Changing your company's inventory accounting to LIFO (last in, first out) is advantageous during inflationary times.
FIFO, LIFO -- does it matter? You bet it does, especially in inflationary times
Impossible as this may sound, inflation in material, labor, and other costs can actually boost a company's cash flow. All it takes is an accounting sleight of hand. The magic words? FIFO to LIFO. While that may sound like mumbo jumbo, all we're really talking about is changing a business's method of accounting for its inventory costs.
Many accounting issues seem to have little to do with growing and running a business. But this one is different. Inventory accounting -- and the key question of whether a company recognizes inflation when accounting for costs -- has an immediate impact on a company's reported profits, tax payments to Uncle Sam, and, ultimately, its all-important cash flow. In an inflationary economy such as ours, this issue is vital for growing businesses to examine, since most rely on an accounting method that ignores inflation entirely and thus exposes them to unnecessary costs.
Consider the case of Dacor Corp., a Northfield, Ill., manufacturer of scuba-diving equipment. After the company switched to an inflation-sensitive method of accounting for inventory costs in 1983, its cash flow increased on average by 10% annually. And the higher inflation goes, the bigger the bang. Last year's cash-flow increase was close to 25%.
Inflation wasn't always this painless for Dacor. The company, founded back in 1954 by the late Sam Davison -- an ex-marine who had invented an easy-breathing regulator on his kitchen table -- grew to be one of the top names in its field, selling nearly 5,000 items that range from masks and regulators to diving outfits. But Dacor remained small enough to be vulnerable to various types of inflation. By the early 1980s its domestic labor costs were increasing at double-digit rates; meanwhile, the costs of imports -- which added up to about 30% of its product line -- had also been rising, although not as rapidly, thanks to the then-strong dollar.
To Davison and chief financial officer David Goldberg, inflation was just another cost of doing business, albeit a painful and unpredictable one. But Dacor's outside accountants, Miller, Cooper & Co., had other ideas. "They came to me with a plan for us to switch inventory accounting methods -- which some of their other clients had done -- and said it would save taxes, therefore generating more cash," recalls Goldberg, an accountant by training. "Frankly, I was worried that it would turn out to be a gimmick," he confesses, "or an enormous paperwork headache for my staff."
Here's how the proposal worked: Dacor, like most small to midsize businesses, relied on FIFO (first in, first out) accounting for inventory expenses. Put simply, every time Dacor sold a piece of scuba-diving equipment -- which meant it could write off the cost of producing the item against its profits -- the company would look back in its records and write off the cost of producing the oldest item in stock. In an inflationary environment, Dacor's executives were in the worst possible bind: their write-offs were artificially low, thanks to FIFO, but their current expenses were quite high, because prices were rising.
Dacor's outside accountants wanted to switch to the LIFO (last in, first out) method. "That would bring their write-offs in line with current expenses," explains Neal Fisher, the Miller, Cooper partner who now works most closely with the company. "Best of all, it would accomplish the goal of increasing their write-offs -- always desirable, since this would cut their tax bill."
The difference between FIFO and LIFO was clear. If it cost $5 to produce the oldest mask in stock and $10 to produce the newest, Dacor would be able to write off $10 each time it sold a mask under the LIFO method. Under FIFO, only $5 could be written off. It sounded great. But there were plenty of complications -- the kind that worry a financial officer with a small staff and a big payroll to handle each week. "There were all these accounting decisions we would have to make -- and it all sounded very, very complex," Goldberg says, shaking his head.
So he took the proposal to his chief executive officer, whose response was admirably straightforward. "He basically didn't understand it," Goldberg recalls, "but said he didn't need to understand all those obscure accounting details. All he wanted to know was whether it made financial sense for us. If I was convinced that it did, he would do it."
After analyzing some of Miller, Cooper's initial projections, Goldberg was ready to make the leap. His fear of hassles, though, was not out of line. LIFO does require more record keeping than FIFO, especially in the early stages. For companies with large inventories or limited computer capabilities, this can be a problem, and unfortunately, Dacor fit into both categories. But by the end of the first fiscal year, the company found that financial rewards had outweighed the extra paperwork.
