Manufacturers, processors, wholesalers, jobbers, distributors and other companies that have a substantial portion of their assets in the form of inventory have an opportunity to improve their cash flows for years to come by reducing the cost of their closing inventory value. Doing so increases the amounts charged to cost of goods sold, thereby reducing gross profits, taxable income and current taxes due. If estimated taxes are based on prior year's liabilities, a reduced current tax liability also reduces quarterly estimates of next year's tax liability, again improving cash flows.
The proper current unit levels of inventory are unchanged, only priced at lower values. You may think of this as an interest free loan from the United States Treasury.
This tax savings is accomplished by using the last in, first out (LIFO) method of pricing inventory. Most companies use the first in, first out (FIFO) method. Using the FIFO method, the item you sell is identified with the earliest (or first) item you purchased. The item remaining in inventory is treated as the latest (or last) item purchased. Thus, the item remaining in inventory is priced at the cost of the earliest (or first) item purchased.
A practical LIFO method for a company that has few individual items in inventory is the specific item method. While simpler in calculation, this method does not always provide the most favorable results since a decline in a specific quantity level affects the final results.
A more practical method for a company that has numerous items in inventory is a dollar value pooling method. One LIFO dollar value pooling method is the double extension method. Under this method, inventory items are grouped into natural business pools. The quantity of each item in the pool is priced out at the base year cost (the year the company first used the dollar value LIFO method) and then at the current year unit cost. The total amounts in the pool are used to determine an index value. If there is an increase in the inventory, the year-end inventory is computed by using the prior year, plus the increase multiplied by the current year index. Don't be concerned if an item was not on hand in the base year. The company can recompute the unit price based on what an item would have cost in the base year.
It is interesting to explore what companies do in the grouping of pools. First, it should be noted that when a company elects to be on the LIFO method of inventory it does not necessary mean that all items of inventory must be computed on the LIFO method.
We have had clients who have applied the LIFO method to certain product lines or certain products within a line. We also have had clients elect LIFO treatment for raw materials only, while a very large New Jersey manufacturer elected to use the LIFO method for materials and overhead and not labor. The overriding consideration for determining which elements of an inventory should be computed on the LIFO method is the expectation that cost related to those elements is volatile and will continue to rise. Many clients did not include labor as part of their LIFO election since labor costs per unit of inventory were decreasing or were expected to decrease. This was usually true, not because hourly rates or costs were decreasing, but because technology had reduced the labor time necessary to produce a product.
The United States Treasury may allow a company to elect the LIFO method of inventory computation using a method that separates labor into two components (time and wages). By treating the time element as equal in the base year to the time element in the current year, only the hourly cost of labor is effectively computed on the LIFO method. The same New Jersey manufacturer has considered changing its LIFO election to encompass this procedure.
One should consider if LIFO makes sense to his/her situation, not on an all or nothing basis, but on an element by element, component by component basis.
Many companies may elect to use another method of computing price indexes for valuing their natural business pools by reference to the stated prices contained in consumer or producer indexes. The United States Bureau of Labor Statistics publishes such indexes. The advantage of using these published indexes is that it saves the work of computing your own, based upon a company's inflation experiences, and is readily accepted by the Internal Revenue Service as an appropriate way of computing an index to finalize the valuation of a dollar-value inventory pool.
Regardless of which method is used, the Treasury may challenge such methods if they believe that it does not clearly reflect income.
A company using the LIFO method for income tax purposes must use this method for all primary financial reports including those used for credit purposes, shareholders, partners or beneficiaries. This applies to the entire period that LIFO method is used. However, supplemental, footnote or explanatory disclosure of non-LIFO income and balance sheet information is allowed. Reports to creditors, or others, using information taken from the primary financial reports and supplemental information are acceptable.
In periods of rising prices, the LIFO method of valuing one's inventory is an effective method of increasing cash flow even if costs of sales may be reduced by labor productivity gains. The time is now to investigate if this cash flow savings opportunity should be pursued for your company.
Gerald Marsden, is the managing partner at Eisner & Lubin LLP. He can be reached at (212) 751-9100 or by email: [email protected]
Note: The foregoing memorandum is based on the current tax laws. If such laws are subsequently modified, any advice given above or any actions taken as a result of the foregoing may have to be revised. This written advice was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.