Calculating Finished Goods Inventory
As a manufacturer of goods, you’re likely to have finished goods inventory in your business. Plus there’s raw materials and unfinished goods to take stock of too. In addition to worrying about sales forecasts and production schedules, there’s also the issue of properly calculating finished inventory for reporting and decision-making purposes.
Firstly, we’ll start with describing finished goods inventory. Then we’ll explain why you should pay attention to finished and other forms of inventory. We’ll also take a side trip to see how accountants treat various forms of inventory. Next, we’ll see how finished goods affects your business. Finally, we’ll introduce a simple formula for calculating it along with an example.
What Is Finished Goods Inventory?
Finished goods inventory are those final goods that are waiting to be sold. They are called finished goods because they’ve gone through the assembly and manufacturing process. And now they wait to be stored in warehouses. Thus, from an accounting point of view, finished goods are assets and they are shown in the balance sheet.
More specifically, you intend to sell them within a year. Thus they are short-term assets. After all, which business owner would not want to turn over their stock as quickly as possible? This promotes healthy cash flow and avoids the dreaded dead stock syndrome where some stocks see no sales in the past 12 months.
The path to finished goods follows a three-step process. Firstly, you purchase and store raw materials before issuing production orders. Secondly, some goods still in the process of assembly. They are called work-in-progress. Finally, the completed goods are entered as finished goods in the inventory.
This calls for an example. Let’s say that you’re a manufacturer of charcoal BBQ grills. You purchase sheet metal for stamping into various grill sizes and configurations. And, there’s work-in-progress inventory because grills take time to powder coat and assemble. Finished BBQ grills are moved into warehouses for sale and distribution around the country.
Why Should You Worry About Finished Goods Inventory?
Arguably, you should worry about finished goods inventory because it impacts your inventory ratios and reporting for accounting purposes. By knowing your finished goods inventory, you can also keep an eye on costs associated with holding inventory. Firstly, let’s recall the three stages of the manufacturing process.
1. Raw materials.
This is materials that are purchased but not yet processed. For your BBQ grills, you’re looking at rolled sheet metal and other parts and components that go into making a charcoal grill. They are most likely kept on the factory floor and near the assembly for ease of access.
This describes an inventory that is still in various stages of completion. Some stages require time to complete before moving on to the next one. For example, BBQ grills may be waiting to be coated with heat resistant paint and then oven-dried. Others may need final touches such as your company logo and legs to be attached.
3. Finished goods.
This is the stuff that we’re talking about here. Here, the inventory exits the manufacturing process and emerges as final goods that are ready for sale. But they need to be entered into your warehouse for safekeeping. After all, it’ll take some time before they are sold and eventually shipped out.
How Are Various Completed Forms of Inventory Treated?
From an accounting perspective only finished, completed goods should be entered into your inventory account. This is a way of saying that raw materials have been combined with labor to produce goods that are ready for sale. Thus, they make up the inventory available for sale in your business.
Work-in-progress, on the other hand, are not finished goods. They are still in various stages of assembly before they can be considered finished goods. The manufacturing workflow is a multi-step process. Thus, unfinished goods should be entered into a work-in-progress account for accounting purposes.
Raw materials, of course, have their own inventory account as well. They are also current assets. You have every intention to use them within the next 12 months. Some businesses add raw materials and work-in-progress inventory together. However, there’s more value for decision-making by reporting raw materials separately. We encourage you to do the same for your business.
Thus management and investors can better gauge the value of inventory by separating them into raw, unfinished and finished stages. They can also judge how much cash is tied up in these forms of inventory. And how long it takes to move them to the next stage and, ultimately, sell them. After all, tying up too much cash in inventory has negative consequences for your business.
How Does Finished Goods Inventory Affect My Business?
Let’s focus on the part where finished goods have the most physical and financial impact on your business: holding or carrying costs. We wrote about inventory holding costs a while back and how it affects your business. It’s the direct and indirect costs of holding inventory in preparation for sale. The more inventory you hold in anticipation of sales, the more it will cost your business.
Firstly, your finished goods need to be stored in a secured warehouse. However, warehouses cost your business because of rent, depreciation, salaries, and running costs such as electricity and insurance. Plus, there are indirect costs such as the opportunity cost of keeping other inventory and the risk of loss, theft, and damage.
