Inventory
Encyclopedia
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate
, or the contents of a house let furnished. This remains the prime meaning in British English. In the USA and Canada the term has developed from a list of goods
and materials to the goods and materials themselves, especially those held available in stock by a business
; and this has become the primary meaning of the term in North American English, equivalent to the term "stock" in British English. In accounting, inventory or stock is considered an asset
.
The scope of inventory management concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.
Inventory management involves a retailer seeking to acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and related costs are kept in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status and handles all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. Also may include ABC analysis
, lot tracking, cycle counting support etc. Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution function to balance the need for product availability against the need for minimizing stock holding and handling costs.
All these stock reasons can apply to any owner or product
s often discuss inventory in terms of goods for sale, organizations - manufacturers, service-provider
s and not-for-profits - also have inventories (fixtures, furniture, supplies, ...) that they do not intend to sell. Manufacturers', distributor
s', and wholesalers' inventory tends to cluster in warehouse
s. 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 client
s 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.
While the reasons for holding stock were covered earlier, most manufacturing organizations usually divide their "goods for sale" inventory into:
For example:
Examples of case studies are very revealing, and consistently show that the improvement of inventory management has two parts: the capability of the organisation to manage inventory, and the way in which it chooses to do so. For example, a company may wish to install a complex inventory system, but unless there is a good understanding of the role of inventory and its parameters, and an effective business process to support that, the system cannot bring the necessary benefits to the organisation in isolation.
Typical Inventory Management techniques include Pareto Curve ABC Classification and Economic Order Quantity Management. A more sophisticated method takes these two techniques further, combining certain aspects of each to create The K Curve Methodology. A case study of k-curve benefits to one company shows a successful implementation.
Unnecessary inventory 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. Too big an inventory reduction too quickly can cause a business to be anorexic. There are well-proven processes and techniques to assist in inventory planning and strategy, both at the business overview and part number level. Many of the big MRP/and ERP systems do not offer the necessary inventory planning tools within their integrated planning applications.
The secondary goal of inventory proportionality is inventory minimization. By integrating accurate demand forecasting
with inventory management, replenishment inventories can be scheduled to arrive just in time to replenish the product destined to run out first, while at the same time balancing out the inventory supply of all products to make their inventories more proportional, and thereby closer to achieving the primary goal. Accurate demand forecasting also allows the desired inventory proportions to be dynamic by determining expected sales out into the future; this allows for inventory to be in proportion to expected short-term sales or consumption rather than to past averages, a much more accurate and optimal outcome.
Integrating demand forecasting into inventory management in this way also allows for the prediction of the "can fit" point when inventory storage is limited on a per-product basis.
One early example of inventory proportionality used in a retail application in the United States is for motor fuel. Motor fuel (e.g. gasoline) is generally stored in underground storage tanks. The motorists do not know whether they are buying gasoline off the top or bottom of the tank, nor need they care. Additionally, these storage tanks have a maximum capacity and cannot be overfilled. Finally, the product is expensive. Inventory proportionality is used to balance the inventories of the different grades of motor fuel, each stored in dedicated tanks, in proportion to the sales of each grade. Excess inventory is not seen or valued by the consumer, so it is simply cash sunk (literally) into the ground. Inventory proportionality minimizes the amount of excess inventory carried in underground storage tanks. This application for motor fuel was first developed and implemented by Petrolsoft Corporation
in 1990 for Chevron
Products Company. Most major oil companies use such systems today.
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:
The benefit of these formulae is that the first absorbs all overheads of production and raw material costs into 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 the 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.
and its inverse
This ratio estimates how many times the inventory turns over a year. This number tells 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 is generally not a good figure (depending upon the 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.
While these accounting measures of inventory are very useful because of their simplicity, they are also fraught with the danger of their own assumptions. There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of 'adjusting' assumptions may be used. These include:
Inventory Turn is a financial accounting tool 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.
