Here’s what accurately reported finished goods inventory helps you do:
- Reduce waste
- Determine profitability
- Optimize inventory management
Those are three very good things. And they all improve when you invest in tightening up your finished goods inventory process and reporting.
So let’s get down to business. Here’s what finished goods inventory is, how to calculate it, and why it's one of the best types of inventory out there.
What Are Finished Goods?
Finished goods are all the products that manufacturers actually sell to buyers, be they upstream vendors or retailers. All the raw materials, all the items in every stage of production, it culminates in finished goods inventory. It’s also known as finished product inventory.
“Finished” is a relative term, though. One manufacturer’s finished goods inventory may be a retailer’s merchandise inventory, dropshipping inventory, or another manufacturer’s raw material or component. It depends where those finished goods go after their completion.
Becoming Finished Goods Inventory
Finished goods inventory becomes finished goods inventory by first being the other two types of manufacturing inventory. Here’s how it all goes down.
Step 1: Raw Materials Inventory
Raw materials inventory is all the ingredients or base component parts that will be used in the production process. They’re considered raw materials inventory until they’re combined with human labor. At that point, the inventory is no longer raw. It’s a work in progress.
Step 2: Work In Process Inventory
Work in process inventory (AKA work in progress or WIP inventory) is everything that happens to inventory in between raw materials and finished goods. This is when the actual manufacturing is happening.
There are some very short or simple manufacturing processes that don’t require specific reporting of WIP inventory. In those instances, companies move straight from raw materials inventory to finished goods inventory.
Step 3: Finished Goods Inventory
When the manufacturing process is finished, the work in process becomes a finished good. Finished goods inventory is what manufacturers depend on to generate revenue.
How to Calculate Finished Goods Inventory
There are two types of finished goods inventories: one at the beginning of an accounting period and one at the end. Whenever anyone speaks about calculating finished goods inventory, they’re talking about ending finished goods inventory.
How to find finished goods inventory requires three piece of information:
- Beginning inventory of finished goods
- Cost of goods manufactured (COGM)
- Cost of goods sold (COGS)
All three of these are used in the finished goods inventory formula.
How to Calculate Beginning Inventory of Finished Goods
How to calculate beginning inventory of finished goods is the same as calculating ending finished goods. You just did it last accounting period.
That’s because beginning inventory of finished goods is the ending finished goods inventory from last period. If you’re calculating finished goods inventory regularly, determining beginning inventory of finished goods is typically as easy as looking at your past balance sheet.
So, how do you calculate finished goods inventory? Let’s look into COGM first.
The formula for cost of goods manufactured is:
Direct Raw Materials Used + Direct Labor Used + Manufacturing Overhead + Beginning WIP Inventory - Ending WIP Inventory
Where “direct” refers to raw materials inventory and labor that actually constitute or assemble the finished product.
COGS Finished Goods Inventory
Finished goods inventory has a big effect on the cost of goods sold (COGS). That’s because a manufacturer creates revenue when finished goods inventory is sold. Recognizing that revenue requires recognizing the COGS—because COGS considers the materials and labor costs applied to each unit sold.
Here’s a great resource for how to calculate COGS. And, long story short, here’s the formula:
COGS = Beginning Inventory + Received Inventory- Ending Inventory
Finished Goods Inventory Formula
The finished goods inventory formula is:
Finished Goods Inventory = Beginning Finished Goods Inventory + (COGM - COGS)
How to Get Finished Goods Inventory: An Example
Let’s say BlueCart Coffee Co. ended last period with $50,000 in finished goods inventory. That means this period their beginning finished goods inventory is $50,000.
Now let’s say their COGM for the period is $80,000 and their COGS is $60,000.
Here’s how to compute finished goods inventory:
Finished Goods Inventory = $50,000 + $80,000 - $60,000
Finished Goods Inventory = $70,000
And this $70,000 worth of finished goods inventory will, of course, be the next accounting period’s beginning finished goods inventory.
The Importance of Calculating Finished Goods Inventory
What’s the big idea? What’s the importance of calculating finished goods inventory?
- It identifies gross profit and current assets. Inventory is frequently a manufacturer’s largest profit driver and current asset. An accurate tally of current assets makes future operating budgets (like your MRO inventory spend) and financial budgets accurate.
- It helps keep waste down. If you know exactly what amount of inventory your business is capable of producing, you’ll make smarter raw materials purchases. You’ll also be able to tweak your safety stock levels and have less sitting inventory which frees up cash and lowers storage costs.
- It drives production efficiencies. You’ll be tracking direct materials and labor costs. Looking over these historical numbers will allow you to tweak processes, integrate automation, and generally iterate toward cleaner, smoother inventory management. You may find that a JIT inventory setup or a VMI agreement make sense after looking at the data.
Finished Goods Inventory Is Reported On The ...
Finished goods inventory is reported on the balance sheet as a current asset. That means they’re short-term assets meant to generate revenue within the next 12 months.
The manufacturing process, as outlined above, has multiple steps. All of these steps should be accounted for in inventory reporting. There is a raw materials account, a WIP inventory account, and a finished goods inventory account. When manufacturing is complete, the WIP account is credited and the finished goods inventory account is debited.
This way leadership and investors can accurately gauge inventory value by high-level insights into each inventory stage. That, importantly, gives them an idea of cash flow and how much cash is tied up in inventory. Two very important indicators of a company’s health.
Finished Goods Inventory Turnover Rate
One big benefit of learning how to figure out finished goods inventory is that you can find your finished goods inventory turnover rate.
Finished goods inventory turnover rate is a ratio. It measures the rate at which a company’s finished goods inventory is sold and replaced (turned over) during a set time frame. Here’s how to find annual finished goods inventory turnover rate:
Finished Goods Inventory Turnover Rate = Annual COGS / Average Month-End Finished Goods Inventory Value
How to Calculate a Finished Goods Inventory Budget
A finished goods inventory budget considers the direct raw materials, direct labor, and overhead costs. In that sense, it’s similar to the COGM calculation, but it doesn’t take in account WIP inventory. All it’s doing is assigning a value to every unit produced based on raw materials, labor, and overhead. It’s not a cumulative indicator.
Calculating a finished goods inventory budget helps set profitable and competitive prices for the products being sold. Consider BlueCart Coffee Co. again.
Direct material: A cumulative $3 for green coffee bean and packaging material. That’s $3 per unit.
Direct labor: Sorting, roasting, and packaging coffee beans takes about 30 minutes per bag. If a roaster makes $20 per hour, that’s $10 per unit.
Overhead: The roasting business has fixed overhead costs of $7 per hour and variable overhead costs of $2 per hour. That’s a total of $9 per hour overhead costs. The overhead costs per unit are then $9 times .5 hours, or the 30 minutes it takes to go from green coffee bean to packaged roasted bean. That’s $4.50 per unit.
Total individual cost: $17.50 per unit.
Total finished goods inventory cost: $17.50 x inventory volume.
Woof. That’s expensive coffee. But you get the point.
So, What’s an Ideal Finished Goods Inventory Level?
It depends on your business. But, as a rule, you want to minimize finished goods inventory to keep storage costs down. What “minimize” means differs for each business. The point here is getting familiar enough with your finished goods inventory level that you can draw actually useful conclusions from it.
Like, how good are you at selling the things you make?
How much cash is tied up in your inventory, and how much could be freed?
Can you decrease the amount of pipeline inventory you have outstanding at any given time?
These are mega-important questions that can only be answered by sound finished goods inventory management. And once you have finished goods inventory numbers you’re confident in, you can start optimizing it.