The cost of a business's inventory goes well beyond just the wholesale cost of goods on the shelves. The business has to get those goods to the shelves in the first place -- and that means paying freight charges. In most cases, the freight charges involved in acquiring inventory can be rolled into the cost of that inventory as reported on the company's balance sheet.
The Internal Revenue Service says a business may include in its inventory cost all the "ordinary and necessary" expenditures of acquiring goods and getting them ready for sale. That specifically includes freight in, or the costs of delivering goods from a supplier to the business. If the company makes products rather than buying them for resale, the freight-in costs of raw materials and parts also can be included in inventory cost.
Once a business has goods in its possession, it can't include any further freight charges in inventory cost. For example, if a company ships goods among its stores, the costs of doing so can't be included in inventory. Instead, those costs are what accountants call selling, general and administrative expenses. Freight out, or the cost of delivering goods from the business to its customers, is also an SG&A expense.
Why It Matters
The accounting treatment of freight costs matters because it affects how much profit the business will show in its financial statements. Expenses reduce profit, and companies do not claim inventory costs as expenses until they actually sell the inventory. Say a company gets a shipment of 100 items, with a total freight charge of $100, or $1 per item. If the company does not include the charge in its inventory cost, then it claims an immediate SG&A expense for $100. That reduces its reported profit by $100. However, if the company does include the freight in its inventory cost, it reports no immediate expenses, so there's no reduction in profit. Then, as it sells the items, it expenses $1 worth of the freight charge for each one sold. If it sold 85 of them, for example, it would expense $85 of the fright charge, reducing profit by $85. The remaining $15 of the charge remains locked up in inventory until those 15 items are sold.
An article in "Entrepreneur" magazine points out that small and growing businesses rarely include freight in their inventory costs. Instead, they report the whole freight charge immediately as SG&A to get the maximum reduction in reported profit. This is for tax reasons. While large companies want to report big profits to their shareholders, smaller ones are more concerned with limiting their tax liability. Companies pay taxes based on their profits, so the lower the reported profit, the smaller the tax bite. Keep in mind that, regardless of how its books treats freight charges, the company has already paid the full charge. The issue is when to claim that charge as an expense.
- KatarzynaBialasiewicz/iStock/Getty Images