Understanding Inventory Methods and How They Affect Your Taxes

Al Capone kept two sets of books — one set sent him to prison. Most businesses maintain a pair of books: one for the IRS and the other for financial reporting. There is nothing underhanded about this — each set of books fulfills a legitimate function. You want to maximize income to impress investors and, at the same time, minimize income to keep a handle on taxes. If your business involves the sale of items from inventory, you will make decisions affecting the amount of your income and thus your taxes. These decisions revolve around the inventory methods you use to account for the cost of items sold and the overall value of your inventory. Below, we share three methods for analyzing inventory to help you keep an accurate count of your inventory.

 The FIFO Method

The IRS definitely prefers that, if possible, you adopt the specific identification method for item costing. That’s helpful – if you’re selling yachts or mink coats.  But how do you tell one package of paper towels from another? In most cases, you intermingle your inventory items with no thought of separately tracking the actual cost and price of each individual item. The IRS realizes this and gives you alternatives for identifying costs.

FIFO is the method used to assign costs in the same order you bought the merchandise. In a normal economy prices rise due to inflation, which means older purchases cost less than newer ones. Thus, FIFO creates the lowest cost of goods sold and the highest ending inventory, gross profits and taxes. This is great for dressing up the quarterly reports, but not so great for your bank account.

That’s why most merchandisers prefer last in, first out (LIFO). As its name implies, LIFO assigns the most recent costs first; thereby, raising your COGS, lowering gross profits and ending inventory. Tax-wise, this is much better. If you use FIFO for financial reporting and LIFO for taxes, you create a “LIFO reserve” – resulting in the excess inventory value of FIFO over LIFO.

The LIFO Method

LIFO comes in a few flavors. Plain vanilla LIFO has you keeping track of the purchase costs each time you place an order. That’s a lot of data. To make things easier, select a variation on LIFO that pools your purchases by grouping items together according to their physical characteristics or by their dollar value. This dollar-value LIFO method measures changes in inventory cost after removing the effects of inflation. To accomplish this, assign a cost index of 100 percent to the ending inventory as of the year you adopt LIFO. You will calculate a new index each subsequent year based on government data, such as the Consumer Price Index. For example, if the CPI shows prices for the category of merchandise you sell rises by10 percent in Year 2, your cost index for that year becomes 110 percent. You deflate changes in yearly-ending inventory to figure your current ending inventory in Year 1 dollars; and then reflate this amount to get your current COGS. If this sounds complicated, don’t despair — there is plenty of software out there to help you through the calculations. The payoff is you can figure your costs without using all that purchasing data.

There are other LIFO variations as well. Whichever one you choose, you must fill out IRS Form 970 for the year you adopt your LIFO method of choice.

Valuing Inventory

You should understand that your gross profits equal your sales revenue minus your COGS, but here is an equation you might not have memorized:

COGS = Beginning Inventory + Purchases – Ending Inventory

Brilliant! This tells you the value you place on your ending inventory directly affects your COGS; which in turn determines your gross profits and taxable income. To make this work, you have to figure the cost of your ending inventory. The IRS gives you three methods from which to choose: the Cost Method, the Lower of Cost or Market Method and the Retail Method. You can use the Cost Method – where you assign to your inventory items all related direct and indirect costs (aka overhead) and adjust for things like discounts, transportation costs and other miscellaneous charges. The Lower of Cost or Market Method allows you to mark down the value of inventory, if the price you earn for the items is below what it cost you to buy the items.  How does that happen? Easy — item prices can suffer from damage, obsolescence, federal health warnings, spoilage and changing public tastes. Be aware the IRS doesn’t permit you to mix LCM with LIFO.

Retail Method

The third alternative method for valuing inventory is called the Retail Method. This method applies a ratio based on your experience of cost to selling price. Apply this to your annual sales revenue to figure your COGS and then use the equation below to calculate your ending inventory.

Whichever method you choose to value inventory, you should always take a physical count of ending inventory to correct for mistakes, shrinkage and damage. The IRS requires a physical count at what it calls “reasonable intervals.” Make use of the latest technology to help count your items:

  • barcode readers, which recognize and count scanned items
  • radio frequency tags and readers, which do not require a line of sight to inventory items in order to count them
  • POS cash registers, which automatically update sales and inventory figures
  • integrated inventory management systems that ties together all of the functions for ordering, tracking an valuing inventory.

Your investment in technology will pay for itself many times over with higher accuracy and lowered costs. Keep in mind – your acquisition costs for this technology are tax deductible!



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Copyright 2014 Eric Bank, Freelance Writer

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