Accounting for Inventory

Introduction

Inventory is one of the most visible and tangible aspects of doing business. Raw material, Goods in process or Work-in-Process and Finished goods all represents various forms of inventory. Each type represents money tied up until the inventory leaves the company as purchased products. Likewise, merchandise stocks in a wholesale or retail store contribute to profits only when their sale puts money into the cash register.

In literate sense, inventory refers to stock of anything necessary to do business. These stocks represents a large portion of the business investment and must be well managed in order to maximize profits.

Meaning and Nature of Inventory

Every business organization needs inventory for smooth running of its activities. It serves as link between production and distribution processes. Inventory is the quantity of goods held by a merchandising company for resale to customers. Merchandising companies determine the quantity of investment items by a physical counts. 

The investment in inventories contributes the most significant part of current assets or working capital. It is largest and most important assets owned by a businesses organization. 

Inventory management is the system that helps to sourcing, storing and dispatching the inventory from suppliers to end consumers. It is the critical task of the business that can affect the entire supply chain of the company.

Classification of Inventory 

Inventories are all those goods and materials that are sold or used in production whereas Stocks are the finished goods that are sold to its customers. Basically, the inventories are categorized into three parts described as bellows:

1. Raw Material: Raw materials form a major input into manufacturer organization. It is required to carry put production activities but have not yet been placed into production 

2. Work-in-Progress (WIP): The stage of inventory which is in between raw material and finished goods is work in progress or semi-finished goods. It is that portion of manufactured inventory that has began the production process but is not yet complete.

3. Finished Goods: The inventory which is completed the production process and ready to sale for the customer is finished goods. Finished goods are merchandise inventory for a wholesaler or retailer held for sale. 

Classification of Inventory Costs

1. Product Cost (Production Based): Product costs are those costs that attach to the inventory and are recorded in the inventory account. These costs are directly connected with the bringing of goods to the place of business of the buyer and converting such goods to a salable condition. Fright cost, for a manufacturing company: direct material, direct labor, direct expenses) other direct cost are the example of product cost.

2. Period Cost (Distribution based): Selling and distribution expenses, office and administrative expenses are not considered to be directly related to the acquisition or production of goods and therefore, are not considered to be a part of inventories. Such costs are period cost. 

Types of Inventory Costs

Inventory Cost are basically associated with ordering, storing and selling costs. The price of product, shipping cost, duties, etc. are the cost that are broken down into three categories described as bellows:

1. Ordering Costs: These costs are related to purchasing, invoicing, labor, transportation and processing costs. 

2. Carrying Costs: These costs are the cost of the business that pays for holding inventory in the stock or warehouse.

3. Stock-out Costs: These costs are the shortage costs that are caused by product shortage.
   

Calculation of Cost of Goods Sold 

Cost of goods sold is also known as Cost of Sale. It refers to  refers to the direct costs of producing the goods sold by a company. It includes cost of direct materials and direct labors. It can be calculated as follows:

• Cost of Goods sold = Cost of Goods Available for sale - Ending Inventory

  Where,
  

Cost of Goods Available for Sale = Beginning Inventory + Net Purchase

Types of Inventory Systems

Inventory system is the process that helps the business to track the status of inventory. Basically, there are two types of inventory system explained as bellows:

1. Periodic Inventory System: Under a periodic inventory system, the quantity of inventory on hand is determined only periodically, as its name implies. ll acquisitions of inventory during the accounting period are recorded by debits to a purchase account. 

2. Perpetual Inventory System: Under a perpetual inventory system, a continuous record of changes in inventory is maintained in the inventory account. That is, all purchases and sales (issues) of goods are recorded directly in the inventory account as they occur. That is the system of record keeping of inventories as an when the purchase and sale made. Under this system, all the transactions are recorded to the inventory account as they happen.

Methods of Inventory under both Systems

Under Periodic and Perpetual Inventory system the following methods of inventory are used as listed bellows:

1. Weighted Average (WA) Method 

2. Last-In-First-Out (LIFO) Method

3. First-In-First-Out (FIFO) Method

Models of Inventory Management

Inventory management models assist the business to measures the inventory levels to enhance the business performance. It helps to ensure the business have sufficient inventory in the stock to keep clients glad. Basically there are three types of inventory models mostly used in the business described as bellows:

1. Economic Order Quantity (EOQ): It is an optimum level of quantity that shows the business to order the inventory for production and fulfillment the demand of the customers. It can be calculated as:

• EOQ = Square root (2AO/C) where,

• A= Annual Demand 

• O= Ordering Cost

• C= Carrying Cost
  

2. Fixed Reorder Quantity System: Under this system, the alert is raised promptly when the level of inventory comes near to fixed amount of quantity.
   

3. Fixed Reorder Period System:  Under this system, the alert is raised promptly when the time period of inventory comes to from predetermined inventory period.

Conclusion

Inventory is one of the most visible and tangible aspects of doing business. Raw material, Goods in process or Work-in-Process and Finished goods all represents various forms of inventory. Every business organization needs inventory for smooth running of its activities. It serves as link between production and distribution processes. There are two types of cost included in the inventory as Product and Period Cost. Cost of goods sold is also known as Cost of Sale. It refers to  refers to the direct costs of producing the goods sold by a company. There are two types of inventory system includes periodic and perpetual. Under both methods, there are three types methods taken into considerations include WA, LIFO and FIFO.

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