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, such enterprises are quite probably in the minority in the 21st century. Where 'one process' factories exist, there is a market for the goods created, which establishes an independent market value for the good. Today, with multistage-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 partially finished product. This somewhat arbitrary 'valuation' of WIP combined with the allocation of overheads to it has led to some unintended and undesirable results.
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 from fire and other disasters, obsolescence, shrinkage (theft and errors), and others. Such holding cost
s 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. Salespeople, 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 customers' 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
).
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 do we have 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.
(COGS). 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 that 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.
s 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 manager's 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.
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 truly variable costs, like materials and components, which 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.
and the analysis of the business cycle
. Some short-term macroeconomic fluctuations are attributed to the inventory cycle.
has passed 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 their expiry date
, or have reached a date in advance of expiry at which the planned market will no longer purchase them (e.g. 3 months left to expiry), clothing that is defective or out of fashion
, music that is no longer popular and old newspapers or magazines. It also includes computer or consumer-electronic equipment that is obsolete or discontinued and whose manufacturer is unable to support it. One current example of distressed inventory is the VHS
format.
In 2001, Cisco wrote off inventory worth US $2.25 billion due to duplicate orders. This is one of the biggest inventory write-offs in business history.
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. It is, for example, used with Parmesan cheese in Italy. 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.
Will (law)
A will or testament is a legal declaration by which a person, the testator, names one or more persons to manage his/her estate and provides for the transfer of his/her property at death...
, or the contents of a house let furnished. This remains the prime meaning in British English. In the USA and Canada the term has developed from a list of goods
Good (economics and accounting)
In economics, a good is something that is intended to satisfy some wants or needs of a consumer and thus has economic utility. It is normally used in the plural form—goods—to denote tangible commodities such as products and materials....
and materials to the goods and materials themselves, especially those held available in stock by a business
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
; and this has become the primary meaning of the term in North American English, equivalent to the term "stock" in British English. In accounting, inventory or stock is considered an asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
.
Inventory Management
Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to proceed the regular and planned course of production and stock of materials.The scope of inventory management concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.
Inventory management involves a retailer seeking to acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and related costs are kept in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status and handles all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. Also may include ABC analysis
ABC analysis
The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control...
, lot tracking, cycle counting support etc. Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution function to balance the need for product availability against the need for minimizing stock holding and handling costs.
The reasons for keeping stock
There are three basic reasons for keeping an inventory:- Time - The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amounts of inventory to use in this "lead time." However, in practice, inventory is to be maintained for consumption during 'variations in lead time'. Lead time itself can be addressed by ordering that many days in advance.
- Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods.
- Economies of scale - Ideal condition of "one unit at a time at a place where a 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
Special terms used in dealing with inventory
- Stock Keeping UnitStock Keeping Unit→A stock-keeping unit or SKU is a number or code used to identify each unique product or item for sale in a store or other business.It is a unique identifier for each distinct product and service that can be purchased...
(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 stockNew old stockNew old stock refers to obsolete equipment, or original parts for obsolete equipment, that have never been sold at retail.The term refers to merchandise being offered for sale which was manufactured long ago but that has never been used...
" (sometimes abbreviated NOS) is a term used in business to refer to merchandise being offered for sale that was manufactured long ago but that has never been used. Such merchandise may not be produced anymore, and the new old stock may represent the only market source of a particular item at the present time.
Typology
- Buffer/safety stock
- Cycle stock (Used in batch processes, it is the available inventory, excluding buffer stock)
- De-coupling (Buffer stock held between the machines in a single process which serves as a buffer for the next one allowing smooth flow of work instead of waiting the previous or next machine in the same process)
- Anticipation stock (Building up extra stock for periods of increased demand - e.g. ice cream for summer)
- 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 accountantAccountant
An accountant is a practitioner of accountancy or accounting , which is the measurement, disclosure or provision of assurance about financial information that helps managers, investors, tax authorities and others make decisions about allocating resources.The Big Four auditors are the largest...
