Q4 Planning | Integrated Approaches to Inventory Costing, Reserves & Tax Strategies

So with that being said, I'm going to pass it over to our other co-presenter, Rob Babine, with our first polling question, which I know Rob is going to get you pretty excited. So go ahead.

Robert Babine: All righty. Well, thank you, Allie, and thank you everyone for joining us. So here we go. Polling question number two. Are we confident in our inventory costing currently? Let's see. While people are answering this question, fun background. When I got into public accounting, my first job as an auditor was an inventory observation and the senior manager, we're at a chemical plant and he said, "We need to make sure that there's chemicals in these barrels and not water." And so they had me go out to a tree where they sprayed a tree to say, "You have to see if there's dead bugs around the tree to make sure the pesticide worked." When out there, it was cold, it was raining, and I turned around and they're all smiling and laughing at me taking photos and saying, "Hey, there we go. Welcome to the club." So that was my first experience and ever since then I loved manufacturing. And so I'm happy to be here, based out of the Boston office and hopefully we give you some good information to walk away with and apply to your Q4 planning at the end of the seminar.

Astrid Garcia: All right, we're going to be closing the polling question now. Make sure you've submitted your answer. All right, back to you, Rob.

Robert Babine: All right, thank you. All right, so before we jump into talking about some of the items we are today, I thought it would be useful to go through the industry trends and economic overview of some areas that are impacting manufacturing because this will impact strategic decisions, accounting decisions, and other factors as time goes on, and it's something we constantly have to remind ourselves with. So I put up here just three big ticket items that we're all facing. To start, labor is an issue we all recognize. Manufacturing is slowed compared to overall employment. And finding skilled workers is difficult due to fewer STEM graduates. If they're not going in for STEM, they're not going for accounting. I don't know where all the workers are going, maybe they got lucky and figured out how to retire early. High cost of wages is something we're all facing and risk associated with union and collective bargaining agreements.

Just look at Boeing, I believe it's 30,000+ workers are on strike. I read that this was their first strike since 2008. It's a massive amount of employees. We narrowly escaped a supply chain crisis with the Canadian rail shutdown and other companies are starting to indicate that they had to curtail expansion. For instance, Alcoa had to curtail a plant in Indiana because they couldn't find enough people to staff that plant. Geopolitical uncertainty and global warming. This is becoming a thing now and happening more and more. We have rising nationalism and protectionism which complicate competition. Wars in other nations have a global impact and government-securing resources and restricted IP transfers can further affect our supply chains. Recently we had an article in the Wall Street Journal about extreme heat causing billions insurance won't cover, and we look at global warming and what's happening with all this heat we're having.

We're losing power, production facilities have to stop because it's too hot to work. We need more breaks. I actually have a client that produces plastics and one type of rubber they produce, they used to not produce it just during two weeks in July, but that two weeks over time has turned into a month and two months. And so now they're looking at ways to... how do they manage that because it is a significant part of their production?

And will reshoring efforts work? So this is something seeing more and more come up. A lot of existing U.S. companies are really trying to support this. They're trying to help people understand long-term cost of going abroad versus staying here and is it really a cost savings to be achieved or is it better to keep the jobs here? We're seeing a lot of increase in foreign direct investment into the manufacturing space, especially around labor technology, in greenfield foreign direct investment as well.

And obviously technology. The trend is moving to smart factories. We're seeing a lot of investment in automation, in software. We're seeing new machines such as computer numerical control, CNC, milling machines, being put into place, which create not only capacity but workplace safety. And then on-site energy production. A lot of companies are looking at how do they produce energy on site now? Utilities are getting expensive. How do they prevent against a power outage caused by heat? So these are things companies are looking to invest in, which impacts costing where we have our inventory, how we determine the cost of our inventory. A lot of impact factors here. I have one client, they used to make very specialized ornaments, Christmas ornaments, and they would only do it Q4, and it was a very laborious process all done by hand, a lot of processes going in on here. And when they produced them, they would have to shut down the rest of the production facility, which was a huge hit to them.

Over time, they started to replace portions of the production line with robotic arms and then they could start to increase production on other parts. They were able to increase capacity for their plant. And with the labor that they had who was assembling these ornaments by hand, they were then re-skilling these individuals to either work on other parts of the production line to operate to computers or the AutoCAD to cut out the stencils needed for the ornaments or to 3D print certain parts. So we're seeing a lot of this and hopefully it continues because it's definitely going to help alleviate labor challenges, create capacity, and hopefully we'll get a nice return for clients on those investments they make.

So we have these industry trends, it's time to refresh our BOM, but before we refresh our BOM, we need to refresh our memory on what does GAAP require, right?

