If your business sells merchandise from inventory, your choice of cost flow assumption can affect your gross profits. The Internal Revenue Service allows you to use the first-in, first-out method or the last-in, first-out method -- FIFO and LIFO. If you choose LIFO, you can further select from one of several submethods, including dollar-value LIFO, or DVL.
Under DVL, you don’t view your inventory as a quantity of physical goods. Instead, you consider your inventory as a quantity of value consisting of annual layers. Each layer is a pool of the entire inventory you purchase during the year. You don’t base your ending inventory value on the count of items, but rather on the dollar value of those items. The DVL method determines the dollar value of your inventory by starting with your initial ending inventory for the year you adopted the method, and then adjusting it for annual changes in inventory value after removing the effects of inflation. The DVL method provides several advantages over other LIFO methods.
Under normal economic conditions, prices rise over time. By using the latest prices first, cost of goods sold -- or COGS -- under LIFO is higher, and taxable income is lower, when compared to FIFO. When you purchase inventory items, you create a new layer of costs. LIFO liquidation occurs when you sell your current layer of inventory and must dip into earlier layers. This lowers your COGS and increases your taxes. An advantage of DVL is that it minimizes LIFO liquidation, because all items you purchase throughout the year belong to the same inventory pool. The only time you liquidate a pool is when the year's ending inventory is less than beginning inventory after correcting for inflation.
Another advantage of DVL is a reduced need for detailed record keeping. Under standard LIFO, you must track your inventory by units, even if you combine similar units into pools. This requires you to track the cost of all purchases and keep records on how you use up your inventory pools through sales. Armed with this information, you can then determine your COGS. If you adopt the DVL method, you make a physical count of ending inventory and apply the proper DVL cost. The DVL method allows you to determine the proper cost without referring to any flow assumptions for inventory units. In other words, you don’t have to worry about applying costs in LIFO sequence to the units you sell during the year.
The third advantage of DVL involves the way you set up the pools. Under regular LIFO, you can create pools of inventory, but each unit in the pool must be essentially identical to every other unit. If you sell or produce items that have annual model changes, you would have to create a new pool for each different model. This increases LIFO liquidation as you sell off your older models. You group DVL pools by year, not unit, so you don't create new pools when you replace units with different ones. By maintaining the older layers, you match your COGS to the most recent purchase prices, which is the whole point of LIFO.