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Understanding Different Types of Inventory
Businesses rely on various types of inventory to efficiently operate and generate profits. These can range from raw materials used in the production process to the finished products ready for sale. Understanding the different kinds of inventory provides insights into a company's operational effectiveness, financial health, and overall business strategy.
The Basic Types of Inventory in Accounting
In accounting, inventory refers to the tangible property a business uses in its operations, either to manufacture, resell, or provide as part of its services.
Traditionally, the basic types of inventory in accounting can be split into four main categories:
- Raw Materials Inventory
- Work-In-Progress (WIP) Inventory
- Finished Goods Inventory
- MRO (Maintenance, Repair, and Operations) Goods Inventory
Raw Materials Inventory
Raw materials inventory refers to the stock of base materials that a company is yet to turn into a finished product through manufacturing, labour, or additional processing.
Different industries will have various kinds of raw materials. For instance, a bakery might consider flour and sugar as raw materials, while a car manufacturer could include steel, glass, and rubber under its raw materials inventory.
Let's take a company that produces wooden tables. Their raw materials inventory would consist of items like wood, nails, and glue, which are all needed to manufacture the final product.
Work-In-Progress (WIP) Inventory
Work-in-progress (WIP) inventory includes goods that are partway through the production process but are not yet complete.
In terms of stages, WIP inventory lies between raw materials and finished goods. This category is significant as it helps businesses track progress in the production process and manage inventory turnover.
Using the wooden table production example, a WIP inventory could include tables that have been assembled but not yet sanded, polished, or varnished.
Finished Goods Inventory
Finished goods inventory refers to the completely manufactured products that are ready for sale.
These are the products that have gone through the production process and are now ready for customers. Monitoring finished goods inventory allows businesses to effectively manage their supply to meet demand, avoid overstocks, and improve cash flow.
For the wooden table manufacturer, a finished good inventory would include the completed, polished, and varnished tables ready to be sold to customers.
MRO (Maintenance, Repair, and Operations) Goods Inventory
MRO goods inventory encompasses items that are used to support and maintain the production process and overall business operations but are not directly involved in the making of the final product.
MRO inventory can consist of cleaning supplies, safety equipment, machinery parts, and office supplies. Businesses need to properly manage MRO inventory to avoid disruptions in their operations.
For instance, the wooden table manufacturer would include items such as drill bits, safety goggles, or cleaning fluids under the MRO inventory—these items support production but are not part of the finished tables.
Getting Acquainted with Types of Inventory Management
Understanding the varieties of inventory management is a crucial aspect of creating an efficient, successful supply chain. Different types of inventory management techniques can help your business with accurate stock control, forecast demand, and implement effective storage practices. This section will steer you through three key inventory management methodologies: Periodic, Perpetual and Just-In-Time.
Periodic Inventory Management
Periodic inventory management is a method where businesses do not keep continuous track of their inventory levels. Instead, inventory counts are conducted periodically (usually at the end of a set financial period), such as annually or quarterly.
This method, although less accurate than modern digital systems, remains commonly used especially by smaller businesses. The simplicity of periodic inventory management makes it a cost-effective approach, avoiding investment in advanced software systems.
However, this method comes with its shortcomings. The gap between each physical count can make it difficult to capture damaged or lost items accurately. It also limits businesses in tracking real-time inventory data, which can lead to overstocking or stockout scenarios.
Under this system, cost of goods sold (COGS) is determined using the following formula:
\[ COGS = \text{Opening Stock} + \text{Purchases} - \text{Ending Stock} \]The 'Opening Stock' is the amount of inventory at the start of the period, 'Purchases' are additional inventory acquired through the period, and 'Ending Stock' is the remaining inventory after sales.
Perpetual Inventory Management
Contrasting with periodic inventory management, perpetual inventory management is an approach where inventory levels are continuously updated in real-time. Each time an inventory item is added or removed, it is immediately reflected in the system.
