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Definition
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 businessfor 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 treatedas an asset.
Manufacturing industry
In a manufacturing business, inventoryis not only the final product manufactured and ready to sell, but also the raw materials used inproduction and the semi-finished goodsin the warehouse oron thefactory floor.
Example:For acookie manufacturer, inventory will include thepackets ofcookiesthat are ready to sell,thesemi-finished stock ofcookies that haven’t been cooled or packed yet, thecookiesset aside for quality checking, and raw materials like sugar, milk,andflour.
Service industry
In a service industry, since there is no exchange of physical stock, the inventory is mostly intangible in nature.So the service industry inventorymostly includesthe 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 cansee that there are certain similarities:
Inventoryis:
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
Raw materials consist of all the items that are processed to make the final product. In acookie manufacturing company,the raw materials areitems like milk, sugar,andflour 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 caneitherbe sourced from a supplier orbe a by-product of a process.Inourcookie manufacturing company, the raw materials will be mostly sourced fromvarious suppliers. However, in a sugar manufacturing company, only thesugarcaneis brought in from different farmers.When it is processed in the factory to extractthejuice,the residualsubstance isknown asbagasse. The juice is sent for boiling and the bagasse is used as a fuel.Here, the sugarcane, juice,andbagasse willallbe 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 inprogress
Whenraw 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
Finished goods are the final items that are ready for sale in the market.Thesegoodshave passed through all stages of production and quality checking. So for thecookie manufacturer, the final packets ofcookies 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 inventory
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.
Buffer inventory
In a manufacturing ora trading business,fluctuations andmarketmovementscannotalwaysbepredicted. Such changes canhave a negative impact on the sales or production process,which can lead toout-of-stock situations.Buffer inventoryattempts to compensate for this byfollowing the adagethat 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 ofunexpected shocks.A sudden spike in demand, delay in transport,orlaborstrikecan be managed ifsufficientbuffer inventory is maintained.
Cycle inventory
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.
Decoupling inventory
Most manufacturingis carried on by multiple machines. Theoutput of one machine isfed into the next machine for further processing. However, the processonly works smoothly if all the machines work in tandem. A breakdown in any of the machines canderail the entire process,whichis whendecoupling inventory comes into the picture. Decoupling inventoryconsists ofitems which are keptin reserve to beprocessed by another machine if the previous machine fails to produceits usual output. In our example ofcookie manufacturing, after thedough has been molded, it goesto the ovenfor baking.To prevent abreakdowninone of the molding machines can delaying thebaking process,the manufacturer might keep some extra pieces of moldeddoughwhich can be sent to the oven for baking while the machine is being repaired.
Transit inventory
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.
