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Principles and Practice of Accounting > Inventories > Meaning and Classification of Inventory
Inventories

Meaning and Classification of Inventory

A company always has some stock lying with them. The stock can be of finished goods or raw materials or of tools and machinery. This stock of materials is what we refer to as inventory. Let us understand the concept and meaning of inventory and the types of inventories.

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What is Inventory?

Inventory is an asset of the firm. It is basically a schedule of all materials held by the company for the purpose of production or sale in the near future. One definition of inventory defines it as resources that are usable but idle at the time. And the term inventory includes all types of stocks – raw material, work progress, finished goods, tools, spare parts etc.

Therefore we can classify inventory as assets held for one of the following three purposes,

  1. assets held for sale in the normal course of business
  2. held for the purpose of production of goods
  3. for the consumption in the production of such goods (any equipment or tools or materials the company requires in the manufacturing process)

At the end of every financial year, the company must make a schedule of its inventory. This is done so we can ascertain the value of the closing stock of the inventory. This closing balance is a very important figure in preparing the final accounts of the company. It will reflect on the asset side of the balance sheet and the credit side of the Trading Account.

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Classification of Inventory

Inventory can be broadly divided into two main categories – direct inventories and indirect inventories. So let us study the difference between these classifications of inventory.

1] Direct Inventories

These are the inventories that are an integral part of the finished product. So basically any physical component which is a part of the final good comes under the classification of direct inventory. Another important feature of direct inventories is that you can assign the stock to specific physical units. Let us now see the different types of direct inventories.

  1. Raw Materials: These are goods which are to be used in the manufacturing process to produce final goods. They are the goods in their raw or natural form. For example, sugarcane is the raw material in a sugar factory, rubber is a raw material in a tire factory etc. A stock of raw materials is always kept so the production process is uninterrupted. Also buying raw materials in stock provides economies of scale. But one has to be careful of the carry costs as well.
  2. Semi-Finished Goods: These are also known as work-in-progress. As the name suggests they are not 100% complete. Some further work has to be done before they can be sold. Say for example in a toy factory, toys that are molded but still have to be painted will be semi-finished goods.
  3. Finished Goods: These are fully completed goods ready for sale, but not yet sold.

2] Indirect Inventories

Indirect inventories comprise of stock items that are necessary for the manufacturing of goods but are not a direct component of such goods. They are ancillary goods, which means we cannot assign them to specific units of the final goods.

Such indirect inventories can be from the manufacturing process or even the selling, distribution or administrative purposes. For example, petrol or lubricants used in production are indirect inventories. And office supplies used in administration also fall under the category of indirect inventories.

Solved Example for You

Q: Can a building be considered inventory in a construction business?

Ans: Yes, for a construction business a building under construction will be inventory. The building is being built in the normal course of business and will eventually be sold as well. So then according to AS 2, it will be a part of the WIP stock.

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