What it means
Manufacturers usually split inventory into three categories: raw materials waiting to be used, work in progress part way through production, and finished goods ready to ship. A retailer or wholesaler generally has only the third, sometimes described simply as merchandise.
The valuation rule is the part that catches people out. Inventory is carried at the lower of cost and net realisable value, meaning the expected selling price less the costs still needed to sell it, so a fall in market value must be recognised immediately while a rise is ignored.
Cost includes more than the purchase price. Freight in, import duty and direct production labour all form part of the cost of the item, while selling costs, storage of finished goods and general overheads are normally expensed as incurred.
Inventory ties up cash without earning anything until it sells. That is why two businesses with identical profits can have very different cash positions, and why a growing company can run out of money while its accounts still look healthy.
The figure is also unusually easy to get wrong, whether through miscounting, theft, damage or simply not writing down goods nobody wants. Because every dollar of overstated inventory is a dollar of overstated profit, auditors treat the year end count as one of the highest risk areas in a set of accounts.
In practice
Real-world examples.
Example
A brewery holds $180,000 of malt and hops as raw materials, $240,000 of beer in fermentation as work in progress, and $310,000 of kegged and bottled stock as finished goods. Its balance sheet shows a single inventory line of $730,000 with the split disclosed in the notes.
Example
A fashion retailer buys a summer range for $600,000 and sells 70% at full price. The remainder is marked down for clearance at less than cost, forcing a write down that turns a profitable season into a marginal one.
Example
An electronics distributor pays $80,000 in import duty and freight on a $920,000 container shipment. Both costs are added to inventory rather than expensed, so the goods are carried at $1,000,000 until they are sold.
Formula
Calculation
Ending inventory = opening inventory + purchases - cost of goods sold
Carrying value = lower of cost and net realisable value
A homeware retailer starts its financial year with inventory of $420,000. During the year it buys $1,880,000 of stock and records cost of goods sold of $1,850,000.
Ending inventory is $420,000 + $1,880,000 - $1,850,000 = $450,000. That is the figure the cost records suggest should be sitting in the warehouse at the year end.
The count then identifies a discontinued range carried at $75,000 that can only be cleared at $45,000 after $0 of further selling cost, so its net realisable value is $45,000 and a write down of $75,000 - $45,000 = $30,000 is required. Reported inventory becomes $450,000 - $30,000 = $420,000, and the $30,000 is charged to cost of goods sold, reducing profit by the same amount.Case study
Seen in the real world.
This is an illustrative and entirely fictional scenario. Ambleside Garden Supplies, an invented regional chain, carried inventory of $1,600,000 in its management accounts going into its year end. The physical count found goods worth only $1,540,000, a shrinkage of $60,000 caused by breakage, unrecorded staff sales and a stocktaking error at one branch.
Worse for the fictional finance team, the count also surfaced $180,000 of ornamental stock from two seasons earlier that could realistically be cleared for $45,000, requiring a write down of $180,000 - $45,000 = $135,000. Between the two adjustments the company took a $195,000 charge and reported inventory of $1,540,000 - $135,000 = $1,405,000.
The invented business changed two things afterwards. It moved to rolling cycle counts instead of one annual count, and it introduced a monthly ageing report so slow moving stock was flagged while it could still be discounted rather than eighteen months later when it was worth almost nothing.
Watch out
Common mistakes.
- Valuing inventory at its selling price rather than its cost, which records profit before anything has actually been sold.
- Treating inventory as a safe asset because it appears under current assets, when unsold or obsolete stock can be worth a fraction of its book value.
- Forgetting to add freight and import duty to the cost of goods bought, which understates inventory and overstates expenses in the period.
Questions
People also ask.
Is inventory an asset or an expense?
It is an asset while held and becomes an expense, cost of goods sold, at the moment the item is sold.
Do service businesses have inventory?
Usually very little, though firms billing on a project basis may carry work in progress representing unbilled costs on jobs still in progress.
What happens if inventory is stolen or damaged?
The loss is written off against profit, either within cost of goods sold or as a separate charge, and the balance sheet is reduced accordingly.
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