Fight Back Against Inventory Inflation with LIFO
Running a business is tough enough in stable times when both prices and trends are smooth and predictable. In reality, the words “stable” and “running a business” are rarely used in the same sentence.
Inflation has been roaring across the economy. The Consumer Price Index has gone up by 8% in the past 12 months, making it the fastest rise in decades. For comparison, this time last year inflation was running at barely 2%. At the wholesale level, things aren’t looking much better. The Producer Price Index (PPI) has risen 10% in the past year, while the PPI for finished goods was up nearly 14%. That is quite the opposite of stable!
Those trends put companies into a bind. Business owners have to absorb higher costs on inventory. They also have to make tough choices about when is the right time to raise prices and pass some of those cost increases on to the consumer.
To add to the puzzle, inflation has a nasty habit of being sticky. Despite the Federal Reserve’s attempts to slow down the pace, inflation has already become a self-reinforcing spiral, and there is no telling how long it may continue.
Since we cannot change inflation, we may as well do the next best thing: appreciate the silver lining that it offers to some companies. If your business has inventory, you may consider turning some of that inventory inflation into tax savings by utilizing last in, first out (LIFO) method of accounting for inventories.
Let’s examine why choosing this accounting method can save you big bucks by lowering your taxable income for the year.
Inventory Accounting: What LIFO Means for You
There are three options for inventory accounting: LIFO (last in, first out), FIFO (first in, first out), and the average cost method.
LIFO and FIFO both operate just like they sound. When a product is sold under LIFO, the newest purchased inventory item (last one in) is used to calculate the cost of inventory for that sale. Under FIFO, the oldest purchased inventory item (first one in) is matched to the sale instead. Under the average cost method, a simple weighted average is computed for all inventory items by dividing total aggregate cost by total items in inventory.
An important side note: The way of accounting for inventory costs doesn’t necessarily match the actual flow of physical items on the counter, in the freezer, or in the warehouse. This is simply an accounting convention — one that can make a real difference come tax time.
Let’s run through an example of how utilizing a LIFO cost flow assumption can lower your company’s taxable income when inventory prices are rising.
Assume you sell an item for $40, and you have three of them in your inventory, purchased in the following order:
Oldest Purchase: $30
Second Purchase: $31
Most Recent Purchase: $32
If you follow the FIFO method, your taxable income would be $40-$30=$10.
If you select LIFO instead, your taxable income would be $40-$32=$8.
By choosing LIFO here in the face of inventory inflation, you’ve lowered your taxable income by 20%! This explains why LIFO has historically been a particularly favored practice among retailers that tend to carry a lot of inventory.
A bit of accounting trivia for you: business owners in the U.S. can take a moment to appreciate the fact that we’re the only country that still allows LIFO accounting. The practice is not permitted under International Financial Reporting Standards (IFRS).
Parting Thoughts
Generally speaking, business owners can decide to put in a new accounting method for inventory during any tax year. You are not required to stick with your new choice forever; in fact, you can elect to revoke it in the future. However, in that case, the business owner would have to wait for five years before they could opt back into LIFO again. That restriction is placed to prevent frequent bouncing back and forth between inventory accounting methods.
Businesses with highly volatile inventories are typically not good candidates for using LIFO (unless they can pool those inventories with less volatile items to balance things out). On the other hand, profitable businesses with significant inventory that is subject to rising inflation may have an opportunity to save some money on taxes.
If you’d like to put yourself in the most advantageous tax position in a rising-inflation world, work with a financial partner who has expertise in working with small businesses. Reach out to the team at TreMonte to discuss how a review of your inventory accounting procedures could save you money come tax time.