Memorandum Findings of Fact and Opinion
These consolidated proceedings involve deficiencies in income tax for 1946 against the petitioners in the amounts as follows:
| Petitioner | Deficiency |
| Ralph Ellstrom | $348.23 |
| Olaf W. Ellstrom | 297.25 |
| Elmer Ellstrom, Jr. | 184.86 |
| Elmer Ellstrom, Sr. | 389.60 |
The issue presented is whether the respondent erred in determining that the closing inventory for the taxable year 1946 of Dearborn Gage Company, a manufacturing firm in which petitioners were equal partners, valued at cost, was less than market where inventories were reported at the lower of cost or market.
Findings of Fact
*248 The facts which are stipulated are found accordingly.
During the taxable year 1946 each petitioner held a one-fourth interest in Dearborn Gage Company, a Michigan copartnership. Each partner filed his income tax return for 1946 with the collector of internal revenue for the district of Michigan, at Detroit, as did the Dearborn Gage Company which kept its books and records on an accrual basis for taxable years ending December 31.
The Dearborn Gage Company, hereinafter referred to as Dearborn, was formed by petitioners on March 28, 1941, and has been engaged continuously in the manufacture and sale of chromium plated gage blocks, a precision measuring device. From its inception Dearborn's inventories at both the beginning and end of its taxable year were computed on the lower of cost or market value, and its federal income tax returns were filed on the same basis.
Dearborn's gage blocks were made in three classes of accuracy, the first being a working set, or "W", with a tolerance of plus or minus eight millionths of an inch, the second being an inspection set, or "I", with a tolerance of plus or minus of four millionths of an inch, and the third being a laboratory set, or "L", *249 with a tolerance of plus or minus of two millionths of an inch. The blocks were sold individually or in complete sets in each of the three classes, the price varying according to the degree of accuracy. The gages were made in three different types, round, square, and rectangular, the latter class being the principal type manufactured. The round and square gages were made in both "W" and "I" accuracies in 126 different sizes and were listed at prices varying from $5.20 to $45.50 per block, depending upon the size and accuracy. The individual rectangular blocks were made in 125 different sizes and were listed at prices varying from $4 to $21 per block subsequent to January 1, 1946. Prior to that date the prices per block had been slightly higher.
In addition to the regular rectangular gage blocks, special sized rectangular blocks were made in "W" and "I" accuracies in 22 sizes at list prices varying from $8 to $73 per block. Special sized square blocks were also made in the same accuracies in 16 different sizes at list prices varying from $11.40 to $56.35 per block.
As of December 31, 1946, Dearborn's physical inventory consisted of 160,847 blocks of which 17,304 were finished*250 and the remainder were in various stages of production. There are five stages of manufacture, as follows:
1. Blocks cut, shaped, hardened, and rough-ground. The labor at the end of the first stage is approximately 1/12 of the cost of finished blocks.
2. Finished steel grinding, etching and buffing. The labor at the end of the second stage is approximately 1/6 of the total finished labor, 1/12 of such labor being used in the second stage.
3. Chrome plating of block. The labor at the end of this stage is approximately 1/3 of the total labor, 1/6 of the labor being added at this stage.
4. Finished off and prepared for lapping. The total labor at the end of this stage is approximately 1/2 of the total labor, 1/6 being added at this stage.