So inventory is the sum of applicable expenditures and charges. Inventory costs is the sum of applicable charges, expenditures, whether direct or indirect to bring a product to existing location or condition. In a nutshell, that's absorption costing, full cost, your direct materials, your direct labor and your overhead such as variable overhead and fixed overhead. So that's GAAP. And when we come down to variable production overhead, we allocate that back based on actual use. So that could be your manufacturing supplies, maybe utilities, those are the costs that vary based on your business activities in the production cycle. And then we have our fixed overhead, which is required to be based on the normal capacity of your production facilities. So that could be your rent, your salaries, and those costs don't fluctuate on business production activities. And then just because tax, which also requires absorption costing, if something's capitalizable for tax does not in itself indicate there's a preferable even appropriate use to capitalize it for reporting.

And we have a slide on this that Allie will touch on in a few. We have those individuals that still have that mindset. Direct costing or variable costing is the way to go. Great for budgeting and cost control, but not so great for reporting. If you're using variable or direct costing, you're missing your fixed overhead, which is required for GAAP and you're going to just create some anxiety for your auditors when they come in and start auditing your inventory costs. Standard costing. See a lot of it, it's great, facilitates management by exception. You're seeing spikes in your labor, you're seeing spikes in your direct material. It helps really analyze those variances. But keep in mind it's not actual cost, and GAAP requires actual cost. So if you're using a standard cost system, every time you go in for a reporting period, you're going to have to update your standard cost so it approximates your actual cost.

And there's really three key variances you have to look at. It's your direct material variance, your direct labor variance, and your overhead variance. So whether you have a positive or negative variance between actual and standard, those costs are capitalized so that way your standard cost approximates your inventory costs. So it's always important to keep that in mind. We see a lot of new systems get set up and they go into standard cost and there's that one feature that never gets clicked on, "Hey, we have to close out a BOM," or, "We have to reconcile standard to actual." And sometimes at the end of the year we have all these costs in here, we go to flush out, and it can lead to a jaw drop on the margin sometimes. So it's important to have controls if you're using a standard costing system on how to get that to approximate actual.

All right, we refreshed our memories on what does GAAP require. So what are some costs that we usually have to absorb into inventory? Typically, depreciation and repairs on production equipment. Our rent and utilities related to production facilities. Indirect labor and payroll taxes. We're looking for a fully burden rate here in insurance related to production. Typically, you're not capitalizing R&D costs, expenses when incurred. If you capitalize R&D costs, you're going to give again your audit partner a heart attack, not really, but create some anxiety. General company expenses: holiday parties, marketing, advertising expense when incurred G&A officer salaries, those typically don't make their way into inventory. If your CEO walks down to the production line, grabs a bunch of cookies and says he's doing QC, no, you still don't capitalize that, but you probably got a shrinkage issue you're going to have to worry about. So the key here is really think about what's important to your business, what makes sense to your business.

So inventory production and conversion costs, they're going to vary by industry, but it's also going to vary by whether those costs are included directly or indirectly in your production process. So as you go through this and you think about costing your inventory, refreshing your BOM and what needs to be updated, it's really important to consider the specific facts and circumstances relevant to you in your business. So we refreshed our mind on GAAP. We went over some costs that go into inventory. So what do we do now with these costs? Once you have your cost identified, you now need to take these costs and group them into overhead pools. So you can have one plant-wide overhead pool or you could have individual pools such as a cost pool for production, packaging, and QC. So what you want to do here is look at what the cost driver is, what's really driving these costs and what is the activity building these costs up during your production cycle?

And once you've identified your cost, you've got your pool, you want to start looking at how do you allocate these costs out. As accountants, we like to see a reasonable and consistent methodology, stay consistent. Areas we see, square footage for rent, maybe labor hours for the assembly line, specific identification with breweries, we see barrels of beer produced. So there's a bunch of different ways to look at this. It's what's important or what makes sense for your business. And some keys here to be successful is collaborate with those individuals on your plant floor that's in charge of operation. You want to talk with them, what's changed, what's happening? Make sure you got everything there to identify cost drivers, cost pools. Create pools that really reflect the usage. For instance, if you are building cars, your individuals are on the production line, that's probably a labor-related allocation base. But then the individual paint in the car, labor's probably not the best metric to use.

Maybe you want to use something like machine hours. So just look at what's really driving that cost. Pools can be based on departments like a distinct department if you want. Pools can be based on activities within the production cycle. So if you have a complex production cycle, if you have multiple processes, maybe you want to look at some activity-based costing method or you could use a product method if you're really looking at profit margin by your products. You want to evaluate various pools. Don't just pick one pool because you think it makes sense like labor hours. Look at multiple pools, evaluate them and then pick the one that works best. And as you do that, you also just want to constantly review and adjust your pools as necessary as you go through the process. And there's plenty of software out there you could probably look at to help automate and track this as well.

