The Institute of Professional Accounting, Graduate School of Business, University of

Chicago

Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory
Policy
Author(s): Gary C. Biddle
Source: Journal of Accounting Research, Vol. 18, Studies on Economic Consequences of
Financial and Managerial Accounting: Effects on Corporate Incentives and Decisions (1980), pp.
235-280
Published by: Blackwell Publishing on behalf of The Institute of Professional Accounting,
Graduate School of Business, University of Chicago
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Journal of Accounting Research

Vol. 18 Supplement 1980
Printed in U.S.A.

Accounting Methods and

Management Decisions: The Case
of Inventory Costing and Inventory
Policy
GARY C. BIDDLE*

1. Introduction
Considerable attention in the accounting literature is devoted to dis
cussing possible motives for and effects of choices among alternative
accounting methods. Although insights have been gained into investor
(stock market) reactions to changes in accounting methods, little is
known about either management motivations for observed accounting
choices or the effects of these choices on subsequent operating decisions.
One explanation for the dearth of empirical findings is that few of the
proposed theories of accounting choice have offered strong links to real
economic incentives. In addition, previous studies have concentrated on
firm characteristics existing before and concurrent with the accounting
choice. Since managers making accounting choices are likely to consider
future conditions as well, this approach may overlook important deter
minants of accounting choices. This approach also precludes the
detection of possible changes in operating policies induced by accounting
choices.
A choice among alternative inventory costing methods, especially
between the last in, first out (LIFO) and first in, first out (FIFO) cost
flow assumptions, can generate potentially large changes in a firm's cash
* University of Chicago. I gratefully acknowledge the comments of Craig Ansley, Sidney
Davidson, Nicholas Dopuch, Allan Drazen, Gary Eppen, Shyam Sunder, Victor Zarnowitz,
and Tom Stober. This paper is based on my dissertation (see Biddle [1980]) which was
supported, in part, by a grant from Arthur Andersen & Co.
235
Copyright, Institute of Professional Accounting 1981

236

FINANCIAL AND MANAGERIAL ACCOUNTING:

1980

flows due to its impact on taxable earnings. These cash-flow effects

provide economic incentives for choices between these methods. More
over, these cash-flow effects depend, in part, on the behavior of year-end
physical inventories. Because year-end inventory levels are subject to
management control, the LIFO-FIFO choice can both affect and be
affected by subsequent inventory management policies. The LIFO-FIFO
choice offers, therefore, the opportunity both to identify factors which
influence accounting choices and to examine associations between these
choices and subsequent operating decisions.
This study investigates whether associations consistent with LIFO
FIFO tax incentives exist between management choices to adopt or not
adopt the LIFO inventory costing method and characteristics of firms'
year-end inventories. Both pre- and postchoice characteristics are ex
amined. Because the LIFO-FIFO choice is voluntary, a postchoice
association would be consistent with managers both anticipating future
inventory characteristics when making a LIFO-FIFO choice and chang
ing inventory management policies in response to that choice. Evidence
consistent with the hypothesis that LIFO adoptions are associated with
changes in inventory management policies would have important
macroeconomic implications. Zarnowitz and Moore [1977] have argued
that a failure to recognize the major shift in inventory costing methods
which occurred in 1973 and 1974 (primarily FIFO to LIFO) resulted
in an underestimation of inventory
accumulations by the U.S.
Department of Commerce. This underestimation resulted from the
different proce dures used under LIFO and FIFO to assign costs to
inventory units. While this effect of LIFO-FIFO choices can bias
macroeconomic mea surements and forecasts, an associated change in
inventory management policies by a large number of firms could
1
directly affect underlying macroeconomic stocks and flows.
The research design involves comparisons between a treatment group
sample of firms which adopted LIFO and a matched pair control sample
of firms which continued to use FIFO (or an average cost method). Two
primary measures of inventory properties are derived from available
financial statement disclosures. One measure approximates physical in
ventory levels, while the other estimates what the difference would have
been each year between each firm's cost-of-goods-sold computed under
the LIFO and FIFO alternatives. The empirical results based on these
measures indicate statistically significant associations between LIFO
adoption decisions and inventory properties and reveal striking cash-flow
consequences associated with LIFO-FIFO choices.

A recent study by Halperin [1979] has also suggested that LIFO adoption may induce
an inefficient use of resources as firms expend resources in managing year-end inventory
levels. This study provides empirical evidence on whether an association consistent with
this argument exists.

INVENTORY COSTING AND INVENTORY POLICY

237237237

2. Previous Research on Choices among Alternative

Accounting Methods
Changes in the accounting methods used by firms can result either
from voluntary choices by managers or from actions by rule-making
bodies (e.g., the FASB, SEC, and IRS) which induce managers to change
methods. Previous studies of management accounting choices have fo
cused on (1) the motives for and determinants of voluntary changes in
accounting methods and (2) the effects of both voluntary and rule
induced changes on stock price behavior.
MOTIVES FOR AND DETERMINANTS

OF ACCOUNTING

CHANGES

Much of the research concerning the motives for accounting

changes has been concerned with identifying a behavioral paradigm for
manage ment choices. The most popular of these paradigms is the
so-called smoothing hypothesis. It suggests that managers will be
motivated when choosing among alternative accounting methods to
choose that method which results in the "smoothest" income stream.
Gordon [1964] introduced smoothing as an implication of a set
of propositions regarding management utility maximization. One of
these propositions was
that
"stockholder satisfaction
with
a
corporation in creases with the average rate of growth in the
corporation's income and the stability of its income" (Gordon [1964,
p. 262],
emphasis added). Although Gordon asserted that the
smoothing hypothesis was testable, he did not suggest how
"smoothness" was to be measured. And apart from the quoted
proposition, he did not suggest how or why investors would
be
affected by, or assess, income stability. Nevertheless, the smoothing
hypothesis has generated considerable interest. Gagnon [1967], for
example, suggested that (managers believe) investors penalize firms
which do not exhibit smooth reported income streams and, as a result,
managers are motivated to choose between the purchase and
pooling alternatives in accounting for business combinations so as to
portray this quality best. His results, however, did not reveal consistent
evidence of smoothing behavior. Studies by Copeland [1968], Cushing
2
[1969], and White [1972] reached similar conclusions.
The smoothing paradigm has been critically evaluated elsewhere," and
it is sufficient here to suggest that it does not offer a strong
theoretical basis for explaining management choices among alternative
accounting methods. Although several other behavioral paradigms have
been pro posed (e.g.,
signaling,
debt
covenant
restrictions,
management compen2
A recent study by Hong, Kaplan, and Mandelker [1978] has examined whether stock
price reactions to the choice of the pooling method over the purchase method of accounting
for business combinations are consistent with managers attempting to influence stock
prices. Their results were not consistent with this explanation.
3
See, e.g., Ball and Watts [1972], Gonedes [1972], and Gonedes and Dopuch [1974, pp.
109-10].

238

GARY C. BIDDLE

sation, threats of antitrust litigation, etc.), empirical results have not

revealed, thus far, more than second-order effects.4
Another line of research in this area has been concerned with empiri
cally identifying characteristics of firms which are associated with vol
untary changes in accounting methods. Representative studies include
those by Moore [1973] (changes in management); Bremser [1975] (statis
tical properties of earnings); Gosman [1973] and Eggleton, Penman, and
Twombly [1976] (firm size, industry membership, and auditor). While
these studies have identified several firm characteristics associated with
certain change decisions, the results seem to have limited generalizability
to other choices, firms, and time periods. And because the factors exam
ined have often been suggested by intuitive (and not theoretical) reason
ing, the observed associations . provide few insights into management
motives for observed accounting changes. For example, even though
Eggleton et al. [1976] identified an association between industry mem
bership and LIFO-FIFO choices, the paper reveals little about why
managers in certain industries decided to change methods. Moreover,
because these studies have often ignored postchange firm characteristics,
they have overlooked possibly important determinants and effects of
accounting choices.
STOCK

PRICE REACTION TO ACCOUNTING CHANGES

The second major theme of research on choices among alternative

accounting methods has relied upon notions of capital market efficiency
and the capital asset pricing model to examine the effects of accounting
changes on stock price behavior.5 Representative studies include those
by Ball [1972] (reactions to accounting changes in general); Archibald
[1972], Baskin [1972], and Kaplan and Roll [1972] (investment credit and
depreciation method choices); Gonedes [1975; 1978] (special and extraor
dinary items); Harrison [1977] (voluntary versus rule-induced accounting
changes); and Sunder [1973a; 1973b; 1975] (LIFO-FIFO changes). Two
primary conclusions emerge: (1) investors interpret financial statement
information conditional on the accounting methods used and (2) investors
react to the real economic (i.e., cash-flow) implications of accounting
changes rather than to their effects on accounting measures. Sunder
[1973 a; 1973 b; 1975], for example, found that the stocks of firms which
adopted LIFO during periods of inflation (and which had generally
nondecreasing inventories) exhibited positive excess returns, even though
this change would have resulted in lower reported net income than if the
firms had remained on FIFO.
4
See, for example, Gonedes [1978] (signaling), Holthausen [1979] (debt covenant restric
tions), and Watts and Zimmerman [1978] (management compensation). Many of these
paradigms lack, like smoothing, strong links to firm cash-flow implications. An active
market for managerial services would induce managers to consider the cash-flow implica- ,
tions of accounting choices (see Fama [1980] and Sunder [1980]).
5
See Sharpe [1964], Lintner [1965], Fama [1970], and Fama and Miller [1972] for a
discussion of these concepts.

