4 Types of Inventory in Accounting and How Costs Flow

In accounting, the four main types of inventory are merchandise (goods a retailer buys ready to resell), raw materials (inputs waiting for production), work in process (partly finished goods), and finished goods (completed products a manufacturer holds for sale). Retailers usually report only merchandise inventory, while manufacturers track the other three.

Consider a roll of canvas. A fabric store can sell it as merchandise, while a pouch maker can use the same roll as raw material. Its purpose in each business determines its classification. So before you pick an account, ask two questions: whose books are you looking at, and how far along is the product on the reporting date?

How costs move from raw materials to cost of goods sold

This 90-second clip comes from our job order costing lesson. It follows one product from materials issued to production through the sale of the finished goods (0:53 to 2:23), which is exactly the cost flow this guide explains. Watch this segment on YouTube.

Which types of inventory does each business report?

Under U.S. GAAP (FASB ASC 330, Inventory), inventory is tangible property a business holds for sale in its ordinary operations, is producing for sale, or will soon use up in making goods or services for sale. It is usually reported as a current asset. Read the description of the business before looking for words such as “finished” or “supplies.” A completed product arriving from a supplier can fit a different category in the buyer’s records.

A manufacturer may also hold factory supplies, such as lubricant for a cutting machine. Supplies waiting to be used in production fit the GAAP definition of inventory, and SEC Regulation S-X lists supplies alongside raw materials, work in process, and finished goods as major inventory classes. Their cost moves into manufacturing overhead as they are consumed. The cutting machine itself is equipment, though, so buying something for the factory does not automatically make it inventory.

What about MRO supplies, packing materials, and safety stock?

If you have seen lists that name MRO as one of the four types of inventory, you were reading the supply chain view. MRO stands for maintenance, repair, and operating supplies, such as machine lubricant, cleaning products, and light bulbs for the factory. Operations teams also talk about packing materials, safety stock (extra units kept as a buffer), cycle stock, and goods in transit.

Those labels describe why stock is held or where it sits. They do not create new balance sheet accounts. In financial accounting, each item still lands in one of the categories above. Safety stock of finished pouches is still finished goods. Packaging that becomes part of the product, such as the box a pouch is sold in, is usually treated as raw materials. MRO supplies used in the factory are carried as supplies and move to manufacturing overhead as they are used.

For the CPA and CMA exams, stick with merchandise, raw materials, work in process, and finished goods, plus supplies when a question mentions them.

When does an inventory cost become an expense?

For a merchandiser, inventory cost has a short route. The business buys goods, carries unsold goods as an asset, and recognizes the cost assigned to units sold as cost of goods sold (COGS). A selling price belongs in revenue. The cost the seller gives up belongs in COGS.

A manufacturer has two additional transfers before the sale. Direct materials issued to production, direct labor, and an allocated share of manufacturing overhead accumulate in WIP. Direct labor pays people who work on the product. Overhead includes indirect production costs such as factory utilities. When a batch is complete, its accumulated cost moves to Finished Goods. The transfer changes the account holding the asset. The sale is the event that moves that cost to expense.

There are two exceptions worth knowing for the exam. First, when the applicable net realizable value or market amount falls below inventory’s carrying amount, the company writes inventory down and expenses the loss in that period. Under U.S. GAAP, most companies measure inventory at the lower of cost and net realizable value (the estimated selling price minus the costs to complete and sell the goods). Companies using LIFO or the retail inventory method use the lower of cost or market instead. Second, abnormal material waste or spoilage and fixed overhead that goes unallocated because the plant sat idle are expensed when incurred instead of being added to inventory. Expected spoilage inherent in normal production is included in inventory cost.

A useful check is to trace a single dollar of canvas. Before cutting, it belongs to raw materials. During stitching, the same dollar is part of WIP. Completing the pouch moves that dollar into finished goods. Adding it to each stage’s ending balance would count one dollar several times.

Worked example: follow a batch of canvas pouches

Suppose Harbor Stitch starts with no inventory, buys $1,500 of canvas, and issues $960 of it to make 80 identical pouches. Workers earn $480 on the batch, and the company applies $160 of manufacturing overhead. All 80 pouches are completed. Harbor sells 50 for $34 each and holds the other 30. There are no losses or other transactions.

Harbor reports ending inventory of $1,140, comprising $540 of raw materials and $600 of finished goods. Sales revenue is $1,700 (50 × $34), so gross profit is $700 ($1,700 − $1,000). Gross profit measures earnings for the period, while the $1,140 of ending inventory is an asset on the reporting date.

How do goods available for sale reconcile?

For a retailer, add beginning merchandise inventory to the cost of goods purchased, including applicable freight-in and net of purchase returns, allowances, and discounts. For a manufacturer’s finished goods account, add the cost of goods manufactured during the period to beginning finished goods. Both computations give the cost available for sale.

