Manufacturing companies have three classes of inventory. Costs flow through them sequentially:
Raw Materials Inventory
↓ (materials requisitioned)
Work in Process Inventory ← Direct Labor added
↓ ← Manufacturing Overhead added
↓ (units completed)
Finished Goods Inventory
↓ (units sold)
Cost of Goods Sold (Income Statement)
The Three Inventory Categories
| Category | What It Contains | Balance Sheet Example |
|---|---|---|
| Raw Materials | Materials purchased, not yet used | Electronic components waiting for assembly |
| Work in Process (WIP) | Partially completed units | Navigation systems mid-assembly |
| Finished Goods | Completed units, not yet sold | Completed navigation systems in warehouse |
These are parent categories for financial reporting. Companies subdivide within them (by SKU, location, batch) for operational tracking.
Classification follows YOUR production process Once you requisition them into production, they move to WIP.
Semi-Finished Materials Materials you purchase that were partially processed by a supplier (e.g., pre-assembled transmissions) still go into Raw Materials from your perspective.
Accounting Entries Mirror Physical Flow
| Event | Debit | Credit |
|---|---|---|
| Purchase materials | Raw Materials Inventory | Cash/AP |
| Use materials in production | Work in Process | Raw Materials |
| Incur labor/overhead | Work in Process | Wages Payable/Various |
| Complete units | Finished Goods | Work in Process |
| Sell units | Cost of Goods Sold | Finished Goods |
Chapter 5 Connection Chapter 5 (Job-Order Costing) shows the source documents that trigger each entry:
- Materials requisition form → materials to WIP
- Time tickets → labour to WIP
- Job cost sheet → accumulates all three cost types per job
Merchandising vs Manufacturing
| Company Type | Inventory Categories |
|---|---|
| Merchandising (retailer) | Merchandise Inventory only |
| Manufacturing | Raw Materials, WIP, Finished Goods |
| Service | Typically none (or unbilled hours as WIP) |
Merchandisers don’t transform anything—they buy finished and sell finished.
Why This Flow Matters
Product costs don't expense immediately—they wait in inventory until the product sells.
This is why product costs take a different accounting path than period costs:
| Cost Type | Path to Income Statement |
|---|---|
| Period cost (office rent) | Expense → Income Statement (immediately) |
| Product cost (factory rent) | MOH → WIP → Finished Goods → COGS → Income Statement |
The Matching Principle requires costs to be recognized in the same period as the revenue they helped generate. Product costs helped create inventory—so they become expenses when that inventory sells.
See Why MOH Instead of Expense? for why factory costs go to MOH instead of directly to an expense account.
North: Where this comes from
- Product vs Period Costs (product costs flow through inventory)
- Matching Principle (costs become expenses when revenue is recognized)
East: What opposes this?
- Period Costs Flow (bypass inventory, expense immediately)
- Service Company Operations (no physical inventory)
South: Where this leads
- Universal Inventory Formula (calculating flows at each stage)
- Cost of Goods Manufactured (what exits WIP)
- Cost of Goods Sold (what exits Finished Goods)
- FMGT-2294 Chapter 5 - Notes from the Textbook (job-order costing mechanics)
West: What’s similar?
- Supply Chain Stages (procurement → production → distribution)
- Value Stream Mapping (visualizing flow of materials and information)