For businesses that sell products, inventory is often the largest asset and cost of goods sold the largest expense. How you record inventory changes reported profit, so getting the basics right matters for decisions and for taxes. The IRS covers inventory in Publication 538 and Publication 334.

Inventory is an asset until it is sold

When you buy goods for resale, the cost goes to an inventory asset account. When the goods are sold, their cost moves to cost of goods sold. Expensing purchases immediately makes months with large orders look unprofitable and months with high sales look better than they were.

What goes into inventory cost

Inventory cost includes the purchase price plus costs to bring goods to a saleable condition and location, such as freight-in, duties and, for manufacturers, materials, labor and some overhead. Freight to customers is a selling expense, not inventory.

Periodic vs perpetual systems

  • Periodic: purchases are recorded to inventory or purchases accounts, and cost of goods sold is calculated from counts: beginning inventory plus purchases minus ending inventory
  • Perpetual: each sale relieves inventory at cost in real time, usually through a point-of-sale or inventory system, with counts used to correct differences

Most small businesses use a perpetual system in their sales software and post summary entries to the books.

Costing methods

Common methods include first-in, first-out (FIFO), average cost and, for some businesses, last-in, first-out (LIFO), which has special requirements. Specific identification is used for unique items. The method must be applied consistently, and changing it generally requires IRS consent.

Small business options

Some small businesses that meet a gross receipts test may be able to use simplified methods, such as treating inventory as non-incidental materials and supplies or following their financial statements. Your tax preparer will review eligibility; see Publication 538.

Counting and shrink

A physical count at least once a year verifies the inventory figure. The difference between the count and the books is shrink: theft, damage, errors. Record it separately so it is visible. Cycle counts of high-value items during the year catch problems sooner.

Obsolete and damaged stock

Items that cannot be sold at normal prices may need to be written down. Document the decision and the items involved.

Monthly routine

We reconcile inventory purchases to supplier statements, post cost of goods sold from sales or count data and review gross margin trends monthly. See our retail and ecommerce pages for industry detail.

Monthly inventory routine

Count high-value items, record purchases and freight, post cost of goods sold, and compare inventory on the balance sheet with your inventory system. Investigate differences before closing the month.

Slow-moving items deserve attention too. Review aging inventory quarterly and decide whether to discount, return or write down items whose value has declined.

Document your costing method in writing and apply it consistently from year to year, since changing methods can require IRS consent.

Key terms

Definitions for terms used in this guide, from our small business glossary:

  • Cost of Goods Sold: Cost of goods sold is the direct cost of the products a business sold during a period.
  • FIFO and LIFO: FIFO and LIFO are inventory costing methods that decide which purchase costs are assigned to the goods you sold.
  • Balance Sheet: A balance sheet shows what a business owns, what it owes and the owners' equity at a specific date.