Dollar-Value LIFO Retail Method With a 3-Year Example

The dollar-value LIFO retail method estimates a retailer’s ending inventory at LIFO (last in, first out) cost when selling prices are changing. Divide ending inventory at retail by the current price index to restate it in base-year dollars, compare that with last year’s base-year amount, then price each layer using its own year’s index and cost-to-retail ratio.

A retailer can finish the year with higher price tags and fewer goods. LIFO assigns the most recent costs to sales, so the goods left in inventory carry older costs. Those older costs sit in layers.

A layer is the slice of inventory added in a particular year, kept at that year’s prices and cost ratio. A pool is a group of similar merchandise that the store tracks together. Before adding a layer to a pool measured in retail dollars, the retailer first needs to know whether the pool actually grew or whether prices simply went up.

Key takeaways

• The dollar-value LIFO retail method removes price changes first, so only a real increase in inventory becomes a new LIFO layer.
• Deflate ending inventory at retail by dividing it by the current price index, then compare it with last year’s amount in base-year dollars.
• Price a new layer as the increase in base-year retail dollars × that year’s price index × that year’s cost-to-retail ratio.
• When the pool shrinks, remove the newest layers first, each at its own index and ratio.
• In the example below, Juniper Supply’s ending inventory at LIFO cost is $31,150 in Year 1, $32,830 in Year 2, and $30,435 in Year 3.

Watch a dollar-value LIFO retail calculation

Professor Farhat works through two year-ends, from deflating retail inventory to pricing the surviving layers. The example below adds a third year in which inventory falls.

Watch this indexed inventory example on YouTube.

Jump to the part you need:

• 0:00 Introduction and simulation overview
• 3:33 Calculating the cost-to-retail percentage
• 7:12 Deflating inventory to base-year dollars
• 9:58 2021 calculation: identifying and valuing the new layer
• 10:13 Reflating the layer and converting it to cost. Reflating means multiplying a base-year amount by the price index to bring it back to that year’s retail prices.
• 12:15 2022 calculation using the year’s price index and cost ratio

How do you calculate dollar-value LIFO retail in 4 steps?

Every dollar-value LIFO retail problem follows the same four steps.

1. Deflate. Divide ending inventory at retail by the current-year price index. Deflating means removing the price change, so the result is in base-year retail dollars.
2. Compare. Subtract last year’s ending inventory in base-year retail dollars. An increase is a new layer. A decrease is a liquidation, which means part of an older layer has been sold off.
3. Price the new layer. Multiply the increase by the current-year price index, then by the current-year cost-to-retail ratio. The cost-to-retail ratio is cost divided by retail value, so 65% means each retail dollar holds 65 cents of cost.
4. Add it up. Add the new layer’s cost to the cost of the older layers still on hand. If the pool shrank, remove cost from the newest layers first, using each layer’s own index and ratio.

Here is the formula for a new layer: layer cost = increase in base-year retail dollars × layer-year price index × layer-year cost-to-retail ratio.

What the price index and the cost-to-retail ratio each measure

The base year supplies a common set of retail prices. An index of 1.10 means the pool’s retail prices are 10% above that base. Dividing $110 of current retail value by 1.10 expresses the same goods as $100 at base-year retail. Both amounts are still retail values.

The cost-to-retail ratio answers a different question. A 65% ratio means that $100 of retail merchandise in that layer carries $65 of cost. Calculate the current-year cost-to-retail ratio as current purchases at cost divided by their retail amount after net markups and net markdowns. A markup raises a selling price and a markdown lowers it. Leave beginning inventory out of this ratio, because the opening layer already has its own historical ratio. Do not confuse this with the liquidity measure called the current ratio, which is current assets divided by current liabilities.

Year 1 under the dollar-value LIFO retail method

Meet Juniper Supply, a hypothetical camping shop. It is the same store used in the stable-price LIFO retail method example, so you can compare the two answers. Its opening inventory was $40,000 at base-year retail and $24,000 at cost. At the first year-end the store holds $55,000 at current retail. Current purchases cost $67,600 against adjusted retail of $104,000, giving a 65% ratio. This time the retail price index is 1.10.

