So far, the articles in this series have set out the theory behind how cost of sales (raw materials & finished items which is called stock) and overheads (all the other expenses) are treated for tax, and applied it to the simple example of Alice the fudgemaker’s new business. It really is a good idea to go back and read the earlier articles because each one builds on what’s gone before, and whilst you can read them in isolation, I think the wider issues will be a lot clearer if you read back. In particular this article builds on the basic concepts explained in TSCB 6 and further discussed in TSCB 8, TSCB 9 & TSCB 10 (go to the Tax tab at the top of the Blog for an Index).
Fortune has smiled on Alice and she’s picked a business where her raw materials and product are perishable and relatively quick to make so that she in effect ‘creates to order’. As a result her stock & other expenses position is relatively simple – at the end of her trading year, the most she’s likely to have is the remnants of her latest batch of perishable raw ingredients and what’s left of her latest batch of fudge as yet unsold.
But what about the rest of us? How do we deal with the rules on tax relief for stock expenses when we carry a lot of raw materials or finished stock, or even, have raw materials acquired long before the idea of selling entered our heads?
Featured seller: CLSCraftCreations (Chiara): See her Etsy shop here and more about her work at the foot of the page
The issue of stock and what you can claim on your tax return is more complex for people who:
- Have a slow sales rate.
- Work in materials that aren’t perishable (so long as they’re kept in appropriate conditions)
- Create items that take significant time to make or have lifestyles such that ‘create to order’ isn’t an option and they need decent levels of ‘ready to send’ stock
- Are using raw materials that have to be bought in bulk and therefore are held for long periods
- Are using raw materials or finished products (such as vintage items) that they acquired over a significant period of time, often way before they ever thought of selling
- High level of raw materials held at year end with adequate records
- High level of finished items held at year end with adequate records
- High level of base stock with inadequate underlying records
The next article, Part 2, will cover the high level of base stock with inadequate records.
Before we move onto ideas about how to deal with those 3 scenarios, I’d like to digress and talk about how NOT to fall into these complexities in the first place!
Avoiding the Complexities
I imagine that quite a number of people have heard about the Japanese car industry’s methods to maximise profits – often referred to as ‘just in time’.
What that means is that they plan every stage of a car from initial design, to components, to the final product (including likely wastage) in such a way that it’s not the car manufacturer that carries most of the burden of the costs.
For example, Nissan have agreements with suppliers that the supplier will hold certain stock levels of Nissan components, and Nissan will then only bring those components into their own business just before they need them – often a day before – ‘just in time’.
That’s great for Nissan because they only incur stock costs as & when they need to so have low volumes of stock held at any one time (and therefore a low risk of making a loss by buying in more than they sell to customers). It's great for the supplier because they have a pretty much guaranteed income stream.
But when things go wrong: it’s not so great for the supplier who has to carry that stock (and the attendant costs) if Nissan doesn’t order as much as anticipated. It’s not so great for Nissan if the supplier doesn’t have what they need when they need it. (I’m picking on Nissan as I’ve been talking to someone who used to work in production control there).
And my point is?
Well, I agree, the Japanese car industry is an extreme example of stock control which any self respecting small crafting business can’t possibly follow, because the crafter needs to have a certain level of raw materials and finished products on hand to be sure they can make repeat orders or fulfill the orders made if a product sells well, and because handcrafting isn’t automated and takes time. Nevertheless, a bit of discipline and restraint in one's buying habits goes a long way to simplify your cost of sales expenses calculation (and maximising profits if you only buy materials for specific purposes at a price you know will enable you to make a profit).
Discipline in your buying habits can save you time & money
How disciplined are you being with your product design and implementation?
- Do you buy pretty supplies (possibly from a retail outlet – and it’s so hard to make additional profit from something you bought retail) that you like, hoping inspiration will strike, and you’ll create a marvel that will sell like hotcakes without thinking too much about the end product and profit? So that you end up with a lot of raw materials you’re not quite sure if you’ll ever use and finished products that you may or may not be able to make again if they prove popular?
- Do you need to have a wide variety of raw materials available because that’s part of your working methods?
- Do you buy in bulk because it’s cheaper and therefore you can maximise your profits?
- Do you consciously work in one particular medium (or a range of complementary mediums) that means that the same single type of raw material can be used in many designs, thus reducing the volume of raw materials required?
