Top 3 Types of Inventory
The three types of inventories are direct material inventory, work in progress inventory and the finished goods inventory where the direct material inventory includes the stock of raw material which the company has purchased for its use in production; work in progress inventory is the cost accumulated to the goods that are partially completed and the finished goods inventory is the stock that has finished all stages of production and is now available for sale.
Inventory means those current assets, which have been or will be converted into the final products of a company for sale in the near future. In other words, inventory represents finished goods or goods in different stages of production that a company keeps at its premises or at third-party locations with ownership interest retained until goods are sold. The three most important types of inventory are the raw materials, the work in progress (WIP) inventory, and the finished goods.
Have a look at the Colgate’s Inventory breakup for 2016 and 2015. There are three types of inventory listed – raw material and supplies, work in progress, and finished goods. Also, note that the majority of Colgate’s inventory is the Finished goods inventory.
Following are the different types of inventory:
#1 – Raw Material Inventory:
Raw materials are the basic materials that a manufacturing company buys from its suppliers, and that is used by the former to convert them into the final products by applying a set of manufacturing processes. For example, aluminum scrap is the raw material for a company that produces aluminum ingots. Flour is the raw material for a company that produces bread or pizza. Similarly, metal parts and ingots are the raw materials bought by a company that manufactures cars, and crude oil is the raw material for an oil refinery.
It is prevalent and easy to observe that the final products of one company are bought as raw materials for some other company. For instance, many oil drilling companies produce crude oil as their final product. On the other hand, the same crude oil is bought by oil refining companies as raw materials to manufacture their final products, i.e., gasoline, kerosene, paraffin, etc.
source: BP Annual Reports
As we note from BP annual report, Crude Oil and Natural Gas are the raw material inventories included in the Types of Inventory Classification.
It is essential to optimize raw material inventory. It is because if a company keeps too much raw material inventory in stock, it will incur higher carrying costs, and there is also the undesirable possibility of the inventory getting obsolete. For example, in the pharmaceutical or food industry, the raw materials may be perishable. If not used within a stipulated time limit, they can get expired and can’t be used in production. On the other hand, a company must have a certain minimum level of inventory at all times to cater to the production volumes, which mostly follow the trend of the market demand. Thus, the optimization of raw material inventory is essential.
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#2 – Work in Progress (WIP) Inventory
Work in progress inventory can also be called semi-finished goods. They are the raw materials that have been taken out of the raw materials store and are now undergoing the process of their conversion into the final products. These are the partly processed raw materials lying on the production floor. And they have also not reached the stage where they have been converted into the final product.
The extent of inventory locked-up as work in progress is lower the better. It is understandable as the inventory under process is of no use till it gets converted into the final product. It may be saleable at some price, but it cannot be sold to generate any revenue for the company’s core business. In fact, in lean manufacturing systems, the work in progress inventory is considered as waste.
So it is most desirable that the volume of inventory that is lying in the form of work in progress be minimized, and the time is taken to convert it into the final, also be minimized so that the locked-up value can be released as quickly as possible. The idea is that this capital, which is locked-up in the form of work in progress inventory, can otherwise be invested somewhere else to achieve much better returns.
#3 – Finished Goods Inventory:
Finished goods are indeed the final products obtained after the application of the manufacturing processes on the raw materials and the semi-finished goods discussed above in the article. They are saleable, and their sale contributes fully to the revenue from the core operations of the company.
Regarding the level of finished goods inventory, there are two types of industries that we need to look at. First, we would take the industries in which the finished goods are mass-produced, and the sale happens after the production. Examples of such industries are the FMCG industry and the oil industry. For a company in such an industry, the correct approach is to maintain the finished goods inventory similarly as the raw material inventory is maintained, i.e., at an optimized level as per the demand in the market.
Ford is reducing its finished goods inventory by trimming production. As we noted above, Ford had a supply of only 78 days in February as compared to 97 days of stock in January.
The other type of industry is one in which the goods are manufactured on demand, i.e., the order is first received, and then the production starts. An example of such industries is the capital goods industry and the customized goods industry. For a company in such an industry, it is neither necessary nor advisable to keep any inventory of finished goods because their finished goods kept ready in stock might never get sold even if they have the slightest deviation from the specifications of the new orders coming from the customers. So they may never get a return on their investment gone in making the finished goods ready.
Other types of Inventory:
There are two other crucial types of inventory, namely packing material inventory and MRO (maintenance, repair and operating) supplies inventory.
As the name suggests, the packing inventory is the inventory of the materials that are used by the company to pack the goods. Within this category, there is something called the primary packing inventory and the secondary packing inventory. Primary packing is something without which the goods can’t be used. For example, the tube of an ointment is its primary packing.
Secondary packing is something used to pack the goods so that they don’t get damaged during handling, transportation, etc. or to make the goods appear more appealing to the customers. For example, the carton used to pack the tube of an ointment is its secondary packing.
MRO supplies or simply supplies or consumables are those materials that are consumed in the production processes but do not form a part of the finished goods or form a tiny part of the finished goods. They are a type of supporting materials for the production process. The maintenance and repair supplies include the lubricating oil, coolant, bolt, nuts, etc. that are used during the production of various machines and machine components. Operating supplies include the stationery and office supplies used by a company.
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3 Types of Inventory Video
Inventories are the assets that will be of have been converted to the final products of a company. They are of three major types, namely raw materials, work in progress, and finished goods. The management of inventory calls for an optimum level of inventory that can be maintained by creating an inventory purchasing plan as per the strategy adopted by the company.