When a company is manufacturing a product, it must purchase parts to be used. These parts are considered raw materials as they will be incorporated into the final products. Raw materials can be further categorized into direct vs. indirect materials. Once raw materials are consumed, they are transferred to a WIP inventory account. If raw materials become obsolete over time, they can be expensed to the cost of goods sold on the Income Statement.

WIP is inventory that is being prepared but not yet a final product for sale. WIP can be difficult to measure as it consists of costs of labour and materials to make the product as well as allocated overhead costs. Finished goods are goods that have been manufactured for sale. They can also be products purchased for resale. They are considered a Current Asset as they are expected to be sold within a year. All three of these sections can appear under Current Assets, but usually, there is only one single line item for Inventory on a Balance Sheet.

A physical inventory count is essential to conduct periodically (quarterly, monthly) to determine the actual level of inventory vs. the amount recorded in your accounting system. The inventory balance is then adjusted on the Balance Sheet to actual at year-end and the difference is adjusted to the cost of goods sold. Inventory is measured at lower of cost or market value. One common valuation method is to determine the net realizable value which is the estimated selling price of inventory less any costs to complete and sell the goods.