All right, so we have our costs, we've got our pools. What's next? Allocating our costs. So we talked about variable overhead. It's based on actual production, actual units produced. And then we have our fixed overhead, which is different. Fixed overhead is based on normal capacity. So normal capacity is referring to a range of production levels expected to be achieved over a number of periods or seasons under normal circumstances, taking into account loss of capacity resulting from planned maintenance. So this is much different than theoretical capacity, which is an optimal amount of work, 24/7, no waste. It's not practical capacity. Practical capacity is your theoretical adjusted downward for setup and maintenance and it's not budgeted capacity, which is planned utilization based on budgets. There's much more on capacity. I'm sure if there's any CMAs on the line, they're probably thinking of 10 other types of capacity out there.

We'll just summarize those three. No GAAP requires normal capacity. Actual level of production may be used if it approximates normal capacity. So that can be okay and it's very judgmental. So you look at, "Well, where's my industry going? What have I done in the past? Where am I going?" And you have a lot of factors to consider here. You can look at your historical product data, seasonality, plan maintenance, what's going to happen to new plant openings or closures? How's labor and supply chain constraints going to hit this? And how new technology is going to impact your production? That example I used earlier, using robotic arms really allowed our client to resume other production capacities when they're making ornaments during Q4. How does your product mix come into play? It was like we work with some breweries and they might say, "Hey, I can do 10,000 barrels of beer and I'm going to do all lagers." And lagers can take a long time to ferment.

And so if you work with them to say, "Can you really do 10,000 barrels of beer based on your current tank machinery setup?" Sometimes they say, "Well, maybe I can only do 5,000 barrels." So you got to look at not only product mix, but what your facility can really do and market demand. What's the market looking like? And is market demand just a one-off blip or is there a new normal demand that's happening because of change in consumer preference? So there's a lot that goes into normal capacity that has to be considered when you're figuring out how to allocate your fixed overhead.

New products can be an area of complexity as well. So when you're scaling up a new product, you typically experience lower production volumes as you increase these outputs to normal capacity. That may not be necessarily due to an unusual or abnormal issues within the company's operations. So again, you're looking for what is normal over a number of periods or seasons, normal circumstances, and you got to try to remove that noise of those one-off mechanical failures, those one-off supply chain constraints, or scaling up a product, "Hey, we haven't made this before," but you know you're going to get it to normal capacity in a few months. That's what you're really looking for. You're not trying to adjust all the time for these one-offs.

So continuing off with normal capacity. Some examples here, like I said, you're not going to change your allocation of fixed overhead based off of a consequence from abnormally low production or an idle plant. So demand labor or something in the short run, you're not going to change it. So let's say you're a brewery, you on average produce 10,000 barrels a beer a year, over the next 12 months you think your sales are going to go down 30%. Other breweries in the region, same. They think, "Hey, yeah, we're going to go down 30% as well, but starting month 13, we're going to be back to our normal capacity of 10,000 barrels." You wouldn't change your normal capacity from 10,000 and go down by 30%. You would keep it at the 10 because it's just one period and you're looking at numerous periods going forward and you expect to go back to normal at month 13.

However, on the flip side, in periods of abnormally high production, you're going to adjust your fixed overhead allocated in the production process. The purpose of doing this is to prevent you from costing your inventory above costs. So if you're producing your inventory and you're in an abnormally high production environment, there's a risk here that you're going to put too much cost and actually really incur into your inventory, which we want to prevent. So let's look at some two fun examples here. Linus's Brewhouse can produce 2000 barrels a beer a month, which approximates normal capacity. Fixed overhead is allocated based on barrels of beer and is 15,000 a month or $7.50 per barrel at normal capacity. In August, Yakama. Yakama is a place in Washington really famous for making hops, incurred above average heat and drought conditions forcing Linus's Brewhouse to curtail production resulting in only a thousand barrels of beer in the subsequent month.

As a result, $7,500 is included in inventory cost while the remaining unallocated amount of $7,500 is recognized as an expense in the period incurred. So you're not changing because you had this abnormal production hiccup where your supplier couldn't deliver your hops. Now we actually had a client that had this issue, they weren't buying hops on their contract, they were buying on the spot market, so they ran into some trouble. They believe that with global warming there's going to be a consistent issue obtaining hops from their supplier in Yakama. So they entered into a commitment contract. Hopefully that helps them, we'll see. Now on the flip side, let's say an Instagram influencer got some beer and raved about an IPA produced by Linus's Brewhouse resulting in abnormal production of 3000 barrels per month.