Here is the data for all three years in one place.

Find the layer. The ending pool is $55,000 ÷ 1.10 = $50,000 at base-year retail. Compare that with $40,000 at the start. The new layer is $10,000 in base-year dollars, even though the price tags show a $15,000 increase.

Value the layer. Convert the $10,000 addition to the selling prices in effect when it arose, then to cost. Its cost is $10,000 × 1.10 × 65% = $7,150. Add the opening $24,000 to obtain $31,150 at LIFO cost. If prices had stayed stable, all $15,000 of the retail increase would have formed a layer, giving $33,750. The $2,600 difference shows the effect of the price assumption on this estimate.

What does this do to cost of goods sold, the cost assigned to the items sold this year? Goods available for sale cost $91,600. That is $24,000 of opening inventory plus $67,600 of purchases. Subtract ending inventory of $31,150 and cost of goods sold is $60,450.

At stable prices, cost of goods sold was $57,850. The $2,600 that left ending inventory moved into cost of goods sold.

Year 2 adds a layer at a different rate

Juniper now reports $62,400 at current retail. The index is 1.20 and the new cost-to-retail ratio is 70%. Deflating gives $62,400 ÷ 1.20 = $52,000. Compare that with the prior year-end total of $50,000 at base-year retail. Comparing with the original $40,000 opening balance would count the Year 1 increase a second time.

Only $2,000 of new inventory at base-year prices qualifies for the Year 2 factors. As a cross-check, last year’s $31,150 plus the new $1,680 equals $32,830. Each row preserves the price level and cost relationship at which that part of the pool entered inventory.

Want to slow down and practice? Try a sample lesson in the free sample course and work through the calculations at your own pace.

Year 3 shows why higher retail dollars can hide a liquidation

The ending retail total rises again, from $62,400 to $63,700. But the index has climbed to 1.30. This gives $63,700 ÷ 1.30 = $49,000 at base-year retail. Measured at common prices, the pool has shrunk by $3,000.

Remove the newest $2,000 base-year layer in full. Then remove $1,000 from the Year 1 layer. That leaves the opening $40,000 and $9,000 from Year 1. Their combined cost is $24,000 + ($9,000 × 1.10 × 65%) = $30,435. You can also subtract $1,680 and $715 from the prior $32,830 to reach the same amount.

The Year 3 index helped identify the reduction. A Year 3 cost ratio is unnecessary here because the surviving goods all belong to earlier layers. A later recovery would create a new layer at the recovery year’s factors.

Here are all three years side by side. Retail dollars rose every year, yet the pool shrank in Year 3.

How to check a layer schedule

Read the heading above each dollar column before comparing balances. The surviving base-year amounts should add up to deflated ending retail. Their historical costs should add up to ending inventory at LIFO cost. Multiplying the whole ending pool by the latest index and ratio would reprice layers that the store still carries.

Watch for these five common mistakes.

1. Comparing retail dollars without deflating them first. A higher price tag total is not proof of more inventory.
2. Comparing with the base-year opening balance instead of last year’s ending balance in base-year dollars.
3. Multiplying a new layer by the cost ratio but forgetting to multiply by the price index first.
4. For the current-year LIFO layer, exclude beginning inventory and include both net markups and net markdowns when calculating the cost-to-retail ratio.
5. Removing the oldest layer first when the pool shrinks. Under LIFO, the newest layers go first.

A cost-based dollar-value LIFO exercise starts with inventory already measured at cost. A retail exercise starts with selling prices and needs the extra cost conversion.

Where does the index come from in practice? It should represent the merchandise in the pool. For decades, U.S. department stores used the Department Store Inventory Price Indexes published by the U.S. Bureau of Labor Statistics (BLS). The BLS stopped publishing those indexes after December 2013, although its guide to department store inventory price indexes still explains how the merchandise groups worked.