INVENTORY COSTING AND INVENTORY POLICY

239
GARY C. BIDDLE
2392
239239239
While examinations of stock prices around dates of accounting changes
have revealed much about investor reactions to accounting changes, this
approach can only indirectly address issues relating to management
motivations for observed changes or their effects on subsequent operating
decisions. Although some accounting changes (e.g., LIFO adoptions by
firms with increasing inventories during periods of inflation) are consis
tent with managers having anticipated stock price reactions, others are
not (e.g., FIFO adoptions during periods of inflation). Moreover, many
accounting choices have no obvious (either theoretical or empirical) stock
price implications.6 The market value rule" does, however, provide at
least one explanation of why managers would be interested in the cash
flow implications of accounting choices.
TOWARD AN UNDERSTANDING OF REAL EFFECTS

Recently, accounting researchers have begun to examine the potential

effects of accounting choices on management decisions. A typical study
is one by Collins [1978]. Instead of examining motives for, determinants
of, or investor reactions to accounting changes, Collins examined whether
the elimination of an acceptable method for accounting for research and
development (R&D) expenditures by the FASB (FASB Statement of
Financial Accounting Standards No. 2-F ASB 2) affected the subse
quent R&D expenditure. decisions of managers induced to adopt new
methods. Collins, therefore, attempted to identify changes in real resource
allocation decisions induced by an accounting change (i.e., its real effects).
Although testimony from hearings on preliminary drafts of FASB 2
indicates that some managers felt they would be forced to reduce R&D
expenditures in response to the change,8 Collins' results were only weakly
consistent with this claim. Vigeland [1978] found no stock price reaction
to the adoption of F ASB 2, further suggesting that managers did not
significantly alter R&D expenditures.9 This absence of significant real
effects may be due to FASB 2's lack of obvious cash-flow implications.
6

Even though F ASB Statement No. 8 (Accounting for the Translation of Foreign
Currency Transactions and Foreign Currency Financial Statements-effective January 1,
1976) has generated considerable controversy (see, e.g., Merjos [1977]), it has no obvious
cash-flow effects and a study of associated stock price reaction (Dukes [1978]) could not
reject the null hypothesis of no effect.
7
The market value rule suggests that managers are motivated when making investment,
production (accounting method), and financing decisions to maximize current shareholder
wealth.
8
In F ASB [1974] is found the testimony submitted to the FASB concerning the Exposure
Draft of Statement No. 2. An example of this testimony is a letter submitted by Alan
Hirasuna of L'Garde Corporation in which he says "It's apparent that the currently
proposed requirement will force companies who normally make R&D investments which
are large compared to their net worth to slow down their rate of investment" (FASB [1974,
p. 569]). More on the alleged effects of FASB 2 can be found in Business Week (July 3,
1979), pp. 4677.
9

A more recent study by Horwitz and Kolodny [1979] provides statistically significant
evidence of an association between the passage of F ASB 2 and changes in research and

The present study also investigates the possible real effects of an

accounting choice on management operating decisions. And like the
change determinant studies, this study examines empirical associations
between change decisions and firm characteristics. Unlike previous stud
ies, this research examines both pre- and postchange associations for a
voluntary accounting choice with obvious cash-flow implications. The
following section outlines some testable hypotheses suggested by this
setting.

3. The LIFO-FIFO Choice, Tax Incentives, and

Inventory Management Decisions-Hypotheses to Be
Tested
Although a variety of factors (such as those mentioned above) may
influence observed choices between LIFO and FIFO, the tax-related
cash-flow implications of this choice will be suggested as a primary
motive. This argument is consistent both with the evidence from the
stock price reaction studies and with discussions in the financial press of
costs and benefits associated with LIFO adoptions." A manager contem
plating a LIFO-FIFO choice could (and presumably would) forecast the
future cash flows which would be produced by each alternative.
Sunder [1976a; 1976 b] has identified four factors which affect (ex
pected) cash-flow differences between LIFO and FIFO: (1) year-end
inventory levels, (2) changes in inventory input (purchase or production)
prices, (3) marginal corporate income tax rates, and (4) discount rates
(where a present value expression is desired). Changing inventory input
prices and positive income tax rates are necessary for cash-flow differ
ences to arise between LIFO and FIFO. (The importance of price changes
is indicated by the renewed popularity of LIFO which has accompanied
recent high rates of inflation.) " While managers cannot easily
influence input price changes, income tax rates, or discount rates
(which depend on firms' costs of capital), inventory levels are subject
to management control. Inventory levels
(and policies)
could be
altered in response to LIFO-FIFO cash-flow incentives.
development expenditures by firms induced to change methods. Horwitz and Kolodny
suggest that such an association may be due to managerial compensation contracts, debt
covenant restrictions, or perceived market inefficiencies on the part of managers. Because
they employ a matched pair sample wherein firms are assigned to the treatment and control
groups on the basis of their pre-FASB 2 accounting methods (deferral and expense,
respectively), a potential threat to the internal validity of their study is that some systematic
difference exists between these groups which has both caused them to choose their
respective pre-FASB 2 methods and has caused them to make different post-FASB 2
expenditure decisions (e.g., different modes of ownership/financing). The preliminary draft
which is available at this writing does not allow a definitive judgment on this point.
10
Representative articles from the financial press include Coopers & Lybrand [1974],
Jannis and Johnson [1975], Keithley and Meek [1977], and Rothschild [1975].
11
See Biddle [1980, appendix BJ for historical trends in the use of alternative inventory
costing methods in various industries in the post-WWII period.

241

INVENTORY COSTING AND INVENTORY POLICY

GARY C. BIDDLE

241241241
Yet LIFO-FIFO tax incentives are not the only factors which affect
managers' decisions regarding desired year-end inventory levels. Storage
costs, order costs, anticipated price changes, order (or manufacturing)
lead times, stockout costs, and sales forecasts can immediately be sug
gested. These factors, many of which will be related to firms' major lines
of activity (industry memberships) may dictate characteristic patterns
for year-end inventories which are not readily alterable by managers.
Because these patterns may or may not be consistent with LIFO tax
advantages, both pre- and postadoption associations between inventory
properties and observed LIFO-FIFO choices should be anticipated.
Two hypotheses are suggested by the preceding discussion. The first,
which will be called the Anticipations hypothesis, suggests that managers
making voluntary accounting method choices will take into consideration
anticipated future events and circumstances affecting the expected costs
and benefits associated with the alternative methods.12 In choices be
tween LIFO and FIFO, year-end physical inventory levels have been
identified as an important determinant of associated future cash flows.
Thus, as applied in this study, the Anticipations hypothesis implies
systematic differences in the post-LIFO adoption inventory patterns of
LIFO adopters and nonadopters which are consistent with LIFO-FIFO
cash-flow incentives. Because some factors which affect inventory prop
erties will not be readily alterable by managers, systematic differences
may also be observed between the preadoption date inventory patterns
of LIFO adopters and nonadopters. While preadoption differences are
not directly implied by the Anticipations hypothesis, they would be
consistent with managers having based their forecasts of future inventory
properties, in part, on their past experiences.
The second hypothesis, which will be called the Incentives hypothesis,
suggests that managers will alter operating decisions in response to
incentives provided by alternative accounting methods (i.e., that account
ing choices may produce real effects). As applied in this study, the
Incentives hypothesis suggests that managers will modify their inventory
policies in response to the cash-flow incentives provided by LIFO and
FIFO. For those firms adopting LIFO, changes should be observed in the
properties of year-end inventories which are consistent with increasing
LIFO cash-flow advantages. Thus, the Incentives hypothesis also implies
systematic differences in the post-LIFO adoption inventory patterns of
LIFO adopters and nonadopters which are consistent with LIFO-FIFO
cash-flow incentives. To the extent these differences are observed, the
Anticipations and Incentives hypotheses both offer explanations: one
relating the LIFO-FIFO choice to managers' expectations regarding
inventory levels and the other relating subsequent inventory management
decisions to the LIFO-FIFO choice. The implications of these hypotheses
are summarized in table 1.
12

Managers making rule-induced accounting choices may similarly consider future costs
and benefits when more than one acceptable alternative remains.

TABLE 1
Implications for Associations Between Costing Method Choice and Year-End Inventory
Behavior
Anticipations Hypothesis. When making the voluntary accounting choice between
LIFO and FIFO, managers will take into consideration future patterns of year-end
inventory levels. These patterns will depend on a number of factors (in addition to tax
incentives available under the LIFO alternative) which may be industry- and firmspecific.
Incentives Hypothesis. Managers will respond to the tax-related incentives provided by the
LIFO cost-flow assumption by altering inventory management policies.

Implications.
(1) Differences should be observed between the postadoption date inventory patterns of
those firms which adopt LIFO and those that do not which are consistent with
increasing the tax-related cash-flow advantages of LIFO.
(2) Changes should be observed in the inventory patterns of those firms which adopt
LIFO which are consistent with increasing the tax-related cash-flow advantages of

LIFO.
(3) According to the previous implications, differences between the inventory patterns of
firms which adopt LIFO and those that do not should increase in a manner consistent
with LIFO cash-flow incentives between the pre- and post-LIFO periods.
(4) Because many of the factors which will affect desired year-end inventory levels are
related to aspects of firms which are not readily subject to management control (e.g.,
manufacturing processes, characteristics of factor and product markets, etc.), pre
LIFO adoption inventory patterns should differ between those firms that ultimately
adopt LIFO and those that do not."
As indicated, this implication represents an extension of the Anticipations hypothesis. The Antici
pations hypothesis itself implies only postadoption date differences.

