A properly managed parts department has numerous benefits - it allows you to optimize turnover, improve productivity and increase profit. Knowing what you have in stock, where it is, how much it is worth, how quickly it moves off the shelf and when it is time to reorder can ensure that both your parts and service departments are successful.

The best way to keep track of this inventory data is through an inventory management system. It is important to remember, however, that these systems are subject to error, both human and mechanical. That is where physical inventory counts come in.

While we often recommend multiple cycle inventory counts per year, it is important that a full Physical Inventory is completed at least once a year to ensure your records are accurate. This can be done at any point throughout the year.  Most dealerships prefer the end of the year, however you could save money by doing it earlier in the year, or mid-year.  These figures can be used for tax purposes regardless of the time of year the Physical was taken.

How Does Inventory Affect Taxable Income?

Taxable income is, as it suggests, is income that you are required to pay taxes on. As is the case with your individual tax return, certain business expenses can reduce this taxable income, in turn lowering your tax liability.  On the other hand, a surplus of inventory is considered taxable income.

Your Costs of Goods Sold (COGS), which includes automotive parts, is one of these expenses. The calculation used for determining COGS is relatively straightforward.

COGS = Beginning Inventory + Purchases – Ending Inventory

As you can see, from this equation, 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, as your COGS will be understated, resulting in more taxable income.   

If, on the other hand, you have an understated ending inventory, you will have an overstated COGS. While this may sound like a good situation to be in, due to the decreased tax payable, an overstated COGS minimizes IRS compliance and could result in negative outcomes if you are audited.

How to Ensure Your Inventory Valuation Is Accurate

There are a number of 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 three main steps when completing a year-end inventory for tax purposes:

Count

First, you must physically count your inventory to determine how many of each SKU you have on hand. Parts that you should not include as part of your inventory count include:

1. Parts that have been sold and passed to the buyer (i.e. parts installed on a car that has been invoiced)
2. Consignment items
3. Items that have been ordered but have not yet been processed into inventory (i.e. parts on purchase orders, in shipment or in receiving)

Choose

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 three popular methods. You can use one or a combination of the following, depending on your situation.

Specific Identification Method – this method is most often used for high value parts, such as cars or engines, and special-order parts. This method assigns the actual cost to each item.

Example: You buy Part A for $2,000, Part B for $3,000 and Part C for $1,000.

                  Inventory = $2,000 + $3,000 + $1,000 = $6,000

If you sold Part B your inventory value would be $3,000

Inventory = $6,000 – $3,000 = $3,000

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

Value

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

Keep in mind, we have never seen an inventory valued any other way than at true cost.  However, sometimes when companies are dissolving and haven’t had a price update done, you may value your inventory at fair market value, which is really hard to determine. 

Once you have taken these three 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 tax year-end, contact us today!