The dollar-value LIFO retail method is an inventory valuation technique used mainly by retailers for their merchandise inventory. It combines two ideas: the retail inventory method, which values inventory from its selling prices and a cost-to-retail ratio, and dollar-value LIFO, which applies last in, first out (LIFO) to pools of goods measured in dollars rather than physical units. A price index removes the effect of price changes so that only real increases or decreases in inventory create or reduce LIFO layers.
The method lets a store with thousands of changing products achieve a LIFO cost flow without tracking individual items. It is accepted for financial reporting under US GAAP and by the Internal Revenue Service for federal income tax purposes. As with other LIFO methods, a business that uses it for tax must generally also use LIFO in its financial statements, under the LIFO conformity rule.
The dollar-value LIFO retail method in plain terms
A department store sells everything from socks to sofas, and its products change every season. Counting the cost of each item would be impossible, but the store always knows what its shelves are worth at the prices on the tags. The retail method turns that tag value into cost using the store's usual markup.
The LIFO part adds a twist. If prices rose ten percent this year, the shelves look ten percent fuller in dollars even if the store holds the same goods. So the store strips out inflation with a price index first, to see whether it really holds more stock. Only the genuine extra stock is added as a new layer, priced at this year's costs, while older layers keep their older, lower costs.
How the method works
- Determine ending inventory at current retail prices, from records or a physical count.
- Convert it to base-year retail by dividing by the current year's price index.
- Compare with the prior year's base-year retail amount. An increase is a new layer; a decrease removes layers, most recent first.
- Convert each layer back to the retail prices of the year it was added, using that year's index.
- Convert each layer to cost using the cost-to-retail ratio of the year it was added. Under LIFO retail, this ratio uses current-year purchases only and includes both markups and markdowns.
Worked example
A retailer adopts the method in Year 1, when ending inventory at retail is $100,000, the price index is 1.00 and the cost-to-retail ratio is 60 percent. The base layer costs $60,000.
In Year 2, ending inventory at current retail is $132,000 and the index is 1.10. In base-year terms this is $120,000, a real increase of $20,000. The new layer is restated at Year 2 prices, $20,000 times 1.10, or $22,000, and converted at Year 2's cost ratio of 62 percent to $13,640. Ending inventory at LIFO cost is $73,640.
In Year 3, ending inventory at current retail is $126,000 and the index is 1.20, so base-year retail is $105,000. Real inventory fell by $15,000, which comes out of the Year 2 layer, leaving $5,000. That remaining layer is worth $5,000 times 1.10 times 62 percent, or $3,410, so ending inventory is $63,410. The reduction is a liquidation of a LIFO layer; older, cheaper costs flow into cost of goods sold.
Price indexes
The accuracy of the method depends on the index. Large retailers may build their own internal index by pricing a sample of goods at base-year and current prices. Many others rely on published government price indexes, which US tax rules permit under specified conditions, rather than the broad consumer price index itself. The index used must be applied consistently from year to year.
Advantages and drawbacks
In a period of inflation, the method matches recent, higher costs against sales, which lowers reported profit and, for tax purposes, defers income tax. Pooling goods by dollar value also reduces the risk of accidental layer liquidations when individual products are replaced by new ones.
The drawbacks are those of LIFO generally. Balance sheet inventory can be far below current cost, which is why companies disclose the LIFO reserve, the difference from FIFO or current cost. The method is complex, needs reliable indexes and records of markups and markdowns, and is not permitted under IFRS. Since 2016, US GAAP has measured FIFO and average-cost inventory at the lower of cost and net realizable value, but inventory measured using LIFO or the retail inventory method continues to follow the older lower-of-cost-or-market rule.