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Inventory 101

Here, I will deal the very basic concepts of how inventory works both in retail and manufacturing setups. I don't intend to be exhaustive in my definitions and concepts although this section can be expanded from time to time.
Policies and provisions inherent to a particular company may differ from the other, but general inventory concepts, procedures, and best practices are essentially the same.

What is inventory?

Generally, inventory is a list for goods and materials, or those goods and materials themselves, held available in stock by a business. In accounting, inventory is considered an asset. Inventory can be categorized into 3 essential types: Materials or components, Work in progress (WIP), and finished goods. 

Materials or components. They consist of the essential items needed to create or make a finished product, such as gears for a bicycle, cathode ray tubes for a television set. They are the auto spare parts that we normally buy from auto parts supply such as Schucks or O'Reilly parts supply. Another good example are Boeing hardware and parts supply that RGIS performs inventory on a regular basis.

Work in Progress (WIP) materials. Are items that are partially completed, but are not the entire finished product. These are unfinished products we could see from assembly lines such as automotives and appliances. They are on their way to becoming whole items but are not quite there yet.

Finished goods. These are final products that are ready to be shipped or purchased by customers and consumers. Finished products can range from birthday cakes that we buy from Red Ribbon or Buricchini to Hallmark greetings cards at Safeway or Walgreens, to Kenmore Washing machines that we buy from Sears or Walmart.

Note: The word inventory may also refer to a list of the contents of a household and for a list for testamentary purposes of the possessions of someone who has died.

What is Inventory Control?

 Inventory control is the delicate balance of the costs versus profits associated with having stock on hand. It is also called stock control. It is keeping the overall costs associated with having inventory as low as possible without creating problems. A proper inventory control balances at all times between having too much and too little in order to maximize profits. Having too many products leads to further losses when they don’t move off of the shelves.
Having too little stock on hand can create problems as well, such as running out of inventory which may translate to financial losses when inventory is not available for customers to purchase.

However, most retailers expect they will have shortages on occasion and they have calculated that the small loss is worth the money saved by not having an overstock. You are torn between forcing to sell your overstock before the absolescence period AND  donating your overstock to a local food bank or goodwill store nearby. Either way, you will still loss profits.

Another important element of inventory control is called reorder point. Businesses and retailers in particular, need to think ahead and calculate the best time for reordering products. Doing so too soon may cause financial difficulties or running out of space. On the other hand, waiting to long to reorder will result in a shortage and running out of inventory before the next shipment arrives.

Inventory control can break a business when implemented poorly, because either expenses will be too high or customers will get tired of dealing with shortages and find another place to spend their money.

TIP: When figuring out a reorder point, it’s necessary to calculate how long it will take the shipment to arrive and the amount of demand for a particular item. The overhead costs, fees, and shipping expenses of ordering large versus small quantities should also be looked at.

What is Beginning Inventory?

Beginning Inventory is the starting amount of inventory stocks that the company have during the start of their business. It is the total amount of stock at the start of their business. It is similar to ending inventory except that it is adjusted for any accounting discrepancies.

Retailers and companies use Beginning Inventory to gauge new ordering requirements and to forecast future sales.

Here's a common steps on how to calculate Beginning Inventory:

  1. Make sure to locate the balance sheet from the previous period. The previous period provides the total amount of inventory available at the beginning of the current sales cycle.
  2. Makes sure to verify if there was any additional inventory that was purchased between the previous and current period. Any transactions or purchases that have occurred after the closing trial balance of the previous may need to be recorded (into the general journal) to ensure accuracy.
  3. Record or post any additional inventories transactions or purchases to the appropriate accounts. This is to ensure accuracy of the total amount of beginning inventory for the period.
  4. Once everything has been posted, calculate the total inventory. These are the combinations of the total from steps 1, Additional transactions in step 2, and items reported in step 3.

Inventory Turnover

A ratio which shows how many times a company's inventory is sold and replaced over a particular period. Inventory turnover can be calculated as:

Inventory Turnover = Sales / Inventory

or, it can also be expressed as:

Inventory Turnover = Cost of Goods Sold / Average Inventory

The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days". Although the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors.

Note: This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.

Reorder Point

It is the level of inventory when a fresh order should be made with suppliers to bring the inventory up by the Economic order quantity (EOQ. The level of inventory that minimizes the total inventory holding costs and ordering costs). It simply answers the question, "When can I reorder a particular item before it runs out from my stock."

The reorder point for replenishment of stock occurs when the level of inventory drops down to zero. In view of instantaneous replenishment of stock, the level of inventory jumps to the original level from zero level.

2 factors that determine the appropriate Reorder Point:
  •  Delivery time stock, which is the stock you needed during the Lead Time.
  • Safety Stock which is the minimum level of inventory that is held as a protection against shortages due to fluctuations in demand.
Therefore, Reorder Point is calculated as:

Reorder Point = Normal consumption during Lead Time + Safety Stock

Note: Lead Time is the difference between the order date and the receipt of the inventory ordered. Or, The amount of time between the placing of an order and the receipt of the goods ordered.

Safety Stock

It is a term used by inventory specialists to describe a level of extra stock that is maintained below the cycle stock to buffer against stockouts. Safety stock (also called buffer stock) exists to counter uncertainties in supply and demand. They are extra units of inventory carried as protection against possible shortfall in raw material or packaging. By having an adequate amount of safety stock on hand, retailers can meet a sales demand which exceeds the demand they forecasted without altering their production plan.

Why do retail businesses use safety stock? For a number of reasons:
  • There are instances when an unexpected increase in demand (such as a competitor may be sold out on a product), which is increasing the demand for their products.
  • Suppliers may deliver their products late, or they have discontinued the production and distribution of the products being ordered.
  • Other factors such as, warehouse worker's on strike, machinery breakdowns, weather conditions, etc.


The percentage of loss of products between manufacture and point of sale is referred to as shrinkage, or sometimes called shrink. It also refers to the the amount by which inventory on hand is shorter than the amount of inventory recorded.The missing inventory could be due to theft, damage, absolescence, or administrative errors.

The term is also used in manufacturing when referring to the loss of raw materials during a production process. It can also mean a spoilage or waste and it can be either normal or abnormal.

Causes of shrinkage:

  • Employee Theft
  • Shoplifting
  • Damage in transit or in the store.
  • Administrative errors such as shipping errors, warehouse discrepancies, and misplaced goods.
  • Cashier or price-check errors in the customer's favour.
  • Vendor fraud.
  • Absolescence. (Perishable goods not sold within their shelf life)

How to Calculate shrinkage Percent.
Calculating shrinkage figures can be accomplished through the following formulas:

Beginning Inventory + Purchases - (Sales + Adjustments) = Booked (Invoiced) Inventory

Booked Inventory - Physical Counted Inventory = Shrinkage

Shrinkage/Total Sales x 100 = Shrinkage Percent

Note: An estimated 44% of shrinkage in 2008 was due to employee theft, totaling over $15.9 billion. Another 35% was due to shoplifting, totaling over $12.7 billion.

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