The retail inventory method values ending inventory by starting from the retail selling prices of the goods still on hand and converting that figure back to cost with a single ratio. A taxpayer that is a retail merchant may use the retail inventory method of accounting, and that method uses a formula to convert the retail selling price of ending inventory to an approximation of cost, the retail cost method, or an approximation of lower of cost or market, the retail LCM method (26 CFR 1.471-8(a)).
It exists because a store knows its ticket prices for everything on the shelf and does not want to look up the invoice cost of every unit. A taxpayer may use the retail inventory method instead of valuing inventory at cost under section 1.471-3 or lower of cost or market under section 1.471-4 (26 CFR 1.471-8(a)).
The Two-Step Calculation
The arithmetic is one ratio and one multiplication. A taxpayer computes the value of ending inventory under the retail inventory method by multiplying a cost complement by the retail selling prices of the goods on hand at the end of the taxable year (26 CFR 1.471-8(b)(1)).
cost complement = cost of goods available / retail value of goods available
ending inventory value = cost complement x retail selling prices of goods on handThe cost complement is where the work is, and the regulation defines both halves of it. The numerator is the value of beginning inventory plus the cost of goods purchased during the taxable year. The denominator is the retail selling prices of beginning inventory plus the retail selling prices of goods purchased during the year, that is, the bona fide retail selling prices of the items at the time acquired, adjusted for all permanent markups and markdowns, including markup and markdown cancellations and corrections, and the denominator is not adjusted for temporary markups or markdowns (26 CFR 1.471-8(b)(2)(i)).
Read the denominator carefully. It is priced at what the goods were offered for when they were acquired, not at what they are marked at now, and the year’s clearance stickers are handled at the other end of the calculation.
The Markdown Rule Splits Cost From LCM
This is the one distinction that changes the answer, and it is the reason the method has two versions.
Under the retail LCM method the denominator ignores markdowns. A taxpayer using the retail LCM method does not adjust the denominator of the cost complement for markdowns, including markdown cancellations or corrections, and markups must be reduced by the markdowns made to cancel or correct them (26 CFR 1.471-8(b)(3)(i)(B)). Leaving markdowns out of the denominator keeps the ratio higher than the true cost ratio, and a lower ending value is what approximates market.
The ending retail figure is treated the opposite way. A taxpayer must include all permanent markups and markdowns but may not include temporary markups or markdowns in determining the retail selling prices of goods on hand at the end of the taxable year, and may not include a markdown that is not an actual reduction of retail selling price (26 CFR 1.471-8(b)(4)).
So a permanent price cut lowers the ending inventory value under LCM twice over, once by leaving the ratio untouched and once by lowering the retail figure the ratio is applied to. A weekend sale price does neither, because it is temporary.
The Regulation’s Own Worked Example
The regulation runs the calculation on a real set of facts, which is worth following because it also shows how a vendor allowance is treated.
R is a retail merchant who uses the retail LCM method and a calendar taxable year, and has no beginning inventory in 2012. R purchases 40 tables during 2012 for $60 each, a total of $2,400, and offers them for sale at $100 each, an aggregate retail selling price of $4,000. Nothing sells at $100, so R permanently marks the tables down to $90 each, and as a result of the $10 markdown R’s supplier provides a $6 per table margin protection payment. R sells 25 tables and has 15 in ending inventory (26 CFR 1.471-8(e), Example 1).
numerator cost of the tables 2,400
margin protection payment not deducted
denominator retail prices at the time acquired 4,000
markdown not deducted
cost complement 2,400 / 4,000 60%
ending retail 15 tables at the marked-down 90 1,350
ending value 60% of 1,350 810The regulation reaches the same figures. R may not reduce the numerator by the margin protection payment, does not adjust the denominator for the markdown, and so has a cost complement of $2,400 divided by $4,000, or 60%. The aggregate retail selling price of the ending table inventory is $1,350, and approximating LCM under the retail method the value of that ending inventory is $810 (26 CFR 1.471-8(e), Example 1).
