Inventory

The inventory account represents the cost of goods a company holds for resale (retail stock, finished goods from a factory) or for use in production (raw materials, work-in-progress). Because goods purchased at different prices flow through inventory as they are sold, the choice of cost-flow method—FIFO, LIFO, or weighted average—directly shapes both cost of goods sold and reported net income, making inventory one of the most judgement-laden items on the balance sheet.

The three layers of inventory

Manufacturers typically track three inventory layers. Raw materials are the inputs—steel, plastic, components—ready to enter production. Work-in-progress (WIP) consists of partially finished goods, with labor and overhead already incurred but assembly incomplete. Finished goods are the completed products awaiting shipment. A retailer may skip raw materials and WIP, holding only finished goods on shelves. Each layer must be counted, costed, and reported separately in footnotes.

The balance sheet typically shows a single inventory line, but the footnote reveals the composition and helps analysts gauge production timing and sell-through rates.

FIFO versus LIFO: the cost-flow choice

When a company buys 100 units at $10 and later 100 units at $12, and then sells 80 units, which cost goes to cost of goods sold? Under FIFO (first-in, first-out), the $10 units are assumed to sell first: 80 units at $10 = $800 cost of goods sold, leaving $1,200 of higher-cost inventory on the balance sheet. Under LIFO (last-in, first-out), the $12 units sell first: 80 units at $12 = $960 cost of goods sold, leaving $1,000 of older, cheaper inventory on the balance sheet.

The choice is not about physical flow—the warehouse may actually mix units or use different rotation logic. It is purely an accounting assumption. FIFO results in lower cost of goods sold during inflation (matching older, cheaper costs to current sales) and thus higher reported profit. LIFO does the opposite: higher cost of goods sold and lower profit, but a lower inventory balance on the balance sheet. In the US, LIFO is permitted for tax purposes and can offer tax deferral in inflationary periods, making it attractive to some companies. IFRS jurisdictions typically prohibit LIFO, defaulting to FIFO or weighted average.

Weighted average and specific identification

Under the weighted-average method, all units in inventory are assigned an average cost regardless of when they were purchased. If the 200 units cost $2,200 total, the average is $11 per unit; selling 80 units costs $880. This smooths the impact of price fluctuations but obscures which actual layers are being sold.

Specific identification allows tracking of individual units or batches—common in jewelry, aircraft, or construction. A jeweler can identify the exact gemstone sold and match its actual cost to revenue. This is the most precise but impractical for high-volume retailers.

From balance sheet to income statement

The choice of inventory method affects not just the balance sheet but also gross profit. A company reporting FIFO profit of $500,000 might report only $450,000 under LIFO in the same year. Investors and analysts must adjust for these differences when comparing companies or tracking trends. Many financial models require a “LIFO reserve” footnote (the cumulative difference between FIFO and LIFO inventory values) to restate comparability.

Valuation and obsolescence

Inventory is recorded at historical cost, not fair value. However, if market value falls below cost—due to technological change, fashion shifts, or overproduction—the inventory must be written down to net realizable value (the expected selling price minus disposal costs). This is not a permanent reversal; if value recovers, some standards allow reversal of prior write-downs (IFRS), while others do not (US GAAP for most items).

Obsolete inventory is a hidden drain on margins. A warehouse of last-season goods or discontinued components represents sunk cost with little resale value. Management must aggressively identify and clear these items, often at steep discounts. Analysts watch gross-margin trends and inventory turnover for signs of obsolescence or slow-moving stock.

Inventory turnover and working capital

Inventory turnover (cost of goods sold divided by average inventory) reveals how quickly a company converts stock to sales. A grocery chain might turn inventory 12 times per year; a luxury car dealer, 2–3 times. Low turnover can signal sluggish sales, excess capacity, or obsolescence. It also ties cash up: inventory sits on shelves for months or years before sale, delaying cash recovery from accounts receivable and sales. Managing inventory—reducing overstocking while avoiding stockouts—is a core working-capital challenge.

Lower of cost or market rule

Under US GAAP, inventory is valued at the lower of historical cost or market value. If a supplier’s price falls or goods become less desirable, the inventory balance is written down. This is a conservative approach: losses are recognized immediately, gains are not. IFRS uses a similar net-realizable-value test but applies it differently across jurisdictions.

See also