Automotive LIFO FAQ

Although it seems contrary to logic, the answer to the question is yes, the reserve can decrease despite increasing inventory levels. The reason is that the key to a LIFO computation is the level of inflation in inventory costs, not the quantity of the inventory. For example:

Assume your business has 100 units in inventory for the first year, and they are equally priced at $10,000. Also, assume inflation for the year is 5%. Each unit would have a LIFO benefit of about 5% of its cost, or $500. The total LIFO reserve for the 100 units is $50,000.

The next year the inventory increases to 110 units (still equally priced at $10,000 each), but this year there is deflation at the rate of 3%. This means that each of the remaining units from the first year (100) has a LIFO benefit of 2% (5% - 3%), or $200. The additional ten units have a negative LIFO benefit of 3% each, or negative $300. This makes the total LIFO reserve for the second year $17,000, a decrease of $33,000, despite the increase in inventory.

Obviously, this is a simple example but it illustrates the principle that inflation (or deflation), not quantity of units, is the most important factor in a LIFO computation.

You must understand that LIFO means last in, first out. In theory, the last item you purchased, at the highest current year price, is the first one sold. In periods of rising inflation, this means that the cost of goods sold is computed from the highest priced items.

There are instances, however, where not all of the items purchased during the current year are sold. The result of this is increased inventory. While LIFO is a benefit when you compare the actual cost of inventory (the price you actually paid for it) to the value of the older inventory you pretend to have in inventory (because you expensed the newer, higher priced items), there is no LIFO benefit in the current year for the part of the inventory which was purchased in the current year because its value for LIFO purposes is the same as its actual cost.

Consider the following example:
Year 1 inventory - 100 items @ $10 each.
Year 2 inventory - 100 items @ $11 each. Purchases for the year - 1,000 items @ $11.
Year 3 Inventory - 200 items @ $12 each. Purchases for the year - 1,000 items @ $12.

The LIFO benefit for year 1 is $0 because the actual cost of the inventory is $1,000 (100 x $10), and the LIFO cost of the inventory is also $1,000 (100 x $10).

In year 2, you can see that the company purchased all its inventory items for $11 each, demonstrating that there was 10% inflation during the year. All of the year's purchases were sold during the year, and the ending inventory was 100 units, again.

The LIFO benefit for year 2 is $100 because the actual cost of the inventory is $1,100 (100 x $11), and the LIFO cost of the inventory is $1,000 (100 x $10).

In year 3, the same number of units were purchased, at an even higher price, but not all the items were sold, leaving an ending inventory of 200 units. Because we are using the principle of last in, first out, we can assume that the inventory that is left is the 100 units with which we began the year (@ $10 each), and an additional 100 units purchased early during the current year (@ $12 each).

The LIFO benefit is computed by comparing the actual cost of the inventory to its LIFO value. Here is the math: actual cost = $2,400 (200 x $12). LIFO cost = $2,200 ((100 x $10) + (100 x $12)).

As you can see, the LIFO benefit on the 100 units considered purchased during the current year is $0 because the same LIFO value is assigned to it as to the actual cost ($12 each). The only benefit which is increased is that which is based on the older 100 units @ $10 each.

Although it seems contrary to logic, the answer to the question is yes, the reserve can increase despite decreasing inventory levels. The reason is that the key to a LIFO computation is the level of inflation in inventory costs, not the quantity of the inventory. For example:

Assume your business has 100 units in inventory for the first year, and they are equally priced at $10,000. Also, assume inflation for the year is 5%. Each unit would have a LIFO benefit of about 5% of its cost, or $500. The total LIFO reserve for the 100 units is $50,000.

The next year the inventory drops to 90 units, and inflation is again 5%. This means that each of the remaining units has a LIFO benefit of 10% (5% + 5%), or $1,000. The total LIFO reserve for the second year is $90,000, an increase of $40,000 despite the drop in inventory. The amount of inflation on the remaining units easily negates the fact that there were fewer units in inventory. Granted, it would have been better if the inventory had remained at 100 units, but it didn't cost the business any of its previously acquired LIFO reserve.

Obviously, this is a simple example but it illustrates the principle that inflation, not quantity of units, is the most important factor in a LIFO computation. You can use the rationale of the example above to determine at what level of inventory and inflation your reserve might begin to decrease. It will probably surprise you to see how low the inventory can drop without decreasing the reserve.