Navigating Finances in 2023: Why LIFO Should Be on Your Radar

In periods of inflation, the Last-In, First-Out (LIFO) inventory method can offer distinct tax advantages to manufacturers and distributors, primarily due to its impact on the cost of goods sold (COGS).

LIFO assumes that the most recently acquired inventory is the first to be sold. In an inflationary environment, this can be beneficial for businesses as it matches the higher costs associated with more recently purchased goods against current revenue. As a result, LIFO tends to reflect a higher COGS compared to methods like First-In, First-Out (FIFO), which assumes that the oldest inventory is sold first. A higher COGS means lower taxable income and, therefore, lower income tax liabilities. Lower income tax payments provide a distinct cash flow advantage for the company. This can be particularly valuable for manufacturers or distributors facing the challenge of rising prices for their inventory. In times of inflation, these businesses may face increased costs for raw materials and goods. LIFO allows them to offset these rising costs against revenue, providing a more accurate representation of their profitability in the current economic climate. This can be crucial for maintaining financial stability and ensuring that the business remains competitive.

Many manufacturers and distributors have elected to use the LIFO inventory method in recent years, primarily because inflation has been very high. In both 2021 and 2022, the Consumer Price Index (CPI) was approximately 7%, which made first-time LIFO elections extremely attractive to many companies. For most companies on LIFO, the long-term historical average annual inflation rates vary between 1% and 4%. Consequently, companies electing LIFO over the last two years have obtained multiple years’ worth of tax benefits in the initial year. CPI for 2023 has been more than 3%, giving companies not currently on LIFO yet another opportunity to elect and realize the benefits of LIFO.

Many inventory classifications are experiencing inflation rates much higher than CPI in 2023. Some of these are petroleum products, meats, poultry and fish, processed fruits and vegetables, tobacco products, sugar and confectionery, and concrete products, to name a few. Companies with inventories of these types are prime candidates to elect LIFO in 2023.

An easy way to approximate the benefits of electing LIFO is to multiply the prior year-ending inventory balance by the current year’s inflation rate. For example, a company with a prior year inventory balance of $5,000,000 in a year of 4% inflation would potentially create a LIFO expense of $200,000 ($5,000,000 * 4%.) This LIFO expense would reduce taxable income and create an initial LIFO reserve of the same amount. If the company had a combined federal and state tax rate of 25%, this would result in a first-year tax savings of approximately $50,000.

An additional benefit of electing LIFO during a period of high inflation is that it reduces the chance of materially recapturing the LIFO reserve in future periods. It is important to note that LIFO is subject to specific accounting regulations, and its application requires consistency. Once a company adopts the LIFO method, it must consistently use this method unless there is a valid reason for change. This consistency ensures comparability in financial reporting over time.

Manufacturers and distributors interested in electing LIFO, especially those whose year ends in December, should begin planning now. These taxpayers must file Form 970 with their timely filed return.

In conclusion, the true benefit of the LIFO inventory method in a period of inflation lies in its ability to align costs with revenue, leading to lower reported profits, reduced income tax liabilities, and improved cash flow and 2023 looks to be another year that many companies may benefit by electing LIFO. However, manufacturers and distributors must carefully consider and analyze the potential benefits and understand the necessity of adhering to accounting regulations to ensure the method’s effectiveness and compliance.

HBK Manufacturing Solutions has extensive experience analyzing and assisting companies with LIFO elections. If you would like to explore the possibility of electing LIFO, please contact HBK Manufacturing Solutions at manufacturing@hbkcpa.com or 330-758-8613.