Types of Inventory:

Now that we've explained what inventory is, we'll look at the different types of inventory that a business might hold.

• Raw Materials: Raw materials are the basic components used to create finished products. These can include physical items such as wood, steel, or fabric, depending on the manufacturing process. Managing raw materials effectively ensures a steady production process and minimizes downtime caused by material shortages.  
• Work in Progress (WIP): Work in Progress inventory represents partially completed goods that are still within the production process. This can include items being assembled or products waiting on additional components. WIP inventory is critical for gauging the efficiency of production workflows and identifying bottlenecks in the process.  
• Finished Goods: Finished goods refer to items that are fully manufactured and ready for sale. These products are stored until they are purchased by customers or distributed to retailers. Maintaining the right balance of finished goods is essential to meet demand while avoiding overproduction or excess storage costs.  
• MRO Inventory (Maintenance, Repair, and Operations): MRO inventory includes supplies that are not part of finished goods but are required to support production and operations. This could consist of tools, repair parts, or safety equipment. Keeping adequate MRO inventory ensures that machinery and processes remain functional without costly interruptions.  

Metrics for Inventory Management:

Here, we'll look at some useful metrics that management teams can use to improve their efficiency with inventory:

• Inventory Turnover: Inventory turnover measures how effectively a business utilizes its inventory over a specific period. The formula for calculating inventory turnover is Cost of Goods Sold (COGS) divided by the average inventory. A high inventory turnover generally indicates strong sales and efficient inventory management, while a low turnover might suggest overstocking or weak demand. Regularly analyzing this metric helps businesses optimize their stock levels and reduce storage costs. To learn more about Inventory Turnover, we recommend this guide.
• Days Inventory Outstanding (DIO): Days Inventory Outstanding represents the average number of days it takes for inventory to be sold and replaced. It is calculated using the formula: (Average Inventory ÷ COGS) × 365. This metric is significant because it highlights how quickly a company can convert its inventory into revenue. A lower DIO is often favorable, as it implies faster inventory movement and better cash flow.
• Stockout Rate: The stockout rate measures the frequency at which inventory levels fall to zero for a specific product or set of products. To calculate it, divide the number of stockouts by the total number of orders. This is a useful metric because stockouts can lead to lost sales, frustrated customers, and potential damage to the brand's reputation. Monitoring and minimizing stockout rates ensures better customer satisfaction and availability of key products.
• Sell-through Rate: Sell-through rate is the percentage of inventory sold compared to the amount brought in during a given period.  Sell-Through Rate (%) = (Number of Units Sold / Number of Units Received) x 100. Sell-through rate  provides insight into how well products are performing and assists in decision-making regarding reordering and managing inventory overstock. A higher sell-through rate typically indicates successful product movement and strong demand. To learn more about Sell-Through Rate, we recommend this guide.

Inventory Management Techniques:

Here, we'll look at the most common inventory management techniques:

• FIFO (First-In, First-Out): FIFO is a method that assumes the first inventory items purchased are the first ones sold. This technique is especially beneficial for businesses handling perishable goods, as it ensures that older stock is used or sold before it expires or loses value. By following FIFO, companies can reduce inventory waste and better reflect the actual costs of goods sold on their financial statements.  
• LIFO (Last-In, First-Out): LIFO works on the principle that the most recently acquired inventory is sold or used first. This approach is advantageous during times of inflation, as it matches current, higher costs with sales revenue, which can reduce taxable income. LIFO is more commonly applied in industries dealing with non-perishable goods, such as manufacturing or chemical production, but it’s important to note that it’s not permitted under International Financial Reporting Standards (IFRS).  
• Just-In-Time (JIT): The JIT inventory technique aims to minimize inventory levels by producing or obtaining items only when they are needed. This system reduces carrying costs and eliminates excess stock. Businesses that adopt JIT benefit from streamlined operations and increased efficiency, but it requires precise demand forecasting and strong supplier relationships to avoid stockouts or production delays.  
• Economic Order Quantity (EOQ): EOQ is a formula-based inventory approach designed to minimize the total costs of ordering and holding inventory. By determining the optimal order quantity, businesses can reduce costs associated with frequent orders and excessive storage. EOQ provides a balance that ensures inventory is replenished efficiently while minimizing carrying expenses and avoiding overstocking or understocking issues.  

Inventory & Financial Statements:

It's also important to understand how inventory will hit the financial statements. Here, we'll look at this in some detail:

• How inventory is reported in the balance sheet: Inventory is classified as a current asset on the balance sheet because it is expected to be sold or used within the company’s operating cycle. It is typically listed after cash and accounts receivable, reflecting its role as a critical component of working capital. The valuation of inventory can affect total assets, depending on the accounting method used, such as FIFO (First-In, First-Out), LIFO (Last-In, First-Out), or weighted average cost.  
• Impact on the income statement through Cost of Goods Sold (COGS): When inventory is sold, it is removed from the balance sheet and recorded as an expense under Cost of Goods Sold (COGS) on the income statement. This expense directly reduces gross profit, making inventory valuation essential in determining profitability. Overstated inventory can lower COGS and artificially inflate net income, while understated inventory has the opposite effect.  
• The link between inventory and cash flow: Inventory management significantly impacts cash flow. Excess inventory ties up cash that could otherwise be used for growth opportunities or debt repayment, while insufficient inventory can lead to missed sales. Changes in inventory levels are reflected in the operating activities section of the cash flow statement. A decrease in inventory typically contributes positively to cash flow, whereas an increase can signify cash outflows for acquiring stock.  

Recommended Resources:

• Inventory Turnover
• Sell-Through Rate
• Product Line
• Gross Merchandise Value (GMV)