IPIC LIFO Overview

The Inventory Price Index Computation (IPIC) method allows taxpayers to use published external indexes to calculate inflation for the purpose of valuing LIFO inventories. The IPIC method was first authorized by the IRS in 1982 in order to provide an approved method that would simplify LIFO calculations & make LIFO more accessible to smaller taxpayers.

A taxpayer using the IPIC method must assign appropriate Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) or Producer Price Index (PPI) categories to inventory items in order to measure the amount of inflation used for LIFO calculations. Manufacturers & wholesalers are required to use PPI while retailers are allowed to use either CPI or PPI. These indexes are used to calculate category inflation indexes. Category inflation indexes are then weighted by inventory dollars (taxpayers using the optional 10% Method must also use BLS weights) to compute a current year inflation index for each pool. Taxpayers using the IPIC method can use the IPIC pooling method for which pools are created using broad CPI or PPI major groups (and not the individual categories). Use of the IPIC pooling method is not mandatory & other authorized pooing methods may be used. The pool cumulative indexes are used to deflate the inventory current-year cost (FIFO or average cost) to base period prices, which is then compared to the prior year’s inventory valued at base period prices. If the current year’s inventory at base is greater than the previous year’s inventory at base, the increment is multiplied by the pool cumulative inflation index to price the LIFO layer. If the current year’s inventory at base is less than the previous year’s inventory at base, the decrement erodes a previous layer (or multiple layers) & is priced using the index(es) originally used to price the layer(s).

On May 19, 2000 the IRS published proposed changes to the IPIC LIFO Regulations under Treasury Regulations Section 1.472-8(e)(3) & solicited comments regarding the proposed regulations. A public hearing was held in Washington, D.C. on September 15, 2000 on the proposed regulations.

On January 8, 2002 the IRS issued final Regulations § 1.472-8(e)(3) in Treasury Decision 8976. The following is a synopsis of most important changes encompassed in the new Regs:

• 100% inflation – All taxpayers may now use 100% of inflation calculated using IPIC for tax purposes. The elimination of the”20% haircut” should encourage more widespread use of IPIC.
• Use of 10% categories & BLS Weights – The use of this method was mandatory under the old Regulations but is now optional. Taxpayers now have the option of using only their actual FIFO inventory balances to calculate weighted average pool indexes. Having this option provides for simplification of pool index calculations for companies that can sort their inventories into the Most Detailed CPI or PPI categories the new Regulations require & taxpayers for whom assigning BLS categories to their inventory in greater detail would be burdensome or impossible can still use the IPIC method.
• Elimination of requirement to use cost complements – The requirement to make stage of production index conversions using gross margin percentages, (i.e., convert the CPI retail selling price indexes to a cost basis for companies not using Retail LIFO) was well intentioned by the IRS but created numerous problems in practical application. This change is greatly welcomed by any company to whom this applied under the old Regulations.
• Use of CPI categories by retailers – Many retailers using CPI categories who do not use the Retail Inventory Method would have been forced to use PPI categories under the proposed Regulations. Under the final new Regulations, these companies can still use CPI categories & can do so without making cost complement adjustments that the old Regulations required. The use of PPI categories for these retailers would have been burdensome because the CPI categories correlate much better with their inventory mix than the PPI categories.
• Use of Weighted Harmonic mean – Since the great majority of taxpayers have used the Weighted Arithmetic Mean in the past, this will require a change for most taxpayers. The new method always produces less inflation or greater deflation than using the Weighted Arithmetic Mean method. The decrease in LIFO benefits this produces is relatively small for most taxpayers (much less compared to using 100% vs. 80% of inflation), though this difference will be significant for some. A likely source of confusion will be the requirement that the Weighted Harmonic Mean is to be used only for pool index FIFO dollars weighting calculations & not for the Category Index BLS weighting calculations required for calculations using the 10 percent categories & BLS Weights method.
• Change in definition of 10% categories – Most taxpayers who continue to use the 10 percent categories & BLS Weights method under the new Regulations will need to sort their inventories in greater detail. This is because the new Regulations definition of the 10% categories threshold is the sum of each pool’s FIFO inventory values. The old Regulations specified that the denominator for the 10% categories was “total inventory value” which almost all taxpayers interpreted to mean either the sum of their FIFO inventory values, the sum of their FIFO inventory values on LIFO, or the sum of their FIFO inventory values for which the IPIC method was used. A small minority of taxpayers used the sum of each pool’s FIFO inventory values as the 10% categories threshold. Not only does the new definition of 10% categories require more detailed BLS category assignment, it makes this process more complicated because instead of there being one threshold amount for all inventories, there will now be as many different 10% thresholds as there are pools.

1. BLS Category Assignment – all items on LIFO are required to be assigned a Consumer or Producer Price Index category. Some companies assign these categories by product hierarchy (category, class, departments, groups, lines etc.) to preclude doing so on an item-by-item basis.
2. Inflation Index Calculation – front-end exercise to compute the following input variables required to complete the back end of the LIFO calculation:
   1. Current-year cost balance (CYC) – total average-cost or FIFO on LIFO balance.
   2. Current year inflation index – involves comparing current vs. prior period BLS price indexes. The detailed IPIC LIFO inflation index steps are described later in this guide.

LIFO Reserve Calculation – computation of increments/decrements, LIFO inventory, reserve & expense (income) values (detailed steps shown in LIFO Inventory Training Basics & Audit Guide

Use of the IPIC pooling method is not mandatory for companies using the IPIC method. The following are alternative pooling methods provided by the IRS:

• By line, type, or class of goods – Wholesalers & retailers can use separate pools for each major line, type, or class of goods. Customary business practices for a trade or industry determine what constitutes a major line, type, or class of goods. Authorized by Regs. § 1.472-8(c).
• Natural business unit pooling – A pooling method authorized by Regs. § 1.472-8(b)(1) for manufacturers & processors. A Natural Business Unit (NBU) includes all inventory items related to a product line or related product lines, including raw materials, work in process, & finished goods. Distinct business units require separate pools. A natural business unit may be defined based on divisions established by internal management, separate production facilities or processes, or separate financial records. Manufacturers that also purchase goods for resale are required by the IRS in Rev. Rul. 79-290, Rev. Rul. 82-192 & PLR 8842061 to use separate pools for manufactured goods & goods purchased for resale.
• Multiple pools – Companies may group together similar items in a pool even if they are not all within the same natural business unit. Grouping goods together to form a pool may be based on such factors as the similarity or interchangeability of raw materials, the similarity of the production processes, the similarity of the use of the products, standard practices within the trade or industry, & whether the goods are treated similarly by a company’s management. Authorized by Regs. § 1.472-8(b)(3)(i).
• Raw materials content – Goods with similar raw materials, including the raw material content of work-in-process & finished goods may be grouped together to form a pool for manufacturers or processors. Raw materials that are not similar in nature may not be grouped together in the same pool even if they are processed or manufactured into the same finished product. Authorized by Regs. § 1.472-8(b)(3)(ii).

To maximize tax savings, companies should use as few pools as possible because this will reduce the likelihood of decrements because decreases in inventory values will be offset by increases in others for groupings of inventory items included in the same pool. Decrements result in lower-cost goods being included in cost of goods sold which increases taxable income.

Unlike for the PPI, the BLS does not introduce new CPI categories & discontinue old ones every three months. The BLS restructured the entire CPI series beginning in January 1998, though & similar restructurings may occur in the future.

The 2002 New Regs specified that LIFO taxpayers using Consumer Price Indexes & the IPIC Pooling Method should use the CPI major expenditure categories (i.e., major groups) as their IPIC pools. These Major Groups are not defined in the Regs. but appear to be these:

10 Percent Method vs. Most-Detailed Categories Method

The IRS Regs. describe an optional method that taxpayers may use for assigning inventory items to BLS categories & for determining category inflation indexes called the 10 Percent method. The 10 Percent method is intended to simplify the use of the IPIC method by allowing taxpayers to sort their inventories into fewer, less-detailed categories than are required for the alternative Most-Detailed Categories method. While the 10 Percent method makes the task of assigning inventory to BLS categories less burdensome, there is a trade-off involved because the math required to calculate category inflation indexes is more complex. The Regs. require taxpayers electing to use the 10 Percent method to first weight inflation indexes with BLS weights, then with inventory dollars. Taxpayers using the Most-Detailed Categories method only use inventory dollars to weight inflation indexes.