5. Final lapping and finishing of blocks. Approximately 1/2 of the labor is added at this stage to complete the block.
Dearborn's inventories of gage blocks as of December 31, 1945, through December 31, 1950, finished at the various stages of production, were as follows:
| Stage | 1945 | 1946 | 1947 | 1948 | 1949 | 1950 |
| 5 - Finished | 16,606 | 17,304 | 13,867 | 9,340 | 4,163 | 3,023 |
| 4 - For lapping | 65,605 | 58,856 | 54,314 | 40,544 | 31,706 | 21,496 |
| 3 - Plated | 1,668 | 1,668 | 1,668 | 1,668 | 1,668 | 834 |
| 2 - Finished ground, | ||||||
| etched, | ||||||
| buffed | 3,453 | 3,453 | 3,453 | 3,453 | 3,453 | 1,727 |
| 1 - Shaped, cut, | ||||||
| hardened, | ||||||
| rough ground | 79,566 | 79,566 | 75,906 | 80,823 | 83,543 | 78,857 |
| Total | 166,898 | 160,847 | 149,208 | 135,828 | 124,533 | 105,937 |
At the end of the taxable year 1945 the total inventory of 166,898 gage blocks was valued at cost in the amount of $80,185.31, which amount was used for the valuation of the opening inventory for 1946. At the end of the taxable year 1946 the cost of the total inventory of 160,847 gage blocks was $83,951.34, consisting of materials in the amount of $3,442.59 and labor in the amount of $80,508.75, computed by Dearborn's auditors as follows:
| "INVENTORY - GAGE BLOCKS | ||||
| December 31, 1946 | ||||
| Percent- | ||||
| Increase | age | |||
| Material | (De- | com- | ||
| 12-31-45 | 12-31-46 | crease) | pleted | |
| "Finished | 16,606 | 17,304 | 698 | 1 |
| For lapping | 65,605 | 58,856 | (6,479) 1 | 1/2 |
| Plated | 1,668 | 1,668 | 1/3 | |
| Finished ground, | ||||
| etched and buffed | 3,453 | 3,453 | 1/6 | |
| Shaped, cut, hardened | ||||
| and rough ground | 79,566 | 79,566 | 1/12 | |
| Total | 166,898 | 160,847 | (6,051) | |
| "Sales - Jan. 1, 1946 - | ||||
| Dec. 31, 1946 | 10,459 | |||
| Units produced | 4,408 2 | |||
| Steel inventory - Jan. | ||||
| 1, 1946 | $ 960.00 | |||
| Purchases | 523.34 | |||
| $1,483.34 | ||||
| Steel inventory - Dec. | ||||
| 31, 1946 | ||||
| 3 Tons at $320 per | ||||
| ton 3 | 960.00 | $ 523.34 | ||
| Unit material cost | $ .1187 | |||
| Cost of sales: | ||||
| 4,747 at $.01745 | $ 82.53 | |||
| 5,712 at $.02648 | 151.26 | $ 233.79 | ||
| Inventory: 4 | ||||
| 4,408 at $.1187 in- | ||||
| ventory | ||||
| 12-31-46 | $ 523.34 | |||
| 61,667 at $.0206 in- | ||||
| ventory | ||||
| 1-1-46 | 1,271.66 | |||
| 94,772 at $.01745 in- | ||||
| ventory | ||||
| 1-1-45 | 1,647.59 | |||
| 160,847 | $ 3,442.59 |
| "INVENTORY - GAGE BLOCKS | ||||
| December 31, 1946 | ||||
| Increase | Finished | |||
| Labor | (De- | unit | ||
| 12-31-45 | 12-31-46 | crease) | equivalents | |
| "Finished | 16,606 | 17,304 | 698 | 698 |
| For lapping | 65,605 | 58,856 | (6,749) | (3,374 1/2) |
| Plated | 1,668 | 1,668 | ||
| Finished ground, | ||||
| etched and buffed | 3,453 | 3,453 | ||
| Shaped, cut, hardened | ||||
| and rough ground | 79,566 | 79,566 | ||
| Total | 166,898 | 160,847 | (6,051) | (2,677) |
| "Sales - Jan. 1, 1946 - | ||||
| Dec. 31, 1946 | 10,459 | |||
| Units produced | 7,782 | |||
| Steel inventory - Jan. | ||||
| 1, 1946 | Shop labor | $18,351.13 | ||
| Purchases | ||||
| Steel inventory - Dec. | ||||
| 31, 1946 | ||||
| 3 Tons at $320 per | ||||
| ton 3 | ||||
| Unit material cost | Unit labor | $ 2,3582 | ||
| cost | ||||
| Cost of sales: | ||||
| 4,747 at $.01745 | Cost of | |||
| sales: | ||||
| 5,712 at $.02648 | 10,459 at | $13,914.65 | ||
| $1.3304 | ||||
| Inventory: 4 | Inventory: | |||
| 5 | ||||
| 4,408 at $.1187 in- | 7,782 at | |||
| ventory | $2.3582 | $18,351.13 | ||
| 12-31-46 | ||||
| 61,667 at $.0206 in- | 46,721 at | |||
| ventory | $1.3304 | $62,157.62 | ||
| 1-1-46 | ||||
| 94,772 at $.01745 in- | ||||
| ventory | ||||
| 1-1-45 | ||||
| 160,847 | $80,508.75" |
