How to Value Inventory

What you spend on inventory is called your costs of goods sold. The higher your cost of goods sold is, the lower your profit—and thus your taxes—will be. For this reason, you must figure your cost of goods sold using an IRS-approved inventory accounting method. Inventory generally must be listed at the lower of its cost or its fair market value. This is also known as book value in accounting terms.

Example: During its first year of operation, Rick’s Music Store purchased $300,000 of inventory. At the end of the year, he has an inventory of compact discs that cost $50,000 and cassette tapes that cost $30,000. Using the cost method, Rick has an ending inventory worth $80,000. Here is Rick’s cost of goods sold:

 

 

$0

beginning inventory

 

+

$300,000

inventory purchased during year

 

+

$80,000

ending inventory at cost method

 

=

$220,000

cost of goods sold

Unsaleable inventory. You may reduce (write down) the book value of any inventory that has become unsaleable. For IRS purposes, this needs to be documented. For instance, if you discard or destroy dead stock, keep evidence of the destruction—photos, videos, receipts, or the statement of a reputable third party who can certify the goods were destroyed. Another option may be to donate inventory to a nonprofit.

Example: Continuing with Rick from the above example, at inventory time, Rick knows his inventory of CDs has held its value, but his cassettes hardly sell. Rick asks his music distributor to appraise the cassettes. The distributor says their fair market value is only $8,000. Accordingly, Rick lowers the inventory on his books to $8,000. Now Rick’s cost of goods sold looks like this:

 

 

$0

beginning inventory

 

+

$300,000

inventory purchased during year

 

-

$58,000

ending inventory at fair market method

 

 

 

 

=

$242,000

cost of goods sold

To sum up, the difference between the two examples is the method of valuing the inventory. Using fair market value instead of cost will reduce Rick’s net income by $22,000. With the taxes saved from the inventory write-down, Rick can build up his CD inventory.

Don’t reduce the book value of the inventory without clear evidence of the loss in value and without reducing the retail price of the goods.

Manufactured goods. Like sellers of goods, manufacturers of goods often maintain an inventory that they value at the beginning and end of each tax year. From this valuation, they determine the cost of goods sold for the year. They deduct the cost of goods sold from their gross receipts to arrive at their gross profit for the year. Unlike sellers of goods, manufacturers can include manufacturing costs into their cost of goods sold.

The most common expenses included in the cost of goods sold by a manufacturing business are:

  • the cost of the raw materials, including freight
  • storage
  • direct labor costs (including contributions to pensions or annuity plans) for workers who produce the products, and
  • factory overhead.

Certain manufacturers are subject to more complex accounting, such as the uniform capital-ization rules. For additional information, see a tax pro or IRS Publication 334, Tax Guide for Small Businesses, and the chapter on inventories in IRS Publication 538, Accounting Periods and Methods.

Excerpted from Tax Savvy for Small Business, by Frederick W. Daily (Nolo).

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