Inventories are goods held by an entity for sale and materials held by an entity for manufacturing goods for sale. Practically, it is usually not possible for entities to fulfill orders from customers without holding some inventory. Therefore, entities hold reasonable quantities of inventory to meet the customer demands. Inventories are presented as current assets in the balance sheet. Items of inventories that are sold are transferred to the income statement as cost of goods sold.
Most businesses, whether large or small, usually require inventory for its operations. It is considered as one of the most important assets of a business as it is related to the main operations and revenue generation of the business. Distributors and retailers have only finished goods inventory, whereas manufacturers typically have following three types of inventories:
- Raw material inventory
- Work-in-process inventory
- Finished goods inventory
Types of inventories
Let’s briefly describe all three types of inventories.
Raw material inventory
Raw materials are the basic materials used in the production of goods. Raw material inventory is processed to manufacture goods that are sold by a business. For example, clay and silica sand is used in the manufacturing of ceramic tiles. So, clay and silica sand are the raw materials for a ceramic tile manufacturing business. Similarly, Wood will be the raw material for a wooden furniture manufacturing business etc.
Raw materials are not instantly processed and converted into finished articles. It usually takes some time on the production floor. Materials in this processing phase are known as work-in-process inventory. For example, clay and silica sand transferred to the production plant of ceramic tiles is treated as work-in-process inventory. Similarly, half-finished wooden furniture which is being processed is also an example of work-in-process inventory.
Finished goods inventory
Finished goods are the end products that are ready and available for sale. Packaged ceramic tiles boxes and polished wooden furniture in the showroom are examples of finished goods inventory.
Once the finished goods are sold to the customers, cost of finished goods inventory is transferred to the income statement as cost of goods sold.
Following diagram shows the flow of costs related to inventories.
Where inventory consists of small number of large or precious items, it is possible to identify individual items of inventory and their actual costs. However, in most of the cases, it is not possible. Usually inventory consists of large number of items and keeping track of actual costs of each item is virtually impossible.
Questions arise like what should be the cost of inventory that has been sold? What amount should be taken to the income statement as cost of goods sold? For example, a retailer purchased identical dry fruits packages at $90, $95, and $100 on the first, second and third days of December 20X1, respectively. On 7th December 20X1, a customer purchased one dry fruit package. What cost should be transferred to the income statement? Whether it should be $90, $95, $100, or average cost?
One of the following inventory valuation methods can be used to answer such questions: