The IPIC Method Revisited: A Simplified Explanation and Illustration of the Inventory Price Index Computation (IPIC) Method
Like
Delphic oracles of antiquity, the Treasury Department has a reputation for
issuing statements veiled in ambiguity and incomprehensibility to the
uninitiated, keeping tax attorneys and tax accountants—the high priestesses of
the tax mysteries—gainfully employed.
And its regulation §1.4728, “DollarValue Method of
Pricing LIFO Inventories,” was no different when it was first issued,
specifically in regard to the use of the inventory price index computation
(IPIC) method, wherein the taxpayer computes an inventory price index (IPI)
based on the consumer price indexes (CPI) or producer price indexes (PPI)
published by the United States Bureau of Labor Statistics (BLS). Therein one previously found esoteric
provisions, such as an arbitrary reduction of the inventory price index by 20
percent, the requirement of the 10 percent categories, the use of BLS weights
to prioritize the categories, the use of a weighted harmonic mean for computing
the inventory price index instead of a weighted arithmetic mean, ad infinitum
ad nauseam. Adding to the confusion was
the use of terminology imprecisely, if not ambiguously, defined, leaving it to
the tax preparer to divine the technical meanings of and distinctions between
an inventory item, category, or pool:
neither the Code nor the regulations define what constitutes an item
[see Wendle Ford Sales, Inc. v. Commissioner, 72 T.C. 447 (1979)]; a category
is categorically dismissed as an accounting method, subject to approval after
an IRS audit; and a pool is nebulously defined as the inventory of a “natural”
business unit.
Ultimately,
public outcry over some of the abovementioned provisions caused the Treasury
Department to issue Treasury Decision 8976 on December 20 2001, simplifying the
computation of the IPI under the IPIC method by no longer requiring 10 percent
categories and the reduction of the inventory price index by 20 percent, as
well as clarifying other provisions of its regulation. In spite of this simplification on the part
of the Treasury Department, many companies still struggle over the proper
application of the IPIC method. Some of
the errors typically made include the improper calculation of the weighted
harmonic average, the failure to assign inventory items correctly to BLS categories,
the use of a very general, if not incorrect, index for the entire inventory, or
the incorrect set up of pools, among others.
Because it is such an opportune time to switch to LIFO from other
inventory cost flow methods, with commodity prices rising dramatically over the
past year, and because the IPIC method is probably the least costly method in
terms of recordkeeping to implement for so many companies, perhaps an expliquer
of its methodology—highlighting and illustrating its basic computational steps—is
warranted at this time.
According to
Federal Regulation § 1.4728, the IPI computation
involves four steps:
1.
Selection of a BLS table and an
appropriate month
2.
Assignment of items in a dollarvalue
pool to BLS categories
3.
Computation of category inflation
indexes for selected BLS categories
4.
Computation of the IPI.
For most “small”, nonpublic companies, determining LIFO pools is not a
major problem, since most are within one product line (or related product
lines) or consist of one operating business unit: that is, most have one pool.
Furthermore, § 1.4728 allows the company to use multiple pooling;
however, multiple pools increase the risk of erosion of LIFO layers, and should
be avoided at all cost. Of course,
companies having gross receipts less than $5,000,000 on average may use one
pool. Likewise, for most small,
nonpublic companies, choosing an appropriate month is not difficult. Usually at its yearend, when an inventory
count is undertaken, that is often the month of choice.
Similarly, the selection of a BLS table for manufacturers, processors,
wholesalers, jobbers, and distributors is not a difficult choice: Table 6 is ordinarily required (retailers
may select BLS price indexes from Table 3).
And the assignment of inventory items should not be an overtaxing matter,
too. According to the regulation, “a
taxpayer’s selection of a BLS category for a specific item is a method of
accounting.” Given the various categories
provided in table 6 for the various commodities, the taxpayer would decompose
its inventory items into the provided categories in a logical and systematic
manner; however, the implicit constraint is that, once selected, the inventory
items should be categorized consistently in the same fashion from year to year.
The next step in the computation of an IPI for a dollarvalue pool—the
computation of category inflation indexes for selected BLS categories—is the
step that has given small, nonpublic companies the greatest difficulty. There are two methods of implementing the
computation: doubleextension IPIC
method; and linkchain IPIC method. The
major difference between the two methods is that the former employs a
cumulative index from the first year of LIFO use; while the latter uses an
index based on the index of the preceding year. More precisely, under the doubleextension method, the category
inflation index for a BLS category is the quotient of the BLS price index of
the current year divided by that of the base year; whereas, under the
linkchain method, the category inflation index for a BLS category is the
quotient of the BLS price index of the current year divided by that of the
prior year.
Once a method is selected and the individual inflation indexes of the
categories are calculated, then the next step would be to derive the IPI for a
dollarvalue pool by computing the “weighted harmonic mean” of the category
inflation indexes. The regulation
provides the following literal formula for its calculation:
“Sum of Weights/Sum of (Weight/Category Inflation Index).” Although it may
appear somewhat imposing at first glance:, the calculation of the
weighted harmonic mean consists of four steps.
1.
To compute the “Sum of Weights”, after
assigning all inventory items to categories, total all dollar values of
inventory items by category, and sum all of these dollar values of the
categories. The dollar values of each
category comprise the “Weights” referred to in the numerator or dividend of the
above formula.
2.
Next calculate the category inflation
indexes for each category by dividing either the base year’s index
(doubleextension method) or the prior year’s index (linkchain method) into
the current year’s index.
3.
Then divide each category’s total
value by its respective category inflation index. The quotient of this division is the “Weight/Category Inflation
Index” variable in the denominator of the above formula. Simply add all of
these quotients to arrive at the “Sum of (Weight/Category Inflation Index)”
value of the denominator.
4.
Now divide the “Sum of Weights”
computed in step 1 by the “Sum of (Weight/Category Inflation Index)” computed
in step 3 to yield the weighted harmonic mean.
For the doubleextension method, the weighted harmonic mean is also the
IPI; however, because the linkchain method uses the prior period’s category
inflation indexes and not those of the base year, its weighted harmonic mean
needs to be multiplied by the prior year’s IPI in order to reflect the
cumulative inflation effect since the inception of LIFO to arrive at the
current year’s IPI.
A simple example may help to illustrate IPI’s computation. Assume a wire and cable company switched
from FIFO to LIFO in 2005, and has the following FIFO values of its inventory
items for the year ending 2005:
Next assume that the Director of Engineering
of the company has assigned the above inventory items to the following BLS
categories found in table 6 on the website http://www.bls.gov/ppi/ppitable06.pdf:
On the webpage http://www.bls.gov/ppi/home.htm,
find “Commodity Data” under “Create Customized Tables” and select group “10
Metals and metal products,” and to the right, select the BLS categories listed
above; specify the appropriate years:
the “not seasonally adjusted” indexes for the selected categories will
display as follows:
Series Id: WPU10230101 