*253 The certified public accountant firm making Dearborn's audit for the closing inventory on December 31, 1946, determined that the market value was lower than cost. The market value was determined to be $18,455.94, computed as follows:
| COMPUTATION OF INVENTORY VALUATION | ||
| December 31, 1946 | ||
| "Sale of 160,847 blocks at $2.29 each - Note A | $368,339.63 | |
| Less 12 1/2% profit - Note B | 46,042.45 | |
| 322,297.18 | ||
| Less selling and admin. expense - based on 1944 | 77,993.44 | |
| 244,303.74 | ||
| Less manufacturing expense - based on 1944 burden | ||
| rate after adjustment as to | ||
| depreciation: [Note C] | ||
| 42.5% of $151,021.26 - labor cost to complete | 64,184.04 | |
| 180,119.70 | ||
| Less-cases-based on 1/2 of blocks being sold in | ||
| sets and cost of 85 piece case | ||
| $11.25 | 10,642.50 | |
| 169,477.20 | ||
| Less - estimated cost to complete inventory | 151,021.26 | |
| Value inventory 12-31-46 | 18,455.94 | |
| Value inventory 12-31-46 per books | 83,951.34 | |
| Adjustment - inventory loss | $ 65,495.40" | |
| Note A - Sales prices based on current reduction, | ||
| by Webber Tool, a competitor, to $195 for | ||
| 85 piece set. | ||
| Note B - Profit includes provision for salaries | ||
| to partners as no salaries are included in | ||
| expense. | ||
| Note C - Manufacturing expenses 1944 | $ 70,658.64 | |
| Less depreciation as charged (includes | 19,522.18 | |
| amortization) | ||
| 51,136.46 | ||
| Add depreciation - current amount | 2,070.62 | |
| 53,207.08 | ||
| Direct labor 1944 | $125,169.21 | |
| Burden rate | 42.5% |
| "ESTIMATED COST TO COMPLETE INVENTORY WORK IN PROCESS | |||||
| December 31, 1946 | |||||
| Estimated | |||||
| present | |||||
| labor cost | |||||
| per | |||||
| To be | block under | Labor cost | |||
| normal | |||||
| Completed | Number | completed | operating | to complete | Cost to |
| conditions | |||||
| (%) | of blocks | (%) | by Olaf | per block | complete |
| Ellstrom | |||||
| 1/12 | 79,566 | 11/12 | $1.42 | $1.30-1/6 | $103,568.41 |
| 1/6 | 3,453 | 5/6 | 1.42 | 1.18-1/3 | 4,086.05 |
| 1/3 | 1,668 | 2/3 | 1.42 | .94-2/3 | 1,579.04 |
| 1/2 | 58,856 | 1/2 | 1.42 | .71 | 41,787.76 |
| 1 | 17,304 | 1.42 | |||
| 160,847 | |||||
| Total cost | $151,021.26" | ||||
| to complete |
Dearborn's profit and loss statement for the taxable year 1946 was as follows:
| Net sales | ||
| Amount | (%) | |
| "Sales | $67,660.12 | 100.0 |
| Cost of Sales: | ||
| Material | 2,801.03 | 4.1 |
| Labor | 16,073.88 | 23.8 |
| Manufacturing expense | 19,384.31 | 28.6 |
| Total | 38,259.22 | 56.5 |
| 29,400.90 | 43.5 | |
| Less adjustment of inven- | ||
| tory to market | 65,495.40 | 96.8 |
| Gross profit (loss) | ($36,094.50) | (53.3)" |
The number of blocks sold by Dearborn for the calendar years 1941 through 1950, inclusive, were as follows:
| 1941 (3/28-12/31) | 35,483 |
| 1942 | 94,940 |
| 1943 | 110,898 |
| 1944 | 81,462 |
| 1945 | 51,283 |
| 1946 | 10,459 |
| 1947 | 11,639 |
| 1948 | 13,380 |
| 1949 | 11,295 |
| 1950 | 18,596 |
*255 Dearborn's sales were principally "W" or working type sets. The record shows that between August 1, 1946, and June 27, 1947, inclusive, the following sets of gage blocks were sold:
| Average | |||||||
| Price range | Catalogue | price | |||||
| Type | Number | per set | Total | list price | received | ||
| of set | sold | Lowest | Highest | received | "W" | "I" | per set |
| 81 | 73 | $170.00 | $437.50 | $30,401.60 | $330 | $425 | $416.46 |
| 85 | 4 | 348.00 | 464.00 | 1,608.00 | 348 | 448 | 402.00 |
| 35 | 17 | 129.00 | 230.00 | 3,080.75 | 165 | 230 | 181.22 |
| 36 | 4 | 189.00 | 264.00 | 901.00 | 210 | 280 | 225.00 |
| 5 | 22 | 18.80 | 45.96 | 713.05 | 25 | 33 | 32.41 |
During the same period 248 miscellaneous individual gage blocks were sold for an aggregate of $21,695.52.
