Inventory is used for the term which means the goods that are up for sale. These inventories also consist of the raw materials which are used to produce these goods and then make them available for sale. Inventory represents the most important assets of a business as the turnover of the inventory is one of the primary sources of revenue generation which helps in subsequent earnings for the company’s shareholders. We will know in detail about the inventory concept in the next few sections.
Inventory valuation means the monetary amount which is linked with the goods in the inventory at the end of an accounting period. The valuation is based on the costs that are incurred to acquire the inventory and get it ready for its sale.
Inventories are considered as the largest current business assets. Inventory valuation allows the owner to evaluate the Cost of Goods Sold (COGS) then eventually the profitability scope. For this, the most widely used methods for valuation are FIFO which is the first-in, first-out method, LIFO meaning the last-in, first-out method and WAC which means weighted average cost. Inventory valuation is computed at the end of each financial year to calculate the cost of goods sold and then to calculate the cost of the unsold inventory.
Meaning and Classification of Inventory
Inventory is said to be the life blood of the industries. An excess or shortage of inventory is quite harmful. Inventories are the most important component of the working capital.
The term ‘inventory’ is the stock on hand at a particular time which comprises the raw materials, goods in the process of manufacture and the finished goods. An inventory has got a primary significance for accounting purposes to ascertain the more or less exact income for a particular period. Inventory also plays a very important part in determining the profit of a business.
The inventories are to be classified into the following:
1. Raw Materials Inventory:
This consists of basic materials that have not yet been still engaged to production in a manufacturing firm. Raw materials which are purchased from the firms are then used in the firm’s production and then utilised in its operations.
2. Stores and Spares:
Stores and Spares includes those products which are the accessories or part to/of the main products that are being produced for the purpose of sale. Examples of this type are bolts, nuts, clamps, screws.
3. Works in Process Inventory:
This includes those materials that have already been committed to the production process but have not yet been completed. The more complex and lengthier the production process, the larger will be the investment in work in process inventory will be needed.
4. Finished Goods Inventory:
These are completed products which are waiting for sale.
Calculation of Inventory Days are required to be done, for this the formula used for the calculation of the inventory is:
Inventory Days = 365/Inventory Turnover
This formula is used to calculate the days in inventory, the number of days in the period which is divided by the inventory turnover ratio. This formula is used to determine how quickly a company can convert their inventory into the sales. A slower turnaround on sales may be a warning sign for the company that there are problems internally or externally.
Inventory Accounting is the body of accounting which deals with valuing and accounting for the changes in the assets which are inventoried. A company's inventory generally involves the goods in three stages of production:
first is the raw goods.
second is the in-progress goods.
third is the finished goods which are ready for sale.
FAQs on Inventories
1. What Do You Mean by COGS?
Ans. Cost of goods sold is the full form of COGS, this refers to the direct costs of producing the goods that are sold by a company. This amount includes the cost of the materials and the cost of labour directly which are used to create the good. Cost of goods sold is also known as cost of sales.
To determine the cost of goods sold during an accounting period, the COGS formula:
COGS = Opening Inventory + Purchases – Closing Inventory.
Gross Income = Gross Revenue – COGS.
Net Income = Revenue – COGS – Expenses.
2. What is the LIFO and FIFO Method?
Ans. LIFO is the abbreviation of Last in First Out and FIFO is the abbreviation of First in First Out.
FIFO which is the first in, first out is the inventory management that seeks to sell the older products first so that the business is less likely to lose the money when the products will expire or become obsolete in the future. LIFO is the last in, first out, here the inventory management applies to all the non-perishable goods and uses the current prices to calculate the cost of goods sold or the COGS.
3. What is WAC?
Ans. In accounting, the Weighted Average Cost or the WAC method of inventory valuation uses a weighted average to determine the amount that goes into the COGS. The weighted average cost method divides the cost of goods that are available for sale by the number of units which are available for sale.