Whether a business provides physical goods, services or a mixture of the two it will inevitably carry some types of inventory. These usually represent a major investment by a business and therefore understanding the different types and how to recognise is important.
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What is inventory?
Inventory refers to the stocks and supplies of materials and consumables that are directly linked to the provision of goods and services by a business. A clear distinction must be drawn between operations consumables and inventory consumables. Materials such as office stationery while used in the day to day running of the business do not qualify as inventory because they are not directly linked to the provision of goods or services. This line can be blurred in a service business but is very easy to draw in a business that deals in goods.
Raw materials are the first inventory type we can distinctly identify. These are more common in a manufacturing concern because businesses of this nature take materials and value add to them to produce a finished product ready for sale. The composition of raw material inventory varies greatly in complexity with the type of manufacturing business. It is easy to understand how raw materials are very important to a business, they make the products. There’s a little.more to it than that. There is a constant consideration of the level of raw materials to keep. There costs associated with keeping raw materials both for warehousing space and management. Some businesses also have to consider the perishable nature of some raw materials and plan around that while providing suitable storage facilities such as cold storage.
Work-in-progress (WIP) inventory
Work in progress or process is the most complicated inventory type. This complexity as a result of the variety of complex processes involved in manufacturing. Let’s consider two examples to understand how complex this type of inventory can get. A business that manufactures assembles cars considers any incomplete cars to be work in progress. This is a very simple example of work in progress. Up until it is complete any unit counts towards work in progress. Now let’s consider a winemaker which has a more complicated process that involves multiple steps until the wine is matured and ready for sale. With the crushed grapes, then extracted juice and brewed wine in casks for fermenting all considered different levels of Work in process. Valuation is such circumstances is a little more complex because it is not easy to discern a value for each stage of the process. Grape juice is certainly not as valuable as brewed wine which is not as valuable as bottled wine.
Finished goods are quite simply inventory that has been completed and is sometimes ready for sale. It’s not always that simple and a little nuance exists depending on the type of business. We have to look at some of the types of finished goods inventory that exist in a business to make better sense of this nuance.
Factory firsts is a term used in manufacturing concerns to denote inventory that is up to quality control standards for sale to customers. This represents a type of inventory that can be sold to clients at full price and thus valued at full cost.
These are finished goods that do not meet the standard that goods need to be for sale from a quality management perspective. As such these are usually sold off at a discounted price, for this reason they obviously cannot be valued at the same value finished goods that meet quality standards. This type of inventory is generally sold off at a lower value but is still worth enough to at least recover costs and maybe make a little profit on top. These goods cannot be valued at full cost and must be valued at the lower of cost or net reliable value, the amount that will be received for them when sold.
Whether a manufacturer or a retailer it is possible to have finished goods inventory that is broken or otherwise damaged. This can be distinguished from factory seconds because breakages are usually not suitable for the intended product use. These are generally sold off at deep discounts for scrap. These goods must be valued at the lower of their production cost or the net reliable value, in this case their scrap value
Maintenance, repair & operations (MRO) goods
There is also a type of inventory referred to as maintenance, repair and operations goods. These are materials that are not directly used in the products at all but are rather used in the maintenance of the machinery involved in product provision. This includes both consumables and spare parts that have to be used regularly. They do not make up any part of product cost but they are classed as a type of inventory because the movement of inventory in the business is their most accurate cost driver. The more products you manufacture the more you make use of conveyor belts for example. Repairs and maintenance on conveyor belts are directly linked to the degree of wear and tear which is influenced by the rate of product movement.
An easily forgotten type of inventory are packaging materials. They are of course not directly involved in the product but are very important to the selling of the product plastic wrapping represents a low value form of packaging but there are cases where packaging materials can be very high value. Pressurised cylinders such as those used in liquid petroleum gas (LPG) are a very good example of high value packaging materials. Packaging material is a type of inventory that may be critical to the manufacturing process and must always be invested in. A process manufacturer that runs out of packaging.materials would have to stop production and this may lead to having to dispose of work in process if it cannot be maintained for long periods in a usable form.
The various inventory types are all important to a business and their reliable measurement has implications for business success and profitability.