Inventory trends: the "Wal-Mart" effect.

• Author: Petersen, Dustin C.

For U.S. manufacturers, productivity has steadily increased. Wal-Mart, Target, Home Depot and other large retail companies have externalized their cost structure. Accordingly, the economies of scale have pressured many mid-sized businesses to change their operations to meet the needs of upstream businesses like Wal-Mart. Many of these changes are in inventory and cost management. The upstream businesses have asked the mid-sized businesses to hold inventory longer and to cut product costs. In doing so, it appears that tried and true tax inventory methods may be outdated and wing up needed business capital in current tax costs.

Two tax inventory methods, LIFO and uniform capitalization (UNICAP), provide opportunities to decrease the tax carrying cost of inventory and to improve cashflow in the face of these inventory trends.

LIFO

In general, LIFO inventory is calculated by comparing current-year costs to base-year costs to determine an inflation factor (index).The index is used to convert the current-year inventory costs on a FIFO basis to base-year costs.

Taxpayers can calculate their own internal indexes or use indexes published by the Bureau of Labor Statistics (BLS). If taxpayers choose the published indexes, they must elect to use the Inventory Price Index Computation (IPIC) LIFO method as described in Regs. Sec. 1.472-8.

When suppliers to large retailers face significant pricing pressure from their customers, they are forced to keep their costs as low as possible to maintain profitability. They generally want to keep inflation low as they strive to "trim" costs where possible. By keeping costs and internal inflation low, the benefits of LIFO may be reduced when using internal indexes. The use of external indexes that may not consider company-specific pricing pressures can lead to significant tax savings when the published indexes show a higher inflationary factor, as their use produces a lower ending inventory value, resulting in a decrease to taxable income.

Another advantage in using the published indexes over calculating an internal index is the decreased administrative burden; taxpayers do not have to track actual individual item costs needed to compute internal indexes (as required by Regs. Sec. 1.472-8(e)(1)).

While software has been an asset in calculating internal indexes, the variability of products can make valuing base-year costs of new products an undue administrative burden. The IPIC method groups products into similar...