Can I have a decrease in inventory and still have an increase in LIFO reserve?

Although it seems contrary to logic, the answer to the question is yes, the reserve can increase despite decreasing inventory levels. The reason is that the key to a LIFO computation is the level of inflation in inventory costs, not the quantity of the inventory. For example:

Assume your business has 100 units in inventory for the first year, and they are equally priced at $10,000. Also, assume inflation for the year is 5%. Each unit would have a LIFO benefit of about 5% of its cost, or $500. The total LIFO reserve for the 100 units is $50,000.

The next year the inventory drops to 90 units, and inflation is again 5%. This means that each of the remaining units has a LIFO benefit of 10% (5% + 5%), or $1,000. The total LIFO reserve for the second year is $90,000, an increase of $40,000 despite the drop in inventory. The amount of inflation on the remaining units easily negates the fact that there were fewer units in inventory. Granted, it would have been better if the inventory had remained at 100 units, but it didn't cost the business any of its previously acquired LIFO reserve.

Obviously, this is a simple example but it illustrates the principle that inflation, not quantity of units, is the most important factor in a LIFO computation. You can use the rationale of the example above to determine at what level of inventory and inflation your reserve might begin to decrease. It will probably surprise you to see how low the inventory can drop without decreasing the reserve

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