What is Inventory - Why It's important for Your Business
Inventory and Your Business Taxes
Inventory is what you sell to customers. It can be:
- Products you buy from a wholesaler and sell in your store or online
- Raw materials that you use to make products to sell
- Component parts that you put together to make products to sell.
Inventory is a business asset because it has value. Of course, its most important value is that you can sell it to make money. It also has value because you can use it as collateral to get a business loan to buy more inventory or pay your bills.
The cost of selling your inventory (called cost of goods sold) is an important cost for your business. It includes the cost of buying those products, raw materials, and component parts. It also includes costs of warehousing (storing) inventory, shipping products to customers, running a storage facility or warehouse, and hiring people to work in the warehouse.
Keeping Track of Inventory
Keeping track of inventory in your accounting system and in your physical business location is important for your business because:
- You need to know how much you have and how much it's worth as an asset on your business balance sheet.
- Costs associated with buying and selling inventory are deductible business expenses that can reduce your business taxes.
- Cost and gross profit from sales of inventory is a major part of your business tax return.
- You can use the value of your inventory as collateral for a loan.
Different Kinds of Inventory
Businesses have two kinds of inventory:
- Supplies sitting on shelves waiting to be used. These include office supplies, cleaning supplies, computer supplies and accessories, and supplies used for specific purposes, but not as part of your sales process. T
- Product inventory. This inventory can be products you purchase at wholesale to sell to consumers at retail. It can also be component parts or pieces of raw materials you use to make products to sell.
Be sure you know the difference between supplies used in your business and supplies used in the cost of sales. General business supplies are shown as an expense in your business tax report, while supplies used in sales are included in cost of goods sold.
The Inventory Process
The inventory process goes something like this:
- You receive wholesale products or components from vendors (people your business buys things from).
- You finish work or repackage and put on shelves waiting for orders.
- You receive orders and sell your products.
- You receive money from your sales.
All of the costs for each part of this process are considered as business costs. These costs must be recorded.
The cost of sales of inventory is included in the Profit and Loss (income statement) of your business.
The value of your inventory at a specific point in time is shown on the business balance sheet.
Costs of Shipping Inventory
When inventory items are shipped to you, there are two ways to pay for them, based on who pays - you or the shipper. It's important to note that have title to (own) the inventory items only when you have them in your possession.
- The shipper can pay the costs. This is called FOB - shipping. Since you don't own the items until you receive them, you can't claim FOB-shipping costs.
- You pay the shipping costs. This is called FOB-destination. You pay when you receive the item since you have ownership at that point.
Keeping track of Product Inventory
It's important to keep track of the cost of inventory items, so you know the profit on sales. There are several ways you can value inventory for accounting and tax purposes:
Actual Cost: This method works best for larger and more expensive inventory items, like autos or jewelry.
Weighted Average Cost: When you have a lot of inventory going in and out and you can't determine the cost of an individual item (pens, for example), you can look at the cost of specific batches of items over a period of time. Let's say you buy pens and put customer logos on them. For example:
- Pen cost
- March 1 - 250 pens at .25 each. Total cost $62.50
- April 14 - 300 pens at .27 each. Total cost $81.00
- May 2 - 275 pens at .29 each. Total cost $79.75
- Weighted average 825 pencils at total cost 223.25 = 825/223.23= .27
LIFO or FIFO. You can also determine the cost inventory sold using one of two possible accounting methods: LIFO and FIFO.
- FIFO is First-in, First-out. The inventory that came in first (the oldest) is assumed to have sold first. (No one actually checks; it's just a
- LIFO is Last-in, First-out. The inventory that came in last is sold first. Since in most cases, costs increase, using LIFO results in a higher cost of inventory and a lower profit.
Inventory and Cost of Goods Sold
The most important thing to know about inventory is that it's essential in calculating the cost of goods sold (COGS). COGS is used to determine gross profit for a business that sells products, and it's used on every business tax form, for sole proprietorships, partnerships, LLC's, and corporations.
The Cost of Goods Sold Calculation is:
- Beginning inventory (the value of all inventory at the beginning of a year)
- Plus Net purchases (after discounts and allowances and returns)
- Equals Cost of Goods Available for Sale
- Less Ending Inventory (the value of all inventory at the end of a year).
For the first year in businesses, the beginning inventory is zero. After that, the beginning inventory of one year is the ending inventory for the previous year. Some businesses take a physical inventory at the end of a year, for several reasons:
- To double-check or "prove" the value of inventory
- To check for spoilage or obsolescence
- To check for theft
- To check for poor record-keeping.
Inventory and Accounting Method
Most companies with inventory must use the accrual method of accounting, but qualifying small businesses with average gross receipts between $1 million and $10 million may be able to use the cash method. If you think you might qualify, check with your professional tax advisor.
There are some restrictions on which inventory cost system you use. Before you use one of these inventory methods, have a discussion with your tax professional about which is best for your specific business situation.
Inventory and Taxes
A few more things you need to know about inventory and taxes:
- You must keep using the same inventory cost method over the years. You can't keep switching methods for the best tax advantage.
- Most important, remember to keep good track of your business's inventory to make sure you aren't losing any to theft, pilferage, or bad recordkeeping.
Disclaimer: Inventory, like other tax issues, is complex. The purpose of this article is not to give you tax advice, and the author is not a CPA or tax preparer. Before you attempt to make tax decisions, consult with your tax professional.