Inventory Valuation Methods for Manufacturers

One of the most impactful accounting decisions manufacturers make is selecting the method used for inventory costing. Choosing the right method for your business will have a direct impact on both your financial statements and tax liabilities. To help you determine which inventory costing method may be most beneficial for your company, we will examine the inventory methods available to manufacturers for both financial reporting (generally accepted accounting principles, or GAAP) and income tax purposes.

First-In, First-Out (FIFO)

The First In, First Out (FIFO) method operates under the assumption that the oldest inventory is bought first. Under this approach, the cost used for goods sold would be the value of the older inventory, assuming that the remaining inventory on hand is newer.

Since this method of inventory costing most closely resembles the actual movement of inventory, it is often the preferred method for most businesses. During periods of inflation, FIFO can strengthen a company’s financial statements by resulting in higher income. This occurs because as prices rise, a company using the FIFO method would be selling older inventory valued at a lower cost, theoretically resulting in greater revenue. However, higher incomes could potentially lead to greater tax liabilities.

Additionally, the value used to report inventory on your balance sheet will be more reflective of current market prices, which leads to an accurate valuation of assets while limiting inventory obsolescence accounting requirements.

Last-In, First-Out (LIFO)

The Last In, First Out (LIFO) method assumes the cost of inventory purchased most recently is the cost of the inventory sold. In contrast to FIFO, the LIFO method has the opposite effects on a business during times. Since the most recent inventory purchased will have higher costs, the costs applied to goods sold will also be higher, resulting in lower income and potentially lower tax liabilities.

However, LIFO has its challenges. It often requires extensive record-keeping and can lead to additional obsolete inventory accounting requirements. While the underlying tax benefit is noted, the financial statement impact could be detrimental for companies looking to report higher profits on their financial statements, in addition to potentially having a negative impact on a company’s ratio analysis.

Weighted-Average

Another method of valuing inventory is known as the weighted-average method. Under this method, as new inventory is acquired, the average cost of inventory is recalculated and then reapplied to both goods sold and ending inventory.

This approach provides an administrative benefit by simplifying the calculations required to track inventory cost. While the FIFO and LIFO methods require the tracking of layers of inventory, the weighted average method requires a company to track the total quantity and costs of inventory. This method will typically result in income levels between FIFO and LIFO methods.

Specific Identification

The specific identification method tracks the exact cost of each item in inventory and applies that specific cost of each item to the cost of goods sold when the inventory is then sold. This method provides the most accurate valuation of assets and reported income. However, the administrative burden required to track inventory at this level can be time-intensive and costly, especially for small businesses or companies with high inventory turnover rates.

Non-Incidental Materials & Supplies (NIMS)

For tax years beginning before January 1, 2018, eligible businesses required to account for inventories under Internal Revenue Code (IRC) Section 471 could treat non-incidental material and supply costs as deductible expenses for the year in which the costs were consumed or purchased.

Pre-2018, eligible businesses were defined as those with gross receipts of $1 million or less. However, the Tax Cuts and Jobs Act (TJCA) of 2017 expanded the exception to inventory accounting under IRC Section 471(c). It increased the gross receipts threshold for small business eligibility under IRC Section 448(c), as defined in the next section. NIMS is an alternative inventory method that allows the expensing of non-incidental costs through cost of goods sold in the tax year that the inventory is used in the business or the year in which the inventory is paid for, whichever occurs later.

Small Business Taxpayer Exception

Manufacturers qualify for the small business taxpayer exception if their average annual taxable gross receipts for the prior three tax periods do not exceed the threshold set by IRC Section 448(c). The threshold is subject to inflation on an annual basis, which is set at $30 million for 2024 and $31 million for 2025. As noted above, the TCJA brought significant changes and tax reform, including the expansion of the small business taxpayer exception for manufacturers.

Changing Inventory Methods

Any change to your inventory costing method will require approval from the Internal Revenue Service. To obtain approval, a business must complete Form 3115 with its timely filed tax returns (or extensions if applicable) for the year of the change.

Often, when changing the inventory method of accounting, a change in taxable income occurs, resulting in a Section 481(a) adjustment. Depending on whether this adjustment results in a positive or negative impact on taxable income, the overall adjustment must be reported and included on the company’s timely filed tax returns. Specifically, a negative adjustment is fully reported in the year of change, while a positive adjustment is reported over four tax years, starting with the year of the change.

Uniform Capitalization (UNICAP) Rules

When analyzing inventory methods, it is important to address a company’s compliance with the uniform capitalization (UNICAP) rules, pursuant to IRC Section 263A. Under IRC Section 263A, businesses are required to capitalize the direct and indirect costs associated with production or resale activities. Several exclusions apply to the UNICAP requirements, with the most common being the small business taxpayer exception mentioned earlier.

Key Takeaways

Determining the best inventory costing method for your business is not a one-size-fits-all decision. As companies often have varying strategic goals, it is important to identify those goals and ensure that your company’s accounting methods can help you meet those goals. Whether you are looking to lower tax liabilities, strengthen your balance sheet and financial ratios, optimize profitability, streamline administrative duties or create cash flow efficiencies, it is important to be aware of the methods available. If you have any questions regarding the information provided above, please reach out to us at Dannible and McKee, LLP.

Contributing author: Kaitlyn L. Mariano, CPA, is a senior tax manager at Dannible & McKee. Kaitlyn has over 11 years of experience overseeing tax engagements for a variety of clients with a focus on manufacturing, construction, multi-state taxation and high-net-worth individuals. For more information on this topic, contact Kaitlyn at kmariano@dmcpas.com or (315) 472-9127.