Companies that sell the merchandise they buy or produce must account for the cost of goods sold, or COGS, to determine gross profits. You can calculate COGS by subtracting the value of ending inventory from the cost of goods available for sale, which is beginning inventory plus inventory purchases. The dollar-value LIFO method allows you to figure ending inventory based on year-to-year changes to the dollar value of inventory after correcting for the effects of inflation.
The last-in, first-out method assigns inventory costs as if you sell the items you most recently obtained first. Gross profits are your net sales revenues minus COGS. In periods of rising prices, LIFO results in the highest costs and therefore the lowest taxable income. Under LIFO, each time you purchase or produce new inventory, you create a new layer of costs. LIFO liquidation occurs when you exhaust your most recently obtained inventory and must dip into older cost layers, thereby reducing your COGS and increasing your taxable income. The dollar-value LIFO method is a variation of standard LIFO in which you pool inventory costs by year.
In the pooled LIFO method, you assign inventory items to pools based on physical similarity, and you carry the pooled items at average cost for the period. As long as you replenish the pool during the year, you will not create a LIFO liquidation. Under the dollar-value LIFO method, you create pools by year. Instead of grouping items by their physical characteristics, you simply track them by their dollar value, corrected for inflation. You create a new LIFO layer if inventory increases for the year. A decrease is a liquidation. Under the dollar-value LIFO method, you must remove the effects of inflation from each year’s LIFO layer so you can gauge whether increases or decreases to inventory are real or due to inflation.
The government releases price indexes that you apply to dollar-value LIFO method layers to remove inflationary effects. If you manufacture your inventory, you use the Producer Price Index; merchandisers use the Consumer Price Index. You can also develop your own index. To remove the effects of inflation, create cost indexes based on annual changes to the appropriate price index. You set the cost index to 100 percent for the year you adopted LIFO, which is the base year. For each subsequent year, you calculate a new cost index based on the year’s percentage change in the price index. You then apply the cost indexes to each year’s ending inventory to figure end-of-year inventory in base-year dollars -- each year of increase creates a new LIFO layer. By reinflating and adding the annual constant-dollar changes to base-year ending inventory cost, you derive the cost of your current ending inventory.
Suppose you adopted LIFO two years ago and have determined your cost indexes to be 100 and 115 percent. Your base-year ending inventory is $200,000, and since the base year is the first year, the change from the previous year is zero. In Year 2, your physical inventory has a cost of $299,000, which you deflate to $260,000 by dividing it by the Year 2 cost index of 115 percent. The real-dollar increase in inventory is $260,000 minus $200,000, or $60,000. To calculate the Year 2 cost layer, multiply the Year 2 layer, $60,000, by the year’s cost index, 115 percent. Add this reinflated result, $69,000, to the base-year ending inventory of $200,000 to get your Year 2 ending dollar-value LIFO inventory of $269,000.
If your business sells merchandise from inventory, your choice of cost flow assumption can affect your gross profits. The Internal Revenue Service allows you to use the first-in, first-out method or the last-in, first-out method -- FIFO and LIFO. If you choose LIFO, you can further select from one of several submethods, including dollar-value LIFO, or DVL.
Under DVL, you don’t view your inventory as a quantity of physical goods. Instead, you consider your inventory as a quantity of value consisting of annual layers. Each layer is a pool of the entire inventory you purchase during the year. You don’t base your ending inventory value on the count of items, but rather on the dollar value of those items. The DVL method determines the dollar value of your inventory by starting with your initial ending inventory for the year you adopted the method, and then adjusting it for annual changes in inventory value after removing the effects of inflation. The DVL method provides several advantages over other LIFO methods.
Under normal economic conditions, prices rise over time. By using the latest prices first, cost of goods sold -- or COGS -- under LIFO is higher, and taxable income is lower, when compared to FIFO. When you purchase inventory items, you create a new layer of costs. LIFO liquidation occurs when you sell your current layer of inventory and must dip into earlier layers. This lowers your COGS and increases your taxes. An advantage of DVL is that it minimizes LIFO liquidation, because all items you purchase throughout the year belong to the same inventory pool. The only time you liquidate a pool is when the year's ending inventory is less than beginning inventory after correcting for inflation.
Another advantage of DVL is a reduced need for detailed record keeping. Under standard LIFO, you must track your inventory by units, even if you combine similar units into pools. This requires you to track the cost of all purchases and keep records on how you use up your inventory pools through sales. Armed with this information, you can then determine your COGS. If you adopt the DVL method, you make a physical count of ending inventory and apply the proper DVL cost. The DVL method allows you to determine the proper cost without referring to any flow assumptions for inventory units. In other words, you don’t have to worry about applying costs in LIFO sequence to the units you sell during the year.
The third advantage of DVL involves the way you set up the pools. Under regular LIFO, you can create pools of inventory, but each unit in the pool must be essentially identical to every other unit. If you sell or produce items that have annual model changes, you would have to create a new pool for each different model. This increases LIFO liquidation as you sell off your older models. You group DVL pools by year, not unit, so you don't create new pools when you replace units with different ones. By maintaining the older layers, you match your COGS to the most recent purchase prices, which is the whole point of LIFO.
