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Inventory management is a critical financial function, particularly for businesses that sell physical goods. One challenge with inventory management is that inventory is not all the same. Most companies divide inventory into three different types:
EXAMPLE
Suppose a company manufactures button-down shirts. Raw materials would be the fabric, buttons, thread, etc. Work in process items would be half-stiched shirts. Finally, the finished good would be the completed shirt.While these three types of inventory on the surface seem to be clear in their definition, measuring each of them in accounting can be a challenge. Different inventory techniques include:
| Inventory Techniques | Description |
|---|---|
| FIFO | This method stands for First In, First Out. This means that older inventory items are recorded as being sold first, even though the exact physical items may not have been the ones used during the manufacturing. |
| LIFO | This method stands for Last In, First Out. This means that the most recent inventory items are recorded as being sold first. This is favorable to the company because, in a time of rising prices such as inflation, they realize a tax advantage by booking the expense of the more pricey inventory. However, because of this advantage, the International Financial Reporting Standards bar the use of LIFO. Most companies have gone back to using FIFO. |
| Average Cost | This method is fairly straightforward and takes the weighted average of all the units available in inventory during the accounting period. This method uses that average cost to determine the value of the cost of goods sold. |
| ABC Method | This method is used when a company has a need for very selective inventory control because it has items that vary greatly in value and inventory cost. Class A items may be very expensive finished products that are very tightly controlled down to the individual item level; they require very accurate recordkeeping. Class B items require a bit less control and less detailed record-keeping, and Class C items are much less expensive and require minimal individual control. |
There are several reasons why a company carries any quantity of inventory.
Seasonality is an issue to consider in inventory management. Many industries are subject to dips and rises in the demand as a result of seasonality. Sourcing the same amount of each product every month is not practical for these industries. Inventory management and seasonality-impacted businesses can become quite complex, and the inaccuracy of forecasting can have a substantial impact on profitability.
Another challenge with inventory management is the issue of perishable goods. From food to fashion, some goods either simply go bad or lose most of the value for no other reason than culture has passed it by; this is called a perishable good. Perishable goods have an even greater opportunity cost when it comes to mismanaging inventory. If too much of a perishable good is ordered, not only will it cost the organization an unnecessary inventory fee, but it also adds to the risk of never being sold at all. It would end up being a complete sunk cost. Understanding shelf life or trend life can add a great deal to the profitability of a business.
Finally, a business must be able to determine its economic order quantity. This is the quantity that minimizes holding costs and ordering cost. Quantitative formulas to calculate the economic order quantity consider the following:
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