To prevent inventory from being measured at above cost, Linus's Brewhouse decreased fixed overhead costs allocated to each barrel to five bucks. So 15,000 divided by 3000. And again, you don't want to risk over costing your inventory. Now if this was a real situation, the questions would be, "All right, will this one-off influencer create a consistent trend into the future or is this really just a couple of months?" Something like this is probably just a couple of months, so you wouldn't automatically assume your normal capacity will be increased over time. You could probably start tracking incremental increases to capacity and say, "Hey, you know what? We have over time got to a higher level of barrels of beer produced, so our new normal capacity is 3000 versus 2000."

Again, got to consider seasonality demand. A lot of factors should be considered when you're looking at, what is your normal capacity?

Ah. Polling question. All righty, this is a fun one. What is your Company's strategy for finding lost inventory? This is a good one. I put my best detective hat on. Blame the intern, declared a tax write off, or hope it magically appears before the year-end observation.

AC: This question is probably going to give Blair a heart attack, Rob, with his self. So for any of Blair's clients on the line.

Robert Babine: And hopefully it doesn't influence anyone to misplace inventory for that tax write-off either if they had a great year so far this year.

AC: Yes. And I think it was telling in the first polling question, I believe there was about half of the group that was not confident in their inventory costing. That was the first result. So hopefully with Rob refreshing a bunch of what should be done under GAAP, maybe it's good time to go to the drawing board and get yourself more confident in your costing.

Robert Babine: Exactly. Yep.

Astrid Garcia: All right, we're going to be closing up the polling question soon. Make sure you submitted your answer.

Okay, back to you, guys.

Robert Babine: All righty, thank you. Let's see. Detective hat on, 51%, tax write off, 23%, magically appears before year-end, 18%. Those are some good answers. I like it. 7%, the intern. That's how we should be, protect the staff. All right.

So other considerations when refreshing your bill of materials. We're touching on a lot. Cost accounting could be hours of discussions. So we're bringing up these things that we see frequently when we go out and help our clients. Please reach out if you want to dig deeper into this. As Allie said earlier, she's a tax nerd. I'm an accounting nerd. I can talk cost accounting all day. But some other things just to keep in mind, when you refresh your bill of materials, treatment of loss or yield. Only unexpected loss of raw materials during production are excluded in expense in the period when incurred. So if you're building a product and you know there's going to be some loss or yield of raw material because that's just a natural part of the production of that product, that's on your BOM.

So for example, if you're producing 400 yards of linear plastic, which requires 50 pounds of thermoplastic materials and of that 50 pounds, five is used to set up and calibrate the machine, your BOM isn't going to have 45 and you're just going to scrap the five and not do anything with it. Your BOM's going to account for the full 50 of that thermoplastic material to create 400 linear yards.

And another thing, constant question comes up, "Hey, GAAP says our inventory is the cost of our applicable expenditures and charges directly or indirectly incurred to bring an item to its existing condition and location. What about storage costs?" Intuitively it seems like you would include storage costs, but there's a real challenge on how do you really objectively determine and allocate that. So storage cost is a period cost and you expense that when incurred. All righty. Oh, another polling question.

All right, have you adjusted your inventory costing reserves since COVID? Let everyone go with that. And interesting thing here, I read the other day, it was Deloitte put out their 2024 manufacturing survey and one of a fact they had in there I thought was interesting was lead times still have not returned to pre-COVID levels. I guess pre-COVID levels were right around 63, 64 days and lead times are still up about 32% from that even post-COVID. So there's still a lag here in lead time that companies have to plan for and be strategic about.

Astrid Garcia: All right, so I'll be closing the polling question soon. Make sure that you submit your answer in a few more seconds. All right, back to you.

Robert Babine: All right, thanks everyone for that. So we got 46%, 53%. All right, well, we got to start updating that cost, 53%. We got to keep Blair around. He's got to keep his hair from turning gray. So with that, we'll turn it over to Blair.

Blair Robbins: All right, thanks, Rob. Better gray than no hair at all, I guess, the way things go around here sometimes. But before I jump into the next section on inventory reserves, I do see one question that came in the Q&A, I thought it might be a good time to address it. What costs would companies that don't own their manufacturing facility but use third-party co-manufacturers need to absorb into their inventory cost? And so from my experience at least, it's typical that you wouldn't have a lot of costs that aren't directly billed by your co-manufacturer or third-party processor in that case.

There may be some minor cost if you have a little bit of retooling work to do, if you provide to them different molds and things like that that they might be using, there's certain depreciation costs associated with that that could get costed into the inventory. But at least from what I see out there, it's typically not as much if you're using an outside party. If it's just that you don't own your facility and you're leasing it, obviously then you have direct costs that you would be bringing into your production that would get absorbed into inventory. So Rob, I don't know if you see anything different out there with your clients, but that's with mine.

