Smart Inventory Valuation: Essential Practices for Profit and Tax Optimization

Inventory management is a major ongoing matter for any company that manufactures or holds products to sell. Having strong management practices in place is critical for both revenue and tax purposes.

So what is Inventory Valuation? Why is it important to your business? And how do you choose which method is right for you?

Inventory Valuation is the process of assigning value to a company’s inventory. Inventory can typically be a large portion of the company’s assets, so it is critical to calculate the value in a consistent manner that supports your financial goals. 

Inventory & Profitability

Appropriate inventory valuation methods will help maximize your profitability. Inventory directly affects COGS (Cost of Goods Sold), Net Income, and Ending Inventory, therefore affecting the accuracy of your Financial Statements. 

There are different methods and perspectives on inventory valuation depending on the purpose—whether it's for financial reporting (books), tax reporting (tax), or physical management (warehouse). Here’s a breakdown of the differences and considerations for each:

1. Financial Reporting - this refers to how you track and manage your inventory within your company’s accounting records. 

• FIFO- First In First Out is the most common method used, it assumes the first products the business sells is from the first (oldest) products or materials purchased and values the inventory accordingly. FIFO tends to produce the highest profit in the current year

• LIFO- Last In First Out This method assumes the newest inventory is sold first. LIFO  method usually results in a lower tax liability because the profit is lower due to the COGS being higher.

  One thing to note is that LIFO is only legal in the US.

• Weighted Average Cost- uses a weighted average to work out the value that goes into COGS and Inventory.  To calculate the weighted average cost, divide the total cost of goods purchased by the number of units available for sale.

• Specific Identification- This method tracks each individual item from purchase to sale. Typically the Specific Identification method is used for high-value one-of-a-kind items. It allows the company to track the profitability of each item. 

For further details, Shopify has an excellent article with more about these options and why you would use each method. 

2. Tax Reporting

Most often, your bookkeeping records will dictate how your tax returns report your inventory. 

However, there are some specific regulations and requirements from the IRS:

• LIFO Conformity Rule: If a business uses LIFO for tax purposes, it must also use LIFO for financial reporting.

• Lower of Cost or Market (LCM): Inventory must be reported at the lower of cost or market value to recognize potential declines in the value of inventory.

• Section 263A (Uniform Capitalization Rules): Requires certain costs to be capitalized into inventory, including direct costs and a portion of indirect costs.

3. Warehouse Management

For warehouse management, the primary concern is the physical tracking and handling of inventory rather than its valuation. Methods used include:

• Perpetual Inventory System: Continuously updates inventory records for each purchase and sale. It helps maintain accurate inventory levels and manage stock efficiently.

• Periodic Inventory System: Updates inventory records at specific intervals, such as monthly or annually. Physical counts are essential to verify inventory levels.

• ABC Analysis: Categorizes inventory into three groups (A, B, and C) based on their importance, often determined by value and turnover rate. This helps in prioritizing inventory management efforts.

Optimizing Inventory Processes for Your Company

To maximize outcomes from your inventory processes, you need to consider both the management and tax implications of your decisions. The chosen financial reporting method (FIFO, LIFO, Weighted Average Cost, or Specific Identification) directly influences your net income and financial statements, impacting profitability and funding opportunities.

Your inventory valuation method should not be changed every year so you should try to choose the method that will serve you best for at least 2-3 years. 

If you need support in navigating this or other complex decisions that have a major impact on your business and the taxes you pay, we’re here to help. Sonder Accounting has specialized in inventory based businesses since 2016, particularly in the food/bev, cosmetics, nutraceuticals, and overall wellness industries. Send us an email to connect: hello@sonderaccounting.com