A Guide to Inventory Depreciation for Small Business Owners


Your inventory doesn’t last forever.

Over time, the items in your inventory fall apart from wear and tear, become obsolete or get stolen. Even though your inventory depreciates — that is, it loses value — every year, it isn’t taxed like your other long-term assets are.

But there are tax breaks you can claim for inventory depreciation. Here’s what you need to know.

Do You Depreciate Inventory?

Do you depreciate inventory? Yes, in the sense that you keep track of value losses on your balance sheet.

Your balance sheet tracks your assets (i.e., what your business owns) and your liabilities (i.e., what your business owes). Your inventory is one of your assets. When you add to your inventory, its value goes up. When you sell things from it, your balance goes down as you turn inventory into cash.

Inventory depreciation works the same way. At the end of the accounting year, you take stock of what’s left in your inventory. If some of it is too old or damaged to sell or if you lost some to theft, you write down — that is, you devalue old or damaged inventory — your inventory on your balance sheet to reflect what remains.

Write-downs are a common accounting practice. Retailers reported $61.7 billion in shrink from theft and shoplifting in 2019, according to the National Retail Federation.

So how does inventory depreciation fit into your small business taxes?

Are There Tax Breaks for Inventory Depreciation?

You don’t usually deduct the cost of your investments into long-term capital assets like equipment and buildings at once (Well, unless you use the 179 deduction). Instead, you deduct the IRS-determined depreciation every year. For example, the IRS expects a vehicle to last five years, so you can deduct 20% of the purchase price each year until you’ve written off the entire investment.

Inventory depreciation doesn’t work the same way. The IRS considers inventory a short-term asset that won’t last more than a year. So even though inventory loses value over time, the depreciation tax rules don’t apply.

But you can still receive a small tax break when you buy inventory.

When you buy inventory, you can’t deduct the purchase right away. Instead, you subtract the cost of goods sold from your revenue when you make a sale, which lowers how much you owe in taxes. If you buy chairs wholesale for $50 apiece and sell them for $100, your taxable profit is $50.

What About Lost or Stolen Inventory?

When inventory is lost or stolen or becomes so damaged that you can’t sell it, you deduct it as part of your cost of goods sold. At the end of each accounting period — usually at the end of the year — you review your remaining inventory compared to what you purchased to see how much of your inventory went to sales and how much was lost to theft and depreciation.

Let’s say that Steve bought $1 million worth of inventory for his hardware store at the start of the year. He sold half of it — $500,000 worth — to customers. He also lost $50,000 worth of it to theft and depreciation. His total cost of goods sold for the year would be $550,000 — the cost of what he sold plus the costs from theft and depreciation. He can deduct this amount from his revenue.

Steve can adjust the remaining value of his inventory on his balance sheet to $450,000, as that’s what’s left over. Even if your inventory loses value from depreciation, you still get to deduct what you originally paid for it as part of your cost of goods sold.

How Do You Record Your Inventory Value?

One tricky part about tracking inventory is that your purchase prices likely don’t stay the same. Inflation might spike prices, supplier discounts might come and go, or you might change vendors. You can’t just record how much you spent; you have to record what you spent on every inventory unit to calculate your cost of goods sold deduction.

There are a few systems you can use for this.

  • First in, first out. First in, first out is just what it sounds like. Businesses usually sell the oldest batch of inventory before moving through newer ones, so the cost of goods sold is figured with the oldest batch. Let’s say you bought your first batch of a product at $40 a unit but spent $50 a unit on the next one. Using the first in, first out system, your business would use $40 as your cost of goods sold until you’ve sold through that batch. Once you moved into the second batch, your cost of goods sold would jump to $50.
  • Last in, first out. Last in, last out is the opposite of first in, first out. Your business sells the newest batches of inventory first before putting out older batches. In this example, your cost of goods sold would start at $50 a unit and drop to $40 when the newer inventory runs out.
  • Weighted average cost. With the weighted average cost method, you average your inventory costs for the cost of goods sold. If you bought half of your inventory items at $40 apiece and the other half at $50 apiece, your cost of goods sold would be $45.
  • Specific identification. Using this method, you track every single inventory unit to identify its purchase price for every sale.

Which System Should You Use?

The system you pick can make a difference in your taxes and finances. Because inventory prices typically rise over time, using a last in, first out system can reduce your taxes. Assuming you keep resupplying, you’ll keep selling the most expensive purchases at a higher cost of goods sold, lowering your taxable profit. You hold on to your less expensive purchases indefinitely.

This timing is just a tax move. It doesn’t mean that you’re physically keeping old inventory on the shelves; you’re just using the cost of goods sold of the recent purchases for your tax reporting.

On the other hand, using the first in, first out system increases your profits and the book value of your business, which can help you qualify for small business loans and equipment leasing. Because you’re selling the less expensive inventory first, your business holds on to more expensive batches, increasing your asset value on the balance sheet. It also lowers your cost of goods sold, which increases your profit margin.

Each strategy might be right for your business, depending on your needs.

Tracking inventory depreciation and suppley.

How Can You Get Help Keeping Track?

Tracking inventory for your taxes can get complicated. An inventory management system could track your inventory so that you know what you have on-hand and when you need to resupply. This information can help you identify which products are selling well and which are routinely stolen.

An inventory management system could also help track your cost of goods sold according to your value-tracking system. Some of these programs can be linked directly to small business tax software, too, so you have what you need at your fingertips when you file your tax returns.

As you figure out your plan for inventory, consider speaking with a tax professional. They can help you figure out which system makes the most sense for your business and ensure that you’re getting the maximum tax break for your inventory depreciation.

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