Identification of Inventory Items

Besides deciding how you will value your inventory — at cost, or at the lower of cost or market — you must also decide how you will identify which items were sold, and which are still in inventory. The most basic way of doing this is called the "specific identification method," in which you match each item sold with its cost (or market value).

The specific identification method is easy to understand, but may be totally impractical for your business. It may work well for companies that sell relatively few big-ticket items like cars or pianos. But if your business has a large, quick-moving inventory of smaller items, you soon would be doing little but tracking inventory if you had to do it piece by piece.

Example The "We're Widgets World Wide" ("4W") company, buys and sells thousands of widgets each year. Because 4W depends on several suppliers for widgets, and frequently must outbid other wholesalers for them, the price that 4W must pay usually varies daily. Listed below are just four of the thousands of widgets that came into 4W's inventory in this year: Widget 2301, bought 1/1, $49.00; sold 12/1 Widget 3904, bought 6/1, $49.50; sold 9/1 Widget 5039, bought 6/30, $50.45; sold 7/14 Widget 7932, bought 7/1, $50.20; sold 12/15

Although modern computer-based inventory control systems could allow you to track each widget, the IRS doesn't require it. Instead, you can usually choose one of two identification methods. These methods make broad assumptions about which inventory items were sold and which remain in inventory, without reference to the particular inventory items that were actually bought and sold. These two methods are known as the "first-in, first-out" (FIFO) and the "last-in, first out" (LIFO) methods.

The FIFO method assumes that sales are made from the items that have been longest in the inventory. This conforms to the usual business practice of trying to sell the older items first, before they become obsolete, spoiled, or out-of-fashion. This is also the method the IRS prefers.

In contrast, the LIFO method assumes that the most recently purchased items are the ones you sold, and the oldest items are still sitting in your warehouse or on your shelf.

One consequence of using FIFO is that if prices are generally going up over time, your gross income will be matched against the lowest-priced items in your inventory, resulting in higher net profits. In contrast, LIFO would match your gross income against the most expensive items in your inventory, resulting in lower net profits and, consequently, a lower tax bill. If your business and inventory are constantly growing over time, LIFO will generally be preferable.

Example Using the four widgets described in the example above, let's say you know that you sold two of these widgets this year, for a price of $60 each. Under FIFO, you'd be treated as having sold the first two widgets you purchased, so your net income would be $120.00 - ( $49.00 + $49.50) = $21.50. Under LIFO, you'd be treated as having sold the last two widgets you purchased, so your net income would be $120.00 - ($50.45 + $50.20) = $19.35.

The IRS does not favor LIFO and, if you want to use it, you must file IRS Form 970, Application to Use LIFO Inventory Method, and follow some very complex tax rules. There is also a "simplified" dollar-value LIFO method available to small businesses (those with average annual gross receipts of $5 million or less for each of the last three tax years). For more information, see your tax advisor.