Inventory in a Manufacturing Environment

If you make goods and sell them, you will have goods in different stages of completion at any particular time. There are three main categories of inventory for a manufacturer:

• Raw materials inventory: This category will include raw materials you have purchased but which are still sitting on the shop floor. For example, if you make furniture, you will still have lumber that you have purchased before the end of the year that you have not started to work on.

• Goods-in-process: At the end of the year, you will also have goods that you have started to produce, but have not yet completed. Going back to our furniture manufacturer, she may have 24 dining room tables for which the tops and pedestals have been completed but have not yet been attached to each other. These are goods-in-process. Goods-in-process may have a labor and overhead component to them as well as some work and expense already invested in them.

• Finished goods inventory: These are exactly what the term says they are: finished goods. These are items that were completed and ready for sale but which had not been sold at the end of the period.

Now that you know what's in your inventory, how do you track it? There are two main methods:

• Periodic inventory method: This method is the simplest. When you purchase goods or raw materials, you put them into the COGS (cost of goods sold) account. At the end of the period, you take a physical inventory count and make an adjustment between the inventory account and COGS to correct both accounts to actual. The benefit of this method is its simplicity. The downside is that the balance sheet and income statement will be correct only at the end of the period. At any point during the year, the COGS could be misleading, perhaps indicating that the expense is higher than it actually is.

• Perpetual inventory method: This method requires more accounting transactions and is more difficult for small businesses. Under this method, when you purchase goods or materials, you make an accounting entry to increase the inventory account. When you make a sale, you make an entry to remove the cost of the item from inventory and put it into COGS. In theory, both inventory and cost of goods sold should be correct at any particular moment. At the end of the year, you take a physical inventory count to compare against the two accounts. You would adjust any difference to actual in the books at the end of the year.

Advances in technology are making perpetual systems easier to use. Many bar code systems now link to the accounting records and automatically deduct the item from inventory when it is sold.

Which system is right for your business? You must weigh the benefit of having more timely and accurate information against the cost and aggravation of tracking that information. If you have a bar code system, the perpetual system will work well for you. It will also work well if you sell big-ticket, slow-moving items, due to the small volume of extra transactions involved. However, if you sell many small items and are bookkeeping manually, the periodic system will suit your needs and won't make you crazy!