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An inventory consists of a list of goods and materials held available in stock.
Each country has its own rules about accounting for inventory; this article concentrates on economic theory, United States financial accounting rules, and Eliyahu M. Goldratt's throughput accounting. Economics is unaffected by boundaries and throughput accounting is independent of national regulations because it affects public financial reports only indirectly.
Organizations in the U.S. define inventory to suit their needs within Generally Accepted Accounting Practices (GAAP), the rules defined by the Financial Accounting Standards Board (FASB) and enforced by the Securities and Exchange Commission (SEC) and other federal and state agencies. Inventory management affects organizations' internal operations through their cost accounting methods. The bar codes printed on nearly all goods are called Stock Keeping Units, or SKU's for their role in managing inventory.
While financial accounting uses standards that allow the public to compare firms, cost accounting functions internally to an organization and with much greater flexibility. A discussion of inventory from standard and theory of constraints-based (throughput) cost accounting perspective follows some examples and a discussion of inventory from a financial accounting perspective.
Non-manufacturing (service) organizations may have inventories of goods for sale and goods (fixtures, furniture, supplies, ...) that they do not intend to sell. Manufacturing organizations usually divide their "goods for sale" inventory into material and components to be used in making a product (Materials and Components or Raw Materials), materials and components that have begun their transformation to finished goods (Work in Process, or WIP), and finished goods that are ready for sale to customers. For example:
An organization's inventory is a mixed blessing, since it counts as an asset on the balance sheet, but it ties up money that might be used for other purposes and requires additional expense for its protection. It may also be a significant tax expense, depending on the particular country's laws regarding depreciation of inventory. (See Thor Power Tools Decision.)
Inventory is listed as an asset on an organization's balance sheet because it can be turned into cash by selling it. Some organizations hold larger inventories than their operations require to inflate their apparent asset value and profitability.
In addition to the money tied up by acquiring inventory, it is subject to costs for space, utilities, insurance, staff to handle and protect it, fire and other disasters, obsolesence, shrinkage (theft and errors), and others. Such holding cost are high, between a third and a half of its acquisition value per year. An organization that reduced its inventory by $1,000,000 would add that amount to its net income, an attractive prospect that helps to explain the popularity of programs like Just In Time (JIT) inventory.
Businesses that stock too little inventory are unable to take advantage of large orders from customers if they cannot deliver. The conflicting objectives of cost control and customer service often pit an organization's financial and operating managers against its sales and marketing departments. Sales people, in particular, often receive commission payments, so goods that are unavailable reduce their personal income.
Standard cost accounting uses ratios called efficiencies that compare the labor and materials that were actually used to produce a good with those that the same goods would have required und standard conditions. As long as the actual and standard conditions are similar, there is little problem. Unfortunately, standard cost accounting methods were developed about 100 years ago, when labor was the most important cost in manufactured goods. Standard methods continue to emphasize labor efficiency even though that resource now constitutes a (very) small part of cost in most cases.
Standard cost accounting can hurt managers, workers, and firms in several ways. For example, manufacturing managers' performance evaluations can be harmed by a policy decision to increase inventory. Increasing inventory requires increased production, which means that processes must operate at higher rates. When (not if) something goes wrong, the process takes longer and more than standard labor time is used. The manager is responsible for the excess even though s/he has no control over the production requirement or the problem.
In adverse economic times, firms use the same efficiencies to downsize, rightsize, or otherwise reduce their labor force. Workers who are laid off under those circumstances had even less control over excess inventory and cost efficiencies than their managers.
Many financial and cost accountants have agreed for many years that standard cost accounting should be replaced. They have not, however, found a successor.
Eliyahu M. Goldratt developed the Theory of constraints in part to address the cost accounting problems in what he calls the "cost world". He offers a substitute, called Throughput accounting, that uses throughput (money for goods sold to customers) in place of output (goods produced that may be sold or added to inventory) and considers labor as a fixed rather than as a variable cost. He defines inventory simply as everything the organization owns that it plans to sell, including buildings, machinery, and many other things in addition to the categories listed here. The only variable costs in throughput accounting are the operating expenses like materials and components that vary directly with the quantity produced.
Finished goods inventories remain balance sheet assets, but managers and workers are no longer evaluated by labor efficiency ratios. Instead of an incentive to reduce labor cost, throughput accounting focuses attention on the relationships between throughput (revenue or income) on one hand and controllable operating expenses and changes in inventory on the other. Those relationships direct attention to the constraints or bottlenecks that prevent the system from producing more throughput rather than people who have little or no control over their situations.
A group of British artists has adopted the name Inventory: see Inventory (artists).
Inventory is also the name of item storage available to computer game characters, especially in role playing games.
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