What is Inventory Profit?
Inventory profit is the increase in value of an item that has been held in inventory for a period of time. For example, if inventory was purchased at a cost of $100 and its market value a year later is $125, then an inventory profit of $25 has been generated. There are two possible reasons for inventory profit, which are noted next.
Inventory Profit from Appreciation
The market value of an inventory item may increase over time. This is most common when commodities are held in stock. A company could generate a profit through speculation, holding onto inventory in the hope that its market value will rise.
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Inventory Profit from Inflation
The value of the currency in which inventory is recorded declines, so that the amount of currency required if someone were to purchase the inventory increases. Inflation is a common cause of inventory profit in a first in, first out (FIFO) inventory costing system, where the cost of the oldest items in stock are charged to the cost of goods sold when units are consumed. Since the oldest items in stock should have the lowest cost in an inflationary environment, this leads to an inventory profit.
How to Analyze Inventory Profit
If an inventory is well-managed, it should turn over with great regularity, which means that there is little time for an inventory profit to accrue. Conversely, an inventory with low turnover has a greater opportunity to generate a profit, since more time passes before it it consumed. Realistically, there is at least as good a chance for the value of inventory to decline as to increase, so the probability for an inventory profit to occur in any size is relatively low.
When reviewing the performance of a business, it is best to strip out the effects of inventory profit in order to determine the amount of profitability generated by operations. Thus, an inventory profit should be considered an occasional and incidental part of doing business, except in situations where management is deliberately holding inventory in order to achieve price appreciation.
