Inventory 101

Note:

Lines 36 and 38 are considered interchangeable - 36 is usually used for items purchased direct for resale like pre-made clothing, accessories, etc. Line 38 is usually used for materials that are then created into goods for sale, like fabric, wax for candlemaking, etc. However, they both function the same in the mathmatical formula.

Lines 37 and and 39 are usually only used in major manufacturing businesses to include factory and salary costs. You do not usually see them filled in on a Shopify/Etsy style small business.

Example 1:

Becky has a small clothing business. She makes items to order, but always has some fabric stock on hand for customers to choose from.

• Her first year in business, Becky's beginning inventory value is $0 on Jan 1 - she hasn't bought anything yet since she just started!
• When she purchases fabric, she records the price, the print, and how much she bought. She uses those records to keep track of her purchases for the year.
• Through her first year in business, she purchases $12,000 in fabric. She takes $200 of that fabric for personal use to sew her daughter a prom dress.
• This means her purchases for the year are $11,800 - ($12,000 minus the $200 she used for personal use)
• At the end of the year, on Dec 31, she measures her remaining inventory and compares it to her records. She determines that she has $3,500 worth of fabric still left 'in stock' and no unfinished goods/works in progress. 
• Her COGS, or "Cost of Goods Sold", is $8,300. This is telling the IRS that $8,300 worth of items out of the $12,000 she purchased for the year have been sold.

Example 2:

It is Salina's third year in business. She imports t-shirts from abroad and re-sells them on her website. She does not have any made to order products or 'works in progress', because every item is premade.

• Salina's beginning inventory value is $2000 on Jan 1 - this matches her ending inventory on Dec 31 of the previous year. If it does not match, Salina will need to submit an explaination to the IRS of why it is different (see question 34 on the tax return screenshots).
• She records each purchase she makes from her vendors, including the shirt print, size, and price per shirt. At the end of the year, her purchases equal $23,000 worth of t-shirts.
• She stocks them all for sale and does not take any items for personal use. Therefor, her purchases for the year are the full $23,000.
• She has no cost of labor or materials and supplies since she re-sells finished items. She has no other costs related to inventory.
• At the end of the year, on Dec 31, she counts how many unsold t-shirts she has left and compares it to her records. She determines she has $7,300 worth of t-shirts left.
• Her COGS, or "Cost of Goods Sold", is $17,700. This is telling the IRS that approximately $17,700 worth of t-shirts were sold.

Example 3:

It's Larry's second year in business. He purchases both pre-made ballcap hats and raw leather that he engraves with a laser.

• His first year in business, Larry made a mistake on his inventory counting. He adjusted his methods and now has a correct count/value of $7,300, but it is different than last year's Dec 31 ending inventory, which was listed at $8,000.
• Therefor, on his schedule C, Larry checks the box that says there was a change in his determination and attaches a brief explaination of what was miscounted and why the change happened. This tells the IRS that we are aware the past year's ending value and current year's beginning value does not match - otherwise, their systems may flag it as an inaccurate math calculation.

• Then he puts in his correct Jan 1 inventory number of $7,300 as his beginning year value.
• He records each purchase of hats and leather, including the prints or designs, sizes, colors, and costs. His total purchases for the year are $5,000 in ballcap hats and $1,200 in leather to turn into patches. None of these items are kept for personal use. He has no cost of labor or other costs.
• At the end of the year, he counts his ballcaps and measures his leather and compares them to his purchase records. He finds he has $3,000 in ballcaps and $500 worth of leather left.
• His ending inventory is therefor $3,500.
• His cost of goods sold is $2,700, meaning that throughout the year he sold $2,700 worth of products to customers.