For tax purposes today, a retailer can compute its index from BLS consumer or producer price data. This is called the inventory price index computation (IPIC) method, and it is found in Treasury Regulation 1.472-8(e)(3). The Treasury Department and the IRS noted the end of the department store indexes in a 2016 proposed regulation on the IPIC method.

How is dollar-value LIFO retail different from other retail and LIFO methods?

Four methods get mixed up all the time. Here is how they differ.

The conventional retail method aims for lower of cost or market, which is why it leaves markdowns out of the ratio. The LIFO retail versions aim for cost, which is why markdowns go in.

What do GAAP, the tax rules, and IFRS say about this method?

Under U.S. generally accepted accounting principles (GAAP), inventory is covered by Topic 330 of the Accounting Standards Codification (ASC), which is published by the Financial Accounting Standards Board (FASB). Inventory measured with LIFO or the retail inventory method is still measured at the lower of cost or market.

The simpler lower of cost and net realizable value rule from FASB Accounting Standards Update 2015-11 does not apply to it. Net realizable value is roughly the expected selling price minus the costs to finish and sell the goods.

For U.S. income tax, LIFO falls under Section 472 of the Internal Revenue Code. Treasury Regulation 1.472-1(k) covers a retailer that combines the retail method with LIFO, and Treasury Regulation 1.472-8 covers the dollar-value method.

International Financial Reporting Standards (IFRS) take a different view. IAS 2, Inventories, does not permit LIFO, so this method is not available to a company that reports under IFRS.

Practice questions and answers

Can a $4,000 retail increase create no layer?

Yes. A pool starts at $20,000 with an index of 1.00 and ends at $24,000 with an index of 1.20. Ending base-year retail is still $20,000. The entire increase comes from prices.

What is the cost of a $3,000 addition at base-year retail?

Assume the layer-year index is 1.15 and its cost ratio is 64%. The addition is $3,450 at layer-year retail and $2,208 at cost ($3,000 × 1.15 × 64%). Add that cost to the older surviving layers.

What happens if the newest layer cannot absorb a decrease?

Suppose a pool falls $5,000 in base-year retail dollars and its newest layer holds $3,500 on that basis. Remove the whole $3,500 and then $1,500 from the next-newest layer. Value each reduction with its own historical factors.

Frequently asked questions

What does a price index of 115 mean in a problem?

If the base period is 100, convert 115 to 1.15 by dividing by 100. If the exercise already gives 1.15, use that factor directly.

Is the base-year dollar balance a count of physical items?

It measures a pool of different goods at common retail prices. A change indicates growth or contraction on that basis. It does not tell you how many individual tents, lamps, or other items the store holds. Textbooks and the quiz above often call this a change in quantity. Read that as quantity measured in base-year retail dollars, not as a count of units.

What is the difference between the LIFO retail method and the dollar-value LIFO retail method?

The LIFO retail method assumes retail prices are stable, so any increase in ending inventory at retail counts as a new layer. The dollar-value LIFO retail method adds a price index. It removes the price change first, so only a real increase in the pool becomes a layer. For the version without an index, see the LIFO retail method at stable prices.

What is the formula for a new dollar-value LIFO retail layer?

Layer cost = increase in base-year retail dollars × the layer year’s price index × the layer year’s cost-to-retail ratio. In Juniper’s first year, that is $10,000 × 1.10 × 65% = $7,150.

Why are markdowns included in the LIFO retail cost-to-retail ratio?

LIFO is a cost method, so the ratio should approximate cost. Including both net markups and net markdowns does that. The conventional retail method leaves markdowns out of the ratio because it is aiming for lower of cost or market instead.

Is the dollar-value LIFO retail method allowed under IFRS?

No. IAS 2, the IFRS standard on inventories, does not permit LIFO. The method is used under U.S. GAAP, where FASB ASC Topic 330 covers inventory.

About the author

Mansour Farhat, CPA, CIA, DBA, teaches accounting at Farhat Lectures and on the Farhat Lectures YouTube channel. Read more about Professor Farhat.