Learn about the three main types of inventory and why it’s important for businesses to properly track their inventory.
What Is Inventory?
Inventory is the product you sell to customers. Inventory can be acquired by a business and sold to customers without change to the product. Inventory can also be altered or combined with other pieces of inventory to create a new product that is sold to customers. The most important feature—from the standpoint of defining inventory—is that a business acquires these things intending to sell them to a customer in some form or manner. Costs associated with buying and selling inventory are deductible business expenses that can reduce your business taxes. Cost and gross profit from sales of inventory is a major part of your business tax return. You can use the asset value of your inventory as collateral for a business loan.
How Does Inventory Work?
The inventory process goes something like this:
You receive wholesale products or components from vendors (people your business buys things from).You alter, combine, repackage, or otherwise prepare that inventory for display for your customers.You receive orders from customers that want to buy your products.You receive money from your sales, which can be used to acquire more inventory.
Keeping track of inventory in your accounting system and physical business location is important for your business because you need to know how much you have and how much it’s worth as an asset on your business balance sheet. Tracking inventory costs is also essential because it’s used to calculate the cost of goods sold (COGS). COGS determines gross profit for a business that sells products, and it’s used on every business tax form, whether the business is a sole proprietorship, partnership, LLC, or corporation. There are several ways you can value inventory for accounting and tax purposes.
Actual Cost Tracking
This method works best for expensive physical inventory items, like cars or jewelry. You likely have fewer expensive inventory items cycling through your business, so you can track the individual costs of each.
Weighted Average Cost Tracking
When you have a lot of inventory going in and out and you can’t determine the cost of an individual item, you can look at the cost of specific batches of items over a period of time. For example, let’s say you buy pens and put customer logos on them. You might track your pen inventory cost like this:
March 1: 250 pens at $0.25 each—total cost $62.50April 14: 300 pens at $0.27 each—total cost $81.00May 2: 275 pens at $0.29 each—total cost $79.75Weighted average: 825 pens at a total cost $223.25, or $0.27 per pen
LIFO or FIFO Cost Tracking
You can also determine the cost inventory sold using one of two possible accounting methods: LIFO and FIFO.
First-in, first-out (FIFO) assumes that the inventory that came in first (the oldest) is sold first. Last-in, first-out (LIFO) assumes that the inventory that came in last is sold first. In many cases, costs increase over time, so using LIFO results in a higher cost of inventory and a lower profit.
Inventory and Accounting Method
Most companies with inventory must use the accrual method of accounting, but qualifying small businesses with average gross receipts below $25 million may be able to use the cash method. Check with a professional tax advisor if you think your business may qualify for the cash method.
Types of Inventory
There are three main types of inventory. A business may use just one type of inventory, or they may use all three.
Raw Materials
Raw materials are bought by businesses that plan to rework the materials into a product that is sold for customers. For example, a restaurant may take raw materials like carrots, meat, and spices and turn those ingredients into a stew. The stew is the finished product sold to customers.
Work-In-Process
As the name suggests, work-in-process inventory is any item that is on its way between being a raw material and a finished good. Some pieces or ingredients may be missing from the item, or it may need to be properly packaged before being put out on the shelves.
Finished Goods
Finished goods are any items that are ready to be sold to customers. Some businesses, such as retail clothing stores, buy finished goods directly from wholesalers resell them to customers. Other businesses create finished goods from raw materials and sell those to customers.
