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What is inventory

Inventory is an asset (economic resource) which an organization plans to use within one year or one operating cycle whichever is longer. If assets are going to be used for more than this period of time then it should be capitalized. Inventory does not necessary supposed to have one year of an expiration date, but just meant to stay on a company shelves for a year, less than a year or the operation cycle.

Inventory is a balance sheet account with normal debit balance. This means that if you buy more inventory items, you need to increase the account. In contrast, if you used, sold items or have some spoilage (shortage), then you should reduce this account by crediting it.

For a manufacturing company inventory usually has three stages, such as raw materials, work in process, and finish goods. For example for bread-baking company the raw materials will be such ingredients as flour, eggs, yeast, sugar. Work in process will be when they mixed needed ingredients together according to their recipes and put it aside to raise. Finish goods will be when they baked and took the bread out from the oven and ready process it further to selling departments.

Relationships (ties) between three inventory accounts and income statement

Direct (raw) Materials
Work in process
Finish goods
Income statement
Beg. DM     Beg. WIP     Beg. FG     Sales (Revenues)
+ Purchases - DM used
+ DM used - COGM3
End. DM     + DL1     End. FG     Gross Margin
      + MOH2           - Period cost (G, S & A expense)5
      End. WIP           Net Operating Income

1DL – Direct labor – this is called also touch labor those who actually make some products or provide services. For example, a backer who mixes ingredients for making breads will be direct labor or a nurse in the hospital is also direct labor.

2MOH – stands for manufacturing overhead – these are all other costs that are not included in direct materials and direct labor. For example, MOH are indirect materials and indirect labor.

3COGM – cost of goods manufactured is the cost that a manufacturing company incurred for the certain period. Usually it is very rarely when cost of goods manufactured is equal cost of goods sold because the company might produce more than can sell or less.

4COGS – cost of goods sold is the cost that a manufacturing organization produced and sells for the period. When the manufacturing company sells some portion of its finished goods then the cost of goods sold (COGS) will appear on the income statement for the same period.

5Period cost (G, S & A expense) – those are expenses that are not related with actual production process. In this category can be included such expenses as advertising and office salaries.

For a retail store there is commonly no raw materials, work in process, and finish goods stages in their inventory. This is mainly because they just resell products that other manufacturing companies produce. Usually they have just their store merchandise.