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Merchandising businesses buy their inventory items at wholesale and sell them at retail. Manufacturers acquire raw materials at wholesale prices, create products and then sell them either to other companies at a wholesale price or to the public at retail. In either case, wholesale purchase costs help determine your inventory costs. Your gross profit margin is the difference between selling prices and costs.
Cost Method
The Internal Revenue Service requires you to report your inventory value at cost, not price. You can select from three methods to arrive at inventory value. The cost method is unique in that it doesn’t consider retail prices. Under the cost method, you apply all direct and indirect costs to your inventory. You value beginning inventory as a carryover from the previous year’s ending inventory and account for inventory purchases at the wholesale cost, adjusted for discounts, transportation and miscellaneous acquisition charges. If you manufacture your inventory, you may have to treat some of your costs as long-term assets under the uniform capitalization rules -- check with your accountant, because these rules require expert interpretation.
Lower of Cost or Market
The "lower of cost or market," or LCM, method depends on the comparison of wholesale and retail prices. Normally, the LCM method gives the same results as the cost method. However, sometimes retail prices drop below your costs. When this happens, you reduce the value of goods purchased and on hand to reflect the net realizable value, or NRV, of inventory, which is the market price minus costs to complete and sell the merchandise. Under U.S. generally accepted accounting principles, your adjusted market price is no higher than NRV and no lower than NRV minus your gross profit margin. If you use international financial reporting standards, you do not include your gross profit margin in the calculation.
Retail Method
You can estimate the value of cost of goods sold (COGS) and ending inventory using the retail method. Start by accurately figuring a cost-to-price ratio for each class of merchandise. Subtract this ratio from 100 percent to compute your markup percentage. Calculate the retail value of your goods on hand, composed of beginning inventory plus inventory purchased, adjusted for all price increases and reductions. Subtract your sales revenue to find your ending inventory at retail. Finally, reduce your ending inventory retail value to cost by multiplying the difference between the retail value and cost of goods on hand by the appropriate markup percentage. Perform this procedure separately for each class of goods you sell, which can be quite a job if you own a department store.
Taxes
Whichever method you use to value ending inventory, you subtract it from the cost of goods on hand to figure COGS. When you subtract COGS from net sales revenue, your result is your gross profit for the period. After you subtract your other operating costs and interest on debt, you arrive at your net income before taxes. You may have to adjust this number because of extraordinary gains or losses. The result is your taxable income, which you multiply by your tax bracket to discover your tax bill for the year. The lower your ending inventory, the higher your COGS, which reduces your taxable income and tax obligation.
Cost Method
The Internal Revenue Service requires you to report your inventory value at cost, not price. You can select from three methods to arrive at inventory value. The cost method is unique in that it doesn’t consider retail prices. Under the cost method, you apply all direct and indirect costs to your inventory. You value beginning inventory as a carryover from the previous year’s ending inventory and account for inventory purchases at the wholesale cost, adjusted for discounts, transportation and miscellaneous acquisition charges. If you manufacture your inventory, you may have to treat some of your costs as long-term assets under the uniform capitalization rules -- check with your accountant, because these rules require expert interpretation.
Lower of Cost or Market
The "lower of cost or market," or LCM, method depends on the comparison of wholesale and retail prices. Normally, the LCM method gives the same results as the cost method. However, sometimes retail prices drop below your costs. When this happens, you reduce the value of goods purchased and on hand to reflect the net realizable value, or NRV, of inventory, which is the market price minus costs to complete and sell the merchandise. Under U.S. generally accepted accounting principles, your adjusted market price is no higher than NRV and no lower than NRV minus your gross profit margin. If you use international financial reporting standards, you do not include your gross profit margin in the calculation.
Retail Method
You can estimate the value of cost of goods sold (COGS) and ending inventory using the retail method. Start by accurately figuring a cost-to-price ratio for each class of merchandise. Subtract this ratio from 100 percent to compute your markup percentage. Calculate the retail value of your goods on hand, composed of beginning inventory plus inventory purchased, adjusted for all price increases and reductions. Subtract your sales revenue to find your ending inventory at retail. Finally, reduce your ending inventory retail value to cost by multiplying the difference between the retail value and cost of goods on hand by the appropriate markup percentage. Perform this procedure separately for each class of goods you sell, which can be quite a job if you own a department store.
Taxes
Whichever method you use to value ending inventory, you subtract it from the cost of goods on hand to figure COGS. When you subtract COGS from net sales revenue, your result is your gross profit for the period. After you subtract your other operating costs and interest on debt, you arrive at your net income before taxes. You may have to adjust this number because of extraordinary gains or losses. The result is your taxable income, which you multiply by your tax bracket to discover your tax bill for the year. The lower your ending inventory, the higher your COGS, which reduces your taxable income and tax obligation.
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