4. LIFO-FIFO Cash Flows and Properties of Year-end

Inventories
This section outlines some testable implications of the Anticipations
and Incentives hypotheses. Because desired year-end inventory levels are
influenced by a number of factors, the discussion first identifies properties
of year-end inventories which influence LIFO-FIFO cash flows. A one
period optimal inventory quantity model is then presented which illus
trates how LIFO-FIFO cash-flow incentives will affect inventory man
agement decisions.
INVENTORY PROPERTIES WHICH AFFECT LIFO FIFO

CASH FLOWS

The cash-flow implications of the LIFO-FIFO choice arise from the

fact that these methods are used to compute the cost-of-goods-sold
( COGS), which is subtracted from revenues to determine taxable earn
ings. It can be shown that the difference between LIFO- and FIFO-based
measures of COGS equals the difference between the inventory holding
gains realized under each method. That method with the smallest holding
gain (largest holding loss) realization will produce the largest COGS.
Positive holding gains occur when a firm holds inventory units and input
prices increase. Negative holding gains (holding losses) occur when units
are held and prices decrease. Holding gains (losses) are said to be realized

when these units are sold. Since under the FIFO alternative those units
which are held in beginning inventories are assumed to be the first that
are sold each period, if a firm "turns over" its physical inventories at
least once (i.e., if it sells at least as many units as are in the beginning
inventory), then the holding gains on these units will be realized. Since
most firms have physical inventories which turn over at least once during
an annual accounting period, the use of the FIFO cost-flow assumption
means that all of the holding gains ( or losses) associated with beginning
inventory units will be realized each period. The only way a manager
using FIFO could reduce holding gain realizations would be to hold fewer
beginning inventory units. To avoid the holding gain realizations when
prices are increasing, he must also forego the holding gains. And to
increase holding loss realizations when prices are falling, he must incur
holding losses.
In contrast, the LIFO cost-flow assumption dictates that those units
which are held in the beginning-of-period inventory will be assumed sold
only if unit sales exceed unit purchases. As a consequence, if prices are
increasing, a manager can indefinitely postpone the realization of holding
gains associated with beginning inventory units (and on any units which
have been added to inventory in subsequent periods) by purchasing at
least as many units as are sold each period. This insures that the COGS
under LIFO will not be less than what it would have been under FIFO.
Thus, the LIFO cost-flow assumption offers the opportunity to postpone
indefinitely the realizations of holding gains on inventories. If prices are
decreasing, a manager may be able to realize sufficient LIFO holding
losses by drawing inventory levels down to provide a higher COGS on
LIFO than on FIFO.
Of course, other factors over which managers may have little control
will also influence desired year-end inventory levels. A manager contem
plating a LIFO-FIFO choice would have to assess the cumulative effect
of these factors on inventory properties as they affect LIFO-FIFO cash
13
flows. The preceding discussion suggests that with increasing inventory
13

One way in which insights could be gained into the determinants of LIFO-FIFO
choices (and their effects) would be to examine the underlying factors which affect desired
year-end inventory levels. For example, one could investigate whether firms with longer
order lag times are less likely to adopt LIFO (ceteris paribus). Aside from the formidable
data acquisition problems which would arise in an empirical study of factors like order lag
times, it is not clear that a general optimal inventory model exists which would enable all
of the relevant factors even to be identified. And without a general inventory model, it
is not clear how various factors ( once identified) would be combined to predict desired
year end inventory levels. While several recent studies (e.g., Cohen and Pekelman [1978;
1979], Cohen and Prastacos [1978], Prastacos [1978], and Cohen and Halperin [1979])
have examined LIFO inventory systems in the context of optimal order quantity
models, only two (Cohen and Pekelman [1979] and Cohen and Halperin [1979]) have
considered LIFO tax incentives.
Using a simplified model relating desired year-end inventory levels to known future
demand distribution, tax rates, discount rates and inventory input prices, selling prices,
holding costs, and stockout costs (each on an annualized basis), Cohen and Pekelman [1979]

INVENTORY COSTING AND INVENTORY POLICY

245
GARY C. BIDDLE
244
2442 prices, a firm with generally increasing and less variable physical
input
inventory levels would find greater advantages to a LIFO adoption than
an otherwise identical firm with decreasing or more variable inventories.
A MODEL OF OPTIMAL INVENTORY POLICIES IN THE PRESENCE
OF LIFO-FIFO TAX INCENTIVES

The one-period optimal inventory quantity model presented in Appen

dix A illustrates how LIFO-FIFO cash-flow incentives should influence
management decisions regarding year-end inventory levels. The model
(which parallels and extends a similar presentation by Cohen and Pek
elman [1979]) treats costs, decisions, and outcomes on an annual basis.
(This is appropriate since for income tax purposes a firm's costs and
inventory flows are aggregated annually.) The decision variable is an
"order up to" quantity (i.e., inventory units available for sale), and
demand is treated as if it arrives on the last day of the year. In spite of its
obvious simplicity, the model provides several testable implications.
These are: (1) Under conditions of input price inflation, LIFO inventories
will be greater than FIFO inventories. (2) Under conditions of input
price deflation, LIFO inventories will be smaller than FIFO
inventories. (3) The existence of additional LIFO layers with prices which
reflect current price changes will increase the differences (predicted in (1)
and (2) above) between the optimal level of inventory available for sale
under LIFO and FIFO.
While an extension of this model into a multiperiod setting would
result in greater realism, available evidence (see Cohen and Pekelman
[1979]) does not indicate major alterations would result in the conclusions
reached above. Moreover, in a multiperiod setting, the expected profit
expression for the LIFO case becomes quite complex and can only be
solved by assuming values for the model parameters and applying a
procedure like multidimensional search (see Cohen and Pekelman
[1979]).
One additional implication, however, will be offered. Under conditions
of input price inflation, the one-period model suggests that managers
using LIFO will be motivated to hold larger year-end inventories to avoid
the holding gain realizations which would occur if year-end inventories
fell below previous year-end levels. In a multiperiod setting, managers
found that the LIFO optimal inventory policy was nonstationary and nonmyopic in a
multiperiod setting (Cohen and Pekelman [1978, pp. 16-17]). Cohen and Halperin [1979]
considered the influence of intrayear inventory purchase decisions on year-end LIFO tax
effects. (The idea is that by timing intrayear purchases differently, the firm may be able to
alter the costs assigned to LIFO layers.) Although they used an even simpler model (which
considered only tax rates, holding costs, and input prices in a deterministic setting with
known subperiod sales and a fixed horizon), a linear programming formulation for one firm
over a period of only three years (twelve quarters) involved ninety-five variables and
seventy-eight constraints (Cohen and Halperin [1979, p. 15]). In general, the data which
would be required to predict desired year-end inventory levels using models such as these
are not readily available for an empirical study such as this one.

will be similarly motivated to avoid LIFO layer liquidations. Yet, in a

multiperiod setting, an addition to inventories in one period implies that
higher levels must be maintained in future periods if liquidations are to
be avoided. Additions to inventories in one period can produce, therefore,
greater inventory holding costs in future periods. As a result, managers
using LIFO in a multiperiod setting face greater incentives both to avoid
inventory liquidations and inventory additions than those using FIFO
(ceteris paribus). This suggests the following implication. (4) Under
conditions of input price inflation, LIFO inventories will be less variable
14
than FIFO inventories. Assuming the other implications of the one
period model also apply to the multiperiod setting, faster and less variable
rates of inventory growth should be observed for the treatment group
firms.

5. Research Design and Methodology

The empirical tests conducted in this study rely on pre- and post-LIFO
adoption comparisons between two groups of firms: a treatment group of
firms which adopted LIFO and a control group of firms which did not
adopt LIFO. Because the firms self-selected into these groups by adopting
or not adopting LIFO, random assignment could not be used to provide
experimental equivalence. However, each control group firm has been
matched with a treatment group counterpart on the basis of sales and
industry membership to control for the effects of other factors which
might influence associations between inventory properties and LIFO
adoption decisions.
While this design is not a true experimental design ( due to the absence
of random assignment), in the class of (ex post) quasi-experimental
designs it offers several advantages which increase the internal validity
15
of the comparisons. If, for example, comparisons were made between
the pre- and post-LIFO adoption inventory properties of the treatment
group firms alone, an important threat to internal validity would be the
possibility that some other event besides the LIFO adoption could have
produced any observed changes in inventory properties. This is known as
the history threat. This design would also be subject to the maturation
threat-the possibility that an observed difference may be due to the
firm's natural evolution or maturation through time. The use of control
group firms reduces the history and maturation threats by allowing
relative assessments of treatment group firm characteristics (i.e., relative
to the control group firms).
14

This implication is consistent with the analytical results of a recent study by Halperin
[1979]. Halperin examined the economic efficiency aspects of the LIFO method and
concluded that "the LIFO firm will ... use some of its productive resources to maintain
year-end inventory levels as a result of the fact that the year-end inventory maintenance
activity increases after-tax profits" (Halperin [1979, p. 65]).
15
For a discussion of experimental design issues and terminology, see Campbell and
Stanley [1963].

