Accounting for distributors turns on one asset and one number: inventory on the balance sheet, and cost of goods sold on the income statement. Because a distribution business buys finished goods and resells them without significant modification, almost everything else follows from how well you value inventory, how completely you capitalize the cost of acquiring it, and when you recognize revenue on the way out. Get those three right and gross margin means something. Get them wrong and every downstream metric lies.
Choosing an Inventory Valuation Method
The method you use to assign costs to inventory units feeds directly into both the inventory value on your balance sheet and the COGS figure on your income statement. Three methods are widely accepted, and each produces materially different results when prices move.
First-In, First-Out
FIFO assumes the oldest units on hand sell first, which mirrors the physical flow of most perishable and date-sensitive goods. When costs rise, FIFO pushes older, lower costs into COGS, which produces the lowest COGS, the highest reported profit, and the highest ending inventory. The trade-off is a bigger tax bill in inflationary periods, since taxable income rises with reported income.
Last-In, First-Out
LIFO does the opposite: the most recently purchased units are treated as sold first, pushing the newest and typically highest costs into COGS. During inflation this shrinks taxable income, which is why many U.S. distributors elect LIFO for federal tax purposes under IRC Section 472.1Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories There is a conformity requirement attached: if you use LIFO on your tax return, you must also use LIFO in financial statements issued to shareholders, partners, or creditors.2eCFR. 26 CFR 1.472-2 – Requirements Incident to Adoption and Use of LIFO Distributors reporting under IFRS cannot use LIFO at all; IAS 2 permits only FIFO and weighted average cost.3IFRS. IAS 2 Inventories
Weighted Average Cost
Weighted average cost recalculates a blended per-unit cost by dividing the total cost of goods available for sale by total units available, either after every purchase or across a full period. The same average cost then applies to every unit, which smooths out price swings. Distributors buying large quantities of interchangeable items at fluctuating prices tend to prefer this approach because it removes the layer-tracking work that FIFO and LIFO require.
Writing Inventory Down When It’s Worth Less Than Cost
Whichever valuation method you choose, you can’t carry inventory on the balance sheet at more than what you can actually sell it for. Under ASC 330, inventory measured using FIFO or weighted average cost must be written down to the lower of cost or net realizable value whenever NRV drops below cost. NRV is the estimated selling price in the ordinary course of business, minus the reasonably predictable costs to complete the sale and ship the goods.4FASB. ASU 2015-11, Inventory (Topic 330)
In practice this means running an obsolescence reserve. Slow-moving SKUs, damaged stock, and products losing market relevance need periodic review, and when estimated selling prices fall below capitalized cost, you book a provision expense that reduces the inventory carrying value and hits current earnings. Skip this step and you overstate assets, delay loss recognition, and hand an auditor an easy finding.
Physical counts belong in the same discussion. Shrinkage from theft, damage, or counting errors creates a gap between what the system shows and what’s actually on the shelf, and those losses have to be identified through counts and written off. Many distributors run cycle counts throughout the year instead of shutting down for a single annual count, which catches shrinkage faster and keeps the books closer to reality.
Landed Cost: What Gets Capitalized Into Inventory
The number on a supplier invoice is only the starting point. Accounting rules require you to add every cost necessary to bring the product to a saleable condition in your warehouse. That total is the landed cost, and it becomes the inventory asset on the balance sheet. When the unit later sells, the full landed cost moves into COGS, so underestimating landed cost overstates gross margin on every sale.
Costs that must be capitalized into inventory include:
- Inbound freight from the supplier to your facility. Freight invoices covering mixed shipments need to be allocated across products, typically by weight or volume.
- Customs duties and tariffs on imported goods, which are part of the product’s cost rather than a general operating expense.
- Brokerage and declaration fees paid to customs brokers for clearing goods.
- Transit insurance premiums covering goods during shipping, because securing the inventory in transit is part of acquiring it.
Allocating these costs to individual SKUs is where the bookkeeping gets tedious. A container of mixed products from an overseas supplier arrives with a single ocean freight charge, one insurance premium, and one brokerage fee, all of which have to be split proportionally by weight, unit count, or invoice value. Getting the allocation wrong doesn’t just distort one product’s margin; it shifts profitability between product lines and quietly corrupts purchasing decisions.
The mistake runs in both directions. Failing to capitalize a landed cost overstates the period’s operating expenses and understates inventory. Capitalizing something that should be expensed, like outbound freight, overstates inventory and delays the expense until the unit finally sells. Neither error is harmless.
Section 263A: The Tax Rules That Go Further
The IRS imposes a separate set of capitalization rules on resellers under Section 263A, and they reach beyond the landed costs you’d naturally think to capitalize.5Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses This is one of the places where book accounting and tax accounting diverge, and it catches many distributors off guard.
