What Is Inventory? From Raw Materials to Finished Goods
Once upon a time, there were goods so organized, so efficient, that it laid the foundation to streamline an entire production process.
Every company that offers a product has the materials to create it. Those materials make up inventory: the building blocks of production.
What is inventory?
Inventory is a collection of materials a company uses to create its products. Taking inventory is the act of counting and listing out the materials.
Inventory is considered one of the most important assets for a company. This is because inventory is indirectly a significant revenue source. On a balance sheet, the value of inventory is labeled as a current asset until the product is distributed and moved to cost of goods sold (COGS).
Most businesses utilize inventory management software to organize their inventory. Inventory solutions help companies gather real-time inventory analytics, budget for purchasing materials, predict future needs using stock data history, and integrate automated inventory management tools.
Types of inventory
Companies will accumulate many types of inventory items for the production process. There are four main types of inventory most companies have on hand, plus a few others that are not as common, but still valuable.
1. Raw materials inventory
Raw materials are all the essential items needed to create whatever good you offer. This includes items that will eventually be part of the finished product or any materials needed along the way. There are two different types of raw materials: direct and indirect.
Direct raw materials specifically help build the final product. The cost of direct materials is easily measured and budgeted because companies can determine their direct raw material needs in conjunction with the number of products they create.
Tracking and reporting the costs of direct materials is especially important because it directly impacts the price of the final product and its market value. An example of direct raw materials is the fabric used to produce a clothing line.
Indirect raw materials are still necessary for production, but are not necessarily part of the final product. Indirect raw materials are more challenging to budget for because they aren’t necessarily on a one-to-one basis with products created.
This makes tracking and reporting costs more complicated and not as linear as direct materials. An example of indirect materials is the sewing machines used to put together the fabric in the production of a clothing line.
Some companies use materials management to streamline the way they organize their materials. Materials management controls how materials move through the supply chain and ensures all necessary materials are available to create the final product.
2. Work in progress inventory
Work in progress (WIP), or work in process, inventory is made up of items that are currently utilized in production. This inventory may include raw materials, but the difference lies in where the materials are in the production process. As soon as those raw materials are used, they’re part of a company’s WIP inventory.
An example of WIP inventory is the wood used to create a coffee table. Once the wood is cut or dyed, it’s considered a work-in-progress item.
3. Finished goods inventory
Finished goods inventory comprises all the items that make it through the entire production process and are considered finalized products. These products have been inspected and are ready to be sold.
For example, a piece of art is not truly complete until the paint is dry. Once it’s hung in a gallery with a price assigned, it’s considered a finished good.
4. Maintenance, repairing, and operating inventory
Maintenance, repairing, and operating (MRO) inventory is all of the small materials used throughout the production process that don’t end up being part of the final product. This includes anything used to fix, assemble, or organize the goods.
An example of MRO inventory is the gloves used by warehouse employees assembling the product. Another example is the computer used to count inventory items and create reports.
Other types of inventory
The following types of inventory are not used by every company, but are still beneficial to the production process.
- Safety: Items that come into production in the event of any unexpected supply and demand surges or issues.
- In-transit: Any inventory currently moving throughout the production or supply chain pipeline.
- Packing: Materials used to pack up items for shipping.
- Decoupling: Extra raw materials at every stage that are used if a phase of the process halts.
- Anticipatory: Like safety inventory, companies use these materials to prepare for future changes. However, business forecasting predicts these changes in advance.
- Excess: Inventory left over after a product’s life cycle.
Why is inventory important?
You know the saying, “you don’t know what you got until it’s gone”? When it comes to inventory, you don’t know what you got until you spend way too much time looking for it.
of retail executives claim that inventory optimization is top priority as they approach a new fiscal year.
Source: Symphony RetailAI
Inventory is the building block for company success
Inventory affects whether production and distribution will be successful before it even begins. Although it may seem somewhat indirect, inventory has a huge impact on overall company revenue.
Think about it this way: inventory = products, products = sales, sales = profits.
