Why Do Businesses Take Inventory?

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My son used to work for a CPA firm, and every year he spent the holidays "taking inventory" at client locations.  One year, he worked at a large office supply company counting paper, pens, and staplers.  

Why do businesses take inventory?  And why do they do it at the end of the year?

Why Businesses Take Inventory

Businesses take inventory to answer several questions:

How Much Do We Have On Hand?

Inventory is a valuable business asset.

Businesses take inventory so they know how much they have on hand at a specific point in time.  Inventory includes both finished products, work-in-process (products in various stages of completion), and products to be used to make new sales items (called "cost of goods sold").  For example, a business that makes candles and candle-holders might have finished candles, candles that have been partially completed, and wax and other materials that will be used to make new candles.

The business stops work on a specific date and everything gets counted. In a very small company, everything gets counted.  In larger companies, with many products and many parts to be made into products, inventory is spot-checked or sampled. Counting every bolt that goes into a car, for example, would take too much time, so samples are used to estimate the inventory.

How Often Does Inventory Turn Over?

Inventory turnover shows the number of times a year inventory "turns over" or is sold and replaced.

  Rosemary Peavler, Guide to Business Finance, says that inventory turnover "measures the efficiency of a business in managing and selling its inventory."  The higher the turnover, the higher the sales, the more efficient the business.

What is the Value of Our Inventory?

The value of a company's inventory depends on the valuation method: First In-First Out (FIFO), Last In-First Out (LIFO), or Average Cost.

The valuation method can make a big difference in taxes, and the IRS has rules on valuing inventory.

Is Inventory Disappearing? 

One reason for doing a physical inventory is to make sure that inventory is not disappearing, for one of several reasons: 

  • Some inventory might become obsolete and needs to be discarded. This might be the case for technological obsolescence of electronic devices and computer products. 
  • Some inventory might be unusable ("shrinkage") and needs to be discarded. 
  • Some inventory items might be disappearing due to employee theft. 
  • And some inventory might not have been recorded correctly, for various reasons. 

When discrepancies or issues arise, action needs to be taken, because the value of inventory is being overstated. Obsolete or unusable inventory needs to be removed from the records. Changes in record keeping or investigation of loss due to theft might be needed. 

What is Beginning and Ending Inventory for COGS?

Cost of good sold is an important calculation for businesses that sell products, whether they are manufactured or purchased and res-sold. Cost of goods sold, as the name implies, is a cost of doing business. 

To calculate cost of goods sold for its tax return, the business needs to know the value of beginning and ending inventory.

  The higher cost of goods sold, the lower business income, so this is an important figure.

Can We Get a Loan from Our Inventory?

One final reason to take inventory is to value it for financing purposes.  You can get a loan based on the value of your business inventory.