Unless you sell services in your business, you probably have a product you need to keep track of. Whether it is kept in a warehouse, or in your basement, you probably have more pieces around than you care to admit. That is a drawback of having your own product based business.
No matter how much you, or your significant other, like or dislike having a lot of inventory around, you still need to keep track of it, and be able to report on its value at year end when you do your taxes. So what are some ways you can keep track of the value of your inventory.
When to Take Inventory
The first thing to consider is how often you update your inventory records. Do you update them when you make a sale, or wait until the end of the year?
If you wait until the end of the year (or quarter or even month) to count and value your inventory, you are using a periodic system. When you do this, you are taking a count of your inventory at the end of whatever period you choose, and assigning a value to it at that time. You do need to be consistent when you choose at what time interval to count it, and not change it from year to year. This advantage of this method is that you don’t tie up resources keeping up with inventory. The disadvantage is that you run the risk of running out of material because you didn’t know to re-order more stock.
The perpetual system requires you to update inventory after every purchase or sale. The benefit is that you always know how much inventory you have on hand, so being out of stock is no longer a consideration. The disadvantages are that you will have to spend money on a system to keep up with the inventory, and you have to make adjustments in your system for theft and items that are broken or spoiled.
How to Value Inventory
There are a few methods to determine the value of the inventory you have on hand. The first way is called specific identification. As the name implies, each piece of your inventory is specifically identified in your records, and its cost is the amount you paid for it. This is a good method if you have a small number of products that you sell, such as sailboats, but can be a bit cumbersome if you mass produce screws.
The second method to calculate inventory is the First-In-First-Out, or FIFO, method. With this process, it is assumed that the first items you purchased are the first ones sold. If prices are rising, this will give you a lower cost of goods sold and higher profit, as it is assumed that your cheaper items are sold first. Additionally, you will have a higher inventory total since the higher priced goods are what remains in your stock.
The third method is the Last-In-First-Out method. It is assumed that the last items ordered are the ones that are sold first. If your prices are going up, this will lead to a higher cost of goods sold and a lower profit, since you will have sold the more expensive goods first. Your inventory will also be lower, since the cheaper goods will remain in your inventory.
Lastly, you have the Weighted Average method. With this method, you are taking the average of the items you have purchased, plus the value of your beginning inventory, and dividing this sum by the number of items in your inventory. You would then take this number and multiply it by the number of items in your ending inventory. This gives you the value of your ending inventory.
If you have any questions, shoot them to me at email@example.com, and I would be happy to answer them. If you need help with other tax questions, or with preparing a return, drop me a line, and we can discuss your situation.
Circular 230 Disclosure: To ensure compliance with requirements imposed by the United States Treasury Department, you are hereby informed that the tax advice contained in this blog post is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local law provisions, or (ii) promoting, marketing, or recommending to another person any transaction or matter addressed in this communication.