- Do you plan your product range in advance working on designs initially, then once you know they work to your satisfaction, finding cost-efficient sources for the materials required?
- Do you choose to make ‘one of a kind’ items as a deliberate business strategy and price accordingly to reflect the total effort that goes into producing a one-off design?
The benefits of restraint on stock control complexity
Why those particular questions? Because if you are genuinely running a business with an intention to make profits, those are the questions you should be asking yourself (amonst others). You should only buy in what you know you are going to use and are likely to sell. Anything above & beyond that needs to be for a specific reason, like buying in bulk for the savings etc.
If you restrain yourself and don’t carry excessive levels of raw materials or finished products at your year end; the easier your stock calculations will be – for your book-keeping and for your tax. And also for your cashflow – the value of the raw materials sitting in your stash and in your finished but not yet sold products ties up your working capital and is a drain on your resources until you’ve realised that value by making a sale.
Don’t get me wrong, there are very valid business reasons for carrying a large volume of raw materials and/or finished products, but ‘I didn’t think it through from a business perspective’ isn’t one of them. And for tax, carrying stock that you don’t actually need to carry for business reasons is a real pain!
What do I need to do if I genuinely need high levels of raw materials or finished stock in my business?
So, assuming that you’re one of the many (unlike Alice) who have actively considered it and have decided they need to carry large volumes of raw materials and/or finished products – how do you keep tabs on it all for tax?
Mostly you need to have good records - you need to make sure you know what you bought & when, how much of what you bought has been used to make products and what's been sold and what hasn't. Simple to say, but as ever, the devil is in the detail:
High Level of Raw Materials at Year End
This isn’t hard – you just follow the HMRC standard calculation in Helpsheet 222 on page 2 under Cost of Sales (as explained in TSCB 6 and TSCB 10). Basically, you’re just like Alice, but you’ve got lots lots more, so your annual stocktake might take a whole day, whereas Alice’s takes about an hour. In addition it will take you more time during the year to keep track of all your stock added than it does for Alice.
And they key to successful stock control, is to actually control it – with some sort of ongoing inventory list that shows what came in, what’s been used and what’s left. Boring, but necessary.
The bottom line is – carrying more raw materials takes more time to keep track of.
The question each business needs to ask themselves is: where is the tipping point? At what stage does the value of the time spent (or wasted) dealing with keeping track (and any attendant costs such as storage of stock) outweigh the advantages of having all those raw materials/ stock on hand?
For example, if you sell vintage items, and you habitually have listings of say 150 items in your shop, and sell 50 a month, you’re going to need a pretty big storeroom of stock to reliably replenish your stock at those levels – because (depending on your focus) by definition vintage items are not easily replaceable. On the other hand, if you have 5 lockup containers of vintage stock, and you only list about 20 at a time and sell one or two a month – then your vintage stock is a bit of a dead weight.
The point here is the need to keep stock and listings and sales in proportion to each other: so that the time you do spend on administering it all is time you need to spend rather than time that could be more usefully used doing something else if only you'd set up your business differently.
High Level of Finished Stock at Year End
In TSCB 6, which was my first attempt to summarise the rules on stock expenses for tax, I talked about how to value unfinished products at year end, and also the need to include finished products that haven’t yet been sold at the year end. I’m repeating myself here because it’s important - but you need to understand it’s not just raw materials and unfinished products that you need to keep a track of the underlying costs, its finished items as well. The finished products left unsold at the year end issue wasn't illustrated in the Alice examples in TSCB 10 because she didn't have a business that carries high levels of unsold finished stock.
Personally, I don’t 'create to order' because my lifestyle means I’d have a lot of unhappy customers if I couldn’t fulfill orders (that’s assuming I had any customers), so I have taken the business decision to make my products in batches. This means that I don’t just have raw materials, I also have finished products. And because I now only buy raw materials to actually put a product design into effect and because my sales are slow, I have far more finished products than raw materials.
So, if when I follow the HMRC Helpsheet 222 Cost of Sales (page 2) method of calculating my stock expense to put on my tax return, my annual stocktake needs to include not just raw materials but also finished products.
And for the annual stocktake, I need to know the value of raw materials that are sitting in that particular product design as finished products, and how many I have of that design at that cost.
