Inventory management is very important for product selling businesses. As an accountant, it is important because it is part of the calculation of their single most important expense – cost of goods sold. It is crucial that the business owner determines as accurately as possible the inventory on hand as of the end of the prior year and end of the month for the period being evaluated. This should include all finished products. For businesses that assemble their finished products, the inventory of the major components should be performed as well. These amounts along with the purchases made throughout the year will determine the cost of goods sold. For those interested, the formula is Beg Inv+ Purchases – End Inv = COGS.
Often a retailer in their first few years of business is focused on purchases with minimal regard to inventory. Their belief is that if they control purchases, that is effective inventory management. To a large extent that is true but it fails to effectively compare cost to the revenues from sales. Just because you purchased an item does not always mean it was sold. Inventory items can be lost, stolen, or unsold in addition to being sold. By using the above formula the retailer factors in complete inventory activities throughout the year.
For clients who do not use sound inventory management practices, my firm often reveals that their inventory costs are much higher than they perceived. The business owner may argue that the actual amounts are much different than what they had thought. We share with them that the cost of goods sold formula as the basis for our calculations. While there is some back and forth, the end is usually the costs originally presented are very close to the amount ultimately approved by the owner.
If there is an upside it is that the higher cost leads to lower net income and thus lower taxable income on the corporate tax return. The owner also start improving the inventory system by conducting physical inventory count and better monitoring of purchases. Thus the next corporate tax return is a much smoother experience.
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