Inventory management is a vital aspect of retail and manufacturing businesses. Inventory is traditionally defined as everything that needs to be sold for your company to make a profit. Some might think that inventory should always be stocked, regardless of demand, because it is not good to disappoint customers. However, many costs are associated with holding inventory that may not sell, proving that over-stocking inventory is not prudent. Furthermore, inventory costs are directly related to the income tax you must pay at the year-end. Purchasing and storing inventory is considered your cost of doing business, which must be accounted for in your income statement.
Depending on your method of stating your inventory, the costs may vary.
Inventory Management and Taxable Income
Before calculating taxable income, you need to determine the costs of acquiring the inventory. Inventory costs commonly include the purchase price, freight charges, and amount of sales tax paid. All these expenses and the cost of goods sold must be included in your income statement. The cost of goods needs to be calculated separately and reduce your gross income, reducing the income tax that needs to be paid. When your cost of goods sold is higher, it will reduce your net taxable income and decrease the tax paid.
There are four approved methods of recording your inventory. The two most common are FIFO (First In, First Out) and LIFO (Last In, First Out).
Inventory Management Using FIFO
As the name suggests, the inventory rotates chronologically in and out of storage. All the inventory items that are bought first are sold first. Because inflation directly relates to the inventory cost, you must use cheap units first. Similarly, because your cost of goods sold is low, your net income increases, leading to increased income tax that must be paid.
Inventory Management Using LIFO
LIFO is quite the opposite of FIFO, as you use your new inventory first and then move on to the oldest. Inflation always raises the prices of products; therefore, more expensive units are sold first. This, in return, increases the cost of goods sold dramatically and reduces your net income. A reduced net income means you must pay a lower income tax at the end of the year.
Conclusion
Both methods of inventory management have advantages and disadvantages. Your current needs and product demands will often help you determine which method is best. Companies typically prefer to use LIFO more often, but this method requires permission from the IRS by filling out Form 970. You can also be liable for tax liability if you change your business’s industry. The difference between FIFO and LIFO will be calculated, and you must pay the tax on the balance.
Large tax payments concern large corporations as their earnings can top billions of dollars. Their primary concern is to save each dollar possible, especially when they can avoid needlessly paying that money in taxes. Small businesses may not have to worry about these issues at the outset. Still, as the business grows, owners and stakeholders will need to examine processes and formulate a solid plan for inventory management. As a business owner, you must account for every dollar spent acquiring and holding the inventory. If you fail to track and calculate inventory and accompanying costs accurately, these funds can come back and hurt you in the form of a significant income tax bill.
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