The Effects of LIFO Inventory Costing on Resource Allocation: A Public Policy Perspective.

Abstract ABSTRACT: The use of the LIFO inventory method is advantageous to taxpayers in periods of rising inventory prices since it can reduce the amount of taxes which must be paid on inventory profits. This tax reduction can be accomplished most successfully if the taxpayer does not permit the level of ending inventories for a year to be any less than that level was at the beginning of the year. In this paper, the year-end inventory maintenance activity by firms who use LIFO is analyzed in the context of economic efficiency. The methodology employed is the construction of an analytical model for after-tax economic profit maximization by a firm which uses LIFO, an analysis of the profit maximizing conditions from a Pareto-optimal perspective, and the conclusion that year-end inventory maintenance is an inefficient use of resources. The paper concludes by suggesting a replacement cost solution to the problem of accounting for inventories as a more efficient alternative to LIFO.