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 §1.472-8, “Dollar-Value 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 above-mentioned 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 § 1.472-8, the IPI computation involves four steps:

 

1.      Selection of a BLS table and an appropriate month

2.      Assignment of items in a dollar-value 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, § 1.472-8 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 year-end, 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 dollar-value 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:  double-extension IPIC method; and link-chain 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 double-extension 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 link-chain 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 dollar-value 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 (double-extension method) or the prior year’s index (link-chain 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 double-extension method, the weighted harmonic mean is also the IPI; however, because the link-chain 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
Not Seasonally Adjusted
Group:      Metals and metal products
Item:       No. 1 copper scrap, including wire
Base Date:  8612

 

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
Not Seasonally Adjusted
Group:      Metals and metal products
Item:       Electric wire and cable
Base Date:  8212

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
Not Seasonally Adjusted
Group:      Metals and metal products
Item:       Copper and copper alloy wire & cable, bare & tinne
Base Date:  8612

 

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
Not Seasonally Adjusted
Group:      Metals and metal products
Item:       Other wire and cable
Base Date:  0406

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 double-extension method as well as the link-chain method, since in the first year of adopting LIFO, the cumulative index of the double-extension method is also the prior year index of the link-chain 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 double-extension 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 link-chain 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 link-chain method: 

 

 


 

 


Again, the basic difference between the double-extension and link-chain 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 link-chain method deriving its category inflation indexes from commodity indexes of the prior year rather than those of the base year, as in the double-extension method. 

 

Unfortunately, this simple distinction may be overlooked in the thirty-eight pages of regulation §1.472-8.  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 double-extension and link-chain. 

Article written by William Brighenti, CPA, CVA, Certified QuickBooks ProAdvisor, Sage Master Builder Consultant, Director of Accountants CPA Hartford Connecticut.

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