How does my inventory value affect my bottom-line and taxes?
Your Profit & Loss report and Balance Sheet are interconnected. How you value inventory determines costs of sales (aka: cost of goods sold) and therefore profit. The formula is:
Costs of sales = (beginning inventory) + (inventory purchases – inventory returns) – (ending inventory)
Ending inventory depends on how you value inventory on your Balance Sheet. Therefore, the lower the inventory, the higher the costs of sales, which results in lower profit. Conversely, a higher inventory valuation results in lower cost of sales and higher profits.
What is included in cost of inventory?
Technically, the cost of inventory includes all costs incurred to make the products available for sale. That might include taxes, freight, manufacturing costs, labor and overhead. Businesses often choose to expense certain costs to reduce profit, thereby lowering taxes.
Tracking the cost of inventory is complicated and regulated, so it should be discussed with your accountant or tax professional. It is important to do this as soon as you expect to have inventory. It may be difficult to change the costing method once you have selected it.