| Summer 2006 |
Manufacturing/Distribution Advisor
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Is LIFO Right For Your Company?
As long as inflation has been generally at bay, few manufacturers or
distributors have paid much attention to the last-in, first-out method
of inventory valuation known as LIFO.
But for more companies that face rising prices, LIFO deserves consideration
as a valuable tax management tool.
Under LIFO, the last inventory purchased is treated as the first sold. The
method permits the balance sheet to show year-end inventory valued at earlier,
lower prices, regardless of when the inventory moved.
When Prices Go Up
As an example, consider a company that buys ten castings in January and six
more in December, for a total of sixteen. It pays $50 each for the first set and
$80 each for the second. During the year the company sells eight of the
castings.
If the company uses the more common FIFO (first-in, first-out) valuation
method, its income statement shows cost of goods sold as $400 (the eight parts
sold cost $50 each). Its year-end inventory is valued at $580 (the eight
remaining parts include two bought at $50 and six bought at $80).
A LIFO calculation reverses these results. Using LIFO, the cost of goods sold
is $580 (six $80 parts and two $50 parts). The eight parts that remain in
inventory at year-end are valued at $400 (eight parts at $50).
For just one example, LIFO is tailor-made for automotive dealerships, whose
suppliers raise prices every year like clockwork.
The LIFO method results in lower inventory values and higher values for cost
of goods sold. When a company faces rising prices, that results in a lower
income tax bill.
Easy to Try Out—Once
It's easy to move to LIFO, and if things don't work out, it's easy to retreat—with one big catch. A company that leaves LIFO can't return to it for five
years without IRS permission, and that's rarely granted. So make an informed
decision by performing accurate cost forecasts.
LIFO can give controllers headaches. Tracking costs in various pools of
inventory—raw material, work-in-progress and others—is tedious, particularly
for larger companies. Matters grow more complex when inflation affects some
items but not others, resulting in uneven LIFO benefits.
The IRS also requires that the same valuation method be used on financial
statements, where the lower-net-income result of a LIFO calculation may be less
attractive to lenders. But companies are permitted to footnote their statements
with net income calculated from a non-LIFO method, which may provide a healthier
picture. Educating your banker about the tax benefits of LIFO along with the
impact of LIFO on your financial statements is a key to your successful
adoption, as you don't want this benefit to cause problems in how the credit
analysts use this data.
Complexity Reduced
In times of low inflation, these drawbacks have historically outweighed the
benefit of switching to LIFO for many firms, since the potential lessening of
the tax burden that LIFO offers is small or nonexistent.
But simplified LIFO computation rules have made the method much more
attractive. Several years ago, the IRS began allowing companies to calculate
inflation or deflation in various inventory categories by reference to standard
indices published by the Bureau of Labor Statistics.
This relieves LIFO users of some administrative burdens and also makes more
accurate forecasting possible. As with the standardized deduction on a 1040,
this provision may not save as much as more detailed analysis.
The LIFO election is taken on IRS Form 970 and is available as late as the
extended due date for returns.
Is LIFO for you? Our firm can help you gain a line of sight to the bottom
line.
Editor's Note: Bober, Markey, Fedorovich
& Company frequently works with clients on matters such as
this. Please call your partner / manager contact if you would like assistance in this area.
Manufacturing/Distribution Advisor is produced quarterly by Bober, Markey, Fedorovich & Company's
Manufacturing/Distribution
Services Team. If you would like additional information about the services that we can provide to manufacturers and wholesale distributors, please call or email our team leader, James E. Merklin, CPA, M.Acc. at (330) 762-9785 or
jimm@bobermarkey.com.
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