The definition of inventory changes slightly depending on the industry. Here’s a small list of definitions:
Most common definition
Inventory refers to all the items, goods, merchandise, and materials held by a business for selling in the market to earn a profit.
Example: If a newspaper vendor uses a vehicle to deliver newspapers to the customers, only the newspaper will be considered inventory. The vehicle will be treated as an asset.
In a manufacturing business, inventory is not only the final product manufactured and ready to sell, but also the raw materials used in production and the semi-finished goods in the warehouse or on the factory floor.
Example: For a cookie manufacturer, inventory will include the packets of cookies that are ready to sell, the semi-finished stock of cookies that haven’t been cooled or packed yet, the cookies set aside for quality checking, and raw materials like sugar, milk, and flour.
In a service industry, since there is no exchange of physical stock, the inventory is mostly intangible in nature. So the service industry inventory mostly includes the steps involved before completing a sale.
Example: For a research consultancy firm, inventory consists of all the information collected for a project. In the hotel industry, a vacant room is inventory for the owner.
Meaning of inventory: Breaking down the definitions
If we break down all the definitions, we can see that there are certain similarities:
i) An asset, tangible or intangible,
ii) An asset that can be realized for revenue generation or has a value for exchange, or
iii) An asset which is in process but is meant for sale in the market
What are the different types of inventory?
Now, let’s focus on some of the types. To make it easier to understand, let’s continue with the example of a cookie manufacturer :
Raw materials consist of all the items that are processed to make the final product. In a cookie manufacturing company, the raw materials are items like milk, sugar, and flour that are used in the different stages of production.
When we talk about raw materials, it is essential to understand that raw materials used by a manufacturing company can either be sourced from a supplier or be a by-product of a process. In our cookie manufacturing company, the raw materials will be mostly sourced from various suppliers. However, in a sugar manufacturing company, only the sugarcane is brought in from different farmers. When it is processed in the factory to extract the juice, the residual substance is known as bagasse. The juice is sent for boiling and the bagasse is used as a fuel. Here, the sugarcane, juice , and bagasse will all be treated as raw materials.
The concept of raw materials as inventory items exists only in the manufacturing industry. In a trading industry, there is no processing or manufacturing involved, so there are no raw materials.
Work in progress
When raw materials have been sent for processing but have not yet been approved as finished goods, this stage is known as work in progress. In a cookie manufacturing company, after the raw materials have been processed and the cookies have been molded, they go for a quality check before they are passed for final packaging. All the cookies which are waiting for their quality check are considered work in progress. To put it in simple words, the work in progress category consists of all the items that have been processed but not sent for sale.
Finished goods are the final items that are ready for sale in the market. These goods have passed through all stages of production and quality checking. So for the cookie manufacturer, the final packets of cookies that are sent to the market for selling after undergoing quality checks will be the finished goods.
Raw materials, semi-finished goods, and finished goods are the three main categories of inventory that are accounted for in a company’s financial accounts. There are other types as well which are maintained as a precautionary measure or for some other specific purpose.
MRO stands for Maintenance Repairing and Operating supplies, this type of inventory is mostly relevant for manufacturing industries. MRO items are not accounted as inventory items in books of accounts, however, they play a crucial role in the day-to-day working of an organization. MRO supplies are used for maintenance, repair, and upkeep of the machines, tools, and other equipment used in the production process. Some examples of MRO items are lubricants, coolants, uniforms and gloves, nuts, bolts, and screws.
In a manufacturing or a trading business, fluctuations and market movements cannot always be predicted. Such changes can have a negative impact on the sales or production process, which can lead to out-of-stock situations. Buffer inventory attempts to compensate for this by following the adage that prevention is better than cure. Buffer inventory (also known as safety stock), consists of the items stored in the warehouse of a store or a factory to cushion the impact of unexpected shocks. A sudden spike in demand, delay in transport, or labor strike can be managed if sufficient buffer inventory is maintained.
Cycle inventory is a term used to describe the items that are ordered in lot sizes and on a regular basis. Cycle inventories are usually materials which are directly used in the production or they are part of some regular process.
Most manufacturing is carried on by multiple machines. The output of one machine is fed into the next machine for further processing. However, the process only works smoothly if all the machines work in tandem. A breakdown in any of the machines can derail the entire process, which is when decoupling inventory comes into the picture. Decoupling inventory consists of items which are kept in reserve to be processed by another machine if the previous machine fails to produce its usual output. In our example of cookie manufacturing, after the dough has been molded, it goes to the oven for baking. To prevent a breakdown in one of the molding machines can delaying the baking process, the manufacturer might keep some extra pieces of molded dough which can be sent to the oven for baking while the machine is being repaired.
Transit inventory refers to items that are being moved from one location to another, such as raw materials being transported to the factory by railway or finished goods being transported to the store by truck.
What is the impact of inventory in businesses
Inventory is a major asset for any manufacturing or trading business, so it’s important for business owners to understand what it really means. In addition to the common definition, certain industries like manufacturing and service use specialized definitions that account for all of the assets relevant to that industry. Knowing the different types of inventory, including types that aren’t specifically used in accounting, can help business owners understand how their inventory is working for them. If you wish to learn more about the inventory management process, then check out this video to get a quick overview of that.