LIFO Inventory Costing

Could Make Raw Material Cost Increases Easier to Manage

If your company is experiencing spikes in raw material costs, you may be able to soften the blow by taking a fresh look at how you account for your inventory.

Many businesses are currently facing dramatic increases in the cost of materials.  Extruded plastics resin has increased 36 percent from December 2008 to June 2011(1); steel has increased 34 percent from March 2010 to April 2011(2); and iron ore has increased 25 percent from 2008 to 2009 alone(3).

These kinds of sudden increases may lead to a strain on cash in the short term, but it could help to defer a tax liability to a later date. One way to manage your current tax liability is by managing how your inventory is priced.

By adopting the Last In First Out (LIFO) method of accounting for inventory, a company can record inventory at the traditionally lower cost of their “oldest” inventory, while expensing the cost of their “newest” inventory.

This allows a higher cost of goods sold to be expensed, resulting in a lower gross profit to be taxed.  For example, a Company with $5 million in inventory with prices increasing an average of 2.5 percent per year, would defer $125,000 of income the first year, and after 5 years would have deferred over $657,000 of income.  As you can see, this could result in substantial tax savings over time.

What’s the downside? First, while it may defer a tax liability, it doesn’t eliminate it permanently.  In times of falling prices, the current year effect may actually increase your taxes that year; however, from inception you will still have saved taxes. If you eventually sell or liquidate your inventory your tax savings would be recaptured at that time.

Second, there is still some possibility that eventually all companies will be required to account for inventory under FIFO, so the transition to LIFO could be seen as a limited time opportunity. Regulators are gradually steering the United States toward the use of international accounting rules, under which LIFO is not permitted. However, there is plenty of uncertainty around whether and when U.S. companies will ever be required to follow international rules. There’s also a good deal of speculation that perhaps the requirement may only apply to large companies or only to public companies. That means the window of opportunity to benefit from the LIFO method and the deferred tax liability that it could produce should still be around for a few years to come.

To further explore how adopting LIFO could benefit your company, please contact your Meaden & Moore representative or Bill Smith at (216) 241-3272 or bsmith@meadenmoore.com.

(1) Plastic News

(2) Steelonthenet.com

(3) U.S. Geological Survey