MEASURING PHYSICAL INVENTORY LEVELS AND COGS

DIFFERENCES

The Anticipations and Incentives hypotheses suggest associations be

tween LIFO-FIFO choices and firms' year-end physical inventory levels.
Yet, because any two firms are likely to hold different types of inventory
goods (even if they are in the same industry), and since a given firm will
hold different goods at different points in time, actual physical unit
counts would not provide meaningful comparisons. Moreover, physical
unit counts are rarely disclosed. Instead, firms typically disclose year-end
inventory dollar amounts which have been determined by applying cost
flow assumptions to physical inventory counts.
Due to some recent disclosure pronouncements, most firms which have
adopted LIFO in fiscal years 1973 and thereafter have continuously
disclosed what their year-end inventory dollar amounts would have been
if they had instead applied FIF0.16 When a firm uses the FIFO (or an
average cost) assumption, its year-end inventory amounts will reflect
recent input costs. Since virtually all firms "turn over" their inventories
at least once each year, FIFO-based year-end inventory amounts will
generally be composed of units purchased during that year.17 If an
assumption is made about the rate of inventory procurement (purchase
or production) in a year ( e.g., uniform), the relationship between
FIFO based year-end inventory amounts and annual inventory dollar
purchases reveals the timing of inventory unit purchases. By applying
available price indexes to these inventory purchases, a dollar-based
measure of year-end physical inventories can be obtained.
This approach was used to obtain an equivalent dollar-unit measure of
year-end physical inventory levels.18 Because this measure is denomi
nated in dollars of equivalent purchasing power, it is comparable both
across firms and through time. Two versions were derived: one equivalent
unit measure is based on monthly price indexes (EUM), while the other
is based on annual price indexes (EVA). The following relationships
describe their derivation (firm subscripts are omitted):

EUM, -

u,.

<1> {

($EI/ -

u,.

;t:

P,. ,2-1

)1( u..r;

12-,l}
EUAt = $EI//E't
16

See Accounting Principles Board Opinions No. 20 and No. 22, Securities and Ex
change Commission Rule 5-02-6b of Regulation S-X and Accounting Series Release
No.
141, and Internal Revenue Service Revenue Ruling 73-66 and Revenue Procedure 73-37.
17
All of the firms employed in this study had inventory turnovers greater than one in all
years utilized.
18
Derstine and Huefner [1974] apparently used a similar methodology (they called it
"the Dollar- Value LIFO method" [1974, p. 218]) to derive an estimate of the differences
between FIFO and LIFO inventory dollar values. Their study, which was designed to assess
the effects of inventory costing method choice on the financial ratios of twenty-four
companies, did not provide any examples or further description of the conversion method
ology. Notice that their estimates were of dollar amounts and not of physical inventory
levels.

INVENTORY COSTING AND INVENTORY POLICY

248
GARY C. BIDDLE
248248248
2482
these hypotheses, the treatment group firms should exhibit larger COGS
Differences in the post-LIFO periods relative to their control group
counterparts and should exhibit relatively larger COGS Differences in
the post-LIFO than in the pre-LIFO periods.
EMPIRICAL TEST METHODOLOGIES

Three nonparametric statistical techniques are employed in the sub

sequent empirical tests of the Anticipations and Incentives hypotheses.
Although some direct comparisons are made between the paired treat
ment and control group firms, the primary empirical tests examine
changes between the pre- and post-LIFO periods in the relative attributes
of the paired firms. Nonparametric techniques are appealing for these
comparisons, since they require few assumptions about the underlying
attribute populations. The Wilcoxon matched pairs signed ranks test (see
Hollander and Wolfe [1973, pp. 27-33]) utilizes both the signs of the
changes and their ranks (i.e., their relative sizes) in testing whether the
median change across the firm pairs is significantly different from zero.
Although this test is potentially the most powerful of the three employed,
it assumes that the changes come from independent, continuous, and
symmetric distributions with a common median. While data transfor
mations can be employed to provide changes of the same general mag
nitude, the nonrandom sample selection procedures may result in viola
tions of these assumptions. (The independence assumption, for example,
includes size independence across firm pairs.)
The matched pairs sign test examines only the signs of the pre- to post
LIFO changes in testing whether the median change is significantly
different from zero (see Hollander and Wolfe [1973, pp. 39-45]). Although
the sign test is less powerful than the Wilcoxon test, it does not require
size independence across firm pairs and assumes only that the changes
come from independent distributions with a common median. Like the
Wilcoxon test, the sign test does not require independent pre- and post
LIFO observations. However, since both tests can accommodate only one
pre- and one post-LIFO attribute observation (i.e., one change observa
tion) for each firm pair, subsequent tests are based on summary measures
(usually averages) over multiple pre- and post-LIFO attribute observa
tions. Both Wilcoxon and sign test results are presented for each empirical
comparison below.
Because the use of summary measures in the Wilcoxon and sign tests
ignores the information contained in the individual observations, a third
nonparametric procedure has been introduced. This procedure (see
Noether [1967, pp. 41-43]) assumes a separate distribution for each group
of pre- and post-LIFO observations previously summarized and tests
whether these distributions are equal. While the N oether technique, like
the sign test, does not require size independence across firm pairs, it does
require independence for the successive attribute observations of each

firm pair. Since the N oether procedure yields

iden

implications almost

tical to those provided by

the Wilcoxon and sign tests, the results are
presented in Appendix B.19

6. Data and Data Collection Procedures

TREATMENT GROUP FIRM SELECTION

The first step in compiling the data was the identification of a treatment
group sample of firms which adopted LIFO. Two factors limited the
range during which this adoption could have taken place. First, because
the IRS ruling (Revenue Ruling 73-66) which permitted the disclosure of
FIFO-based inventory amounts for LIFO adopters applied only to fiscal
years 1973 and thereafter, footnote disclosures of these amounts were not
consistently available in firms' financial statements before 1972. 20 Second,
to insure a sufficient number of data points in the post-LIFO
adoption
period, fiscal 1975 was the last adoption date considered.21 These dates
encompass 1974, which was a year during which a large number of firms
adopted or extended their use of LIFO.
Employing COMPUSTAT primary inventory-costing method codes and
the Disclosure Journal (which is a record of 10-K, 10-Q, and 8-K filings
with the SEC) a total of 251 firms within a COMPUSTAT longevity subsam
ple22 were found to have adopted LIFO or extended its use during
the
period 1972- 75.23 The following data were then gathered from
footnote
disclosures in the annual reports of each of these 251 firms: (1) the
proportion of inventories which were valued using various inventory
costing methods and (2) estimates of what their inventory valuations

A random coefficients regression approach (see Swamy [1970]) was also considered as
a means of aggregating the time series of attribute observations across firm pairs. This
procedure assumes constant variances and zero covariances from period to period in each
component regression as well as the absence of any auto (or serial) correlation of the
disturbance terms. While autocorrelations were found to be generally insignificant, a joint
likelihood ratio test for constant variances between periods (see Keeping [1962,
pp.
214-16]) revealed for the several attribute ratio series (see Sect.ion 7) to which it was
applied significant departures from this assumption. Some trial random coefficients regres
sions on these series produced generally insignificant results.
20
A firm adopting LIFO in 1972 would have made these disclosures in accordance with
APB Opinion No. 20, which deals with accounting changes.
21
At the time of data collection, financial statement disclosures were available only
through fiscal 1978.
22
The longevity subsample of COMPUSTAT firms available at the University of Chicago is
composed of those firms with certain specified financial statement data consistently avail
able over the period of at least 1950- 70. This subsample, which contains 755 firms, was
employed to insure generally longer periods of continuous data availability for time-series
tests.
21
: The Disclosure Journal also identifies changes from LIFO to FIFO. For the period
surveyed (1972-75), there were very few changes in that direction.
19

250
2502

INVENTORY COSTING AND

250250250
GARY C. BIDDLE

INVENTORY POLICY

would have been had they not adopted LIFO. 24 These data were
obtained for the year preceding the year LIFO was adopted or
extended ( these dates were in some cases modified) and for all
subsequent years for which these disclosures were available.
Although 251 firms were found to have extended their use of LIFO
sometime during the period 1972- 75, several problems became evident.
In some cases, LIFO was adopted for only a small portion of inventories,
in others, LIFO was already being used to some extent, and in some
cases, firms had experienced marked changes in size due to mergers,
acquisitions, and divestitures. Previous LIFO use would bias the equiv
alent unit measures, since they rely on a FIFO cost-flow assumption, and
would thus confound time-series tests of inventory properties around
LIFO adoption dates.25 Small LIFO extensions may not provide detect
able changes in inventory policies or detectable incentives for LIFO
adoption, while major changes in firms' sizes (due to mergers, acquisitions,
etc.) could bias both time-series and paired comparisons. To reduce these
problems the treatment group sample was limited to: (1) firms which
converted at least 20 percent of their inventories (based on dollar values)
to LIFO in the LIFO adoption year and a proportion equal to at least 30
percent within three years of their LIFO adoption dates26 and (2) firms
which had not used LIFO for more than 10 percent of their inventories
(based on dollar values) prior to their LIFO adoption dates.
Since no comprehensive record of mergers, acquisitions, and divesti
tures was readily available for the entire post-WWII period, a year-to
year comparison of sales was used to identify major changes in firms'
sizes. To provide a minimum-time series of pre-LIFO adoption data
points for all firms over periods in which their sizes did not markedly
change, the treatment group sample was further limited to: (3) firms with
at least a six-year period prior to their LIFO adoption dates over which
sales were less than double and more than half of what they were the
27
previous year.