Section 263A applies to personal property acquired for resale. For resellers, the IRS identifies four categories of indirect costs that must be capitalized into inventory for tax purposes:6Internal Revenue Service. Examining a Reseller’s IRC 263A Computation
- Purchasing costs, including salaries and overhead for buyers, assistant buyers, and staff who select merchandise, place orders, and manage vendor relationships.
- Handling costs for receiving, processing, repacking, and moving inventory within the facility.
- Storage and warehousing costs, including rent, depreciation, insurance, utilities, and taxes for off-site facilities used to hold inventory.
- A share of mixed service costs from departments like accounting, IT, and security that partially support resale activities.
The effect is that costs you may expense as general overhead on your financial statements, such as warehouse rent or purchasing department salaries, must be partially capitalized into inventory on your tax return. That creates a book-to-tax difference you have to track.
The Small Business Exception
Not every distributor has to run UNICAP. Section 263A(i) exempts small business taxpayers whose average annual gross receipts over the prior three tax years fall at or below the inflation-adjusted threshold under Section 448(c).7Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses – Section: Exemption for Certain Small Businesses For tax years beginning in 2026, that threshold is $32 million.8Internal Revenue Service. Rev. Proc. 2025-32 Distributors approaching the threshold should watch revenue growth closely, because crossing it triggers a mandatory change in accounting method.
Recognizing Revenue When Control Transfers
Under ASC 606, revenue is recognized when control of the goods transfers to the customer, not when you ship, not when you invoice, and not when payment arrives.9FASB. ASU 2014-09, Revenue from Contracts with Customers (Topic 606) For most distributors moving physical products, the transfer happens at a single point in time, and the shipping terms in the sales agreement usually determine that moment.
FOB Shipping Point Versus FOB Destination
Under FOB Shipping Point (or FOB Origin), risk and title transfer the moment goods leave your loading dock. You record the sale immediately, and any freight you pay to deliver the goods is a separate selling expense. Under FOB Destination, you keep risk and title until the goods arrive at the customer’s location, so revenue can’t be booked until delivery is confirmed.
The distinction sounds academic until period-end. A distributor with $2 million in goods on trucks on December 31 will report very different revenue depending on which term governs those shipments. Auditors focus on goods in transit at cutoff for exactly this reason, and misstating it is a common restatement trigger.
Returns, Allowances, and Volume Rebates
Distribution agreements almost always contain provisions that reduce gross revenue after the sale. Trade discounts agreed at the point of sale are simple: net them against revenue immediately. Volume rebates are harder, because you have to estimate the rebate a customer will earn over the contract period, reduce recognized revenue by that estimate, and update the estimate as actual purchase volumes come in.
Sales returns follow the same estimation logic. Based on historical return rates, you set up a reserve that reduces recognized revenue to the amount you actually expect to keep, and you record an asset for the inventory you expect to get back. The point is to recognize revenue only where a significant reversal is unlikely. Distributors with high return rates or liberal policies need robust tracking here, because understating the returns reserve overstates revenue in the current period.
Bill-and-Hold and Consignment
Two common arrangements break the usual pattern of “ship it, then book it,” and both require careful analysis under ASC 606.
Bill-and-Hold
In a bill-and-hold sale, you invoice the customer and recognize revenue even though the product stays in your warehouse, usually because the customer’s own facility isn’t ready or they want to lock in pricing. Under ASC 606, revenue on a bill-and-hold sale can be recognized only when all four of these conditions are met:9FASB. ASU 2014-09, Revenue from Contracts with Customers (Topic 606)
- The customer requested the arrangement for a substantive business reason.
- The product has been separately identified as belonging to that customer.
- The product is currently ready for physical transfer.
- You cannot use the product or redirect it to another customer.
If any one of those fails, you’re holding your own inventory and calling it a sale. The goods stay on your balance sheet, and revenue waits until delivery or until all four criteria are satisfied. Auditors scrutinize bill-and-hold transactions closely because they’ve historically been used to accelerate revenue improperly.
Consignment
Consignment goes the other way. You deliver product to a dealer or retailer, but they haven’t bought it; they’ll pay you only if and when they sell it to an end customer. Under ASC 606, delivering goods on consignment doesn’t transfer control, so no revenue is recognized at delivery. Indicators that an arrangement is really consignment include your ability to require the return of the product, the dealer having no unconditional obligation to pay, and your retention of control until the end customer buys.
Consigned goods sitting at a dealer’s location remain your inventory. They stay on your balance sheet, not the dealer’s, until they sell through, which means your turnover ratios and carrying costs reflect stock you can’t physically see. Accurate records and periodic reconciliation with consignees are essential.
What Gets Expensed After the Product Is on the Shelf
Once inventory is in a saleable condition at your facility, most subsequent costs stop being capitalizable and become period expenses that hit the income statement immediately. Drawing the line between “still getting the product ready” and “selling or administering” is where distributors frequently slip.
