Question

Provide a high-level description of dollar value LIFO and discuss why many firms use it.

Answer 1

Meaning of Dollar Value- LIFO Method

The dollar-value LIFO method is a variation on the last in, first out cost layering concept. In essence, the method aggregates cost information for large amounts of inventory, so that individual cost layers do not need to be compiled for each item of inventory. Instead, layers are compiled for pools of inventory items. Under the dollar-value LIFO method, the basic approach is to calculate a conversion price index that is based on a comparison of the year-end inventory to the base year cost. The focus in this calculation is on dollar amounts, rather than units of inventory.

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.

Method of Calculation:

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:

1. Calculate the extended cost of end-year inventory at base-year prices.
2. Calculate the extended cost of end-year inventory at the most recent prices for the goods.
3. 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:

1. Calculate any increases in units of inventory for the next reporting period.
2. Calculate the extended cost of these new units at base-year prices.
3. Multiply the extended amount by the conversion price index to find the cost of the LIFO layer for the next reporting period.

Why many firms used this method?

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.

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.