Inventory: Definition and Methods for Management

By Indeed Editorial Team

Updated August 24, 2021 | Published February 4, 2020

Updated August 24, 2021

Published February 4, 2020

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

What is inventory?

Inventory is the amount of product that a company has that's available for purchase. This set of goods will eventually be sold to customers for a profit. This makes inventory reported as a current asset on your company's balance sheet. Keep in mind, however, that keeping inventory in stock for a long time isn't necessarily a good thing. This is because you could end up paying storage fees and the product has the potential to become outdated. Here are some examples of inventory:

  • The amount of clothing a company has to sell

  • Hot dogs that a hot dog stand has ready to sell

  • Raw materials needed to build furniture

  • Unfinished cupcakes in a bakery

  • Ingredients needed to make lemonade for a lemonade stand

Related: Learn About Being an Inventory Clerk

Types of inventory

Under the umbrella of inventory, there are several types to consider. Here are some of the different types of inventory:

1. Raw materials inventory

Raw materials inventory refers to the goods used to create a company's product or inventory. In other words, they're the materials needed to produce various goods. Raw materials can be anything from wood and nails to create a piece of furniture or flour, eggs and butter used to make a product for a bakery. The cost of these inventory parts is reported as raw materials inventory on a company's balance sheet.

2. Work-in-progress inventory

Work-in-progress inventory refers to goods that aren't yet completed or fully produced. Examples of this type of inventory include chocolate that still needs icing in a chocolate factory, shoes that have yet to be dyed and essential oils that have yet to be bottled by a wellness manufacturer.

3. Finished goods inventory

Finished goods refers to products that are ready to be sold by a company. These goods have completed the production cycle. Finished goods have previously consisted of raw materials and have also been works-in-progress. Examples of finished goods inventory include finished baked goods in a bakery, completed t-shirts by a clothing designer and a completed house by a home builder.

How to evaluate inventory

In order to evaluate inventory, you should understand how inventory and cost of goods are related. For starters, sold inventory becomes reported under costs of goods sold on a company's income statement. When inventory costs decrease, the cost of goods sold (COGS) lowers. There are three methods used to determine the cost of goods sold. They are as follows:

First In, First Out (FIFO) method

The FIFO method stipulates that the goods that are purchased first are the first to be sold, used or disposed of. This concept is beneficial for businesses because the older the goods are, the higher they risk becoming outdated and the longer a company will have to pay for their storage.

By selling the oldest items first, a company is more readily available to stock newer items. In addition, depending on the item, the longer it's kept around, the more perishable it can become. For example, if a grocery store is selling avocados, they should sell the ones that arrived at their store first in order to avoid them becoming moldy and selling the moldy avocados to customers. All in all, if the FIFO method is not used, it can affect a company's profit margin. Here are the steps to evaluate inventory and cost of goods sold using this method:

1. Determine a start and end date

Determine how much inventory you have at the start date and again at the end date you have selected. For example, you could say you have a certain number of shirts on January 1 and by the end of your COGS calculation, you might have a different amount by February 1. Therefore, January 1 and February 1 would be your start and end dates, respectively.

2. Find out the cost you paid for these goods

Once you've taken inventory, refer to your invoices and determine how much you paid for these goods. Using the example above, let's say you added to your inventory by purchasing 10 shirts for $10 each on Monday and another 10 shirts for $15 each on Friday. Then let's say you sold 15 shirts by Sunday.

3. Calculate COGS

Determine the cost of goods sold by subtracting the amount sold from your inventory starting with the goods that were sold first. You can then multiply them by the purchase cost. For example, the COGS for the example above would be (10 x $10) + (5 x $15) = $175. Therefore, your COGS would be $175.

Average Inventory Cost method

Also known as the weighted-average method, the average inventory cost method uses the average of all inventory purchased to determine the COGS. Here are the steps for calculating COGS using this method:

1. Determine the average cost of purchased inventory

In order to do this, take the sum of all inventory purchase costs for one type of product and divide it by the number of purchased products. This will result in the average cost. For example, if you spent $10 and then $15, your average cost of purchased inventory would be ($10 + $15) / 2 = $12.50.

2. Determine the average cost of goods you produced

If your company produces its own inventory using various raw materials, use the following equation:

total cost / total inventory units = average cost

3. Count your inventory

Count the amount of inventory your company has at the start date as well as the end date. Multiply the average cost by this inventory difference.

4. Calculate the COGS

For example, let's say the total you spent on shirts is $12.50 x 10 shirts = $125. If you sold 5 shirts, the total COGS using this method would be $62.50 because $12.50 x 5 is $62.50.

First In, Last Out (FILO) method

In this method, the goods that were purchased first are the last to be sold. For example, if you're selling pants but you keep stacking newly purchased pants at the top of the shelf, the pants at the bottom of the shelf (the ones purchased first) are staying at the bottom and will be purchased last so long as this process continues. This method is the same as the Last In, First Out (LIFO) method. Here is how to use it to determine your COGS:

1. Determine your most recent purchases

Because the FILO method stipulates that the most recently purchased goods will be sold first, it's important to take inventory on this stock.

2. Find the purchase cost

Determine how much you paid for these goods via your invoices. For example, let's say you started with an inventory of 10 pants for $2 on Monday and another 10 pants for $4 on Friday. By Sunday, you sold 15 pants.

3. Take the sum

To do this, add together the cost of each set of goods you sold. For example, with the 10 pants you purchased for $2, you'd get $20 because 10 x $2 = $20. These pants were the ones sold first and will be used since we're calculating COGS using the FILO method. After this, take the 5 pants purchased for $2 each and get $10 because 5 x $2 is $10. These pants were purchased last. Add the $20 to $10 to get a COGS of $30.

Methods of inventory management

Inventory management refers to the way you take account or track your company's assets. Properly managing inventory is detrimental to your business because it allows you to determine when you should slow down on purchasing raw materials or when you need to restock shelves. Doing so can prevent you from spending unnecessary money. Here are some of the basic methods for inventory management:

  • Just in Time (JIT) method: Under the JIT method, inventory is stalked just as it's needed. In other words, only the exact number of needed products are delivered.

  • Safety Stock method: This method keeps a small amount of extra inventory on hand in the event it's needed.

  • Economic Order Quantity method: This method means your company has the least amount of goods available. In other words, you have just the right amount to meet current demands without selling out or having too many goods or products on hand.

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