For a manufacturer, the formula is: beginning finished goods + cost of goods manufactured − ending finished goods = cost of goods sold. Harbor’s cost of goods available for sale is $0 + $1,600 = $1,600, and its check is $1,600 − $600 = $1,000. Subtracting the unused canvas as well would mix production stages. If the physical count falls short, see how to reconcile inventory shrinkage. For the timing of the entries, compare perpetual and periodic inventory records.

Common mistakes students make with inventory types

These slips cost students points most often, and exam writers like to build wrong answer choices around them.

• Calling every completed product finished goods. Only the company that made the product reports finished goods. A retailer or distributor that buys the same product ready to sell reports merchandise inventory.
• Putting raw materials into the cost of goods sold formula. Cost of goods sold comes out of finished goods (or merchandise). Unused raw materials stay on the balance sheet.
• Counting one cost twice. Raw materials, work in process, and finished goods are stages of the same cost. Add only each account’s ending balance, not the amounts that passed through it.
• Treating the move to Finished Goods as an expense. Completing a batch moves cost from one asset account to another. The expense shows up when the goods are sold.
• Forgetting about supplies. Factory supplies waiting to be used are inventory and become overhead when consumed. Office supplies are not inventory.

Exam tip: Classification and cost flow questions appear in CPA FAR (inventory reporting), in cost accounting topics on CPA BAR and CMA Part 1, and in intermediate accounting courses. Read who owns the goods and what they plan to do with them before you look at the answer choices.

Practice questions and answers

Practice 1: Flour at a grocery store vs. a bakery

A grocery store buys sealed bags of flour to sell. A bakery buys identical bags to make bread. How does each classify unused flour?

The grocery store has merchandise inventory. The bakery has raw materials because the flour will enter production.

Practice 2: Where does a batch’s cost belong?

A batch in production has $420 of direct materials, $250 of direct labor, and $80 of applied overhead. Where does its cost belong?

The $750 total belongs in WIP while the batch is unfinished. Completion transfers that amount to Finished Goods.

Practice 3: Compute a manufacturer’s cost of goods sold

Beginning finished goods are $900. A manufacturer completes goods costing $4,100 and has $1,300 in finished goods at the end. What is COGS, assuming no losses?

Goods available cost $5,000. Subtracting $1,300 gives $3,700 of COGS. Raw materials waiting for production are outside this calculation.

Practice 4: Compute a retailer’s cost of goods sold

A retailer starts the year with $2,000 of merchandise. During the year it buys $9,500 of merchandise, net of returns and discounts, and pays $300 of freight-in. Its year-end count shows $1,800 of merchandise. What is cost of goods sold?

Cost of goods available for sale is $11,800 ($2,000 + $9,500 + $300). Subtracting the $1,800 of ending inventory gives $10,000 of cost of goods sold. Freight-in is part of the cost of the merchandise, so it belongs in the calculation.

Frequently asked questions

Can a retailer have hundreds of products in one inventory account?

Yes. Detailed records can identify each product while a single merchandise inventory balance summarizes their total cost.

Must a manufacturer show every inventory class on the face of the balance sheet?

For companies subject to the U.S. Securities and Exchange Commission’s Regulation S-X, major classes are disclosed separately on the balance sheet or in a note when practicable. The face of the balance sheet can therefore show a total. See Regulation S-X, Rule 5-02(6).

Is a completed product always finished goods?

Ask who made it. A maker’s completed products held for sale are finished goods. A distributor that buys the same products ready for resale records merchandise inventory.

What are the 4 types of inventory in accounting?

Merchandise, raw materials, work in process, and finished goods. A retailer usually reports merchandise. A manufacturer reports raw materials, work in process, and finished goods, and may also report factory supplies.

Are supplies considered inventory?

Factory supplies that will be used up in production are part of inventory, and SEC Regulation S-X lists supplies as one of the major inventory classes. Their cost moves into manufacturing overhead as they are used. Office supplies used for administration are not inventory.

Does IFRS classify inventory the same way?

Mostly, yes. IAS 2 defines inventories as assets held for sale, in production for sale, or materials and supplies to be consumed in production or in providing services. One difference CPA candidates should remember: IFRS does not allow LIFO, while U.S. GAAP does.

Who reports goods in transit or goods on consignment?

Inventory is generally reported by the party that controls the goods. Under typical FOB shipping point terms, control transfers to the buyer when the goods are shipped. Under typical FOB destination terms, the seller retains control until delivery. The full contract and relevant facts determine when control transfers. Goods on consignment stay in the consignor’s (the owner’s) inventory even though the consignee holds them.

Key takeaways

• The four types of inventory are merchandise, raw materials, work in process, and finished goods.
• Retailers report merchandise. Manufacturers report raw materials, work in process, and finished goods, often with factory supplies.
• The same item can be classified differently depending on whose books you are looking at.
• Production costs move from raw materials to work in process to finished goods. They become an expense (cost of goods sold) when the goods are sold.
• For a manufacturer, cost of goods sold equals beginning finished goods plus cost of goods manufactured minus ending finished goods.

Want more practice like this? Start with the Farhat Lectures free sample course. It costs nothing, so you can see how the lessons, videos, and practice questions fit together before you choose a full course.