How does Inventory Management affect Income Tax Paid?

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Inventory management is one important aspect of retail and manufacturing businesses. Inventory is everything that needs to be sold in order for your company to make a profit. Some might think that businesses should be stocked up at all times, regardless of the demand because it isn’t a good notion to disappoint customers. However, there are many costs associated with holding inventory and it might not turn out to be such a wise notion. Furthermore, inventory costs are directly related to the amount of income tax you have to pay at the year-end. The costs of purchasing and storing the inventory are considered as your costs of doing business, which must be accounted for in the income statement. Depending on your method of stating your inventory, the costs may vary.

Inventory Management and Taxable Income

Before calculating taxable income, you need to determine the costs of acquiring the inventory. Commonly, inventory costs will include the purchase price, freight charges and amount of sales tax that has been paid. All of these expenses need to be included in your income statement along with the cost of goods sold. The cost of goods need to be calculated separately and reduces your gross income, which further leads to the reduction of income tax that needs to be paid. When your cost of goods sold is higher, it will reduce your net taxable income and eventually decrease the amount of tax paid.

Inventory Management using FIFO

There are basically four approved methods of recording your inventory. However, the two most commonly used are FIFO (first in first out) and LIFO (last in first out). As the name suggests, the inventory rotates chronologically in and out of storage. All of the inventory items that are bought first are sold first. As the inflation has a direct relation to the cost of inventory, you will have to use cheap units first and so on. Because your cost of goods sold is low, your net income increases, leading to increased income tax that has to be paid.

Inventory Management using LIFO

LIFO is quite the opposite of FIFO as you use your new inventory first and then move on to the oldest. Inflation always raises the prices of products, therefore, more expensive units are sold first. This, in return, increases your cost of goods sold dramatically and reduces your net income. A reduced net income means that that you will have to pay a lower income tax at the end of the year.


Both of these methods of inventory management have their ups and downs. Depending on the need of the hour, companies decide which one to use. Companies normally prefer to use LIFO more often but you have to ask for permission from the IRS by filling out the Form 970. You can also be held responsible for tax liability in case you change the industry of your business. The difference between FIFO and LIFO will be calculated and you will have to pay the tax on the balance.

Large tax payments are a huge concern for large corporations as their earnings are billions of dollars. Their top concern is to save every dollar from taxes. A small business may not have to worry about such issues at the start but, as your business grows, you will have to formulate a solid plan for inventory management. You have to account for every dollar that is spent in acquiring and holding the inventory because it can later come back and hurt you in the form of a significant income tax bill.

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