Taxpayers are allowed to select either the 10 Percent method or the Most-Detailed Categories method for assigning BLS categories to their inventory dollars & calculating pool indexes. Many retailers still use the retail inventory method & do not have inventory systems that allow them to track the actual costs of specific goods at their stores. Requiring taxpayers to sort inventory into most-detailed categories, therefore, would have been a formidable burden for most retailers. The real value of the 10 Percent method is that it allows taxpayers carrying many different inventory items to reduce the burden of assigning all of their IPIC LIFO inventories to BLS categories.

LIFO-PRO, Inc. has performed numerous pro-forma calculations comparing the results of the two methods & over time there is little difference. As a practical matter, taxpayers should consider the following when deciding which index calculation method to use:

1. Time & cost associated with assigning less (10% method categories) or more-detailed categories
2. Whether they have software that automates the 10 Percent method pool index calculations

Most-Detailed Categories Method

Regs. § 1.472-8(e)(3)(iii)(C)(1) states that taxpayers using the Most-Detailed Categories method “must assign each item in a dollar-value pool to the most-detailed BLS category of the selected BLS table that contains that item.” This simply means that all inventory items must be assigned to each most-detailed category of the BLS table selected by the taxpayer (CPI or PPI) for items that are present in inventory. To think of it more simplify, BLS category assignment under this method must be performed on an item by item basis.

BLS Category Assignment Considerations

• Companies that sort their inventory balances using 10% categories are required to use the 10 Percent method
• Companies that sort their inventory by most-detailed CPI or PPI categories may also use BLS Weights & 10% rollups in performing their pool index calculations
• Taxpayers may switch from one IPIC pool index calculation method to the other after the initial adoption of the IPIC Method, but this requires filing a Form 3115
• Once this change in this method is made, the taxpayer cannot change to the alternative method for a five year period

10 Percent Method BLS Category Assignment

IPIC Regs. § 1.472-8(e)(3)(iii)(C)(2) describe a three-step process to assign inventory items to BLS categories when using the 10 Percent method:

1. First, when the current-year inventory value of a specific item is 10% or more of the pool total, that item must be assigned to the most-detailed category that includes that item.
2. Second, for items not assigned to BLS categories in the first step, the taxpayer must examine successively less-detailed categories to determine whether the combined value of the categories included within them is 10% or greater, a process known as “rolling up,” or performing “10% roll-ups.” This step must be repeated until all items in the pool have been rolled up to a less-detailed category level where the 10% threshold is met. The highest level that items can be rolled up to is the General Category level.
3. Third, items not assigned after the previous two steps (i.e., due to the hierarchical structure of BLS categories) must be identified & segregated.

In addition, Regs. § 1.472-8(e)(3)(iii)(D)(5) defines a less-detailed category (in the context of determining a category inflation index) as a BLS category that:

A) subsumes (i.e., includes, or incorporates in a more comprehensive category) two or more BLS categories;

B) does not have a single assigned item whose current-year cost is 10% or more of the current-year cost of all items in the dollar-value pool;

C) has at least one item in at least one of the subsumed BLS categories; and

D) has at least one subsumed BLS category that either does not have any assigned items or is a separate 10% BLS category.

Based on these Regs. sections, three types of index categories may be identified:

• Most-Detailed 10% Categories – Any most-detailed category with a FIFO balance greater than 10% of the pool sum of FIFO balances is an index category by itself. BLS weights will not be applied to these categories when performing index calculations; only actual inventory dollar weighting will be used. Also, these categories are excluded from the roll-ups used to create Other 10% Categories. Most-Detailed 10% Categories are those that are assigned inventory dollars in Step 1 of Regs. § 1.472-8(e)(3)(iii)(C)(2).
• Other 10% Categories – These categories, which are always less-detailed categories, are those with aggregated FIFO balances (for the categories they include) that exceed 10% of the pool sum of FIFO balances. BLS weighting is used for Other 10% Categories in category index calculations. Other 10% Categories are those that are assigned inventory dollars in Step 2 of Regs. § 1.472-8(e)(3)(iii)(C)(2).
• Remaining Categories Grouping – This is the aggregation of all categories which remain after the procedures described above. Due to the hierarchical structure of the BLS categories it is possible that some categories may not be rolled up so that they are included in an Other 10% Category. There might not be any Remaining categories for a given pool. BLS weighting is used for remaining categories in category index calculations. Remaining categories are those that are identified & segregated in Step 3 of Regs. § 1.472-8(e)(3)(iii)(C)(2).