Perpetual inventory management requires more sophisticated systems, such as Barcoding or Radio-Frequency Identification (RFID). These technologies enable real-time tracking of stock, providing accurate inventory data.
Such a system significantly lowers the risk of overstocking or understocking, enables faster response to changes in demand, and can aid businesses in maintaining optimal inventory levels. However, it requires consistent monitoring and a larger investment in automation and technology.
Just-In-Time (JIT) Inventory Management
Just-In-Time (JIT) inventory management is a strategy that aims to improve a business's ROI by reducing in-process inventory and associated carrying costs.
JIT inventory management revolves around the concept of efficiency – having the right amount of stock, at the right time. It involves receiving goods only as they are needed in the production process, which reduces inventory costs and increases efficiency.
However, this system heavily relies on suppliers to deliver materials promptly, which if not managed well, can lead to production and sales halts. Furthermore, any sudden increase in demand may also not be met promptly with this system due to low stock levels.
While JIT can be highly beneficial for businesses with short inventory holding periods or high turnover rates, it requires a high level of collaboration with suppliers, accurate demand forecasting and swift production processes.
Exemplifying Types of Inventory with Real-World Examples
Real-world examples can offer a clearer understanding of how different types of inventory play a part in various industries. Looking into the retail and manufacturing sectors, particular kinds of inventory are more prevalent, and these businesses manage their inventory in unique ways to drive efficiency and profitability.
Types of Inventory Examples in Retail
Retail businesses usually deal with an assortment of goods, and effectively managing these becomes key to their operations. Here, we'll shed light on examples of various types of inventory seen in the retail sector.
Merchandise Inventory: This is the primary type of inventory for retail businesses. It encompasses all the goods that retailers intend to sell directly to their customers. Be it clothing, food items, electronics, or furniture, any item that is on the store shelves for customers to purchase constitutes the merchandise inventory.
For instance, a retail clothing store like Marks & Spencer would classify all its clothing items, such as shirts, trousers, dresses, and shoes, as merchandise inventory. Their objective is to sell these items to end consumers.
Buffer Inventory: In retail, buffer inventory, also known as safety stock, serves as a cushion against unexpected demand or delays in restocking. Retailers generally keep a buffer inventory for popular, fast-moving items to prevent stockouts and loss of sales.
A popular retail grocery store like Tesco, for example, might keep a buffer inventory of staple food items like bread, milk, and eggs that are in constant demand. This ensures they will not run out of inventory during peak shopping times or any supply chain hiccups.
Types of Inventory Examples in Manufacturing
The inventory profile for manufacturing companies differs significantly from retailers as they engage in the creation of goods rather than merly selling them. Here's a look at examples of inventory types in the manufacturing industry.
Raw Materials Inventory: Manufacturing companies stock raw materials that are used to create their finished products. These are the basic elements that undergo processing to become the final product.
A car manufacturing company like Aston Martin, for example, would hold a considerable raw materials inventory consisting of items such as aluminium, steel, glass, and plastics, which are essential for the production of their luxury cars.
Work-In-Progress (WIP) Inventory: These are partly finished goods that are still in the production process. WIP inventory offers insight into the production efficiency and operations of a manufacturing business.
To illustrate, let's look at a smartphone manufacturing company like Samsung. During production, there would be a stage where the circuit board is ready, the casing is moulded, but these parts are not yet assembled. This state of the smartphone would be classified as work-in-progress inventory.
Finished Goods Inventory: These are products that have been fully manufactured, are ready for sale, and are waiting to be shipped to the retailer or end consumer. While this inventory type spells potential revenue, if not managed wisely, it can also lead to high holding costs.
For example, in the case of a cosmetics manufacturing company like Lush, once the soaps, bath bombs, or lotions are fully produced, packed, and ready to be shipped to retail outlets or customers, they are categorised as finished goods inventory.
