Section 263A Calculation – Anyone?

Let me start out by stating, I feel I am a pretty intelligent person.  Passed the CPA exam the first time (way back when it was given in four parts with a pencil and calculator) and have a masters degree in taxation but Section 263A befuddles me.  Yes I know who it applies to, manufacturers, wholesalers and retailers with average annual gross receipts of $10 million for the preceding three years but after that, stumped.  Could it be I have an aversion to cost accounting? I really did hate that course in college.   I understand the concept, matching the costs of producing goods with the revenues received from selling those goods, got it.  But why do they make it so difficult to apply the uniform capitalization rules?

I have worked for respectable firms with very bright accountants and the general consensus is - no one knows how to do it or they are not exactly sure they are doing it right.  This became very evident to me recently.  I have a client that underwent a Federal tax audit a few years back and one of the areas that was chosen for examination was the Section 263A calculation.  This was not surprising to me because this is a very subjective area and very open to interpretation.  The agent examined my calculation and for the most part agreed with my figures. The only change was the absorption ratio.  He stated that based upon his experience, for the type of industry my client was in, it should have been higher.  How do you refute this position? Hmmm.  Not sure but since I was dealing with a timing issue and the adjustment being very small,  I agreed to the change.  I actually felt a sense of accomplishment that maybe I had finally gotten it. 

This feeling was short lived.  The same client was examined the following year and one of the areas the agent chose to focus on was surprise, surprise Section 263A. 

Being that this area was recently examined and I had followed the audit methodology, I felt comfortable and self assured that there would be no change to my calculation.  The IRS brought in a Section 263A specialist to examine the calculation.  Really, there are people who actually audit this area every day, no thanks.... 

With confidence I gave him my workpapers.  How bad could it be? This was just audited the year before and for the most part, no change.  I followed the previous auditor's methodology and documented the workpapers up the ying yang.  After his very thorough review of my calculation, he determined that my absorption ratio was too low.  I said "how can this be, I followed the previous agents workpapers, calculations and methodology, how can it be to low?"  He looked at me, smiled and said "No one really knows how to do it." Not even the IRS!