Category Representation

A taxpayer that uses the 10 Percent method does not need to break down their inventory dollars to the level of greatest detail but it is necessary to account for whether the most-detailed categories actually have items present in inventory. The reason for this is that only the indexes & BLS weights of categories actually present are used for pool index calculations. If category representation is not performed, the BLS weights for items present within a company’s product mix may not be included in the LIFO calculation. Similarly, failing to perform category representation may cause BLS the BLS weights for items not present within a company’s product mix to be included in the LIFO calculation. For this reason alone, it’s highly recommended to use software when using the 10 Percent method.

10 Percent Categories Determination

Assigning inventory dollars to BLS categories is a data-gathering process that precedes pool index calculations. The mechanics of the 10 Percent method pool index calculations determines the appropriate BLS category assignments when using the 10% method. This means that changes in the inventory mix or pooling may require assigning different BLS categories if using the 10% method.

Examples

Example 1 – CPI: This company uses CPI & does not have fuels on LIFO. The following CPI Major Groups each include at least 5% of the total FIFO inventory balances:

BLS IPIC CPI Pools:

*The sum of the other six Major Groups’ FIFO inventory balances is greater than 5% of total inventory, so they will be combined in a third All other goods pool.

Pool 1 Food & Beverages BLS CPI 10% Categories

Pool 2 Other Goods & Services BLS 10% Categories

Pool 3 All Other Goods 10% Categories:

Example 2 – PPI

This company uses PPI & has fuels on LIFO. The following PPI 2-digit codes each include at least 5% of the total FIFO inventory balances:

BLS IPIC Pools:

The sum of the other 11 PPI 2-digit codes inventory balances is less than 5% of total inventory balances so they will be included with the largest pool.

Pool 1 Processed Foods & Feeds (02) & All Other 10% Categories

 025503 Candy & nuts, 02620609 Noncarbonated soft drinks, 026207 Bottled carbonated soft drinks, & 02890172 Chips (potato, corn, etc.) will each probably include at least 10% of Pool 1’s inventory balances. 0261 Alcoholic beverages includes canned & bottled beer & other malt beverages, wine, & distilled spirits. If any of those categories of alcoholic beverages is likely to include 10% of the pool total, then more detailed categories should be used for BLS category assignment to inventory items. 02 Processed foods & feeds can be used for BLS category assignment to inventory items that are all other food & beverage categories because the pool’s 10% threshold is not likely to be met by aggregating (“rolling up”) inventory balances at any four-digit or three-digit level included in the 02 PPI 2-digit code. Similarly, all other inventory in Pool 1 can be sorted at the 2-digit level because no other PPI 2-digit code will likely include 10% or more of the pool total. In fact, some of these PPI 2-digit codes will probably not have any inventory balances—10 Metal & metal products & 13 Nonmetallic mineral products, for example.

Pool 2 Fuels & Related Products & Power (05) 10% Categories

Each of these are likely to include 10% of the pool total.

Pool 3 Chemicals & Allied Products (06) 10% Categories

It may be necessary to use one or more 8-digit category included in 0638 for BLS category assignment to inventory items. For example, if 063802 Central nervous system, 063805 Respiratory system, & 063807 Vitamins, nutrients & hematinic preparations were each more than 10% of the pool total then those would be used as BLS categories & all other pharmaceutical preparations would be assigned into 0638.

Pool 4 Miscellaneous Products (15) 10% Categories

152101 Cigarettes & 15250101 Other tobacco products are most detailed categories that are likely to include 10% of the pool total. All other goods in this pool can be can be assigned 2-digit BLS PPI codes.