How Your Year-End Inventory Affects Your Business’s Taxable Income

  Mike Bachara   |     Dec 01, 2020

5 Steps for a Year End Auto Parts Inventory

Inventory counts are an important part of managing your automotive parts inventory for many reasons. It helps …

  1. Minimize theft 
  2. Identify obsolescence 
  3. Determine the turnover of each SKU 
  4. Ensure your records are up to date

When you can, you should try to do multiple counts per year, even if you’re just focusing on the items that cause you the most grief. But if you do decide to only do one, it should be at year end. And that’s because the year-end inventory is what gets your records ready for tax season.  

Taxable income is income that you must pay taxes on. The good news is that certain business expenses can reduce this taxable income, which means you will owe less taxes for the year. 

Costs of Goods Sold (COGS) is one of these expenses. The calculation used for determining COGS is:

COGS = Beginning Inventory + Purchases – Ending Inventory

As you can see inventory plays a large role in determining your COGS. If your inventory is not properly verified, prior to filing your taxes, you could overstate or understate your taxable income. 

If you have overstated your ending inventory, it will have an adverse effect on your tax payable. Your COGS will be understated, which means you will have more taxable income and tax owing.  

If, on the other hand, you have an understated ending inventory, you will have an overstated COGS. While have a lower tax payable, an overstated COGS minimizes IRS compliance and could result in negative outcomes if you are audited. 

There are many ways you can improve the accuracy of your inventory throughout the year, but year-end inventory is the best way to ensure your inventory records are correct. 

There are 5 steps to complete a year-end inventory for tax purposes:

  1. Train

The first step is to ensure your employees are properly trained. While inventory counts may seem straightforward, there are many mistakes that can be made, which could negatively affect your inventory counting accuracy - counting parts without verifying the part number, counting packages with multiple units as a single unit, missing parts that are not clearly visible or improperly labelled, etc. 

  1. Organize

Once you know your employees have the necessary skills and understanding to conduct an accurate year-end inventory, you want to be sure your inventory is organized and ready to be counted. 

While you do our best to maintain an organized inventory throughout the year, parts can be misplaced or sorted out of order. If you’re one of the many who need to organize their inventory …

  • Make sure the bins, shelves and packaging are properly labelled
  • Organize the same parts in one place 
  • Avoid putting parts that look too similar close together
  1. Count

Now that your inventory is sorted, it is time to start the physical count.

While it may be best to perform your count after hours, it isn’t always possible. If you must count during work hours, be sure to communicate with other departments, such as service and receiving, to ensure that they know their roles and the proper procedures. You also want to let all your employees know not to move parts, unless they are being sold. In this case, they will need to be properly record as sold after counted.

  1. Inventory Method

Once you have counted your inventory you must choose a method for tracking and managing it. This method will determine how you match inventory to their associated costs. There are two popular methods. 

First-In, First-Out (FIFO) – this method assumes that the oldest parts are the first ones you sell. As a result, the value of the inventory you have in stock would equal the inventory costs most recently incurred. 

Example: You make the following purchases

100 units $10 each
50 units $15 each
75 units $20 each 

Your inventory would equal $3250

Inventory = (100 x $10) + (50 x $15) + (75 x $20) = $3,250

After selling 110 units, your inventory would be $2,100

Inventory = $3250 – (100 x $10) – (10 x $15) = $2,100

Last-In, First-Out (LIFO) – the LIFO method is the reverse of the FIFO method. It assumes that the newest items are sold first. As a result, the value of your inventory would be based on the earliest inventory costs incurred. 

Example: You make the following purchases

100 units $10 each
50 units $15 each
75 units $20 each 

Your inventory would equal $3250

Inventory = (100 x $10) + (50 x $15) + (75 x $20) = $3,250

After selling 110 units, your inventory would be $1,225

Inventory = $3250 – (75 x $20) – (35 x $15) = $1,225

  1. Valuation Method 

Now that you know how much inventory you have and which costing method you will be using, you need to value your inventory. This can be done in one of the following ways:

  1. At Cost – you inventory will be valued based on the actual cost
  2. At Lower of cost or fair market value – your inventory value will either be the actual cost or the cost on the current market, whichever is lower
  3. At Fair market value – your inventory will be valued based on the retail rate of your items

Once you have taken these steps, you are ready to accurately report your COGS on your income tax return. 

For help at any stage of your inventory management process, including the preparation, counting and valuation of inventory for year-end, contact us today!

By Mike Bachara

Mike Bachara | Owner of Pro Count West
Mike Bachara | President Pro Count West

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