24
As suggested in IRS Revenue Ruling 73-66, virtually all of the firms disclosed what
their inventory values would have been if FIFO had been employed instead of LIFO.
25
For example, a firm which had previously used LIFO for 40 percent of its inventories
and which extended this use to 60 percent would report in the notes to its financial
statements after the extension what its inventories would have been if it had valued them
using FIFO. In this case, the preextension amounts (based on 40 percent LIFO and 60
percent FIFO) would not be comparable with the postextension amounts (which in the
notes would be 100 percent FIFO).
26
In some cases, firms disclosed percentages or used phrases like "substantially all" to
describe what portion of their inventories were valued using LIFO. In these cases, judgment
was exercised to determine whether the firms had converted a sufficient portion of their
inventories to LIFO to be included in the treatment group sample.
27
Six years was chosen to provide a minimum pre-LIFO adoption period equal in length
to the longest post-LIFO adoption period in the paired sample. This additional condition
reduced the sample by three firms.

SELECTION OF CONTROL GROUP FIRMS

The next major step in the data collection process involved the iden
tification of a matched pair control group sample of firms which were
"similar" to their treatment group counterparts, but which had never
used the LIFO cost-flow assumption. The selection process for the control
sample firms was restricted to the COMPUSTAT files to insure data avail
ability, but was not limited to the longevity subsample due to the limited
number of candidate firms in that subsample. For each of the firms in the
treatment group sample, an attempt was made to identify a control firm
counterpart on the basis of the following criteria: (1) no use of LIFO as
28
indicated by the COMPUSTAT inventory-costing method codes for any
year for which these data were available; (2) the same four-digit SIC
industry classification as the treatment group firm; (3) the same size
(measured by net sales in the LIFO adoption year) where there was more
than one candidate based on the other criteria; (4) a period of at least six
years prior to the treatment group firm's LIFO adoption date over which
sales less than doubled and were more than half of what they were the
previous year.
In several industries (e.g., chemicals and glass) nearly all of the COM
PUSTAT firms were either already using LIFO to some extent or simul
taneously adopted LIFO. As a result, even though the control group
selection criteria were relaxed slightly in a few cases (see below), control
group counterparts were not available for forty-two of the treatment
group firms.
The resulting paired samples of 105 treatment and control group firms
serve as the basis for subsequent descriptions and analyses. They are
presented in table 2 along with their four-digit SIC industry classifications
(according to the 1977 COMPUSTAT files). In those twenty-three cases
where two SIC codes are indicated, control firms were selected from four
digit SIC industry classifications different from those of their treatment
group counterparts. Even here, however, each control group firm has the
same two- or three-digit SIC classification as the corresponding treatment
group firm (except for Super Value Stores and Stop and Shop Compa
nies). In a few instances, the requirement that a control group firm could
not have used LIFO to any extent over the range of available data was
also relaxed. These instances are noted in the far right-hand column of
table 2. For all of the other control group firms, there was no evidence of
LIFO use in the COMPUSTAT files over the entire range of data availability.
Table 2 also indicates the relative sizes of the paired treatment and
control group firms and the number of months by which their fiscal year28
Starting in 1963 the coMPUSTAT inventory method code indicates all methods disclosed
in a firm's annual reports in order of application (i.e., the primary method is reported first,
the next most widely employed method second, etc.). Unless indicated otherwise, the
control group firms did not utilize LIFO to any extent over the entire range of
available data.

252

GARY

c.

BIDDLE

TABLE 2

Treatment and Control Group Samples

Treatment
Group Firm

SIC
Industry
Classification"
(1977

Corresponding
Control Group
Firm

Sales
Ratio**

Texas Gulf Inc.

Brush Wellman Inc.
Dome Mines Ltd.
Dillingham Corp.
Fluor Corp.
Green Giant Co.
American Bakeries Co.
Olympia Brewing
Pepsico Inc.
Royal Crown Cos. Inc.
Stevens (J.P.) & Co.
Belding Heminway
Phillips-Van Hausen
Jantzen Inc.
Boise Cascade Corp.
Evans Products Co.
Brown Co.
Domtar Inc.
Federal Paper Board
New York Times Co.
Cadence Ind. Corp.
McGraw-Hill Inc.
Hall (W. F.) Printing
Reynolds & Reynolds
Intl. Minerals/Chem.
Unilever NV
Grace (W. R.) & Co.
Sherwin-Williams Co.
Purex Corp.
Akzonia
Merck & Co.
Rorer Group
Insilco Corp.
Crompton & Knowles
A very International
Products Res./Chem.
Imperial Oil Ltd.
Amerace Corp.
Monogram Inds. Inc.
Uniroyal Inc.
Dunlop Holding Ltd.
Alliance Tire/Rubber
Aegis Corp.
O'Sullivan Corp.
Genesco Inc.
Seagrave Corp.
General Portland Inc.
Spartek Inc.
Hofmann Industries
NW Steel & Wire Co.
Tubas de Acer. de Mex.
Atlas Cons. Min./Dev.
Masco Corp.
Phillips Industries
Zero Corp.
Eastern Co.
Diebold Inc.
Automated Bldg. Com.
Foster Wheeler Corp.

0.21
1.29
1.93
4.02
0.60
1.03
0.33
1.04
1.21
0.18
0.70
1.13
1.59
0.91
1.67
0.32
2.55
1.01
0.60
1.88
1.82
0.89
1.61
2.24
2.25
0.88
1.01
1.07
1.05
0.64
1.16
0.56
0.20
2.19
1.09
8.15
1.89
1.10
0.80
0.75
0.95
1.86
2.47
4.15
0.61
7.17
0.29
2.38
3.28
1.04
2.66
0.75
1.25
1.51
6.29
0.92
0.65
2.06
1.63

FYE
Notes
Differ(see
ence*** below)

COMPUSTAT)

Cleveland-Cliffs. Co.
Foote Mineral Co.
Homestake Mining
Halliburton Co.
McDermott (J. Ray)
Stokely-Van Camp Inc.
Tasty Baking Co.
Heileman Brewing Inc.
Coca-Cola Co.
Pepcom Inds.
Armstrong Cork Co.
Masland (C.H.) & Sons
Hart Schaffner & Marx
Munsingwear Inc.
Georgia-Pacific Corp.
Masonite Corp.
Scott Paper Co.
Union Camp Corp.
Stone Container Corp.
Times Mirror Co.
Meredith Corp.
Donnelley (R. R.)/Sons
Standard Register Co.
UARCO Inc.
Celanese Corp.
DuPont de Nemours
Monsanto Co.
Stauffer Chemical Co.
Chemetron Corp.
Reichhold Chemicals
Pfizer Inc.
Tampax Inc.
Pratt & Lambert Inc.
Nalco Chemical Co.
Ferro Corp.
Sun Chemical Corp.
Shell Oil Co.
Armstrong Rubber
Cooper Tire & Rubber
General Tire & Rubber
Goodrich (B. F.) & Co.
Mansfield Tire/Rubber
Mohawk Rubber Co.
Rubbermaid Inc.
Brown Group Inc.
Libby-Owens-Ford Co.
Mo. Portland Cement
Basic Inc.
Bliss & Laughlin Inds.
Copperweld Corp.
Lukens Steel Co.
U.S. Reduction
Wallace-Murray Corp.
Allied Products
Std. Pressed Steel
Wolverine Pentronix
Lamson & Sessions Co.
Synalloy Corp.
Combustion Engineering

1000
1000
1041
1600
1600
2030
2050
2082
2086
2086
2270-2200
2270-2200
2300
2300
2400
2400
2600
2600
2650
2711
2721
2750-2731
2761-2750
2761
2800-2870
2800-2841
2800
2810-2850
2810-2841
2820
2830
2830
2850
2860
2890
2890
2911
3000
3000-3079
3000
3000
3000
3000
3000-3069
3140
3210
3241
3290-32.SO
3310
3310
3310
3341-3330
3430
3449
3449
3449
3452-3499
3499
3510

0
0
0
0
7
0
0
0
0
0
2
0
10
4
0
4
5
0
0
0
6
0
9
0
6
0
0
4
6
0
0
0
0
0
1
3
0
3
6
1
0
0
0
0
3
0
0
2
8
5
0
1
0
9
9
0
8
8
0

253

GARY INVENTORY
C. BIDDLE COSTING AND INVENTORY POLICY

Treatment
Group Firm

SIC
IndustryTable
Classification"
(1977
COMPUSTAT)

2.

Corresponding
Continued
Control
Group Firm

Sales
Ratio**

253

FYE
Notes
Differ(see
ence below)

254

GARY INVENTORY
C. BIDDLE COSTING AND INVENTORY POLICY

Clark Equipment Co.

Unarco Inds. Inc.
Dresser Inds. Inc.
Big Three Inds.
Monarch Machine Tool
Emhart Corp.
Ex-Cell-O Corp.
Leesona Corp.
Chicago Pneumatic Tool
Gardner-Denver Co.
Ingersoll-Rand Co.
Parker-Hannifin Corp.
Carrier Corp.
Copeland Corp.
Fedders Corp.
UMC Inds.
McGraw-Edison Co.
Maytag Co.
RCA Corp.
Zenith Radio Corp.
Mallory (P.R.) & Co.
Cummins Engine
Borg-Warner Corp.
Budd Co.
Buell Inds. Inc.
Federal-Mogul Corp.
TRW Inc.
Timkin Co.
Ametek Inc.
Johnson Controls Inc.
Multi-Amp Corp.
Tektronix Inc.
Bausch & Lomb Inc.
Johnson & Johnson
Eastman Kodak Co.
Parker Pen Co.
Fleming Cos. Inc.
Super Value Stores
Carter Hawley Hale
Marshall Field & Co.
K-Mart Corp.
American Stores Co.
Safeway Stores Inc.
Winn-Dixie Stores
Thrifty Corp.
Teledyne Inc.

