How Does Inventory Management Affect Income Tax Paid?

Inventory Management - Complete Controller

 

Inventory management is a vital aspect of retail and manufacturing businesses. Inventory is traditionally defined as everything that needs to be sold for your company to make a profit. Some might think that inventory should always be stocked, regardless of demand, because it is not good to disappoint customers. However, many costs are associated with holding inventory that may not sell, proving that over-stocking inventory is not a prudent decision. Furthermore, inventory costs are directly related to the amount of income tax you have to pay at the year-end. The cost of purchasing and storing inventory is considered your cost of doing business, which must be accounted for in your income statement. LasPass – Family or Org Password Vault 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 these expenses need to be included in your income statement, along with the cost of goods sold. The cost of goods needs to be calculated separately and reduce your gross income, which further reduces the 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.

There are four approved methods of recording your inventory. However, the two most common are FIFO (First In First Out) and LIFO (Last In First Out). ADP. Payroll – HR – Benefits

Inventory Management using FIFO

As the name suggests, the inventory rotates chronologically in and out of storage. All the inventory items that are bought first are sold first. Because inflation has a direct relation to the cost of inventory, you will have to use cheap units first and so on. Similarly, because your cost of goods sold is low, your net income increases, leading to increased income tax that must 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 the cost of goods sold dramatically and reduces your net income. A reduced net income means that you will have to pay a lower income tax at the end of the year.

Conclusion

Both methods of inventory management have their advantages and disadvantages. Your current needs and product demands will often help you determine which inventory management method is best. Companies typically prefer to use LIFO more often, but this method requires permission from the IRS by filling out Form 970. You can also be held responsible for tax liability if you change your business’s industry. The difference between FIFO and LIFO will be calculated, and you will have to pay the tax on the balance. Download A Free Financial Toolkit

Large tax payments concern large corporations as their earnings can top billions of dollars. Their primary concern is to save each dollar possible, especially when they can avoid needlessly paying that money in taxes. A small business may not have to worry about these issues at the outset, but as the business grows, owners and stakeholders will need to examine processes and formulate a solid plan for inventory management. As a business owner, you must account for every dollar spent in acquiring and holding the inventory. If you fail to track and calculate inventory and accompanying costs accurately, these funds can later come back and hurt you in the form of a significant income tax bill.

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