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LIFO cost may be computed using either the specific-goods method or the dollar-value method. The dollar-value approach is more common and encompasses several acceptable computational techniques.

3.2.1 Specific-goods LIFO

Under the specific-goods method, calculations are based on physical units and require separate computations for similar products or items in inventory. Therefore, this method is generally used only in situations involving a limited number of inventory items or basic commodities that can be measured in terms of a common denominator, such as pounds, gallons, or feet. The quantity of each type of item in ending inventory is compared to the quantity of similar items in beginning inventory. Increments (i.e., the layer or increase in inventory quantities generated during the current period) are priced at current-year cost and decrements (i.e., a decrease in quantities often referred to as liquidations or erosions) are included in cost of sales at the unit cost of each respective layer, beginning with the most recent.
Since a separate calculation is made for each type of item, the specific-goods approach may result in numerous liquidations if the quantities of individual inventory items fluctuate from year to year (even though the total number of inventory items remains constant). An increase in the quantity of one item does not offset a decrease in another unless the two items are similar enough to be considered a single specific good (e.g., gasoline of different octane ratings). The specific-goods method, therefore, requires that records be maintained of the quantities and costs of each inventory item for each year in which an increment occurred.

3.2.2 Dollar-value LIFO

Under dollar-value LIFO, inventory quantities are measured in terms of “base-year” dollar value rather than on physical units. Inventory is divided into “pools” of similar items and quantities for each pool are determined based on the cost of items as of a specific date (the base year). The base year is typically the beginning of the year in which LIFO is elected. Increments and decrements are determined by comparing the ending inventory at its base-year cost with the opening inventory at base-year cost. Increments are valued at current-year cost. Decrements are removed from inventory at historical LIFO cost for each respective layer on a LIFO basis. Since a dollar-value pool contains a broad mix of inventory items, new items may be introduced and old items may disappear without causing any decrements in the pool.
The key element in any application of dollar-value LIFO is the calculation of an inflation index, which is needed to relate current costs in inventory to base year costs. The following methods can be used to calculate the inflation index. Dollar-value LIFO — double extension

Under the double-extension method, total base-year cost of ending inventory (for computing increments and decrements) is determined by extending each item at its base-year cost. Each item is also extended at current-year cost to develop an index of current-year cost to base-year cost. That cumulative index is applied to any increment (increase in the quantity of base-year dollars in year-end inventory) in order to value the increment (layer) at current-year cost. Dollar-value LIFO — index method

The index method permits the double extension of a sample of products to represent the inventory population. Under the index method, the inventory at current-year cost is converted to base-year cost using an index developed from a sample of inventory. The index may be computed by double-extending a representative portion of the inventory in a pool or by using sound and consistent statistical methods. Once the base-year cost has been determined, increments are measured in the same manner as under the double-extension method. For tax LIFO calculations, the IRS has historically concluded that the calculation of the index should include all inventory segments. For example, the IRS may object to a sampling method that excludes new inventory items from the index calculation. Dollar-value LIFO — link-chain method

Under the link-chain method, an index is computed that measures the price-level change for the current year based on the ratio of the year-end inventory at current-year costs to the year-end inventory at prior-year costs. The current-year index may be computed by extending 100% of the items or a sample of items in inventory. By multiplying the current-year index by the prior cumulative index, a new cumulative index is developed that, when applied to the closing inventory at current-year prices, results in the calculation of the closing inventory at base-year cost. The closing inventory at base-year cost is then compared to opening inventory at base-year cost to determine whether an increment or decrement has occurred. For tax purposes, the IRS regulations limit the availability of the link-chain method to companies that can demonstrate that, because of frequent changes in inventory items, the double-extension or index method is not practical. As with the index method, the IRS has historically concluded that all inventory segments should be included in the calculation of the index (e.g., new items cannot be excluded). Dollar-value LIFO — published indices

Instead of computing their own indices, retail department stores may use the Department Store Inventory Price Indices prepared monthly by the Bureau of Labor Statistics. Under this method, a single index is used for each department. In addition, specialty stores are allowed to use the Department Store Inventory Price Indices if they have a fairly broad variety of items comparable to a department in a department store. Simplified LIFO

IRS Regulations permit the use of a simplified LIFO inventory method for tax purposes. Entities can elect to use a separate pool for each major category of inventory items and use a single published index for each pool.
Under this simplified approach, businesses can elect to establish LIFO pools using special rules provided under the Inventory Price Index Computation (IPIC) method. Under the IPIC method, the computations of inflation are based on externally published index reports (e.g., the Consumer Price Index Detailed Report or the Producer Price Index Detailed Report).
Given that IPIC is determined using externally-published indices that are general in nature, this method generally does not reflect a specific entity’s inventory costing unique to its individual circumstances, meaning it does not consider, for example, the specific entity’s vendor rebate and allowance programs, sourcing decisions, or price fluctuations based on inventory quantity discounts. In order for the application of IPIC to be considered acceptable for financial reporting purposes, the results of applying IPIC would need to be reviewed annually to ensure that they are consistent with the entity’s actual cost experience. Therefore, much if not all of the potential administrative relief of using a simplified method for tax purposes would be unlikely to be realized. Except in circumstances when it can be demonstrated that the use of IPIC approximates the financial reporting results had an acceptable LIFO method for valuing inventory been used, we do not believe the use of IPIC or another simplified index method is appropriate.

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