The effect of inventory costs on the LIFO layer liquidation decision

Due to double digit inflation during the latter part of the past decade, many companies have switched to the LIFO method of inventory valuation. LIFO layer liquidation occurs whenever a company which uses the LIFO inventory valuation method decides to reduce ending inventory to a level below beginning inventory. During inflationary periods, a company that allows this liquidation to occur will have to pay higher federal income taxes. This paper develops a decision rule of whether or not management should make a special purchase to avoid LIFO layer liquidation. The tradeoffs involved with this special purchase are reduced federal income taxes coupled with higher carrying costs and order or setup costs. Since some carrying costs are tax deductible and some are not, most of the carrying costs are considered individually in developing the decision model. The tax deductible costs that are considered are the cost of capital, property tax, insurance costs, handling costs, and warehouse costs. The carrying costs considered that are not tax deductible are the risk or probability of deterioration and obsolescence. Since the costs and tax payment occur at different points in time, the present value of each of these transactions are made for comparison purposes. The decision rule is based on a comparison between the present value of these costs and the present value of the cost of a LIFO layer liquidation. An example is then used to illustrate the decision rule.