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

Getting reliable advice for your handmade 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 the IRS says about craft 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.

Daunted? Don’t be! Craftybase inventory software is designed for small maker businesses just like you. By entering in your material purchases and keeping your manufacture records up to date you will be able to instantly obtain the material usage and cost of goods sold calculations you need for your end of year accounts.