What Is Dollar-Value LIFO?
Dollar-value LIFO is an accounting method used for inventory that follows the last-in-first-out model. Dollar-value LIFO uses this approach with all figures in dollar amounts, rather than in inventory units. It provides a different view of the balance sheet than other accounting methods such as first-in-first-out (FIFO). In an inflationary environment, it can more closely track the dollar value effect of cost of goods sold (COGS) and the resulting effect on net income than counting the inventory items in terms of units.
How Dollar-Value LIFO Works
If inflation and other economic factors (such as supply and demand) were not an issue, dollar-value and non-dollar-value accounting methods would have the same results. However, since costs do change over time, the dollar-value LIFO presents the data in a manner that shows an increased cost of goods sold (COGS) when prices are rising, and a resulting lower net income. When prices are decreasing, dollar-value LIFO will show a decreased COGS and a higher net income. Dollar value LIFO can help reduce a company's taxes (assuming prices are rising), but can also show a lower net income on shareholder reports.
- The LIFO accounting method uses the last-in-first-out model.
- This model is based on the conversion price index calculation.
Understanding the Dollar-Value LIFO Method
The dollar-value LIFO method is based on a calculation of the conversion price index, which is itself based on calculating a comparison of base year-end costs to the dollar value of year-end inventory. The following steps are used to calculate the conversion price index:
- Calculate the extended cost of end-year inventory at base-year prices.
- Calculate the extended cost of end-year inventory at the most recent prices for the goods.
- Divide number two by number one. This should give you a conversion price index that represents the change in the dollar value of the goods since the base year.
This calculation method should be followed, and the results retained, for every year in which a company follows the dollar-value LIFO method of accounting. The conversion index can be used to calculate the LIFO cost layer for each period, but following these steps:
- Calculate any increases in units of inventory for the next reporting period.
- Calculate the extended cost of these new units at base-year prices.
- Multiply the extended amount by the conversion price index to find the cost of the LIFO layer for the next reporting period.
Why Use the Dollar-Value LIFO Method?
Dollar-value LIFO places all goods into pools, measured in terms of total dollar value, and all decreases or increases to those pools are measured in terms of the total dollar value of the pool. The dollar-value LIFO approach allows companies to place a larger number of goods into a single pool, rather than being restricted to, for example, placing only substantially similar items into a pool, as in the specific goods pooled LIFO method.
Companies that use the dollar-value LIFO method are those that both maintain a large number of products, and expect that product mix to change substantially in the future. The dollar-value LIFO method allows companies to avoid calculating individual price layers for each item of inventory. Instead, they can calculate layers for each pool of inventory. However, at a certain point, this is no longer cost-effective, so it’s vital to ensure that pools are not being created unnecessarily.