Push the markdown further and only the second half moves. On the same facts with the tables permanently reduced to $50, the cost complement is still 60%, the ending retail figure is $750, and the ending inventory value is $450 (26 CFR 1.471-8(e), Example 2).
Vendor Allowances and the Alternative Methods
A supplier payment tied to a price cut is the trap in a retail computation, because pushing it through the numerator understates the cost ratio.
A taxpayer using the retail LCM method may not reduce the numerator of the cost complement by the amount of an allowance, discount or price rebate that is related to or intended to compensate for a permanent reduction in the taxpayer’s retail selling price of inventory, which the regulation names a margin protection payment (26 CFR 1.471-8(b)(3)(i)(A)).
There is a way to take the payment out, and it is a matched pair rather than a free deduction. A taxpayer may reduce the numerator by the amount of all margin protection payments if it also reduces the denominator by the amount of the permanent reduction in retail selling price to which those payments relate (26 CFR 1.471-8(b)(3)(ii)(B)). On the same tables that gives $2,160 over $3,600, which is 60% again (26 CFR 1.471-8(e), Example 3).
Where the related markdowns cannot be identified, the regulation supplies a deemed adjustment that reduces the denominator by whatever amount holds the cost complement percentage where it was before the payment and the markdown were taken into account (26 CFR 1.471-8(b)(3)(ii)(C)). A taxpayer that can determine the amount of a related markdown but not the associated margin protection payments may not use that method to compute an adjustment to the numerator (26 CFR 1.471-8(b)(3)(ii)(C)).
How Far the Method Reaches
Not across a whole store by default. A taxpayer may use the retail inventory method to value ending inventory for a department, a class of goods, or a stock-keeping unit, and a taxpayer maintaining more than one department or dealing in classes of goods with different percentages of gross profit must compute cost complements separately for each department or class of goods (26 CFR 1.471-8(d)).
That last clause is the one a preparer has to test on a real client. A single cost complement across a grocery aisle and a pharmacy counter is not a permitted shortcut, it is a wrong answer, because the two carry different gross profit percentages.
One combination is fixed rather than chosen. A taxpayer using the last-in, first-out inventory method with the retail inventory method uses the retail cost method (26 CFR 1.471-8(c)). LIFO and retail LCM do not go together.
Where a US Firm Meets It
On the return, in the inventory workpaper, and the questions are documentary. Which departments have their own cost complement, and do their gross profit percentages actually differ. Whether the markdowns in the file are permanent or promotional, since only permanent ones belong in the ending retail figure. Whether any vendor allowance in the year was tied to a price cut, which decides whether it can touch the numerator at all.
The book side runs on its own rule, and the retail inventory method sits in the smaller of the two groups: inventory measured using the retail inventory method stayed under lower of cost or market when everything else moved to net realizable value, a split set out in lower of cost or market. The general framework the ledger side runs on is in inventory accounting.
Common Questions
Ending inventory equals the cost complement multiplied by the retail selling prices of the goods on hand at the end of the year (26 CFR 1.471-8(b)(1)). The cost complement is the cost of beginning inventory plus purchases, over the retail selling prices of beginning inventory plus purchases at the prices the items carried when acquired (26 CFR 1.471-8(b)(2)(i)).
No. The retail method is a permitted method of valuing ending inventory for a retail merchant under its own regulation (26 CFR 1.471-8(a)), and it runs on the goods actually on hand at their marked prices. The gross profit method estimates inventory from a historical margin without counting anything, which is why it is used for interim figures and insurance claims rather than for a year-end valuation.
Whichever version is being run. Including markdowns in the denominator approximates cost, and leaving them out approximates lower of cost or market (26 CFR 1.471-8(a) and (b)(3)(i)(B)). The two versions produce different cost complements on identical facts, so the workpaper has to say which one the client is on.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms under layered review, and a trial task lets a firm’s own reviewer grade a real block of inventory and close work before any client file depends on it.
