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The Importance of Year-End Inventory and How It Affects Taxable Income

Year-end inventory is one of the most consequential calculations a retailer must get right because it directly affects how much taxable income you pay in a year.

To understand how your ending inventory affects your taxable income, you must first understand that you pay taxes based on your end-of-year profits. The simplest way to calculate your profits is by subtracting your cost of goods sold (COGS) from your total revenue: 

Profit = Total Revenue – COGS 

This means you must first establish your COGS. Your COGS includes the direct expenses you incur to produce or sell your products or services, such as manufacturing overhead, labor, shipping, and material costs. The Internal Revenue Service (IRS) allows you to use your business’s COGS as a tax-deductible expense, helping reduce your taxable income. This means you pay less in retailer taxes.

You calculate your COGS as:

COGS = Beginning Inventory (the value of items at the start of an accounting period) + Purchases (the value of items you purchase within the year) – Ending Inventory (the value of items at the end of an accounting period)

Thus, if you have an inaccurate ending inventory figure, it’ll affect your COGS and your taxable income.

For instance, if you inflate your ending inventory, you’ll have a lower COGS, translating to more taxable income. Conversely, if you understate your ending inventory, you’ll have a higher COGS, meaning you’ll pay less in income taxes unduly. If the IRS audits your tax returns and catches the error, you would be fined for false deductions. 

To avoid such pitfalls, you must ensure your year-end inventory is accurate. You do this by counting, tracking, and valuing your inventory. Here’s how.

Counting Inventory

Even if you’ve invested in an inventory management system to track your inventory, you’ll need to do a physical count to ensure there are no errors.

The year-end inventory is more consequential because you use these figures for tax reporting. To guarantee smooth counting, ensure your staff is well-prepared and trained for stock-taking. 

Tracking Inventory

While counting retailer inventory is pretty straightforward, managing and tracking inventory over time is more systematic. Fortunately, there are two reliable inventory methods you can leverage. 

First In, First Out (FIFO) 

This method presupposes that you sell your oldest inventory first. Let’s put it into context: Say you buy 50 units at $20 each in the first quarter, 70 units at $15 each in the second quarter, and 100 units at $10 each in the third quarter.

Your total inventory value would be $3,050:

(50 x $20) + (70 x $15) + (100 x $10) = $3,050

If you use the FIFO method to value your inventory after selling 70 units, your inventory value would be $1,750. Here’s how: 

$3,050 – (50 x $20) – (20 x $15) = $1,750

Last In, First Out (LIFO) 

This method presupposes that you sell your newest inventory first. Here’s how it works, referencing the previous example, in which your total inventory value was $3,050:

(50 x $20) + (70 x $15) + (100 x $10)

Using the LIFO method, your inventory value would be $2,850 after selling 70 units. Here’s how:

$3,550 – (70 x $10) = $2,850

Valuing Inventory 

There are three inventory-valuing methods approved by the IRS. These are: 

  1. At cost: You value your inventory at its purchase price, plus other expenses such as shipping costs, import duties, and handling fees.
  2. At the lesser of cost and market value: You value your inventory at its actual cost (the recorded cost of the inventory) or the current market cost. 
  3. At retail value: You value your inventory at its retail rate.
Pro Tip: Consult a Professional Accountant 

Getting your inventory and taxes right can be exacting, particularly if your business is quickly scaling. Nonetheless, you can consult a professional accountant to ensure your year-end inventory records are correct and you don’t pay excess retailer taxes.

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