In the partnership return for 1946 Dearborn claimed a net loss of $54,189.39. In determining the corrected partnership net income respondent disallowed a deduction of $65,495.40 as a write down of the closing inventory and determined the partnership income to be $11,306.01, one-fourth of which was included in the individual income of each petitioner.
Opinion
LEMIRE, Judge: The issue presented is whether the respondent erred in*256 determining that the closing inventory for the taxable year 1946 of Dearborn Gage Company, valued at cost, was less than market where the inventories were reported at the lower of cost or market. It is stipulated that actual or historical cost of the closing inventory for 1946 was $83,951.34, consisting of materials in the amount of $3,442.59 and labor in the amount of $80,508.75. Respondent determined that cost was lower than market and that, therefore, the closing inventory should have been reported at cost resulting in partnership income of $11,306.01 for 1946 rather than a loss of $54,189.39 as reported in the partnership return of income. Petitioners, on the other hand, contend that the market value of the closing inventory was $18,455.94, an amount considerably less than cost.
Where an inventory is valued upon cost or market, whichever is lower, treasury regulations require that the market value of each article on hand on the closing inventory date must be compared with the cost of the article and the lower of such values shall be taken as the inventory value of the article. Regs. 111, sec. 29.22(c)-4. On December 31, 1946, Dearborn's inventory consisted of 160,847 gage blocks, *257 of which 17,304 were completely finished and the remaining 143,543 were in various stages of manufacture. Petitioners' valuation of market was reached by applying to each of the gage blocks, whether finished or unfinished, an estimated uniform sales price of $2.29 per block from which labor, selling, and administration expenses, based on 1944 costs, were deducted. The figure of $2.29 was based upon the sale price of a competitor for an 85 piece set for the sum of $195.
Petitioners' application of a flat rate does not reflect accurately the market value of Dearborn's closing inventory as of December 31, 1946. Petitioners have not shown that the competitors' alleged sales price was for gage blocks similar to Dearborn's in quality, type, or size, all of which factors make a substantial difference in sales prices for both individual blocks and the sets composed thereof. An arbitrary flat rate should not be used in such circumstances but each category of the goods in process should be inventoried at its proper individual value. See American Warehouse Co., 19 B.T.A. 8">19 B.T.A. 8.
Assuming, without deciding, that the competitors' products were similar in all respects to those manufactured*258 by Dearborn, petitioners' application of the $2.29 flat rate was clearly unrealistic in the light of its actual sales prices. The record shows that between August 1, 1946, and June 27, 1947, inclusive, Dearborn sold its 81 piece "W" or working set, which constituted its principal item of sale, for an average price of $416.46. The catalogue list price of such set was $330. Similarly, the prices received for Dearborn's other sets and individual gage blocks were consistently higher than catalogue prices of "W" sets and only slightly less than the catalogue prices of "I" or inspection sets which constituted a relatively small portion of total sales.
While it is true that Dearborn's volume of sales declined rapidly after the end of World War II, it is clear that Dearborn's sales for 1946 were normal for its peacetime business years, as evidenced by its volume of sales for each of the years 1946 through 1949. Petitioners' valuation of market amounts in effect to a depreciation in inventory value for anticipated price changes because of a reduced volume of sales and the attendant increased cost of material and labor. Such method is not in accord with section 29.22(c)-2, Regulations 111, *259 which prohibits deducting from an inventory a reserve for price changes, or an estimated depreciation in the value thereof.
Alternately, on brief, petitioners contend that the market value of Dearborn's inventory was $17,918.88. Such valuation represents a computation by one of petitioners' witnesses at the hearing. The witness based his valuation upon the assumption that each finished gage block would be used to make up an 81 piece set and that each set was worth 25 per cent of its list price of $330. All unfinished blocks were valued at scrap value. There is no evidentiary basis for this assumption since all finished blocks were not sold in 81 piece sets, and because of the nature of Dearborn's production methods it is manifestly unreasonable to value all unfinished blocks at scrap value. No reason appears for valuing the blocks at 25 per cent of the list price other than testimony that the War Assets Administration had, during the period in question, sold gage blocks for approximately 25 per cent of original list prices. Those sales, however, were clearly in the nature of liquidation sales in which gage blocks of all different types, classification, sizes, and quality were disposed*260 of by auction methods. Accordingly, those sales are not satisfactory evidence of the fair market price of Dearborn's inventory.