3531
3531
3533
3533
3540
3550
3550
3550
3560
3560
3560-3570
3560-3570
3580
3580
3580
3580
3610
3630
3651-3662
3651-3662
3679
3713-3711
3714
3714
3714
3714
3714
3714-3728
3811
3820-3811
3825
3825-3823
3830
3841
3861
3950
5140
5140-5411
5311
5311
5331-5311
5411
5411
5411
5912
9997

Bucyrus-Erie Co.
Am. Hoist & Derrick
Schlumberger Ltd.
Smith International
Skil Corp.
Black & Decker Mfg.
Midland-Ross Corp.
Selas Corp. of Amer.
Stewart-Warner Corp.
Curtiss-Wright Corp.
Burroughs Corp.
Pitney-Bowes Inc.
Tecumseh Products
GCA Corp.
Vendo Co.
Tokheim Corp.
Eltra Corp.
Republic Corp.
Raytheon Co.
Motorola Inc.
Ampex Corp.
American Motors Corp.
Eaton Corp.
Arvin Inds. Inc.
Aspro Inc.
Champion Spark Plug
Bendix Corp.
Rohr Industries
Beckman Instruments
Perkin-Elmer Corp.
Fluke (John) Mfg. Co.
General Signal Corp.
ITEK Corp.
Am. Hospital Supply
Minn. Mining & Mfg.
Binney & Smith Inc.
Scot Lad Foods
Stop & Shop Cos.
Gamble-Skogmo
Cook United Inc.
Zayre Corp.
Jewel Cos. Inc.
Great Atl./Pac. Tea
Lucky Stores Inc.
Gray Drug Stores
Litton Industries

5.24
0.56
1.22
0.81
0.52
0.52
0.93
3.53
1.04
1.20
0.94
0.89
1.73
5.12
3.74
4.69
1.19
1.02
2.38
0.67
0.91
0.42
1.00
3.07
0.76
0.84
1.01
1.58

0
1

1.16

0.95
0.16
0.61
1.50
1.97
1.56
2.34
1.85
1.34
0.75
1.23
5.17
1.05
1.21
0.94
1.80
0.56

5
5
7
0
0
0
10

253

0
0
3
1
0
0
0
0
6

2
0
2
1

3
5
0
0
8
3
0
0
3
0
3
5

6
1

0
11
0

10
5
4
5

When two codes are listed, the first is for the treatment and the second for the control firm.
** Net sales of treatment group firm divided by net sales of control group firm in the LIFO adoption
year.
Number of months in the same year between fiscal year-ends of treatment and control group
firms. (Based on 1977 FYE.)
W.R. Grace and Company used LIFO as a tertiary inventory costing method in the years 197477. During this period FIFO and Average Cost were the primary and secondary methods.
h Northwestern Steel and Wire Company used the LIFO inventory costing method between 1960 and
1963.
c General Signal Corporation used the LIFO inventory costing method during the period 1948-61 and
as a tertiary method during the period 1963-69.
d Gray Drug Stores employed the LIFO inventory costing method during the period 1963-68.

ends differed. 29 Forty of the firm pairs had a control group firm with sales
greater than or equal to those of its treatment group counterpart in the
LIFO-adoption year, while the reverse was true for the remaining sixty
five firm pairs. In only two cases is the treatment group firm less than
one-fifth the size and in only six cases more than five times the size of the
corresponding control group firm according to this sales ratio measure.
Table 2 also reveals that a majority of the matched firm pairs (53 out
of
105) have identical fiscal year-end months. Table 3 presents the distri
bution of LIFO adoption dates for the treatment group firms in the
paired sample. The vast majority of these firms (92 out of 105) adopted
LIFO in 1974.
DATA AVAILABILITY

To provide for the computation of the E UA, E UM, and COGS Differ
ence series, all available observations of the following data items were
obtained for each treatment and control group firm: (1) FIFO-based year
end inventory amounts, (2) FIFO-based COGS, (3) sales, and (4) industry
specific wholesale price indexes.
The inventory, COGS, and sales data were obtained from the COMPU
STAT files and from available published financial statements (and notes
thereto as described above). A wholesale price index ( WP!) series was
chosen to match each of the seventy-four four-digit SIC industry
classi fications represented in the treatment and control group samples
based on each firm's 1977 COMPUSTAT code. The industries and the
WP! series chosen for each are listed in table 4. The price index
observations were obtained from the Data Resources Incorporated (
DR!) files at the University of Chicago and from various issues of
Wholesale Prices and Price Indexes (U.S. Bureau of Labor Statistics).
WPis were used as a measure of inventory input prices because of their
wide industry coverage and because most are available on a monthly
basis for the post-WWII period (see table 4). WPis can be expected to
provide a close approxi mation to inventory input price levels and price
changes, especially when inventories include finished and semifinished
goods and when purchases take place at close to a uniform rate
throughout each year. All of the WPis employed use 1967 as their base
year (i.e., the price level in 1967 equals 100).
Tables 5 and 6 present the distributions of joint data availability of the
E UM, E UA, and COGS Differences series for the paired treatment and
control group firms. In each case, the distributions include only those
data ranges over which the sales of both the treatment and the control

29

Fiscal year-end month was not used as a selection criterion for control group firms.
It is presented in table 2 as a descriptive statistic which is important in determining
whether the paired firms would have been reacting to similar economic events in
determining their fiscal year-end inventory levels. Similar fiscal year-end months
contribute to the internal validity of the empirical tests by reducing the possibility that
paired firms were reacting to different forecasts and events.

255
2552

INVENTORY COSTING AND INVENTORY POLICY

GARY C. BIDDLE
255255255

TABLE 3
LIFO Adoption Dates of Treatment Group Firms
Year

1973
1974
1975
Total

Number of Firms
Adopting LIFO
in Each Year

Percent of Sample

11

1.9
87.6
10.5

105

100%

2
92

firm in each pair were less than double and were more than half of what
they were the previous year. Table 5 exhibits the generally longer periods
of pre-LIFO data availability obtained when the equivalent unit measure
is based on annual (EUA) rather than monthly (EUM) price indexes."
The difference in data availability between the E UMs and COGS Differ
ences arises from the need for a start-up year in the calculation of the
31
COGS Differences.
Because during the post-LIFO adoption periods the treatment group
firms disclosed both the proportions of their inventories valued using
alternative costing methods and their inventory valuations under
each, a rough check was
available for the COGS Differences
calculations. Comparisons for ten randomly selected treatment group
firms were made between the COGS Differences obtained from the
estimation algorithm and comparable figures derived from the firms'
financial statement dis closures. While there were some relatively large
deviations in the yearly estimates, over the range of post-LIFO years
the sum of the estimates provided by the algorithm were generally
within 10 percent of the corresponding figure derived from the
32
financial disclosures (see Biddle [1980, pp. 51-52]).
This evidence
suggests that the algorithms used to estimate the COGS Differences and
the EU measures on which they are based provide estimates close to
those which would have been obtained from internal documents.

7. Empirical Results
In the discussion which follows, Sample 1 refers to the 105 matched
pairs of treatment and control group firms listed in table 2. Sample 2 is
that subset of Sample 1 in which (a) the paired treatment and control
group firms have identical four-digit (SIC) industry classifications, ( b)
the treatment group firms have 1974 LIFO adoption dates, and ( c) the
treatment group firms have sales less than five times and more than oneWhen calculating the E UAs, the annual price indexes employed were based on an
average of the monthly indexes ending in the firm's fiscal year-end month.
:ii The E UA estimate was used in the start-up year when available in place of the E UM
estimate.
32
This is the appropriate comparison since the empirical tests employing the COGS
Differences are based on these sums.
30

TABLE 4
Wholesale Price Indexes Selected for Industries Represented in Treatment and Control
Firm Samples
Four
Digit
SIC
Indus
try
Code
1000
1041
1600
2030
2050
2082
2086
2200
2270
2300
2400
2600
2650
2711
2721
2731
2750
2761
2800
2810
2820
2830
2841
2850
2860
2870
2890
2911
3000

3069
3079
3140
3210
3241
3250
3290
3310
3330
3341
3430
3449
3452
3499
3510
3531
3533
3540
3550
3560
3570
3580
3610
3630

