Inventory Definition, Meaning and Examples
Inventory Definition – “Material that will eventually be fabricated and / or sold”.
Meaning of Inventory – It refers to the current asset in the form of raw materials, work in process and finished goods. These are ready for sale items. It appears on under the Current Assets head in Balance Sheet. From inventory meaning three things comes out –
- It consist of raw material
- Work – in – process
- Finished goods
It is a short term asset as it gets clear off within the period of one year. However, there are exceptions always. As one cannot exactly confirm that the inventory will sell out within one year. So the inventory not sold becomes the beginning inventory for the next year.
Components of Inventory
There are three components of inventory which are explained in detail below –
Raw Materials – It refers to all the goods and items that are used in the production process. For example for an automobile maker, the raw materials are car parts, metal, engine, etc.
Work – in – process or Work – in – progress – These are the goods that are going under process to transform into finished goods. Example – chassis of automobile.
Finished goods – It consists of the goods or items that are readily available for sale to the customer. Example – Car, bike, trucks, etc.
Examples include the merchandise in a shop, finished goods in a warehouse, work in progress and raw material.
Related Financial Terms of Inventory
- Indirect Costs Meaning | Definition | Examples
- Assets Meaning – Definition ,Types of Assets and Examples
Importance of Inventory Management for Business
Without knowing about the benefits of inventory management, inventory definition is incomplete. It is important for the firm that it keeps adequate amount of inventory with itself. Production of goods in large quantity is not at all a good decision. As there is holding cost, spoilage or obsolescence costs.
Keeping little inventory is also not healthy for the company. As demand can rise up making the firm unable to fulfill the demand. So, there must be review of inventory periodically. Here comes the role of Economic order Quantity.
Economic order quantity (EOQ) – It refers to the number of units that a firm should add to the inventory after every order. This leads to the minimization of the total cost of the inventory. With EOQ, reorder point and optimal reorder quantity is calculated.
Reorder point – It refers to a certain level of inventory after which inventory is replenished. In other words, this is the minimum quantity that a firm keep as stock. So, when this point triggers, firms again produce and fill their stock.
There are three methods of valuating inventory namely – Last in first out (LIFO), First in first out (FIFO) and weighted average method.
LIFO – In this method, the cost of good sold is based on the inventory which is purchased latest or recently.
FIFO – The earliest purchased inventory is the basis for the calculation of costs of goods sold.
Weighted Average – This method values inventory and cost of goods sold on the basis of average costs of material purchase during the year.