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Understanding Work in Process Inventory: Definitions & Formula

The value of your business’s inventory is constantly changing as products are received, assembled, stored, and sold. Inventory accounting is an important aspect of your fulfillment process because the cost of buying and storing a product is a major factor in your asset calculations for your business.

Though you may buy some items that are already assembled and ready to be purchased, others may require more work. These items and the cost of producing them make up your WIP or work in process inventory.

The work in process inventory is significant to understand to keep accurate inventory accounting. With this guide, we discuss the definition of WIP inventory, related terms, the formula for calculating it, and how to optimize your fulfillment process to manage it.

Define Work in Process Inventory (WIP)

The work in process inventory refers to materials related to products that require additional production at your packing and shipping facilities. WIP as a cost to your business represents the money required to store and process these materials and then assemble them to be shipped as finished items.

WIP inventory is an asset that factors into inventory accounting. Note that WIP inventory is the opposite of finished goods inventory, which refers to products that are shipped to your fulfillment centers already assembled and ready to be sold as you receive them.

Importantly, not all businesses will have the same relationship with a work in process inventory. Many businesses have a supply line from a manufacturer or distributor that delivers finished products ready to be packed and shipped as they are. These are called “finished goods.”

The businesses that more often deal with WIP inventory include those that sell custom items, items with many personalization options, items that require assembly whose parts must be shipped separately, and businesses that sell handmade products. For example, a business that sells cleaning products may not have many items that require WIP inventory since so many of them are single-piece items. But an Etsy store that specializes in homemade and custom clothing will have a far larger WIP inventory to manage.

In summary, inventory becomes classifiable as work in process when your business must use human labor to finish an item before it can be sold. Different companies calculate WIP inventory differently. It is therefore essential that businesses know how it works to determine how it will affect their unique fulfillment process.

Work in Process Inventory vs Work in Progress Inventory

The similarity of the words may lead some businesses to mistake “process” for “progress” when researching these inventory costs. However, the terms refer to different calculation methods.

As opposed to work in process inventory, which calculates short-term completion costs for items that require additional production, work in progress inventory is a long-term cost. It refers to the costs of completing each stage of a long-term project, such as a construction job, so that clients can be billed gradually for completed milestones.

Confusingly, some sites list the terms as interchangeable, just used in different contexts. However, the timeframe difference changes which businesses each term applies to.

Why is WIP Inventory Significant?

WIP inventory is important, more so for companies that sell custom products, due to its direct impact on your business’s balance sheet. Accurate WIP inventory calculations tell you the cost of materials and production to your fulfillment process, how the cost is divided up, and how costs at the end of the accounting period should be calculated.

Your total manufacturing costs to sell finished goods must take WIP inventory into account, not only for proper business management but also to keep accurate records.

Calculating Work in Process Inventory

Consider this example of how work in process inventory is classified. Let’s say your business sells hair brushes online. If the hair brushes come to you completed and ready to be sold, the cost of fulfilling the order can be accounted for in the cost of goods sold (or COGS) on your accounting sheets.

However, for the company that received raw materials like wood, plastics, and bristles to create the hairbrushes, there is a WIP inventory cost. They may calculate it in the cost of the labor required to assemble the hairbrushes, the operation of the machinery required, and more.

This applies to your business if you receive a product that must be assembled from separate parts, customize products to order, and more. The machine hours or labor hours become the WIP inventory cost.

As you may have guessed, it is a difficult number to report accurately because it is a percentage of the total cost of completing an asset of inventory. WIP inventory is time-consuming, but only some of the time will factor into the WIP costs.

Most businesses try to cut WIP inventory costs as much as possible due to the complications in accounting for it. However, it’s hard for businesses to save money on a process that is difficult to quantify in dollars.

To do so accurately, businesses must take several key terms into account, from which we can derive a basic formula for calculating WIP inventory costs.

  •       Cost of Manufactured Goods (COGM) – The Cost of Manufactured Goods is the number you ultimately want to discover by using work in process inventory and other costs as variables. Or if you know the COGM, you can use it to determine your manufacturing costs. The COGM tells you the value of your WIP inventory.
  •       Beginning Work in Process Inventory – This cost is equal to the WIP calculated at the end of the previous accounting period, whether it’s a quarter or a year. This cost must be transferred to the next calculation as the new starting point. Therefore, this number is technically equal to the previous quarter’s ending work in process inventory.
  •       Cost of Manufacturing – To create a finished product, a business may have to pay for raw materials, overhead costs, and the labor required to produce it. These costs are added together to find the total Cost of Manufacturing, which is higher the more WIP inventory your business deals with. In other words, ordering finished products from a manufacturer lowers the amount of work in process inventory you have, which reduces your cost of manufacturing.

Work in Process Inventory Formula

Therefore, the formula from which a business can calculate their COGM using work in process inventory costs can be displayed like this:

Total Cost of Manufacturing + Beginning Work in Process Inventory – Ending Work in Process Inventory = Cost of Manufactured Goods

This formula can be manipulated algebraically to find values that your accounting is missing. For example, if you do not know the Cost of Manufacturing, you can use this altered version of the formula:

Beginning WIP Inventory + Ending WIP Inventory + COGM = Total Cost of Manufacturing

Optimize WIP Inventory for Your Business

Examining your WIP inventory process can reveal gaps in your supply chain, unneeded costs, and the strength of your suppliers. The whole process is based on flow – bringing sellable inventory from a manufacturer, through a supply chain, and to your business.

Therefore, advice for optimizing your WIP inventory is similar to optimizing your supply chain as a whole. Here are a few ways to improve the process in your business.

Hire a 3PL to Manage Your Inventory and Fulfillment Process

A 3PL or third-party fulfillment company provides vital services to eCommerce businesses. They can track inventory, reach out to suppliers, manage the fulfillment process, and route everything through a single system.

By directing orders for your company, a 3PL can optimize your fulfillment process, which includes properly managing your WIP inventory. Some of the features provided by a 3PL include:

  •       24/7 shipment management
  •       Same-day shipping
  •       Demand forecasting
  •       Discounted shipping rates
  •       Cloud-based order fulfillment software
  •       Real-time inventory management and reporting
  •       Calculating beginning inventory and turnover costs

Use the Right Supplier

Initially, your work in process inventory will likely not be completely clear to you. Unless your business specializes in unique custom products, your manufacturer or supplier will oversee your levels of WIP inventory.

Therefore, all the factors that influence how effective your WIP management is – labor costs, production optimization, raw material costs, lead times – can be improved by choosing the right supplier. Simply sourcing materials from a supplier closer to your fulfillment centers can drastically reduce costs.

Optimize Your Workforce

When additional machinery or facilities cannot be added to a fulfillment process to reduce WIP inventory, optimizing the on-site workforce your already have can be an effective substitute.

To do this, businesses must know the operational capacity of their facility and compare it to the demand forecast of their fulfillment process and their WIP inventory. Deploying the ideal number of workers can help manage WIP inventory costs by optimizing your facility even without scaling the inventory itself.

The Takeaway

WIP inventory is a significant aspect of inventory accounting. It is an essential part of calculating your business’s COGM and can therefore be optimized to reduce production costs, provided you know what it is and how it works. A 3PL can help by managing your inventory and improving your supply chain, which includes optimizing your WIP inventory for your unique business model.