Inventory — do we need to count those beans? Yes, I know, these are peas but you get the picture. First decision is whether or not inventory is important — to you, to the IRS or to your state. State? Yes, numerous states have a tax on inventory, so keep that in mind.
Some common examples of inventory include: Merchandise for sale, raw materials, work in process, finished products and supplies that become part of an item for sale. If you’re a retail store or a manufacturer then inventory is important. Keeping up with inventory and “valuing” inventory (if it’s determined to be important) are topics for another day.
Let’s take for example an artist, a jewelry maker. They have all sorts of materials that go into making a piece of jewelry. And at any given time they have materials on hand, jewelry they are working on and finished pieces of jewelry. Do they need to worry about inventory?
When they sell a piece of jewelry, they will want to know what it cost them to make. Yes, to price the item, they do need to know the cost of the materials and their time — does it need to be exact? If it’s exact they aren’t going to have time for making jewelry! But I’ll bet they all have a pretty good idea, and this is good enough. Don’t make it more difficult than it needs to be.
Now, when it comes to tax reporting, time isn’t important, only materials. The formula is:
Beginning inventory + purchases – ending inventory = cost of goods sold.
Chances are that inventory (and this is going to depend of $$$) isn’t going to be very important on the tax return, but here’s a sequence that shows why you need at least a general idea of your inventory and report it. You’ve purchased a lot of materials and made a lot of jewelry, but at the end of the year you still have it. Not reporting it as inventory would make it look like have a bigger loss than you exactly do. So, this stuff should be reported as inventory instead of cost of goods sold. Next year, you have all this stuff so you don’t buy any more, but hey, you sell a ton of it and hardly have anything left at the end of the year. If you reported inventory in the first year, then it would be become your cost of goods sold and you taxable income is less. But say you didn’t classify it as inventory the previous year and took a loss — now you have a big profit to report. Inventory is a way of matching income and expense — it evens out the ups and downs.
Do I need to count those beans? No, but I need to know that the bag costs around a dollar, and at year end I have half a bag left for inventory.