Taming The Inventory Beast

No matter how large or small your enterprise happens to be, if you sell physical goods from an inventory, properly managing that inventory will mean the difference between continued profits or sustained losses. If you do have a profit, please understand that from a taxation standpoint, you may or may not be forced to pay taxes on the majority of that gain..

In order to explain, let’s go through an example.

Joanne B. Owner has a big box store that operates on a calendar year basis. The value of her inventory on January 1st of 2023 was $10M. By the end of the year, it had grown to $12M.

If only looking at this one change, what will happen to her taxable net income at the end of the year? Will it go up, go down, or will there be no change at all?

The answer is that she will pay tax on an additional $2M that calendar year. That’s a difficult concept for many to understand, so let’s look at other examples.

If your bank balance went up $2M during that period, you would decidedly agree about the taxable outcome. If your Accounts Receivables went up by the same amount, hopefully you understand that you’d also be forced to pay the additional tax.

Please understand that most assets work the same way. When assets go up, net income also goes up. When assets go down, net income will generally decrease as well.

But Joanne’s problem is that the inventory cost her $2M and she now has to pay tax on $2M that she doesn’t have. In order to fix this problem, she needs to learn how to Tame the Inventory Beast.

Dates Matter

The first concept that must be understood is that the only dates that matter from an income tax perspective are the beginning and ending dates of the taxable year. What happened with her inventory at any point in between is irrelevant.

If she had begun the year at $10M, pushed it up to $12M in the middle, and let it go back down to $10M by the end of the year, she wouldn’t be looking at any additional tax. Also, if she had been able to push her inventory under $10M to $9M on December 31st, she’d then have another $1M in deductions for the year.

Inventory Valuations

Most tax work is done using LCM or the Lower of Cost or Market Basis. To explain how this works, let’s use another example.

Joanne now owns a used car lot. She goes to the Milwaukee Auto Auction and purchases a car for resale for $10,000. She pays another $100 to have the car transported to her lot.

There’s some paint and body work that needs to be done on the car for another $1,000, so the total cost for this piece of inventory is $11,100. But the car sits on her lot for half a year and doesn’t sell.

Since used cars go down in value an average of $100 per week and her year end is at the end of the 26th week, she writes the car down $2,600 to $8,500.

Is she done yet? Maybe not.

She then grabs a copy of the Milwaukee Auto Auction Catalog from the last auction of the year and sees that the same car with similar miles and upgrades just sold for $8,400, so she further writes it down to that number.

My point is that inventory numbers aren’t stagnant. It’s the Lower of Cost or Market. Spoilage, shinkage, and the overall market for an item should be taken into account.

If the car had then burned to the ground in a fire and had no value, she would then write it down to zero.

Opposites Can Be True

Have you ever noticed that when you walk into a big box store near the end of the year, there’s so much inventory that it’s falling off of the shelves. Ever wonder why?

Because loading up on inventory is how all of the managers get their Christmas Bonuses. It’s the oldest trick in the book.

They load up on inventory increasing their inventory values, they exceed their numbers for the quarter, and get bonuses so their spouses are happy. Their bosses see increased profits, the price of the stock goes up, and everyone goes home happy.

Let me leave you with this.

My point is that inventory management goes in both directions and is an integral part of tax planning.

If you’re in a position where you don’t need to go to a bank and either renew a loan, or ask for more money, then we can keep your inventory numbers low. These are conscious decisions that we can make from a management standpoint.

If you don’t want to buy inventory at the end of the year, you can let it run down, and not take delivery of anything until the following year. On the other hand, if you’re going to be walking into a bank and need strong financials in the shorter term, then you can also let it go up.

This is called tax planning and basic financial management. Managing inventory properly is one of the main ways that we control taxes on entities that sell products from a physical inventory.

We do an enormous amount of work in this arena, especially with mid-sized entities. If you need help in this regard, please don’t hesitate to call me today.

We’re all going to get through this. Let’s get through it together.

Accounting Solutions Ltd. stands ready to complete our mission and purpose of protecting you, your family, and your business. Whether you need Payroll Services, or Accounting and Tax Work, you have but to ask. I’m here and I remain,

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Sincerely yours,

Chris Amundson

President

Accounting Solutions Ltd.

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