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What Is Inventory and Why Is It Important? A 2023 Guide

  • 7 minute read
what is inventory?

The success of your business hinges on how well you handle your inventory—and we’re not just talking about products in your warehouse waiting to be shipped. In this piece, learn what inventory is and get a brief introduction to what successful inventory management looks like.

Table of Contents

What is inventory?

Inventory is the name given to the products and materials that a company holds to sell. While it’s tempting to think that inventory only includes stock that’s waiting to ship, it also refers to works-in-progress (products in the process of being made) and raw materials (items used to create more finished products).

Why is inventory important?

Inventory is important because it’s often the largestcurrent asseta company has. Your inventory determines how many products a brand can make and sell in a given timeframe and is a prime indicator of what’s hot and what’s not.

Managing your inventory should be at the top of your to-do list, as it can offer vital insight into your company’s health. Controlling your inventory strategically will ensure you never have too much or too little stock, both of which can damage your bottom line.

The four different types of inventory and their applications

There are four main types of inventory. Knowing these will help you to classify and track items you have in stock, whether they’re raw materials or finished products.

  1. Raw materials:These are the materials you use to create your end products, like oil for shampoo or wood for furniture. The more raw materials you have in your inventory, the more products you can make.
  2. Components:These are the tools and equipment you need to create your finished products, like screws, nails, or a hammer.
  3. Work in progress (WIP):These are products that are in the process of being made but aren’t yet complete. WIPs can refer to raw materials, components, overheads, and/or packaging materials.
  4. Finished goods:These are your finished ready-to-sell products.

Inventory examples: From raw materials to finished products

To show you how these four categories break down for actual businesses, here are some real-world examples of inventory in each category.

Raw materials

A shoe brand’s raw materials might include leather, fabric, dyes, and thread, while a jewelry brand might utilize gold, silver, platinum, and precious gems to make their products.

Components

The components in your inventory will depend on the type of products you sell and how they’re made. For example, a furniture brand might need screws, hammers, and drill components, while a brand that sells soft toys might need needles, scissors, and threads.

Work in progress

Works in progress incorporate items from both the raw materials and components categories, as well as overhead and packing materials. For example, a coffee brand might include hessian bags, labels, coffee beans, and shipping boxes in their WIP inventory.

Finished goods

Examples of finished goods include anystock-keeping unit(SKU) that’s ready to be sold, like a finished T-shirt design, a pair of completed shoes, or a phone case.

How inventory reveals key insights about business operations

Inventory represents a major company asset, which means it reveals vital information about a business’s health. Understanding inventory levels and demand for each category at any given moment can provide insight into current trends and customer preferences.

Here are some ways you can assess your inventory to reveal key insights into your operations:

  • Measureinventory turnover:If you have a fast inventory turnover, there’s a good chance your products are popular, well-advertised, and desired by your customers. A fastsell-through ratecan also lead to lower holding costs, which can increase your bottom line.
  • Gather data:Keeping track of your on-hand raw materials and finished goods can help you collect crucial product data. This data can influence and improve your future purchasing and fulfillment operations.
  • Identify trends:Determining the rates at which items sell—or how quickly your inventory passes through—shows you which of your products are most popular.
  • Learn more about profitability:Your inventory is the beating heart of your business: inventory analysis can provide detailed insights into your cash flow and profitability while simultaneously reducing how much you spend on wasted inventory and restocking delays.

A brief look at inventory control

Inventory control ensures you have the required stock and supply to meet your customer demand. When done well, inventory control reduces the chances ofoverstocking, which leads to extra holding costs, and understocking, which can lead to a loss of revenuewhen items are out-of-stock.

There are four main inventory control methods:

1. ABC analysis

ABC analysiscategorizes inventory based on its value. Items grouped in the “A” grade are expensive, high-ticket items usually held in small quantities. They have the highest annual consumption value and therefore generate the biggest percentage of revenue. “B” grade items are mid-range products with average sales and stock volumes. “C” grade products are typically low-value, low-cost items that have high sales and therefore require large inventories.

2. FIFO and LIFO valuation

First-in, first-out (FIFO) is aninventory valuationmethod that assumes the first products produced or acquired were sold first. To calculate FIFO, you need to determine the cost of your oldest inventory and multiply it by the amount of inventory sold.

Last-in, first-out (LIFO) is the opposite of FIFO. It’s an accounting method that assumes the most recent items added to your inventory are the first to be sold.

Both methods focus on how items move in and out of awarehousebased on their age.