By the way, if you’re fortunate to have implemented a Just-In-Time supply chain then you should have minimal or no holding costs. Theoretically, your workflow does not involve storing finished goods in warehouses. Your goods are considered sold when they are produced. Thus, your finished goods quickly move on to the next step of the larger supply chain.
Finally, there’s the length of time that you’re holding your inventory until they are sold. This is called the inventory holding days ratio. In a way, it’s a measure of how quickly you turn over your inventory, i.e. how long it takes to convert your finished goods into cash. Ideally, you want a short inventory holding ratio to improve the liquidity of your business and keep your inventory “fresh”.
How Do I Calculate Finished Goods Inventory?
Next, it’s time to look at the finished goods inventory calculation itself. The formula is fairly simple:
Finished Goods Inventory = Beginning Finished Goods Inventory + Cost of Goods Manufactured – Cost of Goods Sold
The Beginning Finished Goods Inventory is the value of unsold goods from the previous year. This is found in the balance sheet as the ending finished inventory from the previous accounting period. Thus, this amount is carried forward into the current year as the beginning finished inventory.
The Cost of Goods Manufactured (COGM) can also be described as the cost of goods completed. This is the total value of inventory manufactured and put into a form that is ready for retail sale. Thus, it includes all the expenses incurred to turn work-in-progress inventory into their finished goods form.
The Cost of Goods Sold (COGS) is the cost of sales. It includes all costs incurred in producing the goods for sale. Firstly, the cost of raw materials itself. Secondly, the direct labor cost used in assembly and production. Finally, overhead costs such as rent and utilities for the factory.
Finished Goods Inventory Example
Let’s get back to our BBQ grills example, shall we?
Like any business that sees sales rise in the summer months, you also see no sales during the winter months. In fact, you make the bulk of your sales in the spring and summer seasons. For the colder months, you switch your product mix to charcoal and gas-powered heaters. But that’s another example for another blog post.
Last year you had $10,000 worth of unsold BBQ grills. This year you ramped up production to produce BBQ grills worth $40,000 as it was an unusually hot summer season. Thus you managed to sell $45,000 worth of grills this year. You finished goods inventory is calculated this way:
Beginning finished goods inventory ($10,000) + Cost of goods manufactured ($40,000) - Cost of goods sold ($45,000) = Finished goods inventory ($5,000)
So, at the end of your financial year you had $5,000 worth of grills in your warehouse. This will be the beginning finished goods inventory for the next year. And thus the cycle continues for your future financial reporting periods.
Can finished goods inventory ever be negative?
I know what you’re thinking. What if you managed to sell more than what you produced? Well, that’s not possible if you’re using an inventory management solution such as EMERGE App. An advantage of inventory management software is being able to see available that you can sell, and physical inventory in your warehouse.
Available inventory that you can sell is the remaining inventory after allowing for committed sales. It includes all purchases and sales that may not be physically in your inventory. This is critical for businesses dealing with backorders and drop shipping. On the other hand, physical inventory describes stock on hand or physical stocks. This is important if your business is a go-to company for immediate stocks.
Your salespeople may accidentally sell stock that you do not have. Outdated paper records or spreadsheet mistakes can contribute to these problems. This means you will not be able to fulfill the order, leading to cancellations and very unhappy customers. That’s why it’s best to use a perpetual system to continuously track inventory levels at any time.
Can finished goods inventory ever be zero?
Possibly. This would involve accurately forecasting sales and thus production schedules. It may not be possible to hit zero but a low finished goods inventory would mean less inventory as current assets. But is this a desirable outcome?
We would argue that it’s better to focus on forecasting and maximizing sales rather than aiming for a target of zero finished goods. Aiming for a minimal to low level of finished goods should the outcome of adopting more efficient purchasing and production workflows.
What’s an ideal inventory level?
There’s no single ideal finished goods inventory level as it’ll differ between businesses and industries. Ideally, you want to minimize your finished goods inventory. You’ll keep your inventory holding costs to a minimum as well. But to do this you need to look at your seasonal sales and inventory records. There’s a thin line between having enough stock on hand to meet seasonable effects or keeping too little stock and missing orders.
It’s critical for manufacturers and suppliers to keep an eye on the inventory of finished goods. Where’s there any form of assembly involved, your business is likely to have separate inventory records for raw materials, unfinished and finished goods. This helps you assess just how much cash is invested between your inventories. It also shows how efficient you are in turning over finished goods into sales. So, don’t overlook your finished goods inventory level!