By William F. Brighenti, CPA, CVA
Despite recent efforts at simplification, many companies still struggle over the proper application of the inventory price index (IPI) computation method. However, the IPI computation method is probably the least costly method in terms of recordkeeping for many companies, so some may want to reconsider the Dollar-Value Method of Pricing LIFO Inventories.
According to Treasury Department Regulation §1.472-8, IPI computation involves four steps:
-- Selection of a U.S. Bureau of Labor Statistics table and the right month
-- Assignment of items in a dollar-value pool to the Bureau’s categories
-- Computation of category inflation indexes for selected categories
-- Computation of the IPI
For most small, nonpublic companies, determining LIFO pools is not a problem, since most only have one pool. While §1.472-8 allows the use of multiple pooling, this increases the risk of erosion of LIFO layers, and should be avoided. Likewise, for most small, nonpublic entities, choosing an appropriate month is not difficult. Most companies choose year-end, when an inventory count is undertaken.
The selection of a Bureau of Labor Statistics table for manufacturers, processors, wholesalers, jobbers, and distributors is not a difficult choice, as Table 6 is ordinarily required. Retailers may select price indexes from Table 3.
The assignment of inventory items should be straightforward. Given the various categories provided for various commodities, the taxpayer would sort inventory items into the provided categories in a logical and systematic manner. The implicit constraint, however, is that the inventory items should be categorized consistently from year to year.
The computation of category inflation indexes for selected categories is the step that provides the greatest difficulty. There are two methods of implementing the computation: double-extension IPI computation and link-chain IPI computation. The former employs a cumulative index from the first year of LIFO use, while the latter uses an index based on the index of the preceding year.
Once a method is selected and the inflation indexes of the categories are calculated, the next step is to derive the IPI for a dollar-value pool by computing the "weighted harmonic mean" of the category inflation indexes. This mean is derived via the following formula: sum of weights/sum of (weight/category inflation index)
This may appear imposing at first glance, but the calculation of the weighted harmonic mean only consists of four steps:
-- After assigning all inventory items to categories, total all dollar values of inventory items by category, and sum all of these dollar values of the categories to compute the "sum of weights." The dollar values of each category comprise the "weights" referred to in the formula to the left.
-- Calculate the category inflation indexes for each category by dividing either the base year’s index (double-extension method) or the prior year’s index (link-chain method) into the current year’s index.
-- Divide each category’s total value by its respective category inflation index. The quotient is the "weight/category inflation index" in the formula. Add all of these quotients to arrive at the "sum of (weight/category inflation index)" value of the denominator.
-- Divide the "sum of weights" by the "sum of (weight/category inflation index)" to yield the weighted harmonic mean.
For the double-extension method, the weighted harmonic mean is also the IPI. Because the link-chain method uses the prior period’s category inflation indexes and not those of the base year, its weighted harmonic mean needs to be multiplied by the prior year’s IPI to arrive at the current year’s IPI. This distinction is easily overlooked in the 38 pages of §1.472-8.
This regulation may intimidate the reader at first glance, but the IPI computation method is perhaps the most efficient LIFO method to employ, particularly in small, nonpublic companies.
William F. Brighenti, CPA, CVA, is a sole practitioner in New Britain, Connecticut. He can be reached at william_brighenti@yahoo.com.
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