A business should keep a close watch on both accounts payable and inventory. Inventory can tie up money. If a business is investing too much money in inventory that is not turning over, the lack of sales revenue can put the business in the position of not being able to pay its accounts payable to its supplier according to the agreed terms which could result in the loss of a supplier or a poor credit rating.
Inventory is the term for the goods available for sale and raw materials used to produce goods available for sale. Inventory represents one of the most important assets of a business because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company’s shareholders.
Inventory is the array of finished goods or goods used in production held by a company. Inventory is classified as a current asset on a company’s balance sheet, and it serves as a buffer between manufacturing and order fulfillment. When an inventory item is sold, its carrying cost transfers to the cost of goods sold (COGS) category on the income statement.
Organizations with inventory items of small unit cost generally update their inventory records at the end of an accounting period or when financial statements are prepared (called periodic inventory method). The value of an inventory depends on the valuation method used, such as first-in, first-out (FIFO) method or last-in, first-out (LIFO) method. GAAP require that inventory should be valued on the basis of either its cost price or its current market price whichever is lower of the two to prevent overstating of assets and earning due to sharp increase in the inventory’s value in inflationary periods. The optimum level of inventory for an organization is determined by inventory analysis. Called also stock in trade, or just stock.
Importance of Inventory Management
Possessing a high amount of inventory for a long time is usually not advantageous for a business because of storage costs, spoilage costs, and the threat of obsolescence. However, possessing too little inventory also has its disadvantages; for example, the business runs the risk of market share erosion and losing profit from potential sales. Inventory management forecasts and strategies, such as a just-in-time (JIT) inventory system, can help minimize inventory costs because goods are created or received only when needed.
Generally, inventory types can be grouped into four classifications: raw material, work-in-process, finished goods, and MRO goods.
- RAW MATERIALS
Raw materials are inventory items that are used in the manufacturer’s conversion process to produce components, subassemblies, or finished products. These inventory items may be commodities or extracted materials that the firm or its subsidiary has produced or extracted. They also may be objects or elements that the firm has purchased from outside the organization. Even if the item is partially assembled or is considered a finished good to the supplier, the purchaser may classify it as a raw material if his or her firm had no input into its production. Typically, raw materials are commodities such as ore, grain, minerals, petroleum, chemicals, paper, wood, paint, steel, and food items. However, items such as nuts and bolts, ball bearings, key stock, casters, seats, wheels, and even engines may be regarded as raw materials if they are purchased from outside the firm.
The bill-of-materials file in a material requirements planning system (MRP) or a manufacturing resource planning (MRP II) system utilizes a tool known as a product structure tree to clarify the relationship among its inventory items and provide a basis for filling out, or “exploding,” the master production schedule. Consider an example of a rolling cart. This cart consists of a top that is pressed from a sheet of steel, a frame formed from four steel bars, and a leg assembly consisting of four legs, rolled from sheet steel, each with a caster attached.
Generally, raw materials are used in the manufacture of components. These components are then incorporated into the final product or become part of a subassembly. Subassemblies are then used to manufacture or assemble the final product. A part that goes into making another part is known as a component, while the part it goes into is known as its parent. Any item that does not have a component is regarded as a raw material or purchased item. From the product structure tree it is apparent that the rolling cart’s raw materials are steel, bars, wheels, ball bearings, axles, and caster frames.
Work-in-process (WIP) is made up of all the materials, parts (components), assemblies, and subassemblies that are being processed or are waiting to be processed within the system. This generally includes all material—from raw material that has been released for initial processing up to material that has been completely processed and is awaiting final inspection and acceptance before inclusion in finished goods.
Any item that has a parent but is not a raw material is considered to be work-in-process. A glance at the rolling cart product structure tree example reveals that work-in-process in this situation consists of tops, leg assemblies, frames, legs, and casters. Actually, the leg assembly and casters are labeled as subassemblies because the leg assembly consists of legs and casters and the casters are assembled from wheels, ball bearings, axles, and caster frames.
- FINISHED GOODS
A finished good is a completed part that is ready for a customer order. Therefore, finished goods inventory is the stock of completed products. These goods have been inspected and have passed final inspection requirements so that they can be transferred out of work-in-process and into finished goods inventory. From this point, finished goods can be sold directly to their final user, sold to retailers, sold to wholesalers, sent to distribution centers, or held in anticipation of a customer order.
Any item that does not have a parent can be classified as a finished good. By looking at the rolling cart product structure tree example one can determine that the finished good in this case is a cart.
Inventories can be further classified according to the purpose they serve. These types include transit inventory, buffer inventory, anticipation inventory, decoupling inventory, cycle inventory, and MRO goods inventory. Some of these also are know by other names, such as speculative inventory, safety inventory, and seasonal inventory.
- MRO GOODS INVENTORY
Maintenance, repair, and operating supplies, or MRO goods, are items that are used to support and maintain the production process and its infrastructure. These goods are usually consumed as a result of the production process but are not directly a part of the finished product. Examples of MRO goods include oils, lubricants, coolants, janitorial supplies, uniforms, gloves, packing material, tools, nuts, bolts, screws, shim stock, and key stock. Even office supplies such as staples, pens and pencils, copier paper, and toner are considered part of MRO goods inventory.
When you’re managing a growing company, you have to watch expenses carefully. Don’t be lulled into complacency by seeing sales increase. Any time and any place you see expenses growing faster than sales, examine your costs carefully to find places to cut or control them. Here are some more tips for using cash wisely:
- Take full advantage of creditor payment terms. If a payment is due in 30 days, don’t pay it in 15 days.
- Use electronic funds transfer to make payments on the last day they are due. You will remain current with suppliers while retaining use of your funds as long as possible.
- Communicate with your suppliers so they know your financial situation. If you ever need to delay a payment, you will need their trust and understanding.
- Carefully consider vendors’ offers of discounts for earlier payments. These can amount to expensive loans to your suppliers, or they may provide you with a chance to reduce overall costs. The devil is in the details.
- Do not always focus on the lowest price when choosing suppliers. Sometimes more flexible payment terms can improve your cash flow more than a bargain-basement price.