To understand inventory assets, you first have to know what an inventory asset is. An inventory asset is a product that a business has to sell. And if a business is a manufacturer, all of the materials used to make that product are considered inventory. Inventory assets are found in the assets section of the business's balance sheets. How a company categorizes its inventory assets is dependent on whether it is a merchandising company or a manufacturer. A manufacturing company builds or creates its products. Generally, the products are sold to retailers or wholesalers. Its inventory is classified as a work in progress or finished goods. On the flip side, a merchandising company is a retailer or wholesaler that produces purchases products from the manufacturer. They then sell the product to someone else with little or no changes.
Raw Materials Inventory and Work in Progress Inventory
The raw materials inventory assets are the materials used to produce. These raw materials may include things like chemicals, metals, woods, liquids, or food ingredients. These are the items that are reported by the manufacturer as raw materials. If a company purchases flavoring and sugar that is a cost. Work in progress inventory is that inventory that is still being completed. A company may have partially finished furniture or liquids may be mixed but awaiting bottling. The monetary amount of work in progress products is reported on the balance sheet. This dollar amount includes the cost for materials, indirect manufacturing costs, and direct labor costs. Direct labor costs are for the employees who make the product. Overhead for an indirect inventory asset includes factory utilities, factory rent, and factory manager salaries.
Finished Goods Inventory
The finished goods inventory is transitioned from the work in progress inventory to the finished goods inventory. This is the final stage of the manufacturing process. The finished goods inventory represents the final manufacturing asset and cost. An example of this would include finished bread, a finished shoe, or a finished home. If the total cost is $50,000, that is the amount that would be reported as finished goods inventory.
Now that you understand what an inventory asset is, you can understand how important it is to know what assets you have. Assets affect operations and cash flow.
Identifying and valuing inventory is a vital component in preparing a federal tax return for small businesses. Inventory is made up of all the items that a business has on hand to sell, as well as all of the goods that the company will use to manufacture income-producing goods. While inventory is not directly taxable, it is used to calculate a business’s cost of goods sold or COGS. COGS is a component in calculating the business’s taxable income.
Inventory is composed of several possible components. All of the goods that are available, or will be available, for sale as part of the company’s main business are included in its inventory. If the company is a manufacturer, the raw materials that the business has on hand to manufacture its products, as well as the partially completed goods that it will eventually sell, are included in inventory. Parts manufactured by other businesses that are used to construct the company’s goods are part of the company’s inventory. The value of each item in the inventory of a manufacturer is the sum of the costs of the physical materials used and the labor expended in making the product. The containers that will hold goods but are not yet being used are also included in inventory.
Inventory Ownership Distinction
Only those items that are the property of the company are included in the inventory. So, if the business is holding some items in its warehouse that it has already sold to another customer, those goods must be excluded for tax purposes.
Example of Inventory Calculation
A company manufactures metal toy trucks. It has $2,000 in raw metal that it will use to make more trucks. It had $500 in prefabricated wheels that it purchased from a supplier, as well as another $500 in packaging that it will use to package the trucks. Approximately $400 of trucks are in various states of completion, with another $600 worth of trucks completed and packaged. In addition to the $600 amount, another $300 worth of trucks are in the warehouse, but those toys have been sold already and are awaiting customer pick-up. The inventory for tax purposes would be $4,000.
Cost of Goods Sold
COGS is an important element in calculating a business’s gross profit, which is used to determine the company’s taxable income. You calculate a business’s COGS by adding the company’s inventory balance at the beginning of the year to the sum of all inventory purchases made during the year. The purchase amount includes all acquisitions of raw materials and finished goods, as well as the labor costs associated with manufacturing the goods for sale. Then, you subtract the balance of inventory at the end of the year. What remains is the COGS for the year.