COMPUSTAT

Industry
Name

Metal Mining
Gold Ores
Construction (Not Bldg.)
Canned-Pres. Fr./Veg.
Bakery Products
Malt Beverages
Bot., Canned Soft
Drinks Textile Mill
Products Floor Covering
Mills Apparel, Other Fin.
Pds.
Lumber & Wood Products
Paper & Allied Products
Paperbd. Cont.-Boxes
Newspapers: Pub.-Print
Periodicals: Pub.-Print
Books: Pub., Printing
Commercial Printing
Manifold Business Forms
Chemicals, Allied Pds.
lndl. Inorganic Chem.
Plastic Mtrl., Syn. Resin
Drugs
Soap, Other Detergents
Paints, Varn., Lacquers
lndl. Organic Chemicals
Agricultural Chemicals
Misc. Chemical Pds.
Petroleum Refining
Rubber, Misc. Plastic
Fab. Rubber Pds., Nee.
Misc. Plastic Pds.
Footwear ex. Rubber
Flat Glass
Cement Hydraulic
Structural Clay Pds.
Abrasive Asbestos
Misc. Min.
Blast. Furn., Steel Works
Prim-Smelt-Refin. Nonfer.
Mtl.
Sec-Smelt-Refin. Nonfer.
Mtl.
Heating Eqpt., Plumbing
Misc. Metal Work
Bolts-Nuts-Screws-RivW ashers
Fabr. Metal Pds.
Nee. Engines,
Turbines
Constr. Mach/Eqpt. (M &
E) Oil FieldM &E
Metalworking M & E
Special Industry Mach.
General Ind. M & E
Off. Comp., Acct. Mach.
Refrig., Service Ind.
Mach.
Elec. Trans., Dist. Eqp.
Household Appliances

WP!
Identi
fication
Cod et
1011 NS
102 NS
1321
024 NS
021 NS
026 NS
026 NS
03 NS
132 NS
035 NS
08 NS
09 NS
0915 NS
C313 NS
0913 NS
0913 NS
0913 NS
0913 NS
06 NS
061 NS
066 NS
063 NS
067 NS
0622 NS
061 NS
065 NS
067 NS
057 NS
07 NS
071 NS
07 NS
043 NS
1311 NS
132 NS
134 NS
13 NS
101 NS
1022 NS
1024 NS
106 NS
108 NS
104 NS
107 NS
119401 NS
112 NS
1191 NS
113 NS
11 NS
116 NS
114 NS
119301
1141 NS
1174 NS
124 NS

WP!
Industry
Description
Iron Ore Nonferrous
Metals Sand, Gravel,
Cr. Stone Processed
Fr./Veg. Cereal, Bakery
Prod. Beverages, Bev.
Malts Beverages, Bev.
Malts Textile Pds. &
Apparel Floor
Coverings
Apparel
Lumber & Wood Products
Paper & Allied Products
Conv. Paper, Paperbd.
Paper
Paper
Paper
Paper
Paper
Chemicals, Allied Pds.
Industrial Chemicals
Plastic Resins, Mtrls.
Drugs, Pharmaceuticals
Other Chem., Allied Pds.
Paint Materials
Industrial Chemicals
Agr. Chem., Chem. Pds.
Other Chem., Allied Pds.
Ref. Petroleum Pds.
Rubber, Plastic Pds.
Rubber, Rubber Pds.
Rubber, Plastic Pds.
Footwear
Flat Glass
Concrete Ingredients
Struc. Clay Pds. ex. Ref.
Nonmetalic Mineral Pds.
Iron, Steel
Prim. (Nonfer.) Mtl.
Refin. Shapes Sec.
(Nonfer.) Mtl.
Refin. Shapes
Heating Equipment
Misc. Metal Pds.
Hardware
Fabr. Struc. Metal Pds.
Gas Engines
Constr. M & E Oil
Field M & E
Metalworking M & E
Mach. & Equipment
Special Ind. M & E
Gen. Purp. M & E
Comp., Related Mach.
Pumps, Compressors,
Eqpt.
Transformers, Pwr Reg.
Household Appliances

Data
Avail
ability
(Key
below)

A
A

A
A
1/47-12/60
1/61-12/78
A

A
A

Table 4. Continued

Data

FourDigit
SIC
Industry
Code

COMPUSTAT

Industry
Name

WPI
Identification
Cod et

WPI
Industry
Description

Avail
ability
(key
below)

3651

Radio-TV Rec. Sets

3662

Radio-TV Trans. Eqp.

3679
3711
3713
3714
3728
3811
3820
3823
3825
3830
3841
3861
3950

Electr. Comp. Nee.

Motor Veh., Car Bodies
Truck, Bus Bodies
Motor Veh. Pts., Acs.
Aircraft Pts., Aux. Eqpt.
Engr. Lab, Res. Eqpt.
Meas., Control Instr.
Indust. Meas. Instr.
Elec. Meas., Test Instr.
Optical Instr., Lenses
Surg., Med. Instr., App.
Photo. Eqpt., Supply
Pens, Pencils, 0th.
Office Mat!.
Whsl. Groceries,
Related Pds.
Ret. Dept. Stores
Ret. Variety Stores
Ret. Grocery Stores
Ret. Drug, Propriety
Conglomerates

5140
5311
5331
5411
5912
9997

117 NS
125 NS
117 NS
117827 NS
1178 NS
141 NS
141102
141 NS

10 NS
1178 NS
1178 NS
1178 NS
1178 NS
154 NS
117 NS
154 NS
119307 NS
01402 NS

CDNS
CFGEFNS
FOOD NS
063 NS
NS

Electr. M & E
Home Electronic E.
Electr. M & E
Elec. Hdw /Rad. Hdw
Electr. Comp., Acs.
Motor Veh., Eqpt.
Motor Trucks
Motor Veh., Eqpt.
Metals, Metal Pds.
Electr. Comp., Acs.
Electr. Comp., Acs.
Electr. Comp., Acs.
Electr. Comp., Acs.
Photo Supply, Eqpt.
Electr. Mach, Eqpt.
Photo Eqpt., Supply
Other Off., Store Mach.

1/47-12/54
1/55-12/78
1/47-11/68
12/68-12/78

*
A

Farm Foods, Proc. Foods,

Feeds
Fin. Consumer Durables
Cons. Fin. Gds. ex. Food
Cons. Finished Foods
Drugs, Pharm.
All Commodities

t Identification code in each case is WPI plus the indicated code.

* Monthly data over entire period 1/1947-12/178.
A Annual data l/1947-12/1972, monthly data l/1973-12/1978.

fifth as large as their control group counterparts in 1974. The sixty-seven

firm pairs contained in Sample 2 comprise, therefore, a set which is less
subject to several possible threats to the validity of the empirical com
parisons.
To simplify the presentation further, some abbreviations are employed.
EU refers to the equivalent unit measures of physical inventory levels,
with E UM and EVA denoting those calculated using monthly and annual
price indexes, respectively. (These measures are denominated in 1967
dollars.) Sales refers to net sales in dollars, while Sales-- indicates net
sales expressed in 1967 dollars. COGSDIF (denominated in dollars) stands
for the COGS Difference (= COGSL - COGSF). Each of these abbrevi
ations may be accompanied by the subscripts T or C, which refer to the
treatment and control group counterparts, respectively. The terms Av
erage and Ave are used interchangeably to refer to both time-series and
cross-sectional averages; their contexts should make clear which type of
average they denote. Other notation includes log for natural logarithmic
transformation,33 !:,. for first differencing in time, and SD for standard
deviation.
:i:i The log transformations permit differences between the attributes of paired firms (and
differences between attribute ratios in different time periods) to be compared across the
firm pairs by abstracting from differences in firm sizes. The log transformation was not
applied to the COGSDIF observations because these can assume negative values.

258

GARY C. BIDDLE

TABLE 5
Pre-LIFO Adoption Data Availability
Number of
Years of
Pre-LIFO
Adoption
Data

EUMs*
Number
of Firm
Pairs

6
8
1
1
5
2
3
0
2
4
5
8
1
4
21
10
8
2
5
3
2
4

27
26
25
24
23
22
21
20
19
18

17
16
15
14
13
12
11

10
9
8
7
6

Total

105

EUAs**

Cum.%

5.7
13.3
14.3
15.3
20.1
22.0
24.9
24.9
26.8
30.6
35.4
43.0
44.0
47.8
67.8
77.3
84.9
86.8
91.6
94.5
96.4
100.0

Number
of Firm
Pairs

15
12
3
7
3
4
2
3
3
5
0
1
16
9
3
3
3
3
4
4

Cum.%

14.3
25.7
28.6
35.3
38.2
42.0
43.0
44.9
47.8
50.7
55.5
55.5
56.5
71.7
80.3
83.2
86.1
89.0
91.9
95.7
96.7
100.0

105

COGS Differences***
Number
of Firm
Pairs

0
8
7
5
2
3
0
2
4
5
8
4
21
10
8
2
5
3
2
4

Cum.%

0.0
7.6
14.3
15.3
20.1
22.0
24.9
24.9
26.8
30.6
35.4
43.0
44.0
47.8
67.8
77.3
84.9
86.8
91.6
94.5
96.4
100.0

105

* Equivalent unit measures of physical inventory levels based on monthly price indexes.
Necessary data include beginning and end of year FIFO-based inventory amounts, FIFO-based COGS,
and monthly industry-specific wholesale price indexes.
** Equivalent unit measures of physical inventory levels based on annual price indexes. Necessary
data include year-end FIFO-based inventory amounts and annual industry-specific wholesale price
indexes.
*** Differences between LIFO-based and FIFO-based costs-of-goods-sold. Necessary data include
beginning and end of year equivalent unit measures of physical inventory levels, FIFO-based COGS, and
monthly industry-specific wholesale price indexes.

