IN THE JANUARY ISSUE, I covered how the gold market affects inventory. Now let’s talk about how your inventory directly impacts your taxable income.
You track inventory to see your profit margins, to keep your taxable income from lurching year to year, and to prove what you own for insurance. It also helps cash flow because awareness allows for opportunities in pricing strategy, merchandising, and sourcing. Counts catch theft, breakage, and mislabels. Lenders and insurers want support for what you have. If you sell every gem in the same period you buy it, you are a rare and magnificent bird. For the rest of us who return from Tucson with pockets full of inspiration, counting inventory is a tedious fact of life.
“A large buy in December that sells in January is Inventory in December and COGS in January.”
Inventory is an asset on the balance sheet, like cash — you own it, and it’s ready to be used. When an item sells, it becomes Cost of Goods (COGS) to offset the related Sales Income on your Profit & Loss report (P&L). That movement, because it is the biggest cost center and often accounts for 50% of Sales Income, has the biggest impact on Net Income and Taxable Income.
Your accounting method matters because it changes the timing. On accrual, you record Sales Income when work is delivered and expenses used, regardless of when payments are made. On cash, you show Sales Income with bank deposits and operating expenses when paid. Either way, COGS still must align with Sales.
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If you qualify as a small business taxpayer with average gross receipts of less than $32 million over the prior three years, you can use the cash method. For a product-based business, this means operating on cash for everything except Inventory. If you rely on inventory reports for pricing or other controls, you must keep Inventory and align COGS with related sales.
The IRS understands the “spend money to make money” rhythm, and they’re trying to help you spread your taxable income to prevent you from having a loss one year and a huge tax bill the next. A large buy in December that sells in January is Inventory in December and COGS in January. Otherwise, you would be deducting more than you sold in December with nothing to offset the sales income in January.
Open your Balance Sheet today. Is your ending inventory accurate? Open your P&L. Does COGS reflect what was sold? Look at your COGS in relation to your Total Operating Expenses; which one is higher? Consider your Net Income and how changes to COGS dramatically change your taxable income. What is or isn’t working?
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