LIFO planning is more of a challenge for companies with inventories that experience large fluctuations in prices. Manufacturers that purchase commodity type raw materials for which the prices are volatile are especially prone to big changes in LIFO indexes from year to year particularly if an internal index method is used to measure LIFO inflation. When an internal index method is used, the index for the year should correlate closely to the inflation or deflation for the raw materials. Even if a large portion of the inventories are work-in-process (WIP) and finished goods, the raw materials component of these inventories will probably constitute a large part of the value of these inventories and it would not be unusual for the raw material value of all inventories to be 80% or more of the total inventory value.
It is very common for large companies, including manufacturers that use internal indexes for book LIFO, to use the IPIC LIFO method for tax LIFO for which PPI indexes are the LIFO inflation measurement source. While the long term LIFO inflation for a manufacturer may be about the same for PPI indexes as it is for internal indexes, the tax PPI index LIFO inflation is less likely to be as volatile as the book LIFO internal index inflation. This is because of the way in which PPI IPIC method LIFO inflation is calculated for WIP and finished goods inventories. IRS Reg. Sec. 1.472-8(e)(3)(iii)(C)(1) reads: “…manufacturers and processors must assign each work-in-process (WIP) item to the most-detailed PPI category that includes the finished good into which the item will be manufactured or processed.”
This means that the PPI codes applicable to the finished goods will be used for all WIP and finished goods dollars including the labor and overhead components of WIP and finished goods. The PPI finished goods inflation is usually less volatile than raw material inventory prices. The further along in the stage of production an inventory item is and the closer that item is to being in the hands of the end user of that product, the less likely big price changes are.
This difference in LIFO inflation measurement generally results in less deflation using the IPIC method v. internal indexes when there is significant deflation for raw material prices. We have seen a number of manufacturers benefit from switching to the IPIC method in years in which there was substantial raw materials deflation and the average PPI deflation was a lot less than the internal index deflation for the reasons described above.
When the double-extension method is used instead of the link-chain method to calculate LIFO internal indexes, the likelihood is even greater that the book LIFO indexes will be volatile because changes in the inventory mix cause changes in the LIFO indexes independent of the actual product inflation.