Outbound freight is the clearest example of a period expense. It facilitates the sale rather than preparing the product, so it’s a selling expense. Warehouse overhead that keeps the facility running without enhancing product value follows the same rule: rent, utilities, property taxes, building insurance, and equipment depreciation are all period costs.
Warehouse labor is where classification gets blurry. Workers receiving, inspecting, and putting away incoming shipments are bringing inventory to its saleable state, so those wages can be capitalized as part of landed cost. Workers picking, packing, and loading outbound orders are performing selling functions, so their wages get expensed. Administrative staff, including supervisors and warehouse managers, are expensed as overhead. The distinction also matters for tax, because Section 263A (for distributors above the $32 million threshold) requires capitalizing a share of handling and storage labor that would otherwise be expensed for financial reporting.
The rationale for expensing post-acquisition costs is straightforward: capitalizing them would inflate inventory and postpone operating expenses until those specific units sold. Gross margin should reflect the profit from buying and selling, not be padded by operating costs buried inside inventory.
Sales Tax, Resale Certificates, and Drop-Shipping
Distributors face a compliance layer that pure service businesses can largely ignore. The 2018 Supreme Court decision in South Dakota v. Wayfair eliminated the old rule that a business needed a physical presence in a state before that state could require it to collect sales tax.10Supreme Court of the United States. South Dakota v. Wayfair, Inc., 585 U.S. 162 (2018) Now, economic nexus (based on dollar volume or number of transactions in a state) is enough. The threshold the Court upheld was $100,000 in sales or 200 separate transactions annually, and most states have adopted a similar standard, though the specifics vary.
For distributors selling to buyers who resell the goods, resale certificates prevent tax from being collected twice on the same product. When a retailer buys from you for resale, they provide a resale certificate that exempts the transaction from sales tax, and you keep that certificate on file as proof that you weren’t required to collect tax.11Multistate Tax Commission. Uniform Sales and Use Tax Resale Certificate Without a valid certificate on file, a state audit will find you liable for the uncollected tax.
The obligation doesn’t disappear either. The retailer collects sales tax from the final consumer, and if the retailer takes product bought under a resale certificate and uses it internally rather than reselling it, the retailer owes use tax on that purchase. Distributors selling to a mix of resellers and end-users need systems that flag which customers have certificates on file and which transactions require tax collection.
Drop-shipping adds another wrinkle. When a retailer sells to an end customer but has you ship the product directly, three parties and potentially three states are involved. Whether you or the retailer owes sales tax depends on where each party has nexus and whether you hold a valid resale certificate from the retailer. There is no single national rule; it varies by state and needs careful analysis whenever shipping patterns cross state lines.
Metrics That Show Whether the Numbers Are Doing Their Job
Once the books are right, a handful of ratios reveal whether the operation is actually healthy. Each depends on accurate inventory valuation and cost classification, which is why the accounting work above isn’t just compliance.
Gross Margin by Product Line
Gross margin is net sales minus COGS, and gross margin percentage (gross margin divided by net sales) is the first number to track by product line. A declining margin percentage across a category signals rising landed costs, insufficient price increases, or both. The accuracy of this figure lives and dies with landed cost allocation. If freight and duties aren’t properly capitalized to the right SKUs, per-product margin is meaningless.
Watch the terminology, too. Margin is profit as a percentage of the selling price; markup is profit as a percentage of cost. A product bought for $60 and sold for $100 has a 40% margin and a 66.7% markup. When a sales team says “40% markup” and the accounting team hears “40% margin,” pricing goes wrong in one direction or the other, and profit either evaporates or the product gets priced out of the market.
Inventory Turnover
Inventory turnover (COGS divided by average inventory) shows how many times your stock cycles through in a year. Higher turnover means less capital sitting on shelves and lower obsolescence risk. Chasing turnover too hard, though, leads to stockouts and lost sales, which never appear on the income statement but show up in missed revenue. Most distributors benchmark turnover by category rather than a single company-wide number, because a fast-moving commodity and a specialty item with long lead times shouldn’t share a target.
Days Sales Outstanding
Days Sales Outstanding measures how long it takes to collect payment after a sale, calculated as average accounts receivable divided by daily credit sales. For distributors extending net-30 or net-60 terms, DSO is a direct indicator of cash flow health. Early-payment discounts, like a small percentage off for payment within ten days, are a common tool for pulling cash in faster, though the discount itself is a cost that reduces net revenue.
Cash Conversion Cycle
The fullest picture of working capital efficiency is the cash conversion cycle, which combines days inventory outstanding, DSO, and days payable outstanding: DIO plus DSO minus DPO. A shorter cycle means less time between paying for inventory and collecting cash from customers, which reduces the working capital needed to fund operations. Distributors with thin margins and high volume live and die by this number. Shaving a few days off the cycle can free up significant cash without touching revenue or costs at all.