How Should Manufacturers Account for Inventory?

First-in, first-out (FIFO) assumes the oldest units are sold first, so ending inventory carries recent costs. Last-in, first-out (LIFO) assumes the newest units are sold first, which can reduce taxable income when costs are rising, but it is not permitted under international accounting standards and carries a book-tax conformity requirement. Weighted average spreads cost across all units, and standard costing assigns predetermined costs with variances recorded against actual results.

The method should match how the plant actually consumes materials. A manufacturer that forces the wrong method gets misleading margins even with clean books.

IRS Publication 538 identifies specific identification, FIFO and LIFO as the accepted ways to match cost to items, and inventory must be valued at cost, lower of cost or market, or under the retail method. For manufacturers, cost includes direct materials, direct labor and the indirect production costs required by the uniform capitalization rules of IRC Section 263A.

The chosen method must be applied consistently year to year. A manufacturer that wants to change methods must generally file Form 3115 and obtain IRS consent, which is why the initial choice deserves care.

Under IRC Section 471(c), businesses with average annual gross receipts at or below an inflation-indexed threshold, roughly $30 to $31 million in recent years, may be exempt from the inventory accounting requirements and can treat inventory as non-incidental materials and supplies. The exception is elective and has its own mechanics.

Eligibility depends on the company's specific receipts history and the applicable indexed amount for the tax year, so it should be confirmed with an advisor rather than assumed.

Inventory sits at the intersection of the balance sheet, cost of goods sold and cash flow. Work in process ties up cash months before the customer pays, and errors in inventory valuation distort product margin, pricing and the monthly reports owners rely on.

When Pagac rebuilt a Metro Detroit electrical-parts manufacturer's reports, the corrected product-level numbers exposed cost swings that the company-level picture had been hiding. Clean inventory accounting is the foundation that makes that kind of visibility possible.