Year 
Jan 
Feb 
Mar 
Apr 
May 
Jun 
Jul 
Aug 
Sep 
Oct 
Nov 
Dec 
Annual 

2004 
143.1 
157.9 
172.5 
174.9 
161.7 
156.9 
163.0 
163.0 
164.4 
175.6 
175.4 
185.3 
166.1 

2005 
184.5 
188.0 
195.0 
198.4 
197.3 
196.1 
202.5 
212.8 
217.5 
233.3 
245.3 
263.7 
211.2 

2006 
278.4 
292.9 
302.3 
326.1 
394.0 
433.8 
449.6 
459.4 
441.6(P) 
426.2(P) 
433.5(P) 
414.7(P) 
387.7(P) 

P : Preliminary. All indexes are subject to revision four months
after original publication. 


Series Id: WPU10260301 

Year 
Jan 
Feb 
Mar 
Apr 
May 
Jun 
Jul 
Aug 
Sep 
Oct 
Nov 
Dec 
Annual 
2004 






173.1 
175.4 
172.8 
173.5 
175.8 
176.8 
171.5 
2005 
170.7 
171.0 
173.8 
174.1 
171.4 
173.1 
177.9 
174.8 
174.7 
173.5 
178.8 
182.4 
174.7 
2006 
183.8 
184.8 
183.5 
185.7 
195.3 
201.1 
204.4 
212.3 
209.2(P) 
214.8(P) 
211.1(P) 
213.6(P) 
200.0(P) 
P : Preliminary. All indexes are subject to revision four months
after original publication. 
Series Id: WPU10260314 


