How to handle inventory in your small business

Inventory is an area that trips up a lot of small business owners.  In this post we'll cover what inventory is and how to keep track of it so that you understand the basics and avoid feeling overwhelmed.

If you sell or make products, chances are you have inventory and need to be keeping track of it.

You'll also want to understand how purchasing inventory affects your taxes so that you don't make mistakes here that could get you in trouble.

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Also, check out the following blogs that help you take fear out of the numbers side of your biz, save money and stay out of trouble:

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7 Sales Tax Basics for the Busy Entrepreneur

Why I Worry About Today's Entrepreneurs

3 Things You Need to Know About Tax and Accounting as Your Own Boss

Do I have to deal with inventory?

If you don't sell products at all, and just sell your services, then inventory is not something you have to deal with.  Yay!

If you purchase items for resale, meaning you don't create them, you just buy them from your vendor and sell them for a higher price to your customer, then you have inventory you need to keep track of. 

This is not the case if you don't actually touch the item you're selling; for example, if you act as a middle person and place orders for your customer but the goods ship directly from your vendor to your customer.  In this scenario you don't have to track inventory.

You also have inventory if you create items that you hold ready to sell or if you keep supplies on hand that become part of your finished product.

What is Inventory?

Inventory is made up of three things and you keep track of the cost of each, not what it might sell for.  Inventory is made up of raw materials, works in progress, and finished goods.  I'll explain each below.

Raw materials are essentially untouched materials that become a part of your finished product.  For example, if you make crocheted purses, yarn and buttons are raw materials (they become part of the purse), but the needle you use to create it is a supply and not part of inventory (it does not become part of the purse).

Works in progress are items in the process of being created, as the name suggests.  If it only takes you a few days to complete a project, it may be unrealistic to keep track of this.  But if it takes you a longer period of time, it may make sense for your business, especially if there is an overlap of starting the project in one tax year and finishing it in another.

Finished goods are products you're done creating that are ready to sell.  If you only purchase already made products to resell in your business, then all of your inventory is finished goods.

How inventory gets treated for tax purposes

Inventory isn't "written off" against your income until it's sold.  Before it's sold, it's considered an asset and an asset is not a tax deduction. 

Once the product is sold, then your inventory is moved to "cost of goods sold" and that amount reduces your income, and therefore your taxes.

The takeaway here is if you purchase $10,000 worth of inventory on December 31st, 2018 and sell it in the middle of January 2019, you won't get the tax benefit until the 2019 tax year.

This is important to understand in making strategic tax decisions.

How to track inventory

One of the simplest things you can do to make tracking inventory simpler is to do an inventory count at the end of each tax year. 

I have a $7 spreadsheet available for sale that you can use to do a year-end count.  It comes with a 4 minute video explaining exactly how to count your inventory and use the sheet.  You can get it right now by clicking here.

The proper way to count inventory is to keep track of it as you purchase and move your products through the process of being created.

In my mind, I picture the 3 parts of inventory in little buckets.

When you purchase raw materials (RM), you keep track of the cost of the materials (and a description of the material and its purchase date).

When you're in the process of creating a good, you move that amount from raw materials to works in progress (WIP).

When the project is completed, you move the amount to finished goods (FG).

When the product is sold, the amount of the finished good cost is moved out of inventory and into cost of goods sold and is now able to be deducted on your taxes.

Simplified example of how to track inventory

So let's use a very simple example and say you are creating a purse and bought yarn for $10 and one button for $1.  At the point of purchase, you have $11 in raw materials (RM). 

You start creating the purse and have used 1/4 of the yarn and no buttons.  At this point you have $2.50 in works in progress (WIP), which brings your raw materials down to $8.50. 

When the purse is finished, you have used the button and half the yarn and you plan to keep the other half of the yarn on hand for a future purse.  Now you have $6 in finished goods, $0 in works in progress, and $5 in raw materials.

Later, you sell the purse that cost you $6 to create for $15.  $6 moves out of inventory and to cost of goods sold.  Finished goods is now $0.  Your profit on the purse is $9, the income of $15 minus the cost of goods sold of $6.  The $9 of profit is the amount you pay taxes on (before writing off other business expenses, like the crochet needle we mentioned earlier).

What now?

If you need a tool to do a year-end inventory count only, check out my $7 year-end inventory count spreadsheet.

If you're still a bit fuzzy on the concept of inventory and learn better with visuals and live explanations, join my Inventory Workshop, happening live on Thursday January 10th, 2019 @ 12pm EST.  As a bonus, this workshop includes the year-end inventory count spreadsheet mentioned above.

Stay Connected

Be sure to stay in touch and check out my free resources.  The best place to start is by getting your Free Starting a Biz Checklist to make sure your business is set up right and you haven't missed a step that could cost you a lot of money or potentially cripple your business.