Imagine the scenario in which we have a company who sells smartphones; the production gets outsourced.
Therefore, your inventories will be mainly comprised of finished products.
Imagine the opposite scenario. The company manufactures smartphones. Therefore, the inventories will be comprised of the finished product (smartphones), but also and mainly of components.
As you can imagine the value of the inventories from the first to the second scenario will be slightly different.
Inventories will be valued according to the “net realizable value” or the amount for which the goods can be sold for after subtracting the expenses incurred to make the sales.
As we saw from the example above, if you own a company who manufactures smartphones, the inventories will be comprised of three kinds of goods that can be valued accordingly.
We can classify the inventories based on how close they are to being sold. A raw material, for instance, if yet in a state that can’t be sold. In fact, that needs to be processed to become a final product.
FIFO vs. LIFO
FIFO and LIFO are two accounting methods used for inventory management.
FIFO stands for first-in, first-out, it means that the oldest items in the inventory will be recorded as sold first (it is simply an accounting assumption).
LIFO stands for last-in, first-out, where the most recent items in the inventory are recorded as sold first, therefore expensed.
Why does it matter?
Inventory management is a key aspect of any business that deals with physical products. Failing to convert inventory quickly into cash can also turn a profitable company into a bankrupt company due to liquidity. That is why it matters to look at things like Inventory Turnover Ratio and other metrics like Cash Conversion Cycles to understand the effectiveness of a business to stay liquid and prevent short-term lack of financial resources, leading to bad credit and bankruptcy.
The way you decide to account for inventory will also change how financial statements will look like.