Robert Babine: Yeah, same thing. We have a client that 3D prints spinal implants, little vertebrates for spinal implants and they purchase that from an outsourced party. So their cost is just the cost of the 3D printed vertebrae. Then the only other cost that they actually have is just sterilization cost and packaging costs and it's all per unit basis and that's what goes into their inventory. So very little in regards to outside costs from that perspective as well.

Blair Robbins: The other thing I'll throw out there and this will segue a little bit into what I'm going to talk about with some of the current trends, but the inventory cost when you're bringing it from an outside party is fully landed costs. So if you're paying tariffs and duties, the shipping costs that it takes to get it to your warehouse facility, all of those should be part of your inventory cost as well. So that's something else to keep in mind that we didn't cover so much in the absorption model because it's not allocations and whatnot, but sometimes there's a little bit of that same methodology and strategy that might go into how to allocate some of those. If you're bringing full containers of product over and it contains multiple different SKUs, how are you going to allocate the customs of duty, the freight, all of that, whether it's a dollar value basis, whether it's a weight basis? It's going to depend a lot on the composition of the products.

If you're shipping heavy objects along with microchips that are going to go into a different product, something like that you might not want to use... dollar value is going to put it all to the small high value items if you're paying by weight when you're shipping the containers from across the globe. So just a few other things that parallel the conversation as well.

So getting a bit into some of the current trends that influence some of the discussion around inventory costing and reserves. We've talked a bit about the impact that COVID-19 had and there's still a bit of a pandemic hangover that lingers around from some of that. A lot of it's just changing in behaviors. We went from having just in time inventory management being popular way to reduce costs, streamline the production process to what I like to call just in case inventory management. Rob mentioned lead times are still high, a lot of demand swelled up right post-pandemic as people got back out there, got back to work, had stimulus money to spend. And so a lot of companies and manufacturers were caught in a situation where their demand far outpaced their supply and their ability to produce, especially given labor shortages all throughout the supply chain.

It created a lot of bottlenecks. And so companies got more accustomed to, "I'd rather pay for it now and have it and not run into a lost opportunity than spend more effort managing my inventory, controlling my costs." I think also given that a lot of companies didn't carry as much debt, interest rates at the beginning weren't as high, it gave more opportunity to do that. Now with the interest rates increasing, balance sheets being more leveraged, you certainly are going to see more of a push to return to some amount of normalcy. I don't know that it's going to swing all the way back to a just in time process because there's a lot of uncertainty that goes all throughout this process still. The other thing that I think benefited a little bit of that behavior was in a high inflationary environment, having more inventory that you bought last year or the year before and certainly helped the pricing model a bit, but people are becoming more sensitive to absorbing price increases.

The inflation rates coming down I think will continue to evolve and change some of the behaviors that we saw that were changed by COVID. One of the other things that is starting to become more apparent is as that type of process flowed through the supply chains, companies, customers were ordering a lot more because they wanted to do the same type of thing where they had a lot more stock on hand planning for that delay in the supply chain, the production process and the lead times to the point where now some of those customers can't take the orders that they had. It could be a combination of that they don't have the demand that they thought they were going to have for the item and so they're trying to cancel the order or also we see quite a bit of they just don't have the capacity to store all the things that they were buying. And so they still want the product, but they're trying to delay shipment of it.

And so if you're building up the materials into your production process and you can't ship the items once they're produce at the door, it's going to create a lot of capacity for physical space issues, which is also only going to compound the cost issues that go into the inventory. Freight costs also factors into the bottleneck situation where a lot of companies might have to air freight something in that's coming from overseas if it's the last component to a production process that they need to get something assembled together and out the door, and those can be exponentially higher than ocean freight when you're bringing those components over. One of the other areas where there's been a change in behavior is diversification of suppliers. This comes from a variety of different points and it creates a lot of new challenges and concerns throughout company's process of managing all of this.

Tariffs certainly has been one of the leading drivers to diversification of suppliers. When the China tariffs got added, a lot of... I should say, when they started being talked about, a lot of companies started trying to diversify where their suppliers were. If they were using third-party manufacturers and trying to get more in different countries. Initially I think a lot of companies were pushing to just other countries within the Asia-Pacific area. We're seeing more now where it's trickling into India, Indonesia, other places throughout the world other than just moving from China to Taiwan, let's say. With that though goes some quality concerns. If you're bringing on a new supplier, being able to manage the quality of the process, making sure that you don't have rework issues where components are coming in, they're not adhering to the quality that the company is accustomed to. There's significant amount of rework that's going to add to the cost of the products as well.