There are two accepted methods of determining market, in the valuation of a manufacturer's inventory. Regs. 111, sec. 29.22(c)-2; G.C.M. 9401, X-1 C.B. 102-106; 2 Mertens, Law of Federal Income Taxation, § 16.22. Respondent contends that under either method of valuation the cost value of Dearborn's closing inventory on December 31, 1946, was less than its market value on that date. We agree.
Under the first view market represents the reproduction cost of replacing through manufacture the specific goods in the inventory on the inventory date. The record shows that the price of materials increased from.0206( on January 1, 1946, to.1187( on December 31, 1946. During the same period the cost of labor increased from $1.3304 to $2,3582. Therefore, on December 31, 1946, the actual market reproduction cost of the materials in Dearborn's inventory was $19,092.54. 2 The actual cost of materials was $3,442.59. On December 31, 1946, the market reproduction cost of labor was $128,528.97. 3 The actual labor cost on that date was $80,508.75. Accordingly, *261 the actual cost of materials and labor in the aggregate amount of $83,951.34 was less than the aggregate market reproduction cost of $147,621.51.
Under the second view of determining market produced goods in a form salable on the open market, the fnished blocks should be valued at the current bid prices prevailing in the open market for like goods on the date of inventory and the goods in a form not salable on the open market, unfinished blocks, should be valued on the basis of estimated cost of replacement through manufacture of the specific goods on the date of inventory. Using the prevailing cost of labor and materials on December 31, 1946, the reproduction cost of Dearborn's unfinished blocks is as follows:
| Stage | Number | Equivalent | |
| of pro- | of | Completed | finished |
| duction | blocks | % | blocks |
| 4 | 58,856 | 1/2 | 29,428 |
| 3 | 1,668 | 1/3 | 556 |
| 2 | 3,453 | 1/6 | 575.5 |
| 1 | 79,566 | 1/12 | 6,630.5 |
| 143,543 | 37,190.0 | ||
| $ .1187 1 | $ 2,3582 2 | ||
| $17,038.55 | $87,701.46 |
The cost of materials and labor and cost*262 to reproduce the unfinished blocks amounted to $104,823.76. It is clear that this figure alone far exceeds the stipulated actual cost of $83,951.34 for Dearborn's entire inventory which included 17,304 finished blocks, and when a figure to reflect the value of the finished units is added the excess of the reproductive cost, or market, over actual cost becomes even greater.
On the basis of the entire record we hold that the petitioners have failed to carry their burden of showing that the respondent erred in determining that the cost of the closing inventory of Dearborn for the taxable year 1946 was less than the market value.
Decisions will be entered for the respondent.
Footnotes
1. Proceedings of the following petitioners are consolidated herewith: Ralph Ellstrom, Docket No. 42353; Olaf W. Ellstrom, Docket No. 42354; Elmer Ellstrom, Jr., Docket No. 42355; Elmer Ellstrom, Sr., Docket No. 42356.↩
1. This figure should be 6,749. ↩
2. The figure 4,408 represents units put into production from raw stock to finished blocks during 1946. ↩
3. The total tonnage of steel in the uncompleted blocks, being those blocks in the first four stages of production, amounted to 9.6 tons. ↩
4. The figures $.1187, $.0206, and $.01745 represent the material cost per block based upon the cost of material at the time the block was put into process. The material cost per block on December 31, 1946, was over five times as much as it was prior to January 1, 1946. ↩
5. The figure 7,782 at $2.3582 represents the labor cost per block finished during 1946. The figure 46,721 represents the equivalent in finished units of the total unfinished blocks based upon the percentage of the total labor cost at the various stages. The figure $1.3304 represents labor cost per block prior to January 1, 1946. The difference between $2.3582 and $1.3304 represents the increase in labor cost per block during 1946.↩
2. 160,847 gage blocks at.1187(. ↩
3. Representing 54,503 equivalent finished units at $2.3582.↩
1. Material per block. ↩
2. Labor per block.↩