In addition to determining the method for identifying inventory items, you must have a method for valuing those items, and for calculating cost of goods sold. The inventory valuation methods that can generally be used for income tax purposes are:
cost,
lower of cost or market, or
retail.
Cost Method
When you value your inventory at cost, you have to include all direct and indirect costs involved in acquiring or producing your inventory. The cost of merchandise you purchase includes the invoiced purchase price less any trade or other discounts, plus any transportation, shipping, or other costs you incur in acquiring the merchandise. These include any costs you must capitalize under the uniform capitalization rules. If you manufacture or produce merchandise, you must include in inventory all the direct and indirect costs involved in the manufacture or production process; here again following the uniform capitalization rules.
There are two different types of discounts that should be taken into account:
Trade discounts are price reductions (generally for the quantity or volume of purchases) that apply regardless of when payment is make. These discounts reduce the cost of inventory.
Cash discounts are reductions for prompt payment, generally expressed as a percentage of the invoice amount for payment within a certain number of days. Cash discounts can be either be treated as reductions of the cost of inventory, or can be included in income for tax purposes. The method chosen must be consistently applied.