s often discuss inventory in terms of goods for sale, organizations - manufacturers, service-provider
Service provider
A service provider is an entity that provides services to other entities. Usually, this refers to a business that provides subscription or web service to other businesses or individuals. Examples of these services include Internet access, Mobile phone operators, and web application hosting...
s and not-for-profits - also have inventories (fixtures, furniture, supplies, ...) that they do not intend to sell. Manufacturers', distributor
Distribution (business)
Product distribution is one of the four elements of the marketing mix. An organization or set of organizations involved in the process of making a product or service available for use or consumption by a consumer or business user.The other three parts of the marketing mix are product, pricing,...
s', and wholesalers' inventory tends to cluster in warehouse
Warehouse
A warehouse is a commercial building for storage of goods. Warehouses are used by manufacturers, importers, exporters, wholesalers, transport businesses, customs, etc. They are usually large plain buildings in industrial areas of cities and towns. They usually have loading docks to load and unload...
s. 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 client
Consumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...
s 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.
While the reasons for holding stock were 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 processWork in processWork in process or in-process inventory includes the set at large of unfinished items for products in a production process. These items are not yet completed but either just being fabricated or waiting in a queue for further processing or in a buffer storage...
, 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.
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 labeled 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 labeled 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.Examples of case studies are very revealing, and consistently show that the improvement of inventory management has two parts: the capability of the organisation to manage inventory, and the way in which it chooses to do so. For example, a company may wish to install a complex inventory system, but unless there is a good understanding of the role of inventory and its parameters, and an effective business process to support that, the system cannot bring the necessary benefits to the organisation in isolation.
Typical Inventory Management techniques include Pareto Curve ABC Classification and Economic Order Quantity Management. A more sophisticated method takes these two techniques further, combining certain aspects of each to create The K Curve Methodology. A case study of k-curve benefits to one company shows a successful implementation.
Unnecessary inventory 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. Too big an inventory reduction too quickly can cause a business to be anorexic. There are well-proven processes and techniques to assist in inventory planning and strategy, both at the business overview and part number level. Many of the big MRP/and ERP systems do not offer the necessary inventory planning tools within their integrated planning applications.
Purpose
Inventory proportionality is the goal of demand-driven inventory management. The primary optimal outcome is to have the same number of days' (or hours', etc.) worth of inventory on hand across all products so that the time of runout of all products would be simultaneous. In such a case, there is no "excess inventory," that is, inventory that would be left over of another product when the first product runs out. Excess inventory is sub-optimal because the money spent to obtain it could have been utilized better elsewhere, i.e. to the product that just ran out.The secondary goal of inventory proportionality is inventory minimization. By integrating accurate demand forecasting
Demand forecasting
Demand forecasting is the activity of estimating the quantity of a product or service that consumers will purchase. Demand forecasting involves techniques including both informal methods, such as educated guesses, and quantitative methods, such as the use of historical sales data or current data...
with inventory management, replenishment inventories can be scheduled to arrive just in time to replenish the product destined to run out first, while at the same time balancing out the inventory supply of all products to make their inventories more proportional, and thereby closer to achieving the primary goal. Accurate demand forecasting also allows the desired inventory proportions to be dynamic by determining expected sales out into the future; this allows for inventory to be in proportion to expected short-term sales or consumption rather than to past averages, a much more accurate and optimal outcome.
Integrating demand forecasting into inventory management in this way also allows for the prediction of the "can fit" point when inventory storage is limited on a per-product basis.
Applications
The technique of inventory proportionality is most appropriate for inventories that remain unseen by the consumer. As opposed to "keep full" systems where a retail consumer would like to see full shelves of the product they are buying so as not to think they are buying something old, unwanted or stale; and differentiated from the "trigger point" systems where product is reordered when it hits a certain level; inventory proportionality is used effectively by just-in-time manufacturing processes and retail applications where the product is hidden from view.One early example of inventory proportionality used in a retail application in the United States is for motor fuel. Motor fuel (e.g. gasoline) is generally stored in underground storage tanks. The motorists do not know whether they are buying gasoline off the top or bottom of the tank, nor need they care. Additionally, these storage tanks have a maximum capacity and cannot be overfilled. Finally, the product is expensive. Inventory proportionality is used to balance the inventories of the different grades of motor fuel, each stored in dedicated tanks, in proportion to the sales of each grade. Excess inventory is not seen or valued by the consumer, so it is simply cash sunk (literally) into the ground. Inventory proportionality minimizes the amount of excess inventory carried in underground storage tanks. This application for motor fuel was first developed and implemented by Petrolsoft Corporation
Petrolsoft Corporation
Petrolsoft Corporation was a supply chain management software company with a focus on the petroleum industry.Petrolsoft Corporation was founded at Stanford University in 1989 by Bill Miller and David Gamboa as Petrolsoft Software Group. It was later incorporated in 1992...
in 1990 for Chevron
Chevron Corporation
Chevron Corporation is an American multinational energy corporation headquartered in San Ramon, California, United States and active in more than 180 countries. It is engaged in every aspect of the oil, gas, and geothermal energy industries, including exploration and production; refining,...
Products Company. Most major oil companies use such systems today.
Roots
The use of inventory proportionality in the United States is thought to have been inspired by Japanese just-in-time parts inventory management made famous by Toyota Motors in the 1980s.http://www.bsu.edu/web/scfrazier2/jit/mainpage.htmHigh-level inventory management
It seems that around 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 accountingManagement accounting
Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control...
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:
- Cost of Beginning Inventory at the start of the period + inventory purchases within the period + cost of productionProduction, costs, and pricingThe following outline is provided as an overview of and topical guide to industrial organization:Industrial organization – describes the behavior of firms in the marketplace with regard to production, pricing, employment and other decisions...
within the period = cost of goods available - Cost of goods available − cost of ending inventoryEnding InventoryEnding inventory is the amount of inventory a company have in stock at the end of this fiscal year. It is closely related with ending inventory cost, which is the amount of money spent to get these goods in stock. It should be calculated at the lower of cost or market.-References:1...
at the end of the period = cost of goods soldCost of goods soldCost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
The benefit of these formulae is that the first absorbs all overheads of production and raw material costs into 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 the 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 turnover 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 Turnover Ratio = 365 days a year / Inventory Turnover Ratio
This ratio estimates how many times the inventory turns over a year. This number tells 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 is generally not a good figure (depending upon the 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.
While these accounting measures of inventory are very useful because of their simplicity, they are also fraught with the danger of their own assumptions. There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of 'adjusting' assumptions may be used. These include:
- Specific IdentificationSpecific IdentificationSpecific identification is a method of finding out ending inventory cost.It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year end inventory...
- Weighted Average Cost
- Moving-Average Cost
- FIFO and LIFOFIFO and LIFO accountingFIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks....
.
Inventory Turn is a financial accounting tool 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 for inventory
Each country has its own rules about accounting for inventory that fit with their financial-reporting rules.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
Financial Accounting Standards Board
The Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest...
(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
Cost accounting
Cost accounting information is designed for managers. Since managers are taking decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations...
functions internally to an organization and potentially with much greater flexibility. A discussion of inventory from standard and Theory of Constraints
Theory of Constraints
The theory of constraints adopts the common idiom "A chain is no stronger than its weakest link" as a new management paradigm. This means that processes, organizations, etc., are vulnerable because the weakest person or part can always damage or break them or at least adversely affect the...
-based (throughput
Throughput
In communication networks, such as Ethernet or packet radio, throughput or network throughput is the average rate of successful message delivery over a communication channel. This data may be delivered over a physical or logical link, or pass through a certain network node...
) cost accounting
Cost accounting
Cost accounting information is designed for managers. Since managers are taking decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations...