Delving into Types of Inventory Management Systems
The inventory management system a business adopts can significantly impact its operational efficiency and, consequently, its profitability. Effective tracking of inventory - knowing how much of a particular product is on hand, where in the warehouse it's located, and when it should be restocked - vitally contributes towards more informed, data-driven decision making. This section provides the underpinnings of both manual and automated inventory management systems.
Manual Inventory Management System
A Manual Inventory Management System is a traditional system where staff manually record inventory data, usually on paper or in spreadsheets. This system can be as simple as notes jotted in a ledger or as complex as sophisticated spreadsheets tracking multiple data points.
Manual systems can be cost-effective and straightforward for small businesses with a limited stock range. It allows these businesses to have a certain level of control over their inventory without the need for substantial technical knowledge or software investment.
Key tasks involved in manual inventory management include:
- Recording every product arrival and departure individually
- Periodically performing physical inventory audits
- Manually updating inventory levels and locations
- Producing reports based on the recorded data
However, manual systems often present several significant drawbacks:
- They can be highly time-consuming and prone to human error.
- Data may not be as readily accessible or easily visualisable as in digital systems.
- There's a lack of real-time information, limiting the ability to make swift decisions based on current data.
- The scope for scalability is limited, making growth and expansion challenging.
Moreover, with manual systems, operating under 'First In First Out' (FIFO) or 'Last In First Out' (LIFO) becomes cumbersome when a business's inventory starts to grow. Accordingly, the risk of oversells, out-of-stock situations, and decrease in customer satisfaction levels also increases.
Automated Inventory Management System
An Automated Inventory Management System uses technology to automatically track and manage inventory levels, orders, sales, and deliveries. It allows businesses to reduce the time-consuming manual count, minimise errors, and gain real-time visibility of their inventory.
Many modern businesses are switching to automated systems due to their efficiency, accuracy, and the ease with which they allow the monitoring of various inventories. These systems streamline the inventory management process and make it easier for businesses to track sales trends and product performance, leading to better business decisions.
Benefits of automated inventory management systems include:
- Real-time inventory tracking resulting in better decision-making
- Improved accuracy and fewer errors
- Time and cost savings due to fewer manual processes
- Easy integration with other business systems
- Greater visibility into inventory levels and trends
Two popular types of automated inventory management systems are the Barcode System and the Radio Frequency Identification (RFID) System.
Barcode System
A Barcode System uses barcodes and barcode scanners to automate the process of tracking inventory. Each product is assigned a unique barcode that stores specific product information, aiding quick and efficient data recording while minimising manual errors.
The barcode on an item, when scanned, sends the encoded data to the system, which then interprets and records it as an inventory transaction. This can be the purchase of raw materials, the sale of finished goods, product returns, or inventory counts.
Using a barcode system offers several advantages:
- Increased accuracy and efficiency
- Streamlined inventory management
- Reduced human errors
- Real-time tracking and reporting
Radio Frequency Identification (RFID) System
A Radio Frequency Identification (RFID) System uses electromagnetic fields to automatically track tags attached to objects. Unlike barcodes, RFID tags can store much more information and be read without line-of-sight, making inventory tracking faster and more efficient.
An RFID system comprises three parts: an RFID tag, an RFID reader, and an antenna. RFID tags contain an integrated circuit and an antenna, which transmit data to the RFID reader (also called an interrogator). The reader then converts the radio waves into usable data, which is sent to the inventory management system.
An RFID system can significantly aid inventory management, improving accuracy, speed and enabling real-time visibility into inventory levels and locations. This system also aids in reducing theft, as tagged products can be tracked throughout the store.
Unravelling Misconceptions: Which is not a Type of Inventory
While learning about types of inventory, it's essential to distinguish between actual forms of inventory and some common misconceptions. By unmasking these misunderstandings, you can acquire a more accurate picture of inventory types and apply this knowledge to your business more effectively.
