By Rieva Lesonsky
Post sponsored by inFlow Inventory.
There are many reasons why it’s important as a business owner to keep careful track of your business inventory, chief among them being that it’s likely your most valuable asset. An accurate inventory helps you to know how much product you have on your website or in your retail location, and what the sum total of those products are worth.
Valuing inventory and taxable income
Thankfully, the Internal Revenue Service only requires you to pay taxes on your profits, not your gross revenue. The value of your inventory plays a large part in determining your taxable income. That’s why keeping proper track of your inventory is a big deal—it can save you money by reducing your tax bill.
According to IRS Publication 538, Accounting Periods and Methods, there are three methods you can use to value inventory:
- Cost method: To properly value your inventory using the cost method, all direct and indirect costs associated with it must be included.
- Lower of cost or market method: This method compares the market value of your merchandise on the date you take inventory with the cost of those products; the value of your inventory is the lower of the two.
- Retail method: This method is a bit more complicated. It estimates the value of the inventory you have on hand and the cost of goods sold.
Let’s take a closer look at these three methods.
As mentioned above, to use the cost method, you need to include all costs—direct or indirect—associated with it, such as transportation costs or other expenses involved while acquiring the merchandise.
The IRS has a further explantion here: Inventory – Manufacturing Tax Tips. The IRS further explains in IRS Publication 538 that if you can’t specifically identify the cost of your inventory, you must use either the “First In, First Out” (FIFO) or “Last In, First Out” (LIFO) methods.
FIFO assumes the products you bought or manufactured first are the first products you sold, used, or got rid of. The merchandise that remains in inventory at the end of the tax year is “matched” with the costs of similar products you most recently bought or manufactured.
LIFO assumes the merchandise you bought or manufactured most recently are the first items you sold, used, or got rid of. The goods that remain in your closing inventory are considered to be from the opening inventory in the order of acquisition, and from those acquired during the tax year.
Lower of cost or market method
As noted, this method compares the market value of your merchandise on the date you take inventory with the cost of those products. This method applies to products you bought and have on hand. Costs include direct materials and direct labor and “an allocable share of indirect costs of the goods being manufactured and finished goods on hand.”
Goods accounted for under the LIFO method do not count if you use this method.
As noted above, this method is a bit more complex than the other two. Essentially, there’s a 4-step process involved in using this method. According to AccountingTools.com:
- Calculate the cost-to-retail percentage, for which the formula is cost ÷ retail price.
- Calculate the cost of goods available for sale, for which the formula is cost of beginning inventory + cost of purchases.
- Calculate the cost of sales during the period, for which the formula is sales × cost-to-retail percentage.
- Calculate ending inventory, for which the formula is cost of goods available for sale − cost of sales during the period.
Before you choose your method, you should consult with your accountant. Once you select the method you will use to value your inventory, you must continue to use that method going forward. The IRS forbids you from switching beween the various methods to find the one that has the most tax advatages during that particular period of time.
Most small businesses opt to use the cost method, because it is the simplest way to keep track of and value your inventory.
Corporate structure impacts tax burden
Another important thing to keep in mind: The type of corporate structure you’ve selected for your business determines how you will report your profits to the IRS. Each structure—such as C Coporation, S Corporation, Limited Liability Companies (LLC), and others—has its own tax advantages and disadvantages. For help figuring out which structure is best for you, check out this free incorporation guide from CorpNet.
For more help keeping records and valuing your inventory, an inventory management software system can be a valuable tool, helping you create reports that quickly summarize your inventory for tax purposes, operational purposes, and planning. Leveraging a deeper knowledge of your inventory assets can save you time and effort at tax time, but, more important, it can help you increase your profits.
Disclaimer: I am not an accountant, CPA, or tax preparer. The purpose of this article is not to give you tax advice. Before you attempt to make tax decisions on your inventory process, consult with a tax professional.