Publication 538 - Accounting Periods And Methods (Page 15 of 19) in pdf

Cost Method

Retail

based on the volume of merchandise you usu-

Item

Cost

Value

ally buy. For example, if you buy items in small

To properly value your inventory at cost, you

Opening inventory . . . . . $52,000

$60,000

lots at $10 an item and a competitor buys identi-

Purchases . . . . . . . . . .

53,000

78,500

must include all direct and indirect costs associ-

cal items in larger lots at $8.50 an item, your

Sales . . . . . . . . . . . . . .

98,000

ated with it. The following rules apply.

usual market price will be higher than your

Markups . . . . . . . . . . . .

2,000

•

competitor’s.

For merchandise on hand at the beginning

Markdowns . . . . . . . . . .

500

of the tax year, cost means the ending

Lower than market. When you offer mer-

inventory price of the goods.

chandise for sale at a price lower than market in

Using the retail method, figure your closing

•

the normal course of business, you can value

inventory as follows.

For merchandise purchased during the

the inventory at the lower price, minus the direct

year, cost means the invoice price minus

Retail

cost of disposition. Figure these prices from the

appropriate discounts plus transportation

Item

Cost

Value

actual sales for a reasonable period before and

or other charges incurred in acquiring the

Opening inventory . . . . . $52,000

$60,000

after the date of your inventory. Prices that vary

goods. It can also include other costs that

Plus: Purchases . . . . . .

53,000

78,500

materially from the actual prices will not be ac-

have to be capitalized under the uniform

Net markups

cepted as reflecting the market.

capitalization rules.

($2,000 − $500

•

No market exists. If no market exists, or if

markdowns) . . . . . . . . .

1,500

For merchandise produced during the

Total . . . . . . . . . . . . . . $105,000 $140,000

quotations are nominal because of an inactive

year, cost means all direct and indirect

Minus: Sales . . . . . . . . . . . . . . .

98,000

market, you must use the best available evi-

costs that have to be capitalized under the

Closing inventory at retail . . . . . .

$42,000

dence of fair market price on the date or dates

uniform capitalization rules.

Minus: Markup* (.25 × $42,000) . .

10,500

nearest your inventory date. This evidence

Closing inventory at cost . . . . . . .

$31,500

could include the following items.

Discounts. A trade discount is a discount

* See Markup percentage, next, for an explanation of

•

allowed regardless of when the payment is

Specific purchases or sales you or others

how the markup percentage (25%) was figured for

made. Generally, it is for volume or quantity

made in reasonable volume and in good

this example.

purchases. You must reduce the cost of inven-

faith.

tory by a trade (or quantity) discount.

M a r k u p

p e r c e n t a g e .

T h e

m a r k u p

•

Compensation amounts paid for cancella-

A cash discount is a reduction in the invoice

($35,000) is the difference between cost

tion of contracts for purchase commit-

or purchase price for paying within a prescribed

($105,000) and the retail value ($140,000). Di-

ments.

time period. You can choose either to deduct

vide the markup by the total retail value to get

cash discounts or include them in income, but

the markup percentage (25%). You cannot use

you must treat them consistently from year to

Retail Method

arbitrary standard percentages of purchase

year.

markup to figure markup. You must figure it as

Under the retail method, the total retail selling

accurately as possible from department records

price of goods on hand at the end of the tax year

for the period covered by your tax return.

Lower of Cost or Market Method

in each department or of each class of goods is

Markdowns. When figuring the retail selling

reduced to approximate cost by using an aver-

price of goods on hand at the end of the year,

Under the lower of cost or market method, com-

age markup expressed as a percentage of the

markdowns are recognized only if the goods

pare the market value of each item on hand on

total retail selling price.

were offered to the public at the reduced price.

the inventory date with its cost and use the lower

To figure the average markup, apply the fol-

Markdowns not based on an actual reduction of

of the two as its inventory value.

lowing steps in order.

retail sales price, such as those based on depre-

This method applies to the following.

ciation and obsolescence, are not allowed.

•

1) Add the total of the retail selling prices of

Goods purchased and on hand.

the goods in the opening inventory and the

Retail method with LIFO. If you use LIFO

•

The basic elements of cost (direct materi-

retail selling prices of the goods you

with the retail method, you must adjust your

als, direct labor, and certain indirect costs)

bought during the year (adjusted for all

retail selling prices for markdowns as well as

of goods being manufactured and finished

markups and markdowns).

markups.

goods on hand.

2) Subtract from the total in (1) the cost of

Price index. If you are using the retail method

goods included in the opening inventory

and LIFO, adjust the inventory value, deter-

This method does not apply to the following.

plus the cost of goods you bought during

They must be inventoried at cost.

mined using the retail method, at the end of the

the year.

year to reflect price changes since the close of

•

Goods on hand or being manufactured for

the preceding year. Generally, to make this ad-

3) Divide the balance in (2) by the total sell-

delivery at a fixed price on a firm sales

justment, you must develop your own retail price

ing price in (1). The result is the average

contract (that is, not legally subject to can-

index based on an analysis of your own data

markup percentage.

cellation by either you or the buyer).

under a method acceptable to the IRS. How-

•

Goods accounted for under the LIFO

Then figure the approximate cost in three

ever, a department store using LIFO that offers a

method.

steps.

full line of merchandise for sale can use an

inventory price index provided by the Bureau of

1) Subtract the sales at retail from the total

Labor Statistics. Other sellers can use this index

Example. Under the lower of cost or market

retail selling price. The result is the closing

if they can demonstrate the index is accurate,

method, the following items would be valued at

inventory at retail.

reliable, and suitable for their use. For more

$600 in closing inventory.

information, see Revenue Ruling 75 – 181 in Cu-

2) Multiply the closing inventory at retail by

mulative Bulletin 1975 – 1.

Item

Cost

Market

Lower

the average markup percentage. The re-

R . . . . . . . . . . . .

$300

$500

$300

sult is the markup in closing inventory.

Retail method without LIFO. If you do not

S . . . . . . . . . . . .

200

100

use LIFO and have been figuring your inventory

3) Subtract the markup in (2) from the closing

T . . . . . . . . . . . . .

450

200

under the retail method except that, to approxi-

inventory at retail. The result is the approx-

Total . . . . . . . . . .

$950

$800

$600

mate the lower of cost or market, you have

imate closing inventory at cost.

followed the consistent practice of adjusting the

You must value each item in the inventory

retail selling prices of goods for markups (but not

separately. You cannot value the entire inven-

Closing inventory. The following example

markdowns), you can continue that practice.

tory at cost ($950) and at market ($800) and

shows how to figure your closing inventory using

The adjustments must be bona fide, consistent,

then use the lower of the two figures.

the retail method.

and uniform and you must also exclude markups

Market value. Under ordinary circumstances

made to cancel or correct markdowns. The

for normal goods, market value means the usual

Example. Your records show the following

markups you include must be reduced by mark-

bid price on the date of inventory. This price is

information on the last day of your tax year.

downs made to cancel or correct the markups.

Page 15

Publication 538 - Accounting Periods And Methods Page 15

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