Inventory is an asset held by an entity that is:
- held for sale in the ordinary course of business i.e. finished goods
- in the process of conversion (production) and will be available for sale once complete i.e. work in progress or work in process also known as WIP
- in the form of materials that are yet to be converted i.e. raw material
- used or consumed in producing goods or provision of services i.e. stores & supplies
1 Types of Inventory
1.1 Finished Goods
Finished goods are items that are complete i.e. production process has concluded and are ready for sale but not yet sold and still in the hands of entity.
For furniture manufacturer a chair displayed at showroom is a ready for sale item or finished good but still held by an entity as no customer has bought it yet.
An important point here is that for an inventory to be classified as finished goods, it must be in “ready for sale” state which depends on many factors. An item may be complete from the aspect of production but not necessarily a finished good. For example a chair still in the warehouse of entity is not ready for sale unless it is displayed in the showroom.
In short, for an item to be a “finished good” depends on the nature of product, norms and customs of industry as well.
1.2 Work in process
Work in process or WIP are items on which production work is not yet completed. They may still require additional material, labour or overheads to be applied.
For example a chair that is yet to be polished, carving to be done, leather cover to be stitched is a work in process and require more labour work, material and electricity or other overheads.
1.3 Raw materials
Raw materials are items that are yet to undergo production process. These are fundamental items that are converted to finished good. For example wood is a raw material for a chair. Wood is a fundamental ingredient to make chair.
1.4 Stores and spares
Stores and spares are items that are used or consumed in the production process or while providing services either to customers or internally to departments. They are usually of insignificant value as compared to other three types discussed above.
For example nails, glue, screws are items that are used in making chair.
2 Understanding Merchandising and Manufacturing Concerns
For beginners it is important to understand right from the start that its not always the case that every entity holds all of the four types of inventory. It may be confusing for students to understand if one entity holds only one type of inventory whereas some other entity holds raw material, work in process and finished goods as well.
The major reason for this difference is the nature of entity itself. Some entities buy products that are already in “ready for sale state” and thus conduct no further processing of any type. Such businesses are called merchandising concern and only hold one type of inventory.
Common retailers, general items store near your home is an example of such entities. Carrefour, Wal-Mart, Metro, Makro and similar type of chains are also examples of merchandising concerns as they hold ready for sale items. Therefore, only have one type of inventory reported in their financial statements.
On the other hand manufacturing concerns are engaged in actually producing finished goods and therefore hold different types of inventories. For example, Kellogg’s will have corn and sugar as raw material, packed boxes of different flavours as finished goods and mixtures of each product which is yet to be packed in boxes as work in process. That is why manufacturing concerns will have three classifications or accounts of inventory to be reported in financial statements as Raw material, Work in process and Finished Goods.