It also has reputational risk, which is outside of our costing conversation, but certainly if you're producing lower quality products because your components weren't up to par, that's going to create an impact on the business as well. And the political instability throughout the globe is not seeming to let up anytime soon. So there will continue to be an importance on having that diverse a supplier network so that as there are different political issues, wars, disruption in being able to ship goods for various reasons, having the ability to multi-source your product is ever more important. I did see a question come through that I'll touch on now that related to offshoring and I think this talks to that a bit. Certainly there's the impact of the political winds. I don't think they're changing anytime soon. One of the questions related to some of these areas, becoming more aware of how valuable they are and trying to absorb some of the cost savings that companies were looking for.

I think that points back to the importance of diversification. They're going to press you for price increases to the extent you're willing to and accepting of them, but the more that you can point to your ability to source elsewhere at a lower price point, I think that's part of the drive to where you're seeing India become more popular lately is because of that.

Lead time and orders, we talked about a bit. I think that's another one of the current trends that's important and then factors into how much inventory companies maintain and the cost of it. Ordering more in advance, having more lead time has become popular. But also coordinating more throughout the supply chain. If you're ordering from a supplier more in advance because you have more orders coming in, that makes sense. If you're just ordering to have things on hand, that tends to lead to more issues down the road with excess quantities, fluctuating prices, things like that. The more you can marry an order coming in that you have a price that you've given to a buyer with the ordering of component materials that you can then lock in your pricing for and have that match, the better off a company will be.

So with that, I'll get into inventory valuation allowances a bit. So ASC 330 states that: a departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost. Where there is evidence that the utility of goods in their disposal in the normal course of business will be less than its cost, whether due to physical deterioration, obsolescence, change in price or other causes, the difference shall be recognized as a loss in the current period. This is generally accomplished by staying such goods at the lower level commonly designated as market. So it's a long way of saying that if you have inventory, you can't sell through at a profit, you need to take an impairment charge when it happens. And the reason I read through the definition is one of the important pieces of it is it's considered a lower cost of market adjustment.

A lot of companies will look at inventory reserves as a moving general reserve. It's really supposed to be treated as a reduction in the cost basis of the product. So what's important about that is the cost doesn't change back higher if the estimate that management has changes in the future. So if you think you're not going to be able to sell for as high as a price in the future, and then a year later that expectation changes, you shouldn't be writing that inventory back up because you've reduced the cost basis in the lower cost of market scenario.

We also want to look at the estimates of the recoverability of inventory as significant estimates with M&A companies. And so with that comes a lot of consideration of the significant inputs in those estimates. And so that could be the future sales price, sales volume, product mix, all of that has to be carefully considered. This can vary from industry to industry what is most important about that. When it comes to sales prices? Certain industries will have a much better handle on, "This is the price. We might have price increases going forward, but it's more static." Other industries like a pharmaceutical industry has a lot of complexity in what the ultimate realized value out of a sale will be because there's much more significance to the discounts, rebates, adjustments and whatnot that will flow through there.

Product mix is also something to consider. Just because the company's business is not declining doesn't mean that within the mix of SKUs there are shifts between what's popular and what's not, and changing trends in sales volume and have a significant impact on the need to take an evaluation reserve. Expiration dates can be very significant to various industries. Again, pharmaceuticals, food processors, they need to be much more focused on expiration dates because it's not just a matter of, "Can you sell that item?" But, "Can you sell it in a sufficient amount of time before its expiration that it will sell through the sales channel and not come back?" Typical in pharmaceuticals is within six months of expiration, the buyers can return the goods and so you typically can't use a sales forecast that goes closer than six months of the product expiration to support the recoverability of an item in that industry.

Food would be similar. You can't ship it to a store and expect it to sell through and not be returned if it's short-dated product at that point. The last part that I'll cover here is the estimate has to be accurate and precise. Conservatism is not a replacement for that accuracy. So times companies will want to default to, "Well, we can just write it down now and then it'll be satisfied. We don't need to worry about being that precise and coming up with the estimates for those projections of sales, the pricing of them," et cetera. But it's important that it be accurate and you need to look back prior estimates and see how they've trended. As I mentioned before, you can't write things back up once they've been written down, and so all that needs to be considered as part of it. The other thing that we look at from an audit perspective is motivation.

So when we asked the question before about what do you do when you lose your inventory and some people thought, "Well, you take the tax write-off and consider a win." The same can be said for valuation allowances, where if it's a blowout here for a company, they might be more inclined to taking write-offs against inventory because they can absorb them without having to worry about debt covenants and things like that. Or on the flip side, if it's been a bad year because of various reasons, that way the company might want to just sandbag that year and move on. So all the things to keep an eye out for as you're going through it.

