Inventory Types

For a manufacturer, inventory is normally classified into one of three categories. The first category is raw material. This is whatever the firm uses as a starting point in its production process. Raw materials might be something as basic as iron ore for a steel manufacturer or something as sophisticated as disk drives for a computer manufacturer.

The second type of inventory is work-in-progress, which is just what the name suggests—unfinished product. How big this portion of inventory is depends in large part on the length of the production process. For an airframe manufacturer, for example, work-in-progress can be substantial. The third and final type of inventory is finished goods, that is, products ready to ship or sell.

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CHAPTER 21 Credit and Inventory Management 725

There are three things to keep in mind concerning inventory types. First, the names for the different types can be a little misleading because one company's raw materials can be another's finished goods. For example, going back to our steel manufacturer, iron ore would be a raw material, and steel would be the final product. An auto body panel stamping operation will have steel as its raw material and auto body panels as its finished goods, and an automobile assembler will have body panels as raw materials and automobiles as finished products.

The second thing to keep in mind is that the various types of inventory can be quite different in terms of their liquidity. Raw materials that are commodity-like or relatively standardized can be easy to convert to cash. Work-in-progress, on the other hand, can be quite illiquid and have little more than scrap value. As always, the liquidity of finished goods depends on the nature of the product.

Finally, a very important distinction between finished goods and other types of inventories is that the demand for an inventory item that becomes a part of another item is usually termed derived or dependent demand because the firm's need for these inventory types depends on its need for finished items. In contrast, the firm's demand for finished goods is not derived from demand for other inventory items, so it is sometimes said to be independent.

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