What is Inventory?

Is inventory an asset?

Is inventory an asset? Over my 20+ years in public accounting, I frequently came across this question. From a small business owner standpoint, this answer isn’t always clear. Most small business owners view inventory as cash out—a business expense.

Inventory an asset or liability?

Inventory is an asset of your company.

Many small and medium business owners view inventory as a liability. The reason is the raw materials, the works in process, and the finished goods all must be:

• Stored somewhere
• Insured against fire, theft, etc.
• Monitored and tracked by employees

These incur expenses for the company. The inventory is costing the business money after it has been made ready for sale, so the business owner views it as a liability. This is one of the paradoxes in accounting. You own something that will cost you money if unsold, yet it is an asset.

If you can sell an item, e.g. convert it to cash, then it should be considered an asset. If you are producing items that you sell on a regular basis, then those items should be inventory assets. In other words, ask yourself, “Are the items I am producing going to create revenue?”

If the answer is yes, then the item truly is an inventory asset.

How do you track?

The major accounting categories to use for general ledger tacking are:

• Raw Materials – The supplies you purchase to combine into your final product.
• Work in Process – These are products that have gone past the raw material phase but are not quite ready for sale. Usually you use this general ledger account for month or year end accounting. This account is considered a place holder account until the product is ready for shipping.
• Finished Goods – The final product that is ready to be sold or shipped.

At each step of the process, your product will incur cost. From an accounting standpoint the easiest category to understand is the raw material.  You already know how much you paid for it, so it is just a matter of calculating the cost per unit. As you begin assembly, you start to add more and more cost and the unit will go from raw materials to a work in process. Then it will end as finished goods on your general ledger.

How to Properly Allocate Costs

Within the accounting world there is this term called “full absorption.” This means that you need to record all direct and indirect costs related to the production of one unit. The main items you need to consider:

1. The cost of the raw material. This is usually the biggest production cost.
2. Next is direct labor. How much did you pay to assemble the product? How many units can be assembled in one hour or one shift? When you know this, you can allocate this expenses to the units.
3. Finally, overhead. This is where it gets tricky. These are the indirect cost related to production. An example of indirect costs are utilities that power the manufacturing area of your company. Those costs are technically related to the production of the product, but you can’t directly assign to any specific unit. Yet, these costs need to be allocated to each unit produced. The allocation method of indirect costs can vary depending on your industry. This part can be overwhelming for even the most seasoned business owner. Consider outsourced accounting services, such as hiring a virtual CFO to help you set up proper cost accounting to make this step easy.

Breakeven

The biggest factor to understand is the breakeven point. If your costs are not properly accounted for in your inventory (raw material, direct labor, overhead), then it will be next to impossible to properly calculate the breakeven point for your sales. For example, say you have a product that has:

• $100 of raw material
• $10 of direct labor
• $12 of overhead

You record the raw material and direct labor but ignore the overhead. So you will incorrectly assume your breakeven point per unit is $110 when in reality it is $122. If you sell it for $120 per unit, a 9% markup, you are losing $2 per unit. This can happen if you don’t track the cost and allocate it correctly. To calculate the appropriate breakeven point, you must account for all costs.

Recap:

• Inventory is an asset
• Track your inventory using general ledger accounts
• Allocate indirect costs

You put a lot of resources into your inventory. Make sure you get the benefit and record your inventory asset.

Steven D Hovland is a Certified Public Accountant and a Certified Forensic Accountant. He has 20+ years of experience in auditing, accounting, and forensic investigations. He is the founder of Delegate CFO, a virtual CFO service company.