What it means
Manufacturers usually track three stages of inventory: raw materials waiting to be used, work in progress part way through production, and finished goods ready to ship. Finished goods is the final stage, and it represents money that has already been spent on materials, labour and factory overhead but not yet recovered from a customer.
Retailers and wholesalers hold the same category, though for them it is simply purchased stock. The valuation rule is that inventory is carried at the lower of cost and net realisable value.
Cost includes everything spent getting the product to its current condition and location, and net realisable value is the expected selling price less the costs of selling it. If a product becomes obsolete or damaged, it must be written down, and that write down hits profit immediately.
Finished goods levels are a management signal as much as an accounting figure. Rising finished goods alongside flat sales usually means production is running ahead of demand, which ties up cash and creates the risk of obsolescence.
Falling finished goods alongside rising sales can mean the business is about to start missing orders. The cash consequences are direct.
Every dollar sitting in the warehouse is a dollar unavailable for wages or suppliers, plus a running cost for storage, insurance and handling that is easy to overlook. This is why inventory turnover, meaning how many times the stock is sold and replaced in a year, is one of the first ratios lenders examine.
Judgement enters through overhead absorption, because part of the factory's fixed costs is included in the value of every unit produced. Overproducing therefore parks fixed costs in inventory instead of charging them to profit, which flatters this period's earnings and stores up a problem for the next.
In practice
Real-world examples.
Example
A seasonal toy manufacturer builds finished goods from June onwards so that it can ship in volume during November. Its balance sheet shows inventory peaking at three times the normal level in September, which its bank has been warned about in advance.
Example
An electronics assembler launches a new model and is left with 4,000 units of the previous version. Because the older model can now only be sold at a discount, the units are written down to net realisable value, cutting reported profit by $180,000 in that quarter.
Example
A craft brewery discovers that 15% of its finished goods will pass their best before date within two months. It runs a promotion at a thin margin, which is still far better than scrapping the stock and losing the full production cost.
Think of it
“Finished goods are products that are done and ready to sell-the end of the manufacturing line.
Formula
Calculation
Closing finished goods inventory = opening finished goods + cost of goods manufactured - cost of goods sold.
A furniture maker begins January with $400,000 of completed stock in its warehouse. During the month it finishes production of goods that cost $1,600,000 to make, and it ships goods whose production cost was $1,700,000.
Closing finished goods = $400,000 + $1,600,000 - $1,700,000 = $300,000. That $300,000 appears within inventory on the balance sheet at the end of January, while the $1,700,000 appears as cost of goods sold in the income statement for the month.
If the warehouse manager's physical count then finds only $285,000 of stock actually present, the $15,000 difference is an inventory shrinkage that must be investigated and written off rather than quietly ignored.Case study
Seen in the real world.
The following is an illustrative and entirely fictional story. Ashgrove Instruments, an invented maker of laboratory equipment, judged its factory managers purely on units produced per shift, and they responded exactly as you would expect by running the lines flat out. Over eighteen months finished goods inventory climbed from $1,200,000 to $3,400,000 while annual sales barely moved.
Reported profit looked healthy throughout, because each additional unit produced absorbed a slice of factory overhead into inventory rather than into cost of sales. The cash position told a different story, and the company drew steadily on its overdraft to fund stock that nobody had ordered.
In this fictional case the reckoning came when a design change made about $900,000 of the accumulated stock unsellable, forcing a write down that wiped out most of a year's reported profit. Ashgrove changed the factory bonus to reward orders fulfilled rather than units built, and finished goods fell back below $1,500,000 within three quarters.
Watch out
Common mistakes.
- Valuing finished goods at selling price rather than production cost, which inflates the balance sheet and recognises profit before a sale has happened.
- Leaving obsolete or slow moving stock at full value because writing it down would spoil the month's results.
- Treating a high inventory balance as a sign of strength, when it usually means cash is trapped in the warehouse.
Questions
People also ask.
Does finished goods inventory include delivery and selling costs?
No, those are expensed when incurred, because inventory cost stops once the product is finished and in place.
How does finished goods inventory affect reported profit?
Producing more than you sell moves fixed factory overhead into inventory and out of this period's expenses, which raises profit now and lowers it later.
How often should stock be counted?
Many businesses run a full count annually plus rolling cycle counts through the year, so errors are caught long before the year end.
From the founder's library
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