An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. To figure taxable income, you must value your inventory at the beginning and end of each tax year. To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items. The rules for valuing inventory cannot be the same for all kinds of businesses. The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year. Items Generally Included in Inventory Include the following items when accounting for your inventory. Merchandise or stock in trade Raw materials Work in process Finished products Supplies that physically become a part of the item intended for sale Containers such as kegs, bottles, and cases, regardless of whether they are on hand or returnable, should be included in inventory if title has not passed to the buyer of the contents. If title has passed to the buyer, exclude the containers from inventory. Valuing Inventory The value of your inventory is a major factor in figuring your taxable income. The method you use to value the inventory is very important. Generally there are two methods for valuing inventory. These methods are cost or lower of cost or market. Cost Method To properly value your inventory using the cost method, you must include all direct and indirect costs associated with it. The following rules apply: For merchandise on hand at the beginning of the tax year, cost means the inventory price of the goods For merchandise purchased during the year, cost means the invoice price less appropriate discounts plus transportation or other charges incurred in acquiring the goods. It can include other costs that have to be capitalized under the uniform capitalization rules For merchandise produced during the year, cost means all direct and indirect costs that have to be capitalized under the uniform capitalization rules A trade discount is a discount allowed regardless of when the payment is made. Generally, it is for volume or quantity purchases. You must reduce the cost of inventory by a trade (or quantity) discount A cash discount is a reduction in the invoice or purchase price for paying within a prescribed time period. You can choose whether or not to deduct cash discounts, but you must treat them the same from year to year. If you do not deduct cash discounts from inventory costs, you must include them in gross income. If you cannot specifically identify the cost of your inventory, you must use either the FIFO or LIFO methods. Lower of Cost or Market Method Under the Lower of Cost or Market Method, compare the market value of each item on hand on the inventory date with its cost and use the lower value as its inventory value. This method applies to the following: Goods purchased and on hand The basic elements of cost (direct materials, direct labor, and an allocable share of indirect costs) of goods being manufactured and finished goods on hand This method does not apply to the following and must be inventoried at cost: Goods on hand or being manufactured for delivery at a fixed price on a firm sales contract (that is, not legally subject to cancellation by either you or the buyer) Goods accounted for under the LIFO method Uniform Capitalization Rules (UNICAP) Under the Uniform Capitalization Rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities subject to the rules. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property. APPENDIX Merchandise Include the following merchandise in inventory: Purchased merchandise if title has passed to you, even if the merchandise is in transit or you do not have physical possession for another reason Goods under contract for sale that you have not yet segregated and applied to the contract Goods out on consignment Goods held for sale in display rooms, merchandise mart rooms, or booths located away from your place of business Do not include the following merchandise in inventory: Goods you have sold, but only if title has passed to the buyer Goods consigned to you Goods ordered for future delivery if you do not yet have title Assets - Do not include in inventory assets such as: Land, buildings, and equipment used in your business Notes, accounts receivable, and similar assets Supplies that do not physically become part of the item intended for sale Work in Process The three elements of work-in-process consist of: Direct Materials - Materials that become an integral part of the finished product, are consumed in the manufacturing process and are identified with specific units or processes Direct Labor - Labor which can be associated with particular units. Labor includes basic compensation, overtime pay, vacation and holiday pay, sick leave pay, and payroll taxes Indirect Costs - Costs necessary for production other than direct production costs. Indirect costs include variable and fixed overhead. They may be classified as to type for identification with various activities and to facilitate groupings for determining unit costs. Under prior law, manufacturers were required to comply with the full absorption rules under Section 1.471-11 of the Regulations. The full absorption rules provided three categories of indirect costs associated with production activities.