To account for all expenses it incurs while making products for resale, a manufacturing company has a cost of goods manufactured account. The cost of goods manufactured includes three types of inventory: direct materials, work in process, and finished goods.
Direct material inventory
The direct material (also known as raw materials) inventory reflects all the materials the company uses to make a product. For example, for a car manufacturer this includes the steel to form the body, leather or fabric for the seats, and all those other gizmos and parts that go under the hood. In essence, any materials that you can directly trace back to making the car are direct material inventory.
Keep in mind that manufacturing companies can use the perpetual inventory tracking method to keep track of their direct material inventory. For example, components that a computer manufacturer needs to assemble laptops may have serial numbers. Those numbers are scanned in when components are purchased from the manufacturer.
The scan posts the cost to the direct material account. The components are scanned again when incorporated into the computer. At that point, the cost is moved to the work-in-process account. Thus, the manufacturer keeps a running total of components in inventory.
Work-in-process inventory
At any point in the manufacturing process, the company probably has items that are in the process of being made but aren’t yet complete, which is considered work in process. With a car manufacturer, imagine the car going down the production line.
At the stroke of midnight on the last day of the accounting period, cars up and down the line are in various stages of completion. The company values its work-in-process inventory based on how far each product has been processed.
Finished goods inventory
Finally, the costs you associate with goods that are completely ready for sale to customers, but haven’t yet been sold, are classified as finished goods inventory. For the car manufacturer, this category consists of cars not yet sold to individual dealerships.
Obviously, any finished goods that haven’t been matched with a customer are part of the manufacturer’s inventory. But suppose the finished goods have a buyer and are in transit to that customer. Who owns the finished goods then?
To make this determination, you need to find out whether the terms of the sale are for free on board (FOB) shipping point or FOB destination. FOB shipping point means the customer owns the merchandise as soon as it leaves the manufacturer’s loading dock; ownership (title) transfers to the buyer at the shipping point to the common carrier (a trucking company, for example).
FOB destination is the opposite: The customer owns the inventory only after receipt; any merchandise in transit to the customer is still counted as part of the seller/manufacturer’s inventory.
