of overcoming financing constraints. This is not a new concept; archaeological evidence suggests that it was practiced in Ancient Rome. Obtaining finance against stocks of a wide range of products held in a bonded warehouse is common in much of the world. Inventory credit on the basis of stored agricultural produce is widely used in Latin American countries and in some Asian countries. A precondition for such credit is that banks must be confident that the stored product will be available if they need to call on the collateral; this implies the existence of a reliable network of certified warehouses. Banks also face problems in valuing the inventory. The possibility of sudden falls in commodity prices means that they are usually reluctant to lend more than about 60% of the value of the inventory at the time of the loan.

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