In these next series of lessons, we're going to get into the basic elements of how product costs are established. One topic that comes into this discussion is inventory. In this lesson, we're going to explain what inventory is, the different types of inventory and how it plays into product cost. Let's get started. What do we mean by inventory? By definition, inventory would be all the materials a company has on hand to manufacturer and then assemble a product. As we'll see, inventory could be things like steel bar stock or maybe fully assembled components to purchase from a supplier all the way through products that are finished, packaged, and ready to sell. It turns out there are three inventory. There are raw materials, work in process inventory and finished goods inventories. The idea behind this terminology reflects the value of materials as they flow through the production process. The value of the inventory is captured in the company's financial statements. Meaning you can look this up and see how much inventory a company has on hand, at least in terms of dollar value. Specifically, inventory shows up on the balance sheet, but more on that later in the course. When products are shipped to the customer, they become something called the cost of goods sold or COGS for short. Something we'll also take a look at later in this course. Interestingly, the cost of goods sold is also captured in the company's financial statements, specifically on the income statement. The point is, product cost is strongly related to how inventory costs are captured as materials flow through the factory. Let's dive into each one of these types of inventory to get a better understanding of what they all are. Raw materials inventory, something just called RM for short, is exactly what it sounds like. The really raw materials that might be stored in a warehouse, such as steel bar stock, bolts of fabric, or silicon ingots like you see here, that are the starting point for all semiconductor devices. Raw materials ultimately have something done to them in the manufacturing process, as we'll soon see. But raw materials aren't always so raw. You can have something called purchased finished parts that are stored in the warehouse as well. These could be things like gears or bearing systems, all the screws, nuts, and bolts that you're going to need. If you don't make silicon ingots, maybe you buy sliced and polished silicon wafers from a supplier that specializes in this process. The idea here is that the relevant costs associated with raw materials inventory are effectively what you paid to buy them from all of your suppliers. That's the raw materials inventory. What about the work in process inventory? Work in process inventory, otherwise known as the WIP, is the point in the production process where the raw materials get converted into real components and systems. Depending on the type of product being made, it could be a very labor-intensive manufacturing process involving many shop personnel, like you see here in the image of a textile factory. Alternatively, it could be a very machine intensive part of manufacturing where you put the part inside the machine, say a computerized CNC milling machine, and then let it run for several hours to do its thing. In this case, the relevant costs are what you pay your manufacturing personnel, as well as the cost of owning and operating all those machines. Finally, the products go into the finished goods inventory, or what accountants might call FG. At this point, the product is finished, as you might guess from its name, finished goods. It's fully assembled, tested, packaged, and ready for shipping. Finished goods are sometimes referred to as stock inventory because that represents that the product is in stock, ready to ship when an order is placed by the customer. You may have also heard of the term just in time manufacturing or JIT. That's really nothing more than maintaining the minimum inventory in each one of these categories, with an additional inventory not too far away, often held by your supplier. The finished goods costs are the sum of everything up to that point. Then when it shipped to the customer, that's when it becomes the costs of goods sold. As we start to think about the cost of raw materials as they flow through the factory, consider this rather practical dilemma. Last month, you bought 1,000 components from your supplier for $10,000 or $10 per unit. This month because of world events, prices went up, and that same 1,000 components now cost you $12,000 or $12 per unit. You're ready to begin production and you need to know which cost to use. The dilemma here is that once all 2,000 components are on the shelf, you can't really tell which ones cost $10 and which ones cause 12 because physically they're all the same. In the shop for folks just pulled the ones that they need. What do you do in this situation? Thankfully our accounting colleagues have come to the rescue on this one. For instance, one way of addressing this dilemma is called the first-in, first-out method, or FIFO if you've ever heard of that term. All that means is from a financial tracking standpoint, you use $10 per unit until you go through 1,000 units, and then you switch over to $12 per unit. Now again, the shop is just pulling material off the shelf without really knowing which part costs what. This is all done by the cost tracking function in a company's enterprise software system. The other approach is the last in, first out or LIFO method of accounting for costs. This is just the opposite. You use $12 per unit until you go through the first 1,000 units, and then you switch over to $10 per unit. Now both systems have their positives and negatives. But those details are really what the accounting team worries about. What is important for us to know is that companies have to pick one method or the other and stick with it for future reporting purposes. They don't have the option of selecting a method based on what works best today and then changing their minds for what might work best tomorrow. Once again, from a practical matter, all these parts are just sitting on the shelf and they're identical to each other. You may have only purchased them at different times. The FIFO and the LIFO methods are two accounting techniques used to determine the cost of the part to carry forward into the next stage of the operation. That's our discussion on inventory. Let's wrap this up with a few main takeaways. Inventory is the material a company has on hand to produce a product. There are three types of inventory. Raw materials RM, work in process or WIP, and finished goods FG. The cost of inventory is captured in the company's financial statements, something we're going to go into later. Depending on how inventory is purchased, the same raw materials might have different costs, and that variability is dealt with by the accounting process known as either first-in, first-out or FIFO or last-in first-out, LIFO. Finally, as we'll soon see, inventory costs are an important element of the product cost. Understanding how costs flow through the manufacturing facility is an important part in how we're going to determine the product cost. Hang in there. We're going to get into that shortly. In our next lesson, we're going to see how companies figure out the cost of a product, especially products that are made in batches using what is known as the job cost approach. You'll quickly see how this all starts to come together. I Michael Reedy and I'll see you next time.