The conversion took place in four stages. First, Goldberg and his outside accountants had to come up with the plan that would work best for Dacor. "When you switch to LIFO, you have to make certain accounting choices," explains Fisher. "For example, you have to decide whether you want to group your inventory into categories known as pools or whether you want to account for the cost of each separate item." Accountants also have to decide when to pinpoint those prices: at the beginning of the current year, at the end, or at the yearly average. What you are betting on here is the pattern of inflation, which varies according to company and industry. "All those choices sound off-putting at first," says Fisher, "but actually, they give companies a great deal of flexibility in designing their own ideal plan."
Because Dacor's inventory was so large, the company decided it would pool items. Businesses with very few product lines in their inventories may decide to account for each item individually. Dacor also decided to average its prices, rather than tie results to any particular date, which is the easiest of the alternatives.
It's especially important for any company making the switch to evaluate all options during stage one. That's because the Internal Revenue Service requires companies to stick to whichever methods they choose for as long as they remain on LIFO. And for most companies that means forever, since the switch back to FIFO is an accounting and tax nightmare, complete with a four-year recapture of prior tax savings.
Once Dacor made its accounting choices, Goldberg and his staff of three began putting every item of inventory into one of four categories: life-support equipment, skin-diving equipment, diving accessories, and clothing. This was a long process -- two to three weeks -- since Dacor was only partially computerized and had to rely on assistance from an outside data-processing agency.
Stage two was tougher, mainly because Goldberg's team performed their regular jobs by day and their LIFO work during evenings and on weekends. They went through each inventory item and checked various financial records to establish what its cost had been to produce or import at the beginning and end of the year of conversion. Like most LIFO tasks, at least at the company level, this was largely a clerical job.
Stage three, the number crunching, was done by Dacor's outside accountants. That's as it should be, since few growing companies have the computer resources, time, or accounting sophistication to perform the necessary LIFO calculations. Miller, Cooper had to come up with an average item cost for every Dacor category. "There are companies whose inventories are so simple that this stage might take a morning," says Fisher. "Dacor took about four days that first year."
The final stage was pure paperwork. At the end of the fiscal year, the accountants notified the IRS that a LIFO conversion had been made. This is done by filling out Form 970, which details the various accounting choices that have been made. "It's impossible to argue with the cash-flow results we've seen," Goldberg says of the switch in accounting methods. "We could really be hurting, given all the inflation that we've seen in our import costs from the weak dollar, but LIFO shelters us from that."
And although Goldberg did face some administrative hassles during those initial stages of conversion, he pooh-poohs them now. "The beauty of LIFO is once you're set up and computerized, it's really easy to update your numbers and inventory lists every year. It's now no more complicated than our old method -- but much more profitable."
SHOULD YOU SWITCH?
Here are some questions to help you decide
Converting from FIFO to LIFO inventory is far from hassle free. You'll want to look carefully at your company and its goals before making any changes.
* Do you anticipate rising labor, material, or other production costs? "Almost every business does," says Miller, Cooper & Co. accountant Neal Fisher. "The exceptions are commodities businesses or high-tech operations, where production costs may shrink dramatically with increased sophistication. There are only a few kinds of businesses that I believe would not benefit from a LIFO switch."
* Is your business and inventory level growing? If so, your company will benefit from a LIFO switch even during those years when inflation is low, because inventory growth will increase current costs and thus the value of a LIFO write-off.
* Are you at least partially computerized? One way to save your company from some of the headaches of conversion is to computerize inventories sooner rather than later. "That's my only regret," says David Goldberg, chief financial officer of Dacor Corp. "If we had been fully computerized, which we became in 1987, everything would have been so much easier."
* Is your business profitable? Obviously, there's no point in increasing tax write-offs during the stage when a start-up is still losing money. At that point in your business, LIFO would be an unnecessary complication. You might postpone the switch until a tax reduction seems attractive.