Year 
Jan 
Feb 
Mar 
Apr 
May 
Jun 
Jul 
Aug 
Sep 
Oct 
Nov 
Dec 
Annual 

2004 
144.7 
149.6 
158.2 
159.2 
154.1 
150.1 
150.4 
152.3 
151.3 
156.7 
157.6 
156.4 
153.4 

2005 
170.3 
169.4 
176.8 
176.2 
175.5 
180.0 
185.2 
189.4 
192.5 
214.6 
233.4 
253.2 
193.0 

2006 
245.2 
242.6 
241.6 
258.4 
348.0 
387.0 
370.2 
362.2 
333.8(P) 
317.8(P) 
315.9(P) 
320.5(P) 
311.9(P) 

P : Preliminary. All indexes are subject to revision four months
after original publication. 


Series Id: WPU10260399 

Year 
Jan 
Feb 
Mar 
Apr 
May 
Jun 
Jul 
Aug 
Sep 
Oct 
Nov 
Dec 
Annual 

2004 





100.0 
99.7 
99.9 
100.8 
101.0 
101.2 
102.2 


2005 
101.9 
102.4 
102.6 
102.3 
102.9 
103.0 
104.7 
106.2 
106.9 
107.6 
112.5 
114.7 
105.6 

2006 
118.6 
120.8 
120.3 
122.1 
144.0 
145.7 
141.3 
142.8 
140.7(P) 
141.7(P) 
139.1(P) 
134.5(P) 
134.3(P) 

P : Preliminary. All indexes are subject to revision four months
after original publication. 
Totaling the inventory items by
categories; dividing the 2005 category indexes by their respective 2004 indexes
to derive the category inflation indexes; and dividing the category totals
(i.e., the weights) by these category inflation indexes yields quotients which,
when totaled, is the value, “Sum of (Weight/Category Inflation Index)”. The computation is illustrated below:
Dividing
the sum of the FIFO values, $132,000, by the “sum of weight/category inflation
index”, $90,940, produces a weighted harmonic mean and an IPI of
1.4515
under both the doubleextension method as well as the linkchain method, since
in the first year of adopting LIFO, the cumulative index of the
doubleextension method is also the prior year index of the linkchain
method. Only in subsequent years does
the difference in the computations of the two methods become apparent. Assuming FIFO values of inventory identical
to those of 2005, the divisor producing the category inflation indexes under
the doubleextension method are still those of the base year, 2004:
Dividing the sum of the FIFO values,
$132,000, by the “sum of weight/category inflation index”, $72,361, produces
an IPI of 1.8242. The linkchain
method, however, uses the indexes of the prior year and not those of the base
year of adopting LIFO:
Dividing the sum of the FIFO values,
$132,000, by the “sum of weight/category inflation index”, $104,453, produces
the quotient, 1.2637. Only after
dividing this quotient by the prior year’s IPI, 1.4515, is the current year’s
IPI, 1.8343, obtained under the linkchain method:
Again, the basic difference between
the doubleextension and linkchain methods is that in the former, the weighted
harmonic mean equals the IPI, whereas in the latter, the weighted harmonic mean
is multiplied—or linked to—the prior year’s IPI in order to compute the current
year’s IPI. This is a consequence of
the linkchain method deriving its category inflation indexes from commodity
indexes of the prior year rather than those of the base year, as in the
doubleextension method.
Unfortunately, this simple distinction
may be overlooked in the thirtyeight pages of regulation §1.4728. Although the regulation may intimidate the
reader at first glance, the IPIC method is perhaps the easiest and most
efficient LIFO method to employ, particularly in small, nonpublic
companies. Typically, the company
selects one pool, systematically and consistently assigns inventory items to categories
as its method of accounting, downloads the commodity indexes from the website http://www.bls.gov/ppi/home.htm ,
and sets up Excel spreadsheets for the IPI calculations each year. Hopefully this article has achieved its
purpose of highlighting and illustrating the basic computations and
implementation of the IPIC method, including those of its two standard
approaches, the doubleextension and linkchain.
Article written by William Brighenti, CPA, CVA, Certified QuickBooks ProAdvisor, Sage Master Builder Consultant, Director of Accountants CPA Hartford Connecticut.
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