Because I know that I will need the figures later for my tax return, as part of my product design & production I habitually work out what raw materials the design uses, and how much time it takes. Unless I change or refine my design, this information is fixed – I know exactly how much of what I need, I have a special notebook specifically for Design requirements - so I can replicate my product without reinventing the wheel and redesigning from scratch. This saves me time, and therefore money because the time saved can be used doing something more productive than trying to work out how & why I did what I did last time.
Then every time I make a batch of that particular design, I record the actual price of the actual materials used to make that batch. I do this bit in a spreadsheet.
I also record how many I made in the batch, and how many are sold and how many are left as I go along. This gives me my basic cost information for that particular manufacturing run of that product. Did that sound a bit grand? I make my cards in runs of 5 or 10 or 12! But each run is just the same as a run of say strawberry jam or car manufacture for a large business – they need to know their profit margins for each run. So do I, it’s just mine is on a far smaller scale.
My annual stocktake of finished products is therefore very simple – I count how many I have of each finished product design, I look at my records and the actual materials price for the relevant batch on the spreadsheet, which gives me my value for my stocktake.
If I have a product design where I make 3 batches in the year (one after another), and all of the first two batches sell, then the underlying raw materials have genuinely left my business and because they aren’t in my business at the year end, I ignore them (because the HMRC method of calculating stock expense means I don’t need to worry about what’s left my business – through sales or destruction etc). I only need to be looking at what’s left unsold at the year end from the third batch for my annual stocktake.
Depending on the type of products you sell, you might find this a bit harder to do.
The key point here is that it is up to you, and is your personal responsibility, to work out how you are going to deal with the value of finished items still on hand at your year end. Once you’ve worked out how to treat them – you need to be factual, reasonable and consistent – then the tax treatment will follow (because tax treatment follows accounting treatment)
I feel I should emphasise that there isn’t any set way for you to deal with your stock and how you keep track of it – there are rules about what valuations you can & can’t use which I discussed in TSCB 9 – but the actual nuts & bolts is down to you and what works for your business.
As a slight aside, I was asked recently if I knew of any software to help with stock control – I have to say, I don’t. But if anyone does, then please put your suggestions as comments and I’ll pass them on to the person that asked the question.
But what if I don't know how much my stock costs are?
Of course, what I’ve talked about above assumes that you know what your stock (raw materials or items bought for resale) actually cost you in the first place! What if you don’t know that?
I would hope that this doesn’t apply to anything the reader has purchased in the current trading period! But, if you started your new business without paying much attention to the admin side, or if you have been 'winging it' on the admin side for a while, it could apply to you.
However, it’s more likely to apply to your business if you bought your raw materials at a time when it was just a hobby you enjoyed with no idea of selling your work, or at least no clear idea that involved the daily realities of bookkeeping! Or if you bought, say, vintage items as a hobby and now want to turn that into a business.
The next article will talk through the issues involved in those scenarios and how to get your stockrecords out of chaos and into order in a way that means that you can work out your cost of sales expense for your tax return as well as running your business and your life.
Finally, you might be thinking that the articles are beginning to stray away from tax into the more general area of business advice. You’re right. This is because ‘tax treatment follows accounting treatment’, and accounting treatment or methodology is a direct consequence of business practice and how you run your business. Therefore, how efficiently you run your business doesn’t just have an impact on your profits, it also has an impact on your tax position (and on the amount of admin you have to wade through).
The most simple, and effective, and above all cheap, form of tax planning is to run a business that is streamlined to maximise profits and minimise tax. So, whilst you shouldn’t structure your business purely around tax issues (the tax tail wags the business dog), it’s a good idea to keep an eye on the tax consequences of what you are doing (the business dog wags the tax tail) to see if you can tweak it a bit to reduce the tax & administrative pain whilst still achieving your business goals.
Featured Seller: CLSCraftCreations (Chiara): started her business to satisfy her desire to "create unique and beautiful items which are a little bit different than the average handbag or broach: some are elegant and stylish, others a bit wacky and cool." You can find her shop at www.CLScraftcreations.etsy.com
Chiara also captains the British Sellers on Etsy team which can be found here on Etsy and on their own blog here. Since the recent changes to the Etsy Forums, the team has grown to over 1,000 members.
UK Tax for Small Crafting Businesses