Inventory vs. Supplies: Financial & Tax Differences

The terms inventory and supplies represent two distinct classes of assets. While they may seem similar, their roles are different, and understanding this distinction is a requirement for accurate financial reporting. The proper classification of an item as either inventory or supplies influences how it is accounted for, impacting a company’s profitability and tax obligations.

Defining Inventory

Inventory includes all goods a business holds with the intention of selling them to customers, as these items are a primary source of revenue. The classification of inventory has three main categories representing different stages of the production process.

Raw materials are the basic components a company uses in its manufacturing, such as flour and sugar for a bakery. The next stage is work-in-progress, which consists of partially completed goods like unbaked cookie dough. The final category is finished goods, which are completed products ready for sale, like a packaged loaf of bread on a store shelf.

Defining Supplies

Supplies are items a business uses to support its daily operational activities but does not sell to customers. These items are consumed during business operations and are not part of the final product being sold.

Common examples include office supplies like paper and pens, operational supplies such as cleaning chemicals for a restaurant, and maintenance supplies like replacement light bulbs. The defining characteristic of supplies is their role in facilitating business activities, making them indirect costs necessary for the company to function.

Financial Statement Treatment

The accounting for inventory and supplies impacts key financial statements. Both are initially recorded as current assets on the balance sheet when purchased, but their treatment diverges when they are sold or consumed.

When an item of inventory is sold, its cost is transferred from the balance sheet to the income statement and recognized as the Cost of Goods Sold (COGS). This COGS figure is a direct expense matched against the revenue from the sale, and subtracting it from total revenue yields the company’s gross profit.

As supplies are used up, their cost is moved from the balance sheet to the income statement as an operating expense, often recorded as “Supplies Expense.” Unlike COGS, this expense is not tied to a specific sale and is part of the broader costs of doing business, which are deducted from gross profit to calculate net income.

Tax Implications

The accounting treatment of inventory and supplies affects the timing of tax deductions. For inventory, costs are capitalized and held on the balance sheet until the product is sold, at which point the deduction is claimed as part of the Cost of Goods Sold. The cost of supplies can be deducted in the year they are used, which can accelerate tax savings.

A practical tool available to businesses is the de minimis safe harbor election, which allows a business to immediately expense low-cost tangible property like supplies that would otherwise be capitalized. This election does not apply to inventory. For businesses without an audited financial statement, items costing up to $2,500 per invoice can be expensed. This threshold increases to $5,000 for businesses with an applicable financial statement, and making this annual election can simplify bookkeeping.