Service Inventory: A Misconception
Often, the term Service Inventory is thrown around, implying that services can be stored and managed just like tangible inventory. However, this notion strays from the actual meaning and characteristics of inventory.
Inventory, by definition, refers to tangible assets that a business holds in its possession with the intention to sell or produce goods. In contrast, services are intangible—they cannot be physically touched, stored, or seen. Services like hairdressing, consulting, or insurance, are examples of this.
Moreover, services exhibit characteristics distinctly different from physical inventory. Services are typically produced and consumed simultaneously, unlike tangible products which are produced, stored, and then consumed. Therefore, inventory management techniques, which involve storage, tracking, and control of physical items, are not applicable to services.
The term 'Service Inventory' indeed might cause confusion. It's preferable to use the term 'Service Capacity' when talking about the capacity to perform service transactions that could meet expected demand. It highlights the provider's ability to deliver a service, rather than storing it.
Digital Inventory: A Common Misunderstanding
The term Digital Inventory may lead some to think it belongs with traditional concepts of inventory like raw materials or finished goods. In fact, this represents a typical misunderstanding.
Digital inventory does not refer to physical products in the traditional sense. Instead, it often refers to digital assets like eBooks, software products, digital music, or even advertisement space on a website. While these items can indeed constitute a business's stock, their digital nature makes them infinite and instantly replenishable, distinguishing them from traditional finite inventory.
For instance, if a business sells software licenses, when one is sold, it doesn't reduce their inventory since another can be generated instantly. This contrasts with a physical product, like a t-shirt, where each sale reduces the seller's inventory.
The management of digital inventory often focuses more on access rights and delivery mechanisms rather than on counting and tracking individual units. It introduces unique considerations, such as reliable download infrastructure, efficient content delivery networks (CDN), and secure digital rights management (DRM).
Cash Inventory: A False Notion
'Cash Inventory' is another term regularly misunderstood to imply that cash can be a type of inventory. However, in traditional business and accounting terminology, this is a false notion.
Inventory refers to assets a business owns that are either in the form of goods ready for sale or will be converted into such goods. Cash, on the other hand, is a medium of exchange and a store of value but is not a saleable good. It's the result of selling inventory or providing a service, not something a business sells.
Indeed, the term can confuse, as businesses must handle cash accurately, taking routine counts - particularly in retail or any sector dealing extensively with physical currency. But it's more suitable to term this 'Cash Management' rather than considering it a form of inventory.
In the end, differentiating tangible inventory from misinterpretations like 'Service Inventory', 'Digital Inventory', and 'Cash Inventory' solidifies your understanding of inventory types, enabling you to manage and balance your business assets more effectively.
A Close Look at Types of Inventory Control
Inventory control refers to the strategies businesses use to maximise profit, minimise costs and effectively manage their inventory. Different inventory control types offer unique methods for managing stock, improving order fulfilment, and reducing lead times. This piece will delve deeper into some of the most widely implemented inventory control techniques.
ABC Inventory Control System
The ABC Inventory Control System is a technique based on the 'Pareto Principle', often referred to as the '80/20 rule'. This principle suggests that typically, 80% of the total value is concentrated in about 20% of the items.
In an ABC inventory system, inventory items are categorised into three classes:
- A-Items: These are the high-priority items, representing a relatively small percentage of total items but significantly contributing to the total inventory cost. Special attention is given to these items to ensure constant availability, and any out-of-stock situations are avoided.
- B-Items: The medium-priority items. They represent a more significant volume than A-items but do not bring significant value in terms of inventory cost.
- C-Items: The low-priority items which constitute the majority of inventory items but account for a small portion of the total inventory cost.
Implementing an ABC inventory system helps in identifying which items need more facility resources and tighter controls and which items require less attention. This system leads to better decision-making regarding purchasing, warehousing, and selling, resulting in cost and process optimisations.
