Do I need to bother with inventory if I'm only a small business?

Getting reliable advice for your small business can be really difficult when you are first starting out: there will be some that will tell you that if you have a small turnover or are treating your business “like a hobby” it’s not really required or just not worth the trouble. Others will say that it is incredibly important to track your inventory no matter your size. What’s the truth? Let’s find out.

What the IRS says about small business inventory

To clarify this confusing situation, let’s start with the official guidance from the IRS.

Looking at Publication 334 (2015), Tax Guide for Small Business it states under Inventories:

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following [$1 million or less of average annual gross receipts] taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental.

So, let’s break down what this actually means - this particular paragraph is often misunderstood as meaning that if you make under $1 million in sales you don’t need to keep inventory. This is simply not true and is a misreading of this statement.

Firstly, what is clear is if you make under $1 million in a year you don’t need to use the accrual method and can instead use the more straightforward cash method of accounting. This essentially means that you can record income when it is received and your expenses when they are paid. This is great news for a small seller as cash basis accounting is a much simpler process than accrual, but doesn’t answer our question about inventory.

Right, let’s move to the next line in the IRS guidance to see if it clarifies the inventory situation further for us:

“These taxpayers can also account for inventoriable items as materials and supplies that are not incidental“…

Right. There are a couple of interesting terms in this line that can confuse, so let’s go through it now carefully.

“Not incidental” are the materials that are required for the manufacture of your products - examples for a handmade business could be fabric or buttons. Without these materials, you essentially would not have a product to sell. (“Incidental” materials on the other hand, are things you purchase that are not involved in the production of your finished goods: office supplies typically are categorised as such).

So, back to the IRS guidance and we find under IRS Reg. Section 1.162-3 states that “Not incidental” materials and supplies are deductible in the year they are used or paid, whichever is later.

This means that all materials and supplies that are directly used for the production of your finished goods must be accounted for:

1. In the year you provided them as finished goods to customers, or
2. In the year you originally paid for the material

Whichever is later.

As a manufacturer, the case will most likely be that you will be providing the material to your customers in the form of a manufactured product well after you paid for the raw material so this means you will need to be using the point 1. rule above.

To do this, you’ll need to be using some way to calculate how much of each purchased supply / material has been used when it has been passed on to the customer via a sale of your manufactured products so that you can tally how much worth of materials at the end of the financial year have been used in the production of each and every product you sold. This is otherwise referred to as your COGS (Cost of Goods Sold). Learn more about how to calculate your COGS for a small business here »

Achieving these tallies with accuracy requires keeping close tabs on what materials have been moved from your inventory on hand to your “consumed” tally - this clearly requires keeping track of both your raw materials and products, i.e. inventory tracking!

To summarise: the IRS says that it doesn’t matter how small your business is, if you produce your products from raw materials then you need to track your inventory in some capacity.

Methods to Track Inventory for Small Business

Let’s start by saying there are several methods you can use to track your inventory for small business. These include manual methods, such as spreadsheets or pen and paper, as well as automated systems like inventory management software - it’s all about how you’d like to work. Let’s take a look at the options now.

Manual Methods

Manual methods involve physically counting and recording the quantity of raw materials and finished products in your inventory. This method is often used by small businesses with a limited number of products and low sales volume.

One way to manually track your inventory is through spreadsheets, which can be created using programs like Microsoft Excel or Google Sheets. You can create columns for item names, quantities on hand, quantities sold, and other relevant information. However, this method requires regular updates every time your inventory changes, which can be time-consuming and prone to errors.

Another manual method is the use of pen and paper. This involves writing down the item names and quantities on hand in a notebook or logbook. While this may seem simple, it can also be tedious and increases the risk of losing important information.

Software Methods

With advancements in technology, there are now many software programs available that can help you track your inventory more efficiently. These programs often have features such as barcode scanning, automatic updates based on sales data, and real-time tracking of stock levels.

Inventory management systems are another option for businesses with larger inventories and higher sales volume. These systems offer more advanced features such as forecasting demand, generating purchase orders, and analyzing sales data to determine optimal stock levels.

When choosing an inventory management system, it’s important to carefully consider your business’s specific needs. Factors such as cost, ease of use, and compatibility with other software programs should all be taken into account.

Additionally, implementing a systematic approach to inventory management can also greatly benefit your business. This includes setting up processes for tracking incoming shipments, regularly conducting physical inventory counts, and establishing reorder triggers based on sales data.

Proper inventory management not only helps ensure that you have enough products on hand to meet customer demand, but it can also help reduce costs by avoiding overstocking or understocking. By having a clear understanding of your inventory levels and sales patterns, you can make more informed purchasing decisions and avoid excess inventory sitting on shelves.

Introducing Craftybase

Craftybase inventory software is designed for small businesses like yours. By entering your material purchases and keeping your manufacturing records up to date, you can instantly obtain the material usage and cost of goods sold calculations you need for your end-of-year accounts and ensure you are compliant with tax requirements.

In addition, our software allows you to track the cost of each individual item in your inventory, including labor costs and other expenses. This can help you accurately price your products and understand the true profit margins for each item.

Craftybase also integrates with popular e-commerce platforms like Etsy and Shopify, making it easy to manage your online sales and inventory all in one place. And with our user-friendly interface, you don’t need to be a tech expert to use our software. We provide step-by-step instructions and have dedicated customer support teams available to assist you with any questions or issues.

With Craftybase, you can streamline your inventory management process, save time and money, and make data-driven decisions for your business. Our goal is to help small businesses like yours thrive by providing powerful tools that are affordable and easy to use.

So why wait? Sign up for a free trial today and see how Craftybase can transform the way you manage your inventory.

Remember, staying on top of your inventory is crucial for the success of your small business - let Craftybase help you achieve that!