Is Inventory Valued at Cost or Retail? GAAP vs. IRS

Inventory is valued at cost, not at retail. The purchase price you paid, plus freight, duties, and any other costs of getting the goods ready for sale, is the number that belongs on your balance sheet and your tax return. Retail prices come in only as an estimation shortcut for high-volume sellers who work backward from selling prices to approximate what the goods originally cost. Even then, the end figure is still a cost figure.

What “Cost” Actually Means

For tax purposes, the IRS recognizes two acceptable ways to value inventory: at cost, or at the lower of cost or market. ¹ Both start from the same place, which is the actual cost of acquiring the goods.

For merchandise you buy for resale, cost means the invoice price minus trade discounts, plus shipping and any other costs you paid to get the goods to your location. For goods you manufacture, cost also picks up raw materials, direct labor, and a share of factory overhead like utilities and equipment depreciation.

Historical cost carries the day because it is objective and verifiable. Invoices, contracts, and payment records document the number. A projected selling price does not have that kind of paper trail, and auditors, lenders, and the IRS all lean on the paper trail.

When Retail Prices Enter the Picture

The retail inventory method is the reason people ask whether inventory is valued at cost or retail. It looks like a retail-based valuation, but it is really a cost estimation technique. Department stores, grocery chains, and similar operations use it because counting thousands of low-price items at original cost after every reporting period would be impractical.

The mechanics are straightforward. You calculate a cost-to-retail ratio by dividing the total cost of goods available for sale by their total retail value. If your goods cost $60,000 and their combined retail price is $100,000, the ratio is 60%. Count your ending inventory at retail prices and multiply by that ratio. Ending inventory marked at $30,000 retail multiplied by 60% gives you an estimated cost of $18,000. ¹

Notice what the number you report is: an estimated cost. The retail price is only an input. The IRS permits the method as long as it is applied consistently and reasonably approximates actual cost. It also doubles as a shrinkage check. If the estimated inventory cost at period-end is materially higher than what a physical count reveals, the gap points to theft, damage, or miscounting.

Writing Inventory Down When Value Falls

Inventory sometimes loses value before it sells. Goods get damaged, styles go out of fashion, or replacement prices drop below what you originally paid. When that happens, you cannot keep carrying the original cost as if nothing had changed. Both GAAP and the IRS require a write-down when recoverable value drops below recorded cost, and this is where selling prices genuinely influence the number on your books.

The GAAP Rule

For inventory measured under FIFO or weighted average cost, GAAP requires you to compare cost against net realizable value: the estimated selling price minus any costs to complete and sell the goods. A product that would sell for $100 but needs $20 in finishing and selling costs has a net realizable value of $80. If that figure falls below the recorded cost, you write the inventory down and recognize the difference as a loss immediately. ²

Once you write inventory down under GAAP, the reduced amount becomes the new cost basis. You do not reverse the write-down if prices later recover. The rule does not apply to LIFO or retail-method inventory; those categories still follow the older lower-of-cost-or-market framework, where “market” generally means replacement cost. ²

The IRS Rule

For tax purposes, “market” in lower-of-cost-or-market means the current bid price on the inventory date, meaning what you would pay to replace or reproduce the goods on the open market. ¹ If replacement cost has fallen below what you paid, you value the inventory at that lower figure. The comparison can be made item by item or by inventory category. Item-by-item catches the most impairment.

Which Cost Attaches to Which Unit

Cost governs the valuation, but when you have bought the same product at different prices over time, you still need a rule for deciding which cost attaches to the units you sold and which cost stays with the units on hand. Under U.S. GAAP, the acceptable methods are first-in first-out (FIFO), last-in first-out (LIFO), weighted average cost, and specific identification. ³ Once you pick a method, you apply it consistently from year to year.

FIFO assumes the oldest units are sold first, so ending inventory is carried at the most recent purchase costs. It keeps the balance sheet close to current replacement prices, but during periods of rising prices it also produces the highest reported profit and the highest tax bill.

LIFO assumes the most recent purchases are sold first. Cost of goods sold reflects current prices, but ending inventory gets stuck at older costs, sometimes much lower ones. The gap is called the LIFO reserve. LIFO carries a conformity requirement: if you use it on your tax return, you must also use it in any financial reports sent to shareholders, creditors, or other outside parties. ⁴ LIFO is also prohibited under IFRS. ⁵

Weighted average blends all purchase prices into a single per-unit cost by dividing the total cost of goods available for sale by the total number of units. It smooths price swings and lands between FIFO and LIFO, and it works well for fungible goods like grain, fuel, or chemicals.

Specific identification tracks the actual cost paid for each individual item. The IRS requires it when items are not interchangeable, such as at a car dealership, jeweler, or art gallery, where lumping unique items into an average would misrepresent both profit and inventory value. ³

Indirect Costs That Get Added Under UNICAP

Beyond the direct purchase price or manufacturing cost, federal law requires many businesses to fold additional indirect costs into inventory value. Under Section 263A, producers and resellers must capitalize a share of indirect expenses like warehousing, purchasing department costs, and administrative overhead that are allocable to inventory. ⁶ Those costs stay locked in the inventory asset until the goods are sold, then flow into cost of goods sold.

The practical effect is that inventory carries a higher value on the balance sheet and the tax deduction for those indirect costs is delayed. You pay more tax now and recover it later when the inventory sells.

The Small Business Shortcut

Not every business that sells physical goods has to work through full inventory accounting. Section 471(c) exempts businesses that meet the gross receipts test under Section 448(c), which for tax years beginning in 2026 means average annual gross receipts of $32 million or less over the prior three years. ⁷ Tax shelters are excluded regardless of size.

Qualifying businesses have two options. They can treat inventory as non-incidental materials and supplies, deducting the cost in the year the goods are sold or paid for, whichever comes later. Or they can follow whatever inventory method they use on their audited financial statements, or on internal books if they have no audited financials. ⁸ Businesses that qualify are also automatically exempt from UNICAP. ⁶ The gross receipts threshold is adjusted annually for inflation, so check the current Revenue Procedure each year to confirm eligibility.

1
Internal Revenue Service. Lower of Cost or Market
2
Financial Accounting Standards Board. ASU 2015-11, Inventory (Topic 330)
3
Internal Revenue Service. Publication 538, Accounting Periods and Methods
4
Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories
5
IFRS Foundation. IAS 2 Inventories
6
Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
7
Internal Revenue Service. Revenue Procedure 2025-32
8
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories