Inventory represents the purchase price of goods held for resale. It normally includes all costs including freight and delivery for example. In a production based business the inventory is made up of the following:
- Raw materials
- Work in process
- Finished product
This is illustrated by the following example.
Production is a complex business process and the cost of inventory includes all items such as labor, depreciation, factory overheads, components and raw materials:
Balance sheet inventory has not yet been sold. The inventory which has been sold to customers is removed from the balance sheet and transferred to COGS in the income statement.
The relationship between these items can be summarized in an inventory BASE analysis as follows:
If prices are changing, it matters which inventory cost is allocated into COGS and which remains on the balance sheet as inventory. Reported profits can be impacted dramatically in an environment of price volatility. There are three options, First In First Out (FIFO), Last In First Out (LIFO) and Average Cost. The balance sheet and income statement impact can be seen in the following example.
Just like accounts receivable, inventories are stated net of write downs. In the case of inventory, a write down is normally due to the resale value being below the carrying amount in the balance sheet. Also, inventories are normally shown as a current asset.
It is possible, in some industries, to have work in progress which takes a long time to produce. Below is an example which shows long term contracts work in progress and also the inventory write down.
Have you read The balance sheet: Asset and liability recognition?