Inventory refers to stock of goods. These goods are maintained by firms to fulfill customers’ demand and to reach its goal. Inventory is reported as a current asset on the firms’ balance sheet. The firms constantly strive to maintain the proper amount of inventory and avoid over and under inventory. Manufacturing and merchandising firms maintain and report inventories differently. In merchandising business, the business has only one inventory which is “Merchandise Inventory”. While in manufacturing business, the business has three types of inventories which are explained below.
1. Raw Material
Raw material is the basic material that is used in the manufacturing process to produce desired finished goods. The manufacturing companies keep record of raw materials in the raw material inventory account. When a firm needs to use raw materials for production of goods, it shifts them from the raw material inventory to the work in process inventory. When the work is completed on the work in process inventories, then they are shifted to the finished goods inventory. The finished goods are those products that are ready for sale. The raw material on hand is appeared as current asset in the balance sheet. The example of raw material is cotton which is used for production of cloth and wood which is used for the production of furniture.
2. Work in Process
The work in process refers to that inventory that is partially completed or in the process of manufacturing. For example, ABC Company manufactures motor cycles. On the last day of the financial period, the company closes its books and counts its inventory and finds that it has 10000 motor cycles in which 3000 partially completed. These 3000 partially completed motor cycles are recorded as work in process. The ending WIP inventory becomes the opening inventory for the next financial period. Once is the work is done on the WIP inventory, it can be sold to a customer as finished goods and is no longer considered a work in process inventory. It should also be considered that work in process (WIP) inventory contains the cost of direct material, direct labor and factory overhead (FOH).
However, not all firms need to address WIP, specifically a firm with a short period of production. For example, bakery ingredients are quickly converted from raw materials to finished goods.
3. Finished Goods
Finished goods inventory is the stock of completed goods. They have been inspected and are ready for sale. When goods that were in process are completed, the finished goods are debited and the work in process is credited. When finished goods are sold on cash, cost of goods sold is debited and the finished goods are credited, while cash is debited and sale is credited. There are two types of manufacturing industries. In the first category, the product is first manufactured and then sold. In the second category, the order is received first and then the product is manufactured as per specifications.
The above three kinds of inventories are reported in the partial balances sheet of manufacturing firm as shown below:
This inventory cycle repeats itself again and again during financial period. Raw material are converted to work in process inventory and then converted to finished goods. Proper inventory system helps business to better plan and meets customers’ demand.