7.11 Dollar Value LIFO Notes

Dollar Value LIFO

  • A variation of LIFO (Last-In, First-Out) inventory costing method.
  • Commonly used by mid-sized companies.
  • Helps overcome the issue of LIFO liquidation.

Grouping Goods

  • Goods that are alike are grouped into pools.
  • This is instead of recording them individually as with the specific goods method.
  • Increases in quantities of one good can offset decreases in another within the same pool.
  • Reduces the likelihood of LIFO liquidation.
  • LIFO liquidation happens when you sell more than you have purchased in a period.

Measurement

  • Increases and decreases in inventory are measured by total dollar value.
  • A specific price index adjusts the current year cost of inventory to the base year cost.
  • Price indices can come from published external sources or be computed internally.

Computation Steps

  1. Compute quantity of inventory at current year dollars.
  2. Divide the current year cost by the price index to get ending inventory at base year cost.
    • \text{Ending Inventory at Base Year Cost} = \frac{\text{Current Year Cost}}{\text{Price Index}}
    • This allows for year-to-year comparisons, removing effects of inflation.
  3. Split the base year cost into layers depending on the year items were acquired.
  4. Multiply each layer by the price index in the year of acquisition to get ending inventory at dollar value LIFO cost.

Inventory Changes

  • If inventory increases, a new layer is formed at the current year cost.
  • If inventory decreases, reduce the amount from the newest layer of inventory (LIFO sequence).
  • Once an inventory layer has been eliminated, it cannot be reconstructed.

Total Cost

  • Total cost of inventory is the sum of all layers.
  • Each layer is valued at the cost in the year the layer was added.

Analogy: Wedding Cake

  • Helpful way to understand dollar value LIFO.
  • Increase in inventory: Add a layer (bake more).
  • Decrease in inventory: Eat a layer (always from the top).
  • Cannot reconstruct a layer once it's gone.

Example: Desert Company

  • Began business in 2017 and uses dollar value LIFO.
  • Calculate ending inventory balance for the year 2021.

2017

  • Ending inventory: $70,000 (in 2017 dollars).
  • Base year, so price index = 1.
  • Inventory at base year cost: $70,000.

2018

  • Ending inventory: $90,300 (in 2018 dollars).
  • Divide by price index to get to base year dollars.
    • \frac{90300}{1.05} = 86000
  • Inventory at base year cost: $86,000.
  • Change in inventory balance: $86,000 - $70,000 = $16,000 (increase).
  • Add a layer to the cake.
    • Base layer: $70,000.
    • New layer: $16,000 * 1.05 = $16,800.
  • Total ending inventory: $70,000 + $16,800 = $86,800.

2019

  • Inventory in 2019 dollars: $90,120.
  • Divide by price index to get to base year cost.
    • \frac{90120}{1.1} = 82000
  • Inventory at base year cost: $82,000.
  • Change in inventory: $86,000 to $82,000 (decrease of $4,000).
  • Eat some cake (decrease that top layer).
  • Decrease top layer by $4,000 (from $16,000 to $12,000).
  • Base layer: $70,000.
  • New layer: $12,000 * 1.05 = $12,600.
  • Total ending inventory: $70,000 + $12,600 = $82,600.

2020

  • Inventory in 2020 dollars: $105,600.
  • Divide by price index to get to base year cost.
    • \frac{105600}{1.2} = 88000
  • Inventory at base year cost: $88,000.
  • Change in inventory: $82,000 to $88,000 (increase of $6,000).
  • Base layer: $70,000.
  • Middle layer: $12,000 * 1.05 = $12,600.
  • New layer: $6,000 * 1.2 = $7,200.
  • Total ending inventory: $70,000 + $12,600 + $7,200 = $89,800.

2021

  • Inventory in 2021 dollars: $100,875.
  • Divide by price index to get to base year cost.
    • \frac{100875}{1.2609375}= 80000
  • Inventory at base year cost: $80,000.
  • Change in inventory: $88,000 to $80,000 (decrease of $8,000).
  • Eat the cake (decrease layers).
  • Top layer: 6,000. We're going to eat that entire layer.
  • Decrease middle layer by the reamining 2,000, leaving 10,000 in the middle layer.
  • Base layer: $70,000.
  • Middle layer: $10,000 * 1.05 = $10,500.
  • Total ending inventory: $70,000 + $10,500 = $80,500.

Summary of Dollar Value LIFO Problems

  1. Start with ending inventory in year-end dollars.
  2. Convert to base year dollars using the price index.
  3. Find the change in inventory from the previous year.
  4. Increase in inventory: Add a layer at the current year's price index.
  5. Decrease in inventory: Reduce a layer.
  6. Once a layer is completely reduced, it cannot be reconstructed.