So some of the common causes of inventory write-downs include... I think the animation is not working on this slide so I'm just going to wing it. But excess quantities are one of the things we talked about where if you're buying too much in advance, it can lead to these needs for write-downs. Delays and product launches are becoming more apparent, especially in the life science industry. We see it where there's challenges in raising funds, you may not be able to follow through with your plan. So the ability and intent of a company to execute its plan is important when looking at these estimates. Changing market conditions, product mix pricing, consumer behavior has been very drastically impacted over the past few years. Considering all of that is important. Inefficiency and early stage production runs, changing technology and how it flows into this. If different technologies is really decreasing the cost of production for a product, competitors can come in and undercut pricing and things like that as well.

Sorry, there's animation. So common pitfalls we see in the reserve analysis are failing to use update sales projections. Don't just dust off the ones from last year when it comes time for audit, come up with true and accurate best estimates of what the future will look like. Failing to consider the exploration of the product layers that we talked about before. Not including all the relevant costs, is something that ties into what Rob talked about previously. If you're missing some of the absorb cost, there are companies that will, for simplicity's sake, just take the direct cost of a product and put them into the inventory system and they keep a side bucket, a different trial balance line item, maybe some of the depreciation costs and other costs that need to be factored into the recoverability of the cost.

Timing of the inventory write-downs is something to consider. As I mentioned, you can't really write down and then back up costs. So making sure that if you're taking charges in an interim period, you're not reversing them back in subsequent years. Just making sure that you're really treating them as adjustments to the cost basis.

And then as a segue into what Allie is going to talk about, from a timing, you also want to consider some of the other implications. So holding on the product that you hope you might sell comes at a real cost of having a warehouse that store it, potentially build new facilities or lease new facilities. If it's a temporary item, then you have to be able to move on from that sooner than later. The inventory logistics of carrying a lot more quantity of product than you used to, and then they book to tax differences, getting rid of product and being able to take it as a tax write-off if you're never actually going to sell it through is a real benefit compared to just having to carry that reserve forever, pay the storage cost and not be able to take the tax write-off.

So with that, let me hand it back over to Allie so that she can get you into the tax implications. So we have a polling question here as well.

AC: Thank you, Blair. Yeah, so our first polling question is do you use a 3PL or any third party service to store and or ship your inventory? I imagine the answer to this I would think would be pretty high. But this is going to lead into our state tax discussion. But taxes overall, when you're thinking about your inventory, we always have to start with what you're doing from a GAAP perspective and what is in your financial statement. Because when we make the book to tax adjustments that Blair was just referring to, it's very important that we understand what is being done for GAAP so we can make the necessary adjustments to ensure that your expenses are deductible for tax purposes. So it looks like I asked her to read a minute. Can I move it along?

Astrid Garcia: Go ahead and close it.

AC: Perfect. So okay, about a 50/50 split here. But first for taxes before we get into the 3PL, I'll leave everybody on the edge of their seats for that one. Let's talk about federal tax considerations. So bouncing off of what Blair was just saying related to inventory reserves, inventory reserves are generally not deductible for tax purposes. Reserves in the IRS's mind is an estimate and the IRS just doesn't like estimates. But with all things tax, there's always exceptions and honestly for manufacturing, I think this could be a good one. So it's important for us to understand on the tax side, what types of reserves do you have in your inventory reserve account? Do you have an inventory shrinkage reserve? So we all know that sometimes inventory, if it's clothing, someone can spill on something in a store, something gets stolen, the tag gets ripped, something happens, and the inventory count that you have at the end of the year doesn't align directly with your books and you're going to have a reserve for that.

The IRS actually allows for tax purposes. You can deduct your inventory shrinkage reserves. And for retailers specifically, there's a safe harbor provision. So this is something that if you're not currently looking at your reserve and breaking it up into components, maybe you should do that because you can get a tax deduction earlier rather than waiting for that true write-off that we were talking about. There's the revaluation reserve. Rob mentioned that your inventory needs to be based on a standard cost and for tax purposes we're allowed to follow that reserve as well to make sure that your inventory is being properly reflected at cost. Again, this is the IRS saying reserves generally not deductible, but if you have a reserve that fits into one of these two categories, they'll allow it, which is great. We always want to deduct things sooner than deferring the deduction. Then some companies also have a lower cost or market reserve.

