Inventory: What is it?

Inventory is something that a business acquires with the intention of selling. Inventory can be purchased wholesale and sold retail, or it can consist of raw materials and component parts that are transformed into a product sold to customers.

What is inventory?

Inventory is the product that you sell to customers. Inventory can be obtained by the business and sold to customers without any changes to the product. Inventory can also be modified or combined with other parts of inventory to create a new product sold to customers. The most important feature – from the perspective of defining inventory – is that the business acquires these items with the intention of selling them to the customer in some way or another.

The costs of purchasing and selling inventory are business expenses that can reduce your business taxes. The cost and gross profit from inventory sales are a significant part of your business tax return. You can use the value of your inventory assets as collateral for a business loan.

Note: Be sure to understand the difference between supplies used in your business and supplies used in the cost of sales. General business supplies – such as office supplies, cleaning supplies, and computers – are listed as an expense on your business tax return, but they are not considered inventory. Supplies used in sales are included in the cost of goods sold, and they are likely considered inventory.

How does inventory work?

The inventory process works as follows:

1. Receive bulk products or components from vendors (the people that the business buys things from).
2. Modify, combine, or repackage the inventory for sale to customers.
3. Receive orders from customers who wish to purchase your products.
4. Receive money from your sales, which can be used to acquire more inventory.

Note: All costs associated with each part of this process are business costs. These costs should be recorded. The cost of sales for inventory is listed in your business’s profit and loss statement (income statement). The value of your inventory is shown at a specific point in time on the business’s balance sheet.

Monitoring inventory in your accounting system and the actual business location is important for your business because you need to know how much you have and how much it’s worth as an asset on your business’s balance sheet.

Tracking inventory costs is also necessary because it is used to calculate the cost of goods sold (COGS). The cost of goods sold determines the gross profit for the business selling products, and it is used in every business tax form, whether the business is a sole proprietorship, partnership, LLC, or corporation.

There are several methods you can use to value inventory for accounting and tax purposes.

Tracking actual cost

This method works best for expensive items in inventory, such as cars or jewelry. You are likely to have fewer expensive inventory items passing through your business, so you can track the individual costs of each item.

Tracking weighted average cost

When you have a lot of inventory coming in and out and you cannot specify the cost of a single item, you can consider the cost of specific batches of items over a period of time. For example, let’s say you buy pens and put customer logos on them. You might track the cost of your pen inventory as follows:

• March 1: 250 pens at a cost of $0.25 per pen – total cost $62.50
• April 14: 300 pens at a cost of $0.27 per pen – total cost $81.00
• May 2: 275 pens at a cost of $0.29 per pen – total cost $79.75

Weighted average: 825 pens at a total cost of $223.25, or $0.27 per pen.

Tracking LIFO or FIFO cost

You can also determine the cost of sold inventory using one of two potential accounting methods: LIFO and FIFO. FIFO assumes that the items that entered first (oldest) are sold first. LIFO assumes that the inventory that entered last is sold first. In many cases, costs increase over time, so using LIFO results in higher inventory costs and lower profit.

Inventory

Accounting Method

Most companies that hold inventory must use the accrual method of accounting, but eligible small businesses with average total revenues of less than $25 million may be able to use the cash method. Check with a qualified tax advisor if you think your business may qualify for the cash method.

Types of Inventory

There are three main types of inventory. A business can use only one type of inventory, or it can use all three types.

Raw Materials

Companies purchase raw materials that they plan to transform into a product sold to customers. For example, a restaurant can take raw materials like carrots, meat, and spices and turn those ingredients into soup. The soup is the finished product sold to customers.

Work in Progress

As the name suggests, work in progress consists of any item that is in the process of being transformed from raw material into a finished product. Some pieces or components may be missing, or may need to be properly packaged before being placed on shelves.

Finished Goods

Finished goods are any items that are ready for sale to customers. Some businesses, such as retail clothing stores, purchase finished goods directly from wholesalers and resell them to customers. Other businesses create finished goods from raw materials and sell them to customers.

Key Points

• Inventory can be anything a business acquires with the intent to sell to customers.
• The main types of inventory are raw materials, work in progress, and finished goods.
• Supplies are considered inventory only if they are directly involved in the product sold to customers – cleaning supplies around the office are considered business assets but not inventory.
• It is important to track inventory costs accurately for tax and accounting purposes.

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Sources:

Internal Revenue Service. “Publication 538: Accounting Periods and Methods,” Page 9. Accessed July 26, 2020.

Source: https://www.thebalancemoney.com/sorting-out-inventory-why-its-important-for-your-business-4041326