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Basics of Inventory and its management

Updated on :  

08 min read

Inventory or stock is an important and common term for businesses that are dealing with goods and products. It forms a major current asset on the balance sheet of such companies and is a component of working capital. Business owners must know how inventory works for their entity and manage it well by following certain valuation rules and best practices.

Definition and meaning of inventory

The inventory of a business covers all goods, merchandise, and materials held by it for sale. Inventory includes raw materials in stock, semi-finished goods in the factory and warehouse, and the finished products ready for sale in a manufacturing concern.

The notified AS 2 as per the Companies (Accounting Standards) Rules, 2006 defines the term inventory. Further, Ind AS 2 notified under the Companies (Indian Accounting Standard) Rules, 2015 also provides the definition. Suppose the entity is not a company but follows the mercantile basis of accounting with business or professional income. Then, it may be subject to the ICDS-II under the Income Tax Act, which also defines inventory.

As per these standards-

Inventory are assets that satisfy the below criteria-

  1. It can be held for selling in the market during the ordinary course of business.
  2. It also covers those processed while in production, to be sold later on.
  3. It further covers raw materials, inputs, and services used to produce finished goods or resale.

It means any asset held for sale or resale in the short term more regularly by a business will be termed inventory, stock, or merchandise. However, certain items are not classified as inventory, such as livestock, agricultural produce, mineral oils and gas.

There are various types of inventory or classifications prevalent among businesses. These include raw materials, work in progress or semi-finished goods, finished goods and maintenance supplies, or the Maintenance, Repair, and Overhaul (MRO).

How to measure inventory in accounts?

The standards direct every business to value inventory as the lower of cost or net realisable value.

The inventory cost includes the purchase, conversion, service, and all other expenses incurred by a business to bring the stock to its current location and form. Purchase costs include non-refundable taxes incurred, freight, trade discounts, additional direct and variable costs to acquire the item. It does not include selling and distribution expenses.

Whereas, net realisable value refers to the selling price estimated in the ordinary course of business. The figure is reduced by estimated completion and sale costs for that item.

What is opening inventory and closing inventory?

The terms opening inventory and closing inventory are also referred to as opening stock and closing stock. These two terms help a business owner ascertain the cost of goods sold during the past financial year. If you add the opening inventory to the cost of production during the year, it would be equal to the cost of sales and the closing inventory totalled.

Opening inventory refers to the available stock’s value as at the beginning of an accounting period, i.e., 1st April of a year. It is that stock carried forward from the previous accounting period or the financial year, i.e., 31st March of the same year.

On the other hand, closing inventory refers to the value of the stock as at the accounting period end or the financial year-end, i.e., 31st March of the year.

For instance, the opening stock of FY 2021-22 is Rs. 1,40,000, then the closing stock of FY 2020-21 would also be Rs. 1,40,000.

Inventory management and its importance

Inventory management is a term used to explain the entire process of bringing all types of inventory into a business until it’s sold. It involves planning and actions towards efficient streamlining of inventory use and is essential for businesses of all sizes and industries.

While some business owners understand the need to track inventory regularly, others do not, causing their business to suffer. Hence, inventory management becomes essential to fulfil purchase orders within the deadlines to achieve customer satisfaction ultimately. Inventory management ensures that the cost of production is at an optimal level, thereby bringing improvement in the profit margin.

For entities with complicated supply chains, balancing the risks of inventory abundance and shortages is difficult. For that reason, inventory control and management methods are present such as just-in-time (JIT), materials requirement planning (MRP), etc.