If your business sells items from inventory, you must decide which methods you will use to assign costs and value inventory. In fact, you have to make the decision twice, once for your financial reporting, or book accounting, and again for your tax accounting. The Internal Revenue Service is perfectly fine with your using different methods for each.
Under the first-in-first-out cost flow assumption, you assign your earliest costs to your inventory first. Under normal economic conditions, prices rise over time, so FIFO minimizes your cost of goods sold, or COGS. The inventory equation says ending inventory equals beginning inventory plus inventory purchases minus COGS. By minimizing COGS, FIFO gives you a higher value for ending inventory. You have greater gross profits -- sales minus COGS -- under FIFO, as well as higher current assets, which includes inventory. This might be good for financial reporting, as it emphasizes your profitability, but is not so good for tax reporting because it creates higher taxable income.
A money-saving tactic is to select FIFO for your financial reporting and last-in-first-out for taxes. LIFO assigns the latest costs to inventory first and therefore gives results opposite to those of the FIFO cost assumption. In normal economic conditions, using LIFO for your tax reporting minimizes your taxable income. If you choose LIFO for taxes and FIFO for financial reporting, you usually report the excess of FIFO inventory over LIFO as your “LIFO reserve.” To use LIFO for tax reporting, you must file IRS Form 970 in the year you adopt this method. The term “LIFO” actually applies to a variety of submethods, such as dollar-value LIFO. You must apply for permission to change from one type of LIFO to another by filing IRS Form 3115.
Another set of choices involves how you will value inventory for financial reporting and taxes. Under the cost method, you assign value to your inventory based on its purchase cost, adjusted for discounts; transportation; and other charges. If you manufacture your inventory, include direct costs and all associated indirect costs. In the “lower of cost or market” method, you reduce the value of inventory for merchandise that fetches a price below your cost. Under the retail method, you calculate your COGS as a percentage of your sales revenue, then calculate ending inventory using the inventory equation.
The IRS prefers you use the specific identification method when possible, instead of LIFO or FIFO. This method has you assigning costs to each individual inventory item. The method is only feasible if you sell high-ticket items, such as cars and furs. You have more choices of inventory methods for financial reporting than those that the IRS allows for taxes. For example, you can assign average costs to your merchandise instead of LIFO or FIFO. In addition, you can adopt the gross profit method to value your inventory for financial reporting, but not for taxes. IRS tax reporting also rules out the combination of the LIFO cost flow assumption and the "lower of cost or market" method for valuing inventory -- if you pick one of these, you can’t use the other.
If you run a small merchandising business, your profit margins depend on the cost of items you sell and the prices you get for them. When you don’t have a physical count available, the retail inventory method allows you to estimate the cost of goods sold, or COGS, and ending inventory. To get accurate results, the method requires certain assumptions regarding historical costs and prices.
In the retail inventory method, you first calculate a cost-to-retail percentage, which is the cost of inventory divided by its selling price. You apply this percentage to sales revenue to get an estimate of COGS. To derive ending inventory, add the cost of beginning inventory to the period’s inventory purchase costs and then subtract your estimate of COGS. For example, suppose your cost-to-retail percentage is 70 percent, you have $1 million in beginning inventory, $1.8 million in inventory purchases and sales of $2.2 million. Your COGS is 70 percent of sales, or $1.54 million. Figure your ending inventory as $1 million plus $1.8 million minus $1.54 million, or $1.26 million.
You would only use the retail method if you maintain a perpetual inventory. Under this scheme, you constantly update ending inventory by the cost of purchases and sales. This method saves the money you would need to spend to take a physical count, as required under the periodic inventory method. However, the longer you put off taking a physical count, the higher the chances for inaccurate inventory estimates. To keep errors in check, companies often perform cycle counting, in which they count a portion of inventory every day until they cycle through the lot, and then begin again.
To get good estimates of ending inventory under the retail method, your markups must be consistent over time and apply to all products you sell. If you have periodic sales or have widely varying profit margins for different products, your estimate might not be very good. You can improve it by grouping inventory by markup percentage and figuring each group separately. You might also be able to apply correction factors to account for, say, after-holiday blowout sales. You can also improve accuracy by measuring purchases and sales precisely, perhaps with the assistance of point-of-sale registers and electronic inventory tracking. Higher-precision inputs to a perpetual inventory system should yield outputs -- COGS and ending inventory -- that are more reliable.
Another potential problem applying to the retail method occurs when you acquire another company with a significant amount of inventory sold at a markup different from yours. In other words, the acquirer and acquiree may have wildly different cost-to-price percentages. You can mitigate this problem by taking a physical inventory. If this is too expensive, you might instead separately apply the retail method to your inventory and to that of your acquiree. However, you normally audit the inventory counts provided by a potential acquiree, thereby avoiding the problem of faulty estimates.