LIFO PROJECTIONS

LIFO PROJECTIONS :

The amount of the annual LIFO expense (increase in LIFO reserve compared to the prior year LIFO reserve balance) is often significant, so many companies attempt to estimate this expense in order to book a LIFO expense amount during the year.

For companies using retail LIFO, changes in cost complements from one year to the next also affects the amount of the change in the LIFO reserve.

The amount of the current year LIFO expense or income is determined by two separate components, the LIFO inflation effect and the LIFO layer erosion effect. The LIFO inflation effect can always be calculated by multiplying the prior year FIFO balance times the current year LIFO inflation percentage. There will not be a LIFO layer erosion effect if there is no LIFO layer erosion. LIFO layer erosions are avoided when there is a LIFO increment instead of a LIFO decrement. A LIFO increment occurs if the current year inventory at base exceeds the prior year inventory at base and a decrement occurs if the converse is true.

There is a simple way to determine (without making a calculation of the current year inventory at base balance) whether a LIFO decrement is avoided: a LIFO increment occurs (and a decrement is avoided) if the current year end FIFO balance exceeds the prior year end FIFO balance by at least the amount of the current year LIFO inflation effect (prior year FIFO times current year inflation). If there is a LIFO decrement, the amount of the LIFO layer erosion effect is determined by the amount of the decrement and the amount difference between the current year LIFO index and the average of the indexes for the LIFO layers eroded.

A simple example of the calculation of the LIFO inflation effect follows:

2001

Base year (2000) FIFO balance	100,000	Row 1
2001 FIFO balance	104,000	Row 2
2001 inflation rate	3%	Row 3
2001 inflation effect	3,000	row 4=1 x 2
2001 FIFO balance required to avoid layer erosion	103,000	row 5=rows 1 + 4

There is no LIFO layer erosion effect for 2001 because there is no LIFO decrement and there is no LIFO decrement because the $4,000 increase in FIFO balance from the prior year exceeded the $3,000 LIFO inflation effect.

2002

2002 FIFO balance	108,000	Row 6
2002 inflation rate	3%	Row 7
2002 inflation effect	3,120	Row 8=2 x 7
2002 FIFO balance required to avoid layer erosion	107,120	Row 9=2 + 8

There is no LIFO layer erosion effect for 2002 because there is no LIFO decrement and there is no LIFO decrement because the $4,000 increase in FIFO balance from the prior year exceeded the $3,120 LIFO inflation effect.

2003

2003 FIFO balance	110,000	row 10
2003 inflation rate	3%	row 11
2003 inflation effect	3,240	row 12=6 x 11
2003 FIFO balance required to avoid layer erosion	111,240	row 13=6 + 12
2003 layer erosion effect	(46)	row 14
2003 net LIFO expense	3,194	row 15=row 12 + 14

There is a 2003 LIFO layer erosion effect because there is a LIFO decrement. There is a LIFO decrement because the $2,000 increase in FIFO balance from the prior year is less than the $3,240 LIFO inflation effect. The amount of the LIFO layer erosion effect is only $46 because the size of the decrement is small and the index of the 2001 and 2002 layers eroded is not much less than the 2003 index. The 2003 net LIFO expense is $3,194 which the sum of the $3,240 LIFO inflation effect minus the $46 layer erosion effect.

For any year in which there is a LIFO increment, the LIFO expense will be the amount of the LIFO inflation effect regardless of how much the current year end FIFO balance has increased compared to the prior year end. Because of this, the effect the amount of an increase in FIFO balances compared to the prior year has on the current year LIFO expense is only that of preventing a LIFO decrement (if the balance increases by at least the amount of the current year LIFO inflation effect). Any further effect of the LIFO reserve by a higher FIFO balance will only occur in the following year.

Knowing this, unless there is a large LIFO decrement expected for the year (usually caused by a significant decrease in the FIFO inventory balance), the amount of current year LIFO inflation is the primary factor influencing the amount of the current year LIFO expense.

Inventory balances are relevant in making midyear or year end LIFO projections but unless the year end inventory balances will be a lot less than at the prior year end, using the actual prior year end breakdown by CPI or PPI category may produce reasonably accurate LIFO projections.

Companies that use the IPIC method can use the amount of CPI or PPI inflation since the prior year end to make midyear projections of their annual LIFO expense. They can do this using the inventory balances as of midyear month end periods but unless the inventory mix has changed a lot since the prior year end and unless the inventory balance is expected to be a lot less than the prior year end and the decrease in inventory is expected to continue through year end, spending time to break down the inventory by the appropriate CPI or PPI categories probably is not a good investment of time. It is far simpler to use the inventory mix as of the prior year end especially since there is no guarantee the midyear inventory mix will be the same as for the next year end.

USING LIFO-PRO SOFTWARE TO RUN PROJECTIONS:

Companies using the LIFO-PRO software can make IPIC method projections very quickly if they use the FIFO balances by CPI or PPI category schedule used for the actual prior year end calculation. The CPI or PPI inflation a company would normally use are either that reflected in most recent 12 months’ published indexes or the amount of inflation since the last year end. The following steps should be followed for running LIFO PROJECTIONs for a company with a December year end, PPI indexes and a December appropriate month.

Scenario 1-Projection using the latest 12 months ending 7/2007 PPI indexes:

Select the proper data folder from the LIFO-PRO Company Selection menu.
Click on the IPIC Data Input... command button on the Main Menu.
From the IPIC Menu, click on the IPIC Method Settings command button and make sure the current year and prior year appropriate index month settings are both December.
From the IPIC Menu, click on the FIFO $s Input command button & the input file used for the actual 12/2006 year end calculation should load. If not, click on the Load Different File command button and load this file.
If there is a FIFO balances by PPI code Excel file reflecting the actual 12/2006 inventory balances and with 2007 as the row 2 year, click on the Calculate Pool Indexes command button. If there is no 2007 sheet, use the 2006 and change the row 2 year to 2007. Click on No when prompted to save the file. When the calculations are complete, the current year indexes will appear in the column so labeled. Make sure the row under the Totals/ avg. row reads “Inflation rates are Jul 2007 PPI indexes divided by Jul 2006”.

Scenario 2-Projection using the latest 7 months ending 7/2007 PPI indexes:

Select this data folder from the LIFO-PRO Company Selection menu.
Click on the IPIC Data Input... command button on the Main Menu.
From the IPIC Menu, click on the IPIC Method Settings command button. In the IPIC Method Settings screen, change the current year appropriate index setting to July (don’t change the prior year appropriate index month setting of December) and click on the third command button labeled “Exit and use these settings for next calculation but don’t save settings” to temporarily change the month.
Same as scenario 1 step 4 above.
Same as scenario step 5 above. Make sure the row under the Totals/ avg. row reads “Inflation rates are Jul 2007 PPI indexes divided by Dec 2006”.

When we make IPIC method LIFO PROJECTIONs for our clients, we present the inflation period scenarios above along with a third scenario showing the scenario 2 inflation annualized.