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, such enterprises are quite probably in the minority in the 21st century. Where 'one process' factories exist, there is a market for the goods created, which establishes an independent market value for the good. Today, with multistage-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 partially finished 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 assetAsset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
on the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
, 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
Thor Power Tool Company v. Commissioner
In Thor Power Tool Company v. Commissioner, 439 U.S. 522 the United States Supreme Court upheld IRS regulations limiting how taxpayers could write down inventory...
.
Inventory appears as a current asset
Current asset
In accounting, a current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months...
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
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
to cover staff to handle and protect it from fire and other disasters, obsolescence, shrinkage (theft and errors), and others. Such holding cost
Holding cost
In business management, holding cost is money spent to keep and maintain a stock of goods in storage.The most obvious holding costs include rent for the required space; equipment, materials, and labor to operate the space; insurance; security; interest on money invested in the inventory and space,...
s 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
Sales
A sale is the act of selling a product or service in return for money or other compensation. It is an act of completion of a commercial activity....
and marketing
Marketing
Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...
departments. Salespeople, 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 customers' expected delivery time. This effort, known as "Lean production" will significantly reduce working capital
Working capital
Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...
tied up in inventory and reduce manufacturing costs (See the Toyota Production System
Toyota Production System
The Toyota Production System is an integrated socio-technical system, developed by Toyota, that comprises its management philosophy and practices. The TPS organizes manufacturing and logistics for the automobile manufacturer, including interaction with suppliers and customers...
).
Role of inventory accounting
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 do we have 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 merchant buys goods from inventory, the value of the inventory account is reduced by the cost of goods soldCost of goods sold
Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
(COGS). 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
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
items that one cannot track individually, accountants must choose a method that fits the nature of the sale. Two popular methods that normally exist are: FIFO and LIFO accounting
FIFO and LIFO accounting
FIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks....
(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
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's 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 ratioRatio
In mathematics, a ratio is a relationship between two numbers of the same kind , usually expressed as "a to b" or a:b, sometimes expressed arithmetically as a dimensionless quotient of the two which explicitly indicates how many times the first number contains the second In mathematics, a ratio is...
s called efficiencies
Efficiency (economics)
In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system is said to be more efficient than another if it can provide more goods and services for society without using more resources...
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 manager's performance evaluation
Performance Evaluation
Performance Evaluation is an international journal published by Elsevier. The current Editor-in-chief is Philippe Nain. The journal was previously published by North-Holland Publisher.-Editors:*1981–1986 Hisashi Kobayashi*1987–1990 Martin Reiser...
. 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. GoldrattEliyahu M. Goldratt
Eliyahu Moshe Goldratt was an Israeli physicist who became a business management guru. He was the originator of the Optimized Production Technology, the Theory of Constraints , the Thinking Processes, Drum-Buffer-Rope, Critical Chain Project Management and other TOC derived tools.He authored...
developed the Theory of Constraints
Theory of Constraints
The theory of constraints adopts the common idiom "A chain is no stronger than its weakest link" as a new management paradigm. This means that processes, organizations, etc., are vulnerable because the weakest person or part can always damage or break them or at least adversely affect the...
in part to address the cost-accounting problems in what he calls the "cost world." He offers a substitute, called throughput accounting
Throughput accounting
Throughput Accounting is a principle-based and comprehensive management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting...
, that uses throughput
Throughput (business)
Throughput is the movement of inputs and outputs through a production process. Without access and assurance of a supply of inputs, a successful business enterprise would not be possible....
(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 truly variable costs, like materials and components, which vary directly with the quantity produced
Finished goods inventories remain balance-sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
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 accountsNational accounts
National accounts or national account systems are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry accounting...
and the analysis of the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
. 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 costCost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
has passed 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 their expiry date
Expiration date
Expiration date can refer to:*The shelf life of a grocery item*Expiration *Copyright expiration*Expiration Date , a 2006 comedy* Expiration Date, a novel by Tim Powers...
