Many firms have adopted the last in, first o·At (LIFO) method of accounting for inventories in order to reduce taxable income and income tax liability in periods of rising prices. Lower tax liabities under LIFO are not assured, however, since a LIFO ...
Many firms have adopted the last in, first o·At (LIFO) method of accounting for inventories in order to reduce taxable income and income tax liability in periods of rising prices. Lower tax liabities under LIFO are not assured, however, since a LIFO company's "cost of goods sold" could include some very low costs from prior years, if that company's inventory purchases or production for the current year are insufficient to meet the year's demand, Moreover, even if the use of LIFO does result in a lower tax liability, the inclusion of any of the old, low costs in cost of goods sold under LIFO means that the tax liability could have been reduced even further by increasing purchases or production, such that these old costs would have remained in inventory.
Increasing production or purchases, however, increases the cost of holding these extra units until the time at which they are depleted from inventory to meet demand. Such costs might include warehousing costs, interest costs, and the opportunity cost of having less funds available for other productive uses. Thus, when prices are rising, a trade-off exists between lower tax costs and higher holding costs associated with more production or purchases.
Accordingly, this paper considers relevant costs for inventory decisions and methods of inventory valuation associated with optimal inventory policy. Thus, when prices are rising, it has presented approach method of optimal inventory policy through the application of Cohen & Halperin's model.
This model uses as information inputs a series of demand, purchase price of inventory, holding costs, and tax rate forecasts. I have illustrated how LIFO taxation affects optimal year-end inventory level decisions for all years in the planning horizon, as well as how intrayear purchase decisions and end of year decisions are related. Accrodingly, it is not optimal al to allow ending levels to "float, " eyen f·hen doing so would not cause the liquidation of a layer. It is also not optimal to plan purchases so as to have inventory contain the lowest cost layer structure at the end of each year if holding costs become high enough to overcome tax benefits.
Although this model was cast with some simplifying assumptions, it call easily be extended to consider problems associated with longer planning horizons, production capacity constraints, alternative demand and cost forecasts, and alternative altitudes toward stockout risk which affect buffer stock requirements. Further research in this area can be directed at inclusion in the model of fixed costs of ordering inventory costs which do not necessarily increase each period, and the development of a general stochastic model with both intrayear and end of year decisions.