Faster production creates customer satisfaction
An organized inventory is efficient. The faster items are found and used in production, the faster products are made. Tracking inventory is essential for making sure the process runs smoothly.
Inaccurate inventory causes significant setbacks and delays the order fulfillment process. Allocating more time to organize inventory creates fewer opportunities for error and reduces the chances of losing or misplacing items.
The more organized the inventory system is, the faster it moves through production. Customers are happy when they get their orders on time. They’re even happier when they get their item faster than anticipated. This kind of satisfaction attracts loyal customers and positive organic publicity.
Inventory can help gain insight into future needs
Success starts at the very beginning of the production process. The outcome of your inventory offers a lot of information.
Excess inventory creates spoilage and means that demand is not prospering as usual. Insufficient inventory creates stockouts and means your company is not keeping up with supply demands. You can determine if you have excess or insufficient inventory by calculating your inventory at the end of your accounting period.
Ending inventory = beginning inventory + net purchases – cost of goods sold
You can help save time and money and prepare for customer demand more effectively by adjusting inventory levels based on your findings and forecasting inventory needs.
Organizing inventory helps cut costs
A disorganized inventory space can cause major problems in the production and distribution process. Any problem that creates setbacks and delays has a cost attached.
For example, simply misplacing inventory items will cause the production process to halt. It also means that the money spent on those lost items essentially goes down the drain. Tracking inventory effectively will help you avoid those losses.
On top of cutting costs, accurate inventory counts can help allocate existing finances more effectively. Keeping a close eye on inventory will uncover needs that aren’t being met. That information can help your company use your budget to its fullest potential.
What is inventory management?
All inventory needs are different; inventory management methods will look different for every company, too. There are four inventory management types you can use to optimize your inventory.
The four types of inventory management systems:
- Perpetual system
- Periodic system
- Barcode system
- Radiofrequency identification (RFID) system
The perpetual inventory system keeps track of inventory continuously. Inventory is updated in real time as items move through the production process. This method is favored by stakeholders, retailers, and business owners because the metrics are constantly updated. However, many labor costs incur when inventory is manually kept.
The periodic inventory system allocates specific time intervals to update inventory. Companies model these intervals after their accounting periods. Implementation of this system is straightforward because it requires little to no technology. However, similar to the perpetual system, human error is a concern.
The barcode inventory system uses barcode technology to track and update inventory. The barcodes are customized to match specific inventory categories. Items are scanned as they move through the supply chain, so inventory counts are updated almost instantly. Some companies may find implementing the barcode system tedious because every item needs a unique barcode.
The radiofrequency identification (RFID) inventory system uses tags that emit radio signals with inventory data. The tags can hold a lot of identifying information about the item, including descriptions, counts, uses, and more. The radio signals help track the amount of inventory items and their location within the space. Although it saves a lot of time, the implementation and upkeep of an RFID system is costly.
Inventory management formulas
Companies use a few formulas to calculate the best way to restock their inventory and prepare for future needs.
The economic order quantity (EOQ) formula calculates a company’s ideal quantity of materials to fulfill the necessary number of products using historical data. You can calculate your EOQ by gathering data on customer demand, setup costs, and holding costs.
Economic order quantity (EOQ):
EOQ = √(2DS ÷ H)
D = demand
S = setup costs (packing, shipping, delivery)
H = holding costs (warehousing, insurance, storage)
The reorder point formula calculates when an inventory item should be repurchased based on previous sales cycles. This formula can be applied to every SKU and relies on identifying patterns.
Reorder point = (average daily unit sales x delivery lead time) + safety stock
The days inventory outstanding (DIO) formula estimates how many days it takes for inventory to eventually turn into sales. DIO helps companies measure success in their inventory efficiency. For this formula, a lower output is favorable.
Days inventory outstanding (DIO) = (average inventory ÷ cost of goods sold) x number of days in a cycle
The safety stock formula helps companies calculate how much backup inventory they need. This formula helps companies avoid overstocking and understocking by finding a good average for emergency inventory.
