Businesses buy inventory, spending their cash reserves to acquire products to meet customer demand, but businesses also own inventory until they sell it, so inventory levels figure into a company's net worth. Every retailer needs to take inventory for income tax purposes, because the amount of inventory on hand is part of the equation for calculating net profit and loss. Retailers, in particular, base their business models on acquiring and selling inventory, so this information is especially relevant to their calculations.
Inventory is the sum total of unsold products that your business has on hand at any given time. The term can either refer to completed products that a retailer purchases wholesale to sell to its customers, or it can refer to products that the retailer manufactures himself. For example, a clothing store that makes some of the clothes it sells must include the items that have been made on site as part of its inventory.
To calculate profit or loss, a business subtracts its operating expenses from its gross revenue. Operating expenses include the cost of materials and inventory as well as payroll, rent, utilities, equipment, licenses, taxes and advertising. Inventory enters into the profit or loss equation because unsold products represent an expense that the business has incurred for something it has not used for operating purposes. The value of inventory on hand must be subtracted from the total expense of inventory purchased when calculating operating expenses.
Income Tax Consequences
To calculate cost of goods sold, or direct operating costs, a retailer adds the amount of inventory she had on hand at the end of the previous tax period to the amount she spent on inventory and payroll during the current tax period. Then she subtracts the amount of inventory remaining at the end of the current tax period. The more inventory she has on hand, the smaller the amount she can write off for direct operating expenses.
Although inventory levels figure into the calculations that determine taxable profit, some business taxes are based on other criteria. City and state revenue taxes are levied relative to a retailer's gross revenue, regardless of how much he has spent to generate that revenue; in fact, businesses must pay revenue taxes even if they have not earned a profit at all. In addition, businesses must pay payroll taxes to state and federal agencies, and these taxes have nothing to do with inventory levels.
Devra Gartenstein is an omnivore who has published several vegan cookbooks. She has owned and run small food businesses for 30 years.
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