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Guide to Understanding the Inventory Concept

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How to Calculate Inventory (Step-by-Step)

In accounting, the term “Inventory” describes a wide array of materials used in the production of goods, as well as the finished goods waiting to be sold.

The inventory balance of a company is recorded on the current assets section of the balance sheet, since unlike fixed assets (PP&E) — which have useful lives of greater than twelve months — a company’s inventories are expected to be cycled out (i.e. sold to customers) within one year, or twelve months.

Generally speaking, the four different types of inventories are raw materials, work-in-progress, finished goods (available-for-sale), and maintenance, repair, and operating supplies (MRO).

  1. Raw Materials: The components and parts of material necessary in the process of creating the finished product.
  2. Work-In-Progress (WIP): The unfinished products in the production process (and thus not yet ready to be sold).
  3. Finished Goods (Available-for-Sale): The finished products that have completed the entire production process and are now ready to be sold to customers.
  4. Maintenance, Repair, and Operating Supplies (MRO): The inventories essential to the production process but not directly built into the final product itself (e.g. the protective gloves worn by employees while manufacturing the product).

Inventory Formula

The formula to calculate the ending inventory balance is as follows.

Ending Inventory = Beginning Inventory BalanceCOGS + Raw Material Purchases

The carrying value of a company’s inventories balance is affected by two main factors:

  1. Cost of Goods Sold (COGS): On the balance sheet, inventories is reduced by COGS, whose value is dependent on the type of accounting method used (i.e. FIFO, LIFO, or weighted average).
  2. Raw Material Purchases: As part of the normal course of business, a company must replenish its inventories as needed by purchasing new raw materials.

Change in Inventory on Cash Flow Statement (CFS)

There is no inventories line item on the income statement, but it gets indirectly captured in the cost of goods sold (or operating expenses) — regardless of whether the corresponding inventories were purchased in the matching period, COGS always reflects a portion of the inventories that were used.

On the cash flow statement, the change in inventories is captured in the cash from operations section, i.e. the difference between the beginning and ending carrying values.

  • Increase in Inventories → Cash Outflow (”Use”)
  • Decrease in Inventories → Cash Inflow (”Source”)

By ordering materials on an as-needed basis and minimizing the time that inventories remain idle on shelves until being sold, the company has less free cash flow (FCFs) tied up in operations (and thus more cash available to execute other initiatives).

Inventory Write-Down vs. Write-Off

  • Write-Downs: In a write-down, an adjustment is made for impairment, which means that the fair market value (FMV) of the asset has declined below its book value.
  • Write-Offs: There is still some value retained post-write down, but in a write-off, the asset’s value is wiped out (i.e. reduced to zero) and is completely removed from the balance sheet.

Inventory Valuation: LIFO vs. FIFO Accounting Methods

LIFO and FIFO are the top two most common accounting methods used to record the value of inventories sold in a given period.

  1. Last In, First Out (LIFO): Under LIFO accounting, the most recently purchased inventories are assumed to be the ones to sold first.
  2. First In, First Out (“FIFO”): Under FIFO accounting, the goods that were purchased earlier are recognized first and expensed on the income statement first.

The impact on net income depends on how the price of inventories has changed over time.

LIFO vs. FIFO Last In, First Out (LIFO) First In, First Out (FIFO)
Rising Inventory Costs
  • If costs have been increasing, COGS for earlier periods will be higher under LIFO since the recent, pricier purchases are assumed to be sold first
  • The higher COGS results in a reduced net income for those earlier periods.
  • If costs are rising, using FIFO would cause the recorded COGS to be lower in the near term.
  • The lower costs are recognized first, so net income is higher in earlier periods.
Declining Inventory Costs
  • If costs have been declining, COGS would be lower under LIFO in earlier periods.
  • In effect, net income for earlier periods would be higher because the lower costs are recognized.
  • If costs have been decreasing, COGS would be higher under FIFO as the recognized costs are the older, more expensive ones.
  • The ending impact is a reduced net income for the current period.

The weighted-average cost method is the third most widely used accounting method after LIFO and FIFO.

Under the weighted-average method, the cost of the inventories recognized is based on a weighted average calculation, in which the total production costs are added and then divided by the total number of items produced in the period.

Since each product cost is treated as equivalent and the costs are “spread out” equally in even amounts, the date of purchase or production is ignored.

Hence, the method is often criticized as too simplistic of a compromise between LIFO and FIFO, especially if the product characteristics (e.g. prices) have undergone significant changes over time.

Under U.S. GAAP, FIFO, LIFO, and the Weighted Average Method are all permitted but note that IFRS does not allow LIFO.

Inventory Management KPIs: Formula and Interpretation

The days inventory outstanding (DIO) measures the average number of days it takes for a company to sell off its inventories.

Companies aim to optimize their DIO by quickly selling their inventories on hand, i.e. a lower DIO implies the company is more efficient at inventory management.

Days Inventory Outstanding (DIO) = (Inventory ÷ COGS)× 365 Days

The inventory turnover ratio measures how often a company has sold and replaced its inventories in a specified period, i.e. the number of times inventories was “turned over”.

Inventory Turnover Ratio = COGS ÷ Average Inventory Balance

When interpreting the KPIs above, the following rules are generally true:

  • Low DIO + High Turnover → Efficient Management
  • High DIO + Low Turnover → Inefficient Management

In order to project a company’s inventories, most financial models grow it in line with COGS, especially since DIO tends to decline over time as most companies become more efficient as they mature.

DIO is usually first calculated for historical periods so that historical trends or an average of the past couple of periods can be used to guide future assumptions. Under this method, the projected inventories balance equals the DIO assumption divided by 365, which is then multiplied by the forecasted COGS amount.

Inventory Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

Submitting ...

Step 1. Operating Assumptions

Suppose we are building a roll-forward schedule of a company’s inventories.

Starting off, we’ll assume that the beginning of period (BOP) balance of inventories is $20 million, which is impacted by the following factors:

  • Cost of Goods (COGS) = $24 million
  • Raw Material Purchases = $25 million
  • Write-Down = $1 million

COGS and the write-down represent reductions to the carrying value of the company’s inventories, whereas the purchase of raw materials increases the carrying value.

  • Ending Inventory = $20 million – $24 million + $25 million – $1 million = $20 million

The net change in inventories during Year 0 was zero, as the reductions were offset by the purchases of new raw materials.

Step 2. Inventory Roll-Forward Schedule Calculation

For Year 1, the beginning balance is first linked to the ending balance of the prior year, $20 million — which will be affected by the following changes in the period.

  • Cost of Goods (COGS) = $25 million
  • Raw Material Purchases = $28 million
  • Write-Down = $1 million

Step 3. Ending Inventory Calculation Example

Using the same equation as before, we arrive at an ending balance of $22 million in Year 1.

  • Ending Inventory = $20 million – $25 million + $28 million – $1 million = $22 million

Inventory Roll-Forward Calculator

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