Safety stock = (maximum daily usage x maximum lead time in days) – (average daily usage x average lead time in days)
Inventory organization methods
There are a few ways that companies can organize existing inventory. All of these methods help make the inventory process more efficient, although some are more favorable than others, depending on what products you sell and how you store and use materials.
- The first-in, first-out (FIFO) method suggests that the first inventory items to be acquired should be used first. This method is favorable for companies that sell perishable products.
- The last-in, first-out (LIFO) method suggests that the most recently acquired inventory items should be used first. This works for companies that sell nonperishable products and hope to disrupt their existing inventory as little as possible.
- The just in time (JIT) method prioritizes purchasing inventory materials on an as-needed basis. Companies that hope to minimize inventory costs by making purchase orders when absolutely necessary prefer this method.
- The ABC analysis method labels all inventory items into three categories from A to C, with A being the most important materials and C being the least. This helps companies prioritize which inventory items need to be reordered and when.
Inventory vs. stock
Inventory and stock are often used interchangeably, but hold different meanings depending on the context. They differ in their use cases, value, and costs.
Inventory includes all the finished goods created by a company plus the materials and components needed to develop the products. Inventory is noted on a company’s balance sheet as an asset. The cost of purchased materials calculates the valuation of inventory.
Stock refers to the number of finished goods that have reached point of sale (POS) and are ready for distribution. Stock is noted in overall business profit records as it contributes to final revenue. Inventory helps determine the final cost of stock by tracking the average cost incurred while creating it. The market selling price determines its value.
Essentially, stock is always inventory, but inventory is not always stock. This is because stock levels can refer to products held by a company that are ready to sell, therefore it falls under the inventory umbrella. On the other hand, inventory is used in production and unavailable to sell directly to customers, so it’s not stock.
Inventory vs. assets
Assets and inventory are also often confused. Companies eventually sell inventory to create a profit, while assets help them use and manage inventory.
For example, inventory is the materials needed to create a product, and assets are the equipment used in production as well as the property where it takes place. In many cases, companies report their inventory as a current asset.
Inventory best practices
There are a few things to keep in mind as you build and optimize your inventory. These best practices outline ways to level up your inventory process, ensuring smooth production for you and a positive experience for your customers.
- Establish inventory KPIs. Creating key performance indicators (KPIs) can help you identify opportunities for improvement in your inventory process. These KPIs can evaluate where the company’s pain points lie and what areas are operating successfully. KPIs should be updated periodically to offer new production goals.
- Always carry safety stock. Safety stock is best for companies that hold nonperishable inventory and are willing to budget for extra materials. While this is not favorable for small businesses that only want to purchase the exact materials needed to create a specific number of products, safety stock is highly recommended. Safety stock creates a cushion to protect your production process if something goes wrong. That “something” applies to materials that go missing, are damaged, or are wrongfully accounted for.
- Prioritize quality control. Many companies know that the most important aspect of production is guaranteeing that the quality of the final product. Making sure that everything meets your standards starts with inventory. This includes ensuring that all purchased materials are kept in good condition as they move through production and distribution.
- Prepare ahead of time. When in doubt, plan it out. Create predictions for future inventory needs by anticipating customer demand. Demand planning uses historical data so companies can predict what future demand may look like and plan accordingly.
- Use inventory automation. Inventory solutions help companies keep a close eye on their inventory, without having to manually track everything. For example, inventory control software integrates with barcode or RFID inventory management systems to collect inventory data, track items as they move through production, and create forecasts for future inventory needs.
Your inventory story starts here
Perfecting the way you hold inventory doesn’t need to be a fairytale.
Inventory tells the story of your product from the very beginning to the very end. Raw materials start building, WIP materials keep the ball rolling, maintenance items offer support, and finished goods complete the narrative. However you choose to hold and manage your inventory, I hope you find your happily ever after.
Ready to continue your journey? Find out how a detailed inventory report can improve how you replenish stock, address issues, service your customers, and more.