Inventory plays a key role when calculating profit, specifically gross profit. However, the dynamics related to inventory can be substantially incorrect from a cash flow perspective. For companies that make and sell inventory, this difference between what is represented on the income statement and what truly happens with cash can be significant. Inventory generally goes onto the profit and loss statement only when it is sold.1 However, this can be very different, time wise, from when money was spent creating it.
There are three types of inventory: raw materials, work-in-process, and finished goods. Raw materials are the basic products and materials companies will buy anticipating converting them into salable products. This process of converting raw materials to finished product likely involves several steps. Think of a car being assembled. There are several steps required to put the car together, adding wheels to the chassis, body to the chassis, doors and windows to the body, and so on. Each process involves the consumption of capacity, and along with it, a cost is calculated. This value is costNC.
This calculated value is important to understand. Inventory is an asset from an accounting perspective. As it is transformed from raw materials to becoming a soon-to-be-finished product, the cumulative value of the effort must be tracked to determine the value of the asset for reporting purposes. A car that arrives at a door station in a production line has less financial value as an asset than when it leaves the station after people and machines do their work to add doors to it. Unfinished inventory is considered work-in-process inventory, or WIP. The value of WIP increases throughout production until it reaches its maximum value as a finished good. At this point, no more work can be done, and it is ready to be sold. It is now a finished good to the company, and for reporting purposes. The calculated value of inventory throughout its steps can be represented in a chart, something like the one in Exhibit 8.1.
Exhibit 8.1 In the beginning To inverntory value is primarily the value of the raw materials. As items are processed, the value of inventory, now work-in-process, increases to point where it reaches its maximum value as a finished product
When you take a step back and think about it, money was spent building the inventory (Exhibit 8.2). From buying materials to buying the capacity used to increase the value at each step of the manufacturing process, money was spent. However, the money spent building inventory isn’t captured on the profit and loss statement until the product is sold. Once sold, the value is taken off the balance sheet and put onto the profit and loss as a cost of the good that was sold. Even this value, however, isn’t costC; it is costNC because this represents the consumption of what you had previously bought.
Exhibit 8.2 You are spending money throughout the process of building inventory. You are paying leases, paying for labor, buying materials, and so on. This money does not make it on to the income statement until the inventory is sold
Let’s rephrase. We spend money building inventory, and this money spent goes into the value of the inventory. When the product is finished, it is ready to be sold. The time between when it becomes a finished product and when it is sold may or may not be known. However, we know we spent money making it, and this money doesn’t show up on the income statement until the product is sold (Exhibit 8.3). Even when sold, it is costNC not costC. This may be okay from a cash flow perspective when the items are purchased and the product is built and sold in the same analysis period. Otherwise, cash spent building an item at the end of one period and sold in a subsequent period means cash is affected while building the items in a completely different analysis period from when the profit calculation occurs. This creates a difference between what was spent and what is calculated as your profit.
Exhibit 8.3 The lag between when you spend money building inventory and when you receive payment for sold inventory can sometimes be significant. This would lead to situations where cash spent today may not be recognized as profit for many months if not years
This disconnect is troubling for many companies. They may show profit on their income statement, but they’re confused about why they do not have any money. For many companies, especially small businesses, their money was spent building inventory that was not used to generate revenues. If there were a direct connection between cash flow and profit, this would not happen. But it does.
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1Accrual accounting rules suggest costs must be matched to when the revenues are recognized. If you build something today and sell it next year, the costs from the item built will show up when you sell the product next year.