Inventory Cost or Market Value

April 13, 2006

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If your business carries inventory, you will need to keep track of it. For tax purposes, as well as for general management purposes, you'll need to know the value of the inventory at the beginning and end of the year.

Although there are many possible ways of valuing inventories, the IRS strongly prefers that small business retailers, wholesalers and manufacturers value inventories under either of these methods: (1) cost, or (2) cost or market, whichever is lower.

If you are using the cost method, the value of the inventory would be all the direct and indirect costs of acquiring it. For example, the cost of goods you purchased would be the invoice price, less appropriate discounts, plus transportation or other charges you incur in acquiring the goods.

For goods that you produced, the cost would be the cost of labor, materials, and plant overhead used in production. Manufacturers must generally use the uniform capitalization ("unicap") rules to determine exactly which costs are to be included in the formula; if you are subject to these rules, you'll probably need an accountant's help to interpret and apply them. Luckily, resellers with average annual gross receipts of $10 million or less for the last three tax years are exempt from the unicap rules.

The second method - the lower of cost or market method - in effect permits you to reduce your gross income to reflect any reduction in the value of inventories. This method is based on the assumption that if the market price falls, the selling price falls correspondingly. If this is so, a business owner will report a lower income, and thus defer until the following year a part of the taxes that would otherwise have to be paid under the cost method. One big drawback to using this method is that you need to compute the value of your inventory both ways in order to determine which is lower.

In Year 1, John Newsome purchased merchandise for $50,000 and sold half of the goods for $60,000. On December 31, Year 1, his inventory was $25,000 (under the cost method) and $15,000 (under the lower of cost or market method). In Year 2, he sells the remaining goods for $50,000. If he had used the lower of cost or market method, his income would have been $10,000 less in Year 1 and $10,000 more in Year 2 than if he had used the cost method, as shown below.

	Cost	Cost or Market
Year 1
Sales	$60,000	$60,000
Less: cost of sales (purchases, less ending inventory)	-25,000	-35,000
Gross income	$35,000	$25,000
Year 2
Sales	$50,000	$50,000
Less: cost of sales (beginning inventory)	-25,000	-15,000
Gross income	$25,000	$35,000

In this example, the selling price of the goods in Year 2 is $10,000 less than in Year 1, the same amount by which the market value of the goods sold in Year 1 fell below cost on December 31, Year 1. But suppose that the selling prices do not drop in relation to the market values. Then, the lower of cost or market method may produce a higher total tax over a two-year period than would the cost method because of an imbalance of income and the graduated tax rates. This could happen, for example, if a tax rate increase takes effect in Year 2.

If you are just starting your business and do not use the LIFO cost method (see identification of inventory items), you may select either the cost or the lower-of-cost-or-market method of accounting. You must use the same method to value your entire inventory, and you may not change to another method without the IRS's consent.

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The IRS is less concerned about the nuances of the specific inventory procedures you use, than with your being consistent from year to year so that your inventory method accurately reflects your income.

You must use the same method to value your entire inventory, and you may not change to another method without the IRS's consent.