3. Batch tracking

Batch tracking groups inventory items together based on their date of manufacture. Utilizing batch tracking helps you to monitor the inventory’s source, destination, and expiration dates, based on the materials used.

4. Safety stock

Safety stock is an inventory control method used to tackle market volatility: companies order more goods than needed to prevent understocking, in order to create a safety net.

Ensuring you have the right amount of stock at the right time reduces storage costs and makes sure you have enough inventory to meet customer demands. When you successfully manage your inventory, you can evaluate your ongoing assets and prevent paying too much for inventory you don’t need.

Top inventory tips for higher profitability

1. Stay on top of inventory count

In order to ensure that your company’s accounting records and balance sheet are up-to-date and accurate, businesses manuallytake an inventory count at the end of each accounting period, typically quarterly or annually. Companies that do a daily inventory count are considered to takeperpetual inventorybecause their count is always current.

Any difference discovered between the inventory count on the company’sbalance sheetand what is actually on hand is termed “shrinkage.” This represents inventory that is missing, for whatever reason. Sometimes the inventory is lost; other times, it is stolen.

2. Use the “just-in-time” inventory model

One way to reduce the size of your on-hand inventory is to use a just-in-time strategy. This strategy means that materials are delivered “just in time” to meet current customer demand. As a result, you have less inventory sitting around that’s waiting to be produced or sold.

To be successful using just-in-time, you have to determine accurately how much you’ll sell in between product deliveries. If you’re selling 250 pairs of shoes a week and you receive deliveries every Friday, ideally you’ll receive 250 this coming Friday to keep up with demand. However, if demand picks up or declines in between deliveries, you can end up with problems.

Having too much inventory is risky because you run the risk of being stuck with merchandise that is obsolete or past its prime. You may have to mark it down to sell it, thereby reducing yourprofit margin.

But having too little inventory, or running short, also presents an issue. Running out of a product that your customers want can lead to dissatisfaction and lost sales, especially if they opt to buy from another retailer that has the item in stock. You lose money because you didn’t have the inventory in stock.

While the object of just-in-time inventory is to reduce the need to store inventory—ideally, it would all be sold just as the shipment arrives—keeping accurate track of the inventory needed to meet demand is challenging, since consumer tastes can change quickly.

3. Invest in an inventory management system

Trying totrack your inventorymanually can be time-consuming and tedious—and it can lead to issues when inevitable human errors crop up. Avoid this problem by utilizing one of the manyinventory managementplatforms out there. These platforms can automatically track your stock levels, identifydead stock, and highlight your most costly inventory.

Why a clear understanding of inventory is essential for business owners and managers

Staying ahead of your warehouse inventory and efficiently managing your supply chain are vital practices for a healthy business: first,understanding your inventoryleads to financial transparency across your business. Knowinghow much stockyou have—and how much it’s costing you at any given time—can also help you claw back any extra spending while continuing to fulfill customer demands.

Manage your inventory with confidence

Only Shopify POS helps you manage warehouse and retail store inventory from the same back office. Compare inventory costs to revenue, see which items are selling out or sitting on shelves, forecast demand, and more.

What is inventory FAQ

What is the definition of inventory?

Inventory refers to the stock of goods that a company has on hand for sale or use in the production of goods for sale. It includes raw materials, work-in-progress products, finished products, and supplies held by a company. Inventory represents a key component of a company’s assets and is typically valued at the cost of its acquisition or production. Proper inventory management is essential for businesses to ensure sufficient stock levels for customer demand while minimizing storage costs and avoiding stockouts. Inventory can be tracked using various methods, including first-in, first-out (FIFO); last-in, first-out (LIFO); and weighted average cost.

What is the main purpose of inventory?

The main purpose of inventory is to keep track of the goods and materials that a business has on hand to be used in its operations or to sell to customers. Inventory management allows a business to know exactly how much product they have available, which helps them manage their supply chain, anticipate demand, and avoid stockouts.

Additionally, inventory can be used as a buffer against unexpected events, such as supplier failures or natural disasters. It also allows businesses to track product movement and identify areas for potential improvement in the production and distribution process. Proper inventory management is essential to successful business operations and profitability.

Is inventory a current asset?

Yes. Inventory refers to raw materials, finished products, and components, all of which are included in the Current Assets account on your balance sheet.

What are the four types of inventory?

  • Raw materials: Materials and components used in the production of finished goods.
  • Work in progress (WIP): Inventory that is partially completed and awaiting further processing.
  • Finished goods: Completed products ready for sale.
  • Components: Materials used to maintain and repair equipment or facilities.
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