Net realizable value of the inventory is less than the cost of the inventory. There's a little bit more criteria to be able to deduct this reserve from a tax perspective, but again, it's possible. So I know there are a lot of companies out there that just have one inventory reserve account and for tax purposes, we just take the flux in that inventory reserve and we disallow that because that would not be deductible, but maybe it's worth having a conversation. If your reserves are material, let's get a better understanding of how you're computing these reserves and maybe we can deduct it a little bit sooner for tax purposes in accordance with your financial statement.

Next is 263A, otherwise known as UniCap. I know that I have a few clients on the line today that love talking to me about this topic, but this is applicable to companies that produce property or if they acquire property for resale and that's real or tangible personal property. There are exceptions to the rule. The one you see the most is if your annual average gross receipts is less than $29 million for the past three years, you're considered a small business taxpayer and this does not apply to you. Lucky you. For the rest of you out there, this essentially requires that there are additional costs that need to be capitalized for tax purposes that don't need to be capitalized for book. So those things can include, we have technical support if you have a cost accountant, if you are training your employees that are working in the factory. Those costs are definitely going to be capitalizable.

And then we have costs that are mixed service costs, your accounting department, your IT department, security, those types of things we need to analyze and a portion of those costs may need to be capitalized for tax as well. Essentially what we do behind the scenes is we come up with an overall absorption ratio, multiply that by your ending inventory to determine what your additional 263A costs are that we're adding back from a tax perspective. This is an adjustment again, that's temporary. It will flux year over year depending on those costs that are being capitalized for book. Along with what your ending inventory balance is. The higher your ending inventory generally, the higher your 263A adjustment will be.

Don't forget the states. So state taxes are very important and where you hold your inventory greatly impacts where you will have your tax footprint, not only for income tax but for sales tax and personal property tax as well. So I know we had the 3PL question before, and oftentimes I have clients that think that, "I'm not holding the inventory, my 3PL is." Yes, but if you hold title to the inventory and your 3PL is in a state, you're deemed to have nexus where your inventory is, even if it's not in a warehouse that you own. So that could create nexus for you in a filing requirement for sales tax, income tax and personal property tax. That's very important. Also, not to get very tax nerdy on you, but from a state tax perspective, oftentimes for manufacturing companies, we are sourcing our sales to where we ship our goods to.

However, there are some states, California, we see the most where they say that, "Okay, if I'm shipping out of California to New Jersey, let's say, and you do not have a physical presence in New Jersey, so you're not paying tax in New Jersey." California says, "Not so fast. If you're not going to pay tax on these goods in New Jersey, I want you to pay tax on these goods in California." So I have a list here of states where if you're considering where you should have a warehouse or where you should be shipping your inventory from, you should really consider what the state tax implications of that would be from an income tax perspective because it could increase your tax bill and that might not be something that's on your radar. Next, property tax. Yes, we have personal property tax, but there are also states that have a separate inventory tax.

So again, when you're making decisions of where you should be holding your inventory, my main point here is that please consider the state tax implications because you might end up with a tax bill that was very much unintended. Some states are nice and have an inventory tax credit that you can use against your income taxes if you're paying inventory tax, but not all states are that nice. And then we have excise taxes. So being cognizant of everyone's time here, I'll talk about the good news is that in some states they assess a tax on the higher of your net worth or your in-state property, and Tennessee determined that that was unconstitutional despite the fact that they were doing it. So they're allowing you to apply for a cash refund if you paid tax on that in-property tax requirement and you paid tax on your returns filed after January 1st, 2021. You can file an amended return before November 30th, 2024 and actually get cash taxes back.

I know Tennessee was sending out notices to companies that this applied to. A lot of us are not sitting in the offices that we used to and we might not be getting all of our mail. So please make sure that that's something that you're checking on your prior Tennessee filings.

And to end on a good note for manufacturing, please know that if you do donate inventory, you can get a higher tax deduction. Normally you would just be able to get a charitable contribution deduction equal to the cost basis of that inventory, but that's not true for manufacturers. You can actually recover basically half of what your gross profit would be up to two times your basis when you donate inventory. So that's a good fact. And then also if the only thing you're doing in a state is selling tangible personal property, you could be exempt from income taxes.

So I know that due to the way fare provisions and whenever that was, some states have economic nexus. If you sell more than $100,000 or $500,000 into a state, you could be subject to income tax, but this public law exempts you from that rule. So we just want to make sure that you're not paying tax where you don't have to. So I think I did that in record time. I feel like an auctioneer. But let's do our last polling question.

I had mentioned in the beginning that we will be doing a series of manufacturing and distribution webinars. What topic are you most interested in hearing about? To me, I always love the tax topics, but definitely respond and we will try our best to actually cover all of these topics. I know that it is one o'clock, so thank you everyone very much for joining us today. Blair, Rob, and I greatly appreciate your time. I will pass it over to Astrid for some closing remarks.

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