, or have reached a date in advance of expiry at which the planned market will no longer purchase them (e.g. 3 months left to expiry), clothing that is defective or out of fashion
Fashion
Fashion, a general term for a currently popular style or practice, especially in clothing, foot wear, or accessories. Fashion references to anything that is the current trend in look and dress up of a person...
, music that is no longer popular and old newspapers or magazines. It also includes computer or consumer-electronic equipment that is obsolete or discontinued and whose manufacturer is unable to support it. One current example of distressed inventory is the VHS
VHS
The Video Home System is a consumer-level analog recording videocassette standard developed by Victor Company of Japan ....
format.
In 2001, Cisco wrote off inventory worth US $2.25 billion due to duplicate orders. This is one of the biggest inventory write-offs in business history.
Inventory credit
Inventory credit refers to the use of stock, or inventory, as collateralCollateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
to raise finance. Where banks may be reluctant to accept traditional collateral, for example in developing countries where land title
Land registration
Land registration generally describes systems by which matters concerning ownership, possession or other rights in land can be recorded to provide evidence of title, facilitate transactions and to prevent unlawful disposal...
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
Bonded warehouse
A Bonded warehouse is a building or other secured area in which dutiable goods may be stored, manipulated, or undergo manufacturing operations without payment of duty. It may be managed by the state or by private enterprise. In the latter case a customs bond must be posted with the government...
is common in much of the world. It is, for example, used with Parmesan cheese in Italy. 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.
See also
- Cash conversion cycleCash conversion cycleIn management accounting, the Cash Conversion Cycle measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth...
- Consignment stockConsignment StockConsignment stock is stock legally owned by one party, but held by another.- Ownership :Ownership of consignment stock is passed only when the stock is used . Unused stock in a warehouse may be returned to the supplier.- Accounting :...
- Cost of goods soldCost of goods soldCost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
- Economic order quantityEconomic order quantityEconomic order quantity is the level of inventory that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was...
- Inventory investmentInventory investmentInventory investment is a component of gross domestic product . What is produced in a certain country is naturally also sold eventually, but some of the goods produced in a given year may be sold in a later year rather than in the year they were produced. Conversely, some of the goods sold in a...
- Inventory management softwareInventory management softwareInventory management software is a computer-based system for tracking product levels, orders, sales and deliveries. It can also be used in the manufacturing industry to create a work order, bill of materials and other production-related documents. Companies use inventory management software to...
- Operations researchOperations researchOperations research is an interdisciplinary mathematical science that focuses on the effective use of technology by organizations...
- Pinch point (economics)
- Service levelService levelService level measures the performance of a system. Certain goals are defined and the service level gives the percentage to which they should be achieved...
- Spare partSpare partSpare Parts may also refer to:* Spare Parts , by Status Quo* Spare Parts is a Doctor Who audio drama.* Spare Parts , by Servotron* "Spare Parts" , by Bruce Springsteen* "Spare Parts"...
- Stock managementStock managementStock management is the function of understanding the stock mix of a company and the different demands on that stock. The demands are influenced by both external and internal factors and are balanced by the creation of Purchase order requests to keep supplies at a reasonable or prescribed...
Further reading
- The First Steps to Inventory Management
- Professional Inventory Management
- Tempelmeier, Horst, Inventory Management in Supply Networks, 3rd Edition, Norderstedt (Books on Demand) 2011
- Extending the Pareto Principle to MRP Controlled Parts and Regaining MRP Control
- Scientific methods in inventory management
- Business Inventories monthly report
- http://sourceforge.net/projects/stockmanagement/
- A very basic guide to setting up an inventory system.
- Cannella S., Ciancimino E. (2010) Up-to-date Supply Chain Management: the Coordinated (S,R). In "Advanced Manufacturing and Sustainable Logistics". Dangelmaier W. et al. (Eds.) 175-185. Springer-Verlag Berlin Heidelberg, Germany.