Economic Order Quantity (EOQ) Model of Inventory Control
The Economic Order Quantity (EOQ) model is a classic inventory control model that aims to determine the most cost-effective purchase quantity — the quantity that minimises the total inventory holding and ordering costs. This approach balances between carrying too much inventory (incurring high holding cost) and ordering too frequently (resulting in high order costs).
The EOQ model is ideal for businesses experiencing constant demand for a particular product, with consistent delivery lead times and stable costs. Using this formula, companies can calculate the optimal quantity that should be ordered to minimise total inventory cost.
The EOQ formula is:
\[ EOQ = \sqrt{ \frac{2DS}{H}} \]Where: \(D\) represents the annual demand, \(S\) is the order cost per order, and \(H\) is the holding or storage cost per unit, per year.
Keep in mind, while the EOQ model offers a scientifically backed method to control inventory, it is based on several assumptions (constant demand, fixed ordering cost, no lead times) which may not hold true in all real-world scenarios.
Just In Time (JIT) Inventory Control Method
The Just-In-Time (JIT) inventory control method is a strategy that aims to minimise inventory by receiving goods only as they are needed in the production process. This approach reduces inventory holding costs by keeping inventory levels low.
Developed by Toyota in the 1970s, the JIT system's critical aspect is to 'pull' inventory through the supply chain rather than 'pushing' it. This means production only commences when there is a customer order, leading to almost no finished goods inventory.
While beneficial for businesses wanting to reduce waste, free up capital, and respond swiftly to market changes, the JIT system requires coordination with reliable suppliers, accurate demand forecasting, and efficient production processes to avoid customer service issues related to stockouts.
Safety Stock Inventory Control Method
The Safety Stock control method is a strategy that involves maintaining a buffer of extra inventory to guard against variability in demand or supply. The primary purpose of safety stock is to reduce the risk of stockouts that may lead to lost sales, production halt, or customer churn.
Factors to consider while calculating safety stock include average lead time, average demand, and the desired service level. However, while safety stock serves as an insurance against unforeseen fluctuations, overdoing it leads to increased holding costs and potential wastage if the products are perishable.
Reorder Point Formula Control Method
The Reorder Point Formula Control Method is a technique for determining when to replenish stock. The reorder point is reached when the inventory level falls to a certain level that you need to place a new order to avoid a stockout.
The Reorder Point is determined using the following formula:
\[ Reorder \,Point = (Average \,Daily \,Usage Rate \times Lead \,Time) + Safety \,Stock \]Essentially, the reorder point considers the product's usage rate and the lead time needed to replenish the stock, alongside the safety stock, if any. The reorder point ensures that an order is placed in time to maintain stock availability and customer satisfaction.
Types of Inventory - Key takeaways
- Perpetual inventory management - employing systems like Barcoding or RFID for real-time inventory tracking. These systems decrease risks of overstocks or understocks, enhance response time to demand changes, and facilitate the maintenance of optimal inventory levels.
- Just-In-Time (JIT) inventory management - a strategy aimed at enhancing business ROI by minimizing in-process inventory and its carrying costs. This management style demands efficient collaboration with suppliers, accurate demand forecasting, and quick production processes.
- Types of Inventory in Retail and Manufacturing - includes Merchandise Inventory (goods for retail), Buffer Inventory (safety stock), Raw Materials Inventory (basic elements utilized for creation of finished products), Work-In-Progress (WIP) Inventory (partially finished products in process), and Finished Goods Inventory (fully manufactured and ready for sale).
- Types of Inventory Management Systems - includes Manual Inventory Management System (manually recorded inventory data) and Automated Inventory Management System (utilizes technology for automatic tracking and management of inventory levels), with Barcode System and Radio Frequency Identification (RFID) System being two popular types of automated inventory.
- Services and Digital Inventory Misconceptions - "Service Inventory" and "Digital Inventory" are not actual forms of inventory. Service Inventory relates to the capacity for a service as opposed to physical goods, while Digital Inventory usually refers to infinite and instantly replenishable digital assets.
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