When manufacturers tally up their inventory of finished products that are ready to ship, they also need to account for unfinished goods still in the production pipeline. These incomplete products are called work-in-process inventory, and they can represent a significant capital investment that the business (eventually) needs to convert into cash. Here are some key things to understand about work-in-process inventory, and why it matters for manufacturers as well as for companies that hire them to make their products.
What is work-in-process inventory (WIP)?
Work-in-process inventory (WIP) is an accounting term for goods somewhere between raw materials and finished goods. It represents materials costs, labor, and overhead spent in production during a specific period, such as a month, quarter, or year. It is a separate accounting entry, valued at the estimated partial cost of completion, while the raw materials inventory account is valued at purchase cost, and the finished-goods inventory account is valued at full production cost.
Work-in-process inventory typically occurs when goods undergo processing before being sold or used. For example, a clothing manufacturer must cut fabric into pieces, stitch them together, add buttons or other fasteners, and attach labels. A half-completed shirt at the end of a quarter would be considered work-in-process inventory.
Manufacturers account for WIP on the balance sheet as a current asset because they expect the products to generate revenue once they are completed and sold. Goods that are completed are counted as finished goods inventory, meaning they are ready for sale.
Why WIP is important
Tracking WIP inventory is critical for a manufacturer in several ways, including:
Efficiency
Accurately recording WIP helps a business make better use of resources, identify and fix production bottlenecks, and manage costs. Inaccurate WIP accounting can lead to production errors and mismanaged inventory. Procurement managers might order more materials than necessary, causing overstocking and extra storage costs. Or, they might order less than needed, leading to slowdowns that drive up production and overhead costs.
Cash flow
WIP inventory represents cash tied up in goods not ready for sale. Many companies, especially small and medium-sized enterprises, turn to short-term financing, including WIP financing—using the WIP as collateral for a loan—to address lack of short-term cash flow. Applying for this type of financing requires accurate WIP accounting and valuation. Errors in the WIP valuation may lead to the cancellation of the financing agreement.
Financial reporting
Accurate accounting is also important for financial reporting, and WIP is a crucial part of a company’s balance sheet. Accurate WIP accounting provides a clear picture of a company’s financial health and sends the right message to investors, lenders, and stakeholders.
Raw materials vs. WIP inventory vs. finished goods
Manufacturers account for inventory in three distinct stages as follows:
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Raw materials. These are the basic ingredients for manufacturing a product, for example, bolts of fabric for clothing or metal for making electronic circuits and wires. Raw materials haven’t been moved into production yet.
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Work in process. The WIP stage is for materials that are in some phase of production, such as handling by factory workers or fabrication by machinery. WIP is goods awaiting further work before becoming finished goods.
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Finished goods. These are goods that have moved through the complete manufacturing process and are ready for sale. Finished goods often go from the production line to warehouses and distribution centers before shipping to sellers.
How to calculate WIP inventory
Ecommerce companies that manufacture their own products, or that collaborate with contract manufacturers, can calculate WIP using a three-part formula:
(Beginning WIP Inventory + Production Costs) - Finished Goods = Ending WIP Inventory
Let’s look at each of these parts:
1. Beginning WIP
This is simply the previous period’s ending WIP inventory, carried over to the current period. Beginning WIP serves as the baseline from which production and inventory changes are measured during the period.
2. Total production costs
All spending on raw materials, labor, and overhead incurred during the period directly affects the valuation of inventory still in production. Managers use total production costs to make decisions about product pricing, budgeting, and manufacturing efficiency.
3. Cost of finished goods
Also called cost of goods manufactured (COGM), cost of finished goods helps managers assess how efficiently resources are being used in the manufacturing process. COGM includes all costs from the beginning WIP inventory levels up to the final finished goods.
Here’s a hypothetical example for calculating WIP inventory. A personal-care products maker has $50,000 of WIP inventory at the end of the fourth quarter—creams and lotions that are partially completed. It carries that over to the first quarter as beginning WIP. Its total production costs in the first quarter are $250,000, and cost of goods manufactured is $270,000. Calculating WIP inventory for the end of the first quarter is:
($50,000 + $250,000) - $270,000 = $30,000
The personal-care products maker has reduced its WIP inventory from $50,000 to $30,000, which it then carries over to the second quarter as beginning WIP, and the calculation is repeated.
In general, lower WIP is good because it suggests a manufacturer is using materials and labor more efficiently. An increase in WIP might indicate an inefficient process with production bottlenecks that lead to higher costs for storing excessive amounts of unfinished goods. On the other hand, rising WIP inventory isn’t necessarily bad if sales are increasing even faster amid strong customer demand.
Tips for optimizing your WIP inventory
Efficiently managing WIP inventory means striking the right balance between running too lean while avoiding flab. The following tips can help:
Get leaner
Practice lean manufacturing, meaning reducing waste and boosting productivity. Use just-in-time (JIT) production and lean inventory management to get most from your materials and labor and keep waste to minimum. Manufacture only the quantity that’s needed to minimize WIP inventory and related costs for storage and maintenance of unfinished goods.
Set a timetable
Create a schedule for production that keeps all stages moving smoothly, balancing customer demand against available resources. Setting a realistic production schedule can help to avoid bottlenecks, as well as prevent overproduction that can lead to excess WIP inventory
Automate
Very small businesses with simple operations may find a spreadsheet is adequate to track production and inventory. Larger manufacturers can use software that monitors production flow and costs in real time, leading to more accurate WIP inventory record keeping. Barcodes, QR codes, and RFID (radio-frequency identification) labeling of goods facilitate accurate inventory tracking. Integrate these systems with other software your business may be using.
Set limits for WIP
Minimum and maximum WIP limits can help avoid overproduction or underproduction. The WIP minimum should be just enough to keep production moving, while the maximum WIP should be based on the size of your workforce and the capacity of your production equipment. The simplest way to establish a maximum for WIP inventory is to use a recent historical average, such as the average monthly WIP value for the past 12 months. Real-time tracking through the stages of manufacturing makes smart WIP limits possible.
Collaborate
Manufacturers can collaborate with ecommerce businesses that use them for contract production. Manufacturers can keep ecommerce companies in the loop about their production processes, schedules, and costs, as a way to determine appropriate inventory levels and help ecommerce retailers set product prices.
Outsource
Consider using inventory management services when your manufacturing business grows enough to need outside help. Specialized providers of inventory and warehouse management, called third-party logistics (3PL), can free up a business to focus on growth in new markets and add customers.
Work-in-process inventory FAQ
What is the difference between work-in-process and work-in-progress inventory?
Work in process and work in progress are sometimes used interchangeably when referring to inventory. But typically, work in process refers to the manufacturing of uniform products in a relatively short period, such as apparel or consumer electronics. Work in progress is often used in industries where each product is unique, such as a building, and time to completion is longer—weeks, months, even years.
How does optimizing WIP inventory benefit an ecommerce business?
Optimizing WIP helps avoid overproduction and controls the costs of inventory storage, as well as reduce the risk of products in inventory becoming lost, stolen, or falling out of favor with customers. Optimizing also helps ecommerce businesses maintain the right amount of inventory to avoid underproduction and out-of-stock situations, potentially leading to lost sales and customers.
What is an example of work in process?
An example of work in process would be a maker of wooden patio furniture. Its raw materials are lumber, metal joiners and fasteners, plastic washers, stain, and varnish. Work in process would be lumber cut into table legs and tops, but not yet assembled or varnished.
What does work-in-process inventory include?
Costs of raw materials, labor, and overhead for unfinished products are included in work-in-process inventory.