COMPARISONS BETWEEN

TREATMENT AND CONTROL GROUP

FIRMS IN THE PRE-LIFO

AND POST-LIFO PERIODS

The first empirical evidence which is examined involves comparisons

between the paired treatment and control group firms in the years
preceding their (treatment firms') LIFO adoption dates and parallel
comparisons in the post-LIFO adoption periods. The comparisons are
based on a set of five attribute measures suggested by the previous
discussion: Average Change in Log EUs is a measure of the rate of
growth of physical inventory levels. Standard Deviation of Changes
in log EUs is a measure of the variability of growth of physical
inventory levels. Ratio of Average EUs to Average Salese. is a measure
of the size of physical inventories which is scaled by sales to control
for any sys-

259
2592

INVENTORY COSTING AND INVENTORY POLICY

GARY C. BIDDLE
259259259

TABLE
TABLE 7 6
Post-LIFO Adoption Data Availability
Number of Years
of Post-LIFO
Adoption Data
(Includes Year of
LIFO Adoption)

EUMs,* EUAs,** and COGS Differences"

Number
of Firm
Pairs

6
5
4
3
2

74
25
2
3

Total

105

Cumulative
Percent

1.0%
71.5
95.3
97.2
100.0

Equivalent unit measures of physical inventory levels

based on monthly price indexes. Necessary data include be
ginning and end of year FIFO-based inventory amounts,
FIFO-based COGS, and monthly industry-specific wholesale
price indexes.
Equivalent unit measures of physical inventory levels
based on annual price indexes. Necessary data include year
end FIFO-based inventory amounts and annual industry-spe
cific wholesale price indexes.
Differences between LIFO-based and FIFO-based
costs-of-goods-sold. Necessary data include beginning and end
of year equivalent unit measures of physical inventory levels,
FIFO-based COGS, and monthly industry-specific wholesale
price indexes.

tematic differences in the sizes of paired treatment and control firms.

Average COGSDIF ( COGSDIF is the difference between LIFO- and

FIFO-based COGS) summarizes the interaction of inventory and price
level changes as they affect potential cash-flow differences between the
LIFO and FIFO alternatives. As defined, a positive (negative) COGSDIF
implies larger potential cash flows under the LIFO (FIFO) alternative.
Ratio ofAverage COGSDIF to Average Sales controls for size differences
between paired firms which may bias comparisons based on Average

COGSDIFs.
Table 7 presents the results of Wilcoxon and sign test comparisons
based on these attribute measures estimated over the respective ranges
of data availability of the firm pairs in Sample 1. The first two columns
present standard normal deviates (and associated significance levels) for
the Wilcoxon and sign tests, respectively, while the next two columns
present the rank sums and counts on which the tests are based. The
vectors of differences utilized in these tests are composed of treatment
firm measures less those of their control group counterparts.
The results in table 7 indicate that the paired treatment and control
group firms in Sample 1 experienced similar average rates of inventory
growth in the pre-LIFO periods, as indicated by the insignificant
Z statistics. However, after they adopted LIFO, the treatment group
firms experienced significantly (statistically) higher average rates of
inventory growth. According to the tests based on the second attribute
measure,

Wilcoxon and Sign Test Comparisonet between Sample 1 Treatment and Control Group
Firms in Pre-LIFO Periods and in Post-LIFO Periods (Difference= Treatment Control)
Wilcoxon

Variable
and Period

Z*

Statistic
(Signif.)

Physical Inventory Growth [Ave(D. log EU)]

Pre-LIFO

Sign Test
Z*

Statistic
(Signif.)

Positive
Rank Sum
(# Pos.
Ranks)

Negative
Rank Sum
(# Neg.
Ranks)

Number
of Firm
Pairs

EUMs
-0.85 (.1971)
-0.10 (.4602)
2516 (52)
3049 (53)
EUAs..
-1.21 (.1131)
-1.27 (.1020)
2404 (46)
3161 (59)
Post-LIFO
EUMs
4.08 (.O)
3.81 (.O)
4059 (72)
1506 (33)
EUAs . .
4.14 (.0)
4.20 (.O)
4076 (74)
1489 (31)
Variability of Physical Inventory Growth [SD(D. log EU)]
Pre-LIFO
1781 (41)
EUMs
-3.20 (.0006)
-2.24 (.0125)
3784 (64)
EUAs . .
-3.19 (.0007)
-2.05 (.0202)
1786 (42)
3779 (63)
Post-LIFO
EUMs
-1.49 (.0683)
-0.88 (.1894)
2317 (48)
3248 (57)
EUAs . .
-0.65 (.2587)
-0.10 (.4602)
2580 (52)
2985 (53)
Ratio of Average Physical Inventories to Average Sales
[Ave(EU)/
Ave(Salesd]
Pre-LIFO
EUMs
-0.00 (.4980)
-0.09 (.4641)
2781 (52)
2784 (53)
EUAs . .
-0.20 (.42210)
-0.29 (.3859)
2721 (51)
2844 (54)
Post-LIFO
EUMs
2.73 (.0031)
2.05 (.0202)
3638 (63)
1927 (42)
EUAs
2.75 (.0030)
1.85 (.0322)
3643 (62)
1922 (43)
Average Difference Between LIFO- and FIFO-based COGS [Ave( COGSDIF)]
Pre-LIFO
1.73 (.0414)
2.05 (.0202)
3325 (63)
2240 (42)
Post-LIFO
4.41 (.0)
4.39 (.0)
4161 (75)
1404 (30)
Ratio of Average
COGSDIF to Average Sales
[Ave( COGSDIF)/
Ave(Sales)]
Pre-LIFO
-0.39 (.3477)
-0.88 (.1894)
2660 (48)
2905 (57)
Post-LIFO
3.67 (.0001)
3.22 (.0006)
3930 (69)
1635
105

105
105
105
105
105
105
105
105

105
105
105
105
105
105
105
(36)

t Based on all available observations for each firm pair.

* Standard normal deviate. (One-tail significance.)

the control group (non-LIFO) firms in Sample 1 exhibited generally more

variable rates of inventory growth than their treatment group counter
parts, though these differences were more pronounced in the pre- than in
the post-LIFO periods.
Comparisons based on the third attribute measure indicate that the
paired treatment and control group firms held similar levels of physical
inventories relative to sales in the pre-LIFO periods, but that the treat
ment group firms held significantly larger inventories in the post-LIFO
periods. The tests based on the fourth attribute measure (Average COGS
DIF) reveal that the treatment group firms (which actually adopted
LIFO) had available to them greater potential LIFO tax benefits in both
the pre- and post-LIFO periods. Yet this comparison may be
somewhat misleading, since table 2 indicates that the treatment group
firms tend to be larger than their control group counterparts. The
fifth attribute measure controls for systematic differences in size by
scaling the Average COGSDIF measure using Average Sales. The
Wilcoxon and sign test comparisons based on this scaled measure
indicate that relative to sales, the control group firms had slightly
(though not significantly) larger potential LIFO cash-flow benefits
available to them in the pre-LIFO

261

GARY C. BIDDLE
INVENTORY COSTING AND
261261261

INVENTORY POLICY

TABLE
8
periods. The treatment group firms,
however,
again exhibit significantly
larger potential LIFO cash-flow benefits (Average COGSDIFs) in the
post-LIFO periods.
Table 8 presents the same set of comparisons as table 7 for the firm
pairs of Sample 2 with the attribute measures estimated over the periods
six years prior and up to six years after the LIFO adoption dates (for
Sample 2 this means 1968- 78). 34 These estimation periods were employed
to reduce any biases associated with comparing firm pairs using attribute
observations from different periods in real time, to provide pre- and post
LIFO period estimates with roughly equal sampling error, and to provide
the largest possible sample size.
The results presented in table 8 are almost identical to those in table
7. Again, the control group firms exhibit faster rates of inventory growth
in the pre-LIFO periods (with the difference being even more pronounced
than in table 7), while the treatment group firms again exhibit signifi
cantly faster growth rates in the post-LIFO periods. The variability of
inventory growth is again found to be higher in both the pre- and post
LIFO periods for the control group firms, though the differences are
generally insignificant in both cases. The paired treatment and control
group firms are again found to hold similar levels of physical inventories
relative to sales in the pre-LIFO periods, with the treatment firms
exhibiting larger inventories in the post-LIFO periods (though the levels
of statistical significance are less than were found in table 7). Comparisons
based on the Average COGSDIF measures again indicate significantly
larger potential LIFO cash-flow benefits for the treatment group firms in
both the pre- and post-LIFO periods. Comparisons based on the measures
of Average COGSDIF scaled by Average Sales again indicate insignificant
differences between the paired treatment and control group firms in the
pre-LIFO periods and significantly larger Average COGSDIFs (relative
to sales) for the treatment group firms in the post-LIFO periods.
The relationships portrayed in tables 7 and 8 between the paired
treatment and control group firms are uniformly consistent with the
implications of the Anticipations and Incentives hypotheses. Both hy
potheses suggest that the treatment group firms should exhibit faster and
less variable rates of inventory growth, larger inventories, and larger
COGSDIFs in the post-LIFO periods than their control group counter
parts. Only those tests based on the variability of inventory growth
fail to exhibit high levels of statistical significance. It was also
suggested in connection with these hypotheses that because some firm
characteristics are not readily alterable by managers, differences should
also be observed in the pre-LIFO periods. The evidence in tables 7 and 8
suggests instead that the inventory attributes of the paired treatment
and control group firms did not markedly differ in the pre-LIFO periods.
14
;

Because the treatment group firms in Sample 2 adopted LIFO in 1974, five years is the
maximum post-LIFO period. For attribute measures based on changes, there are five years
of pre-LIFO and up to five years of post-LIFO observations.

Wilcoxon and Sign Test Comparisons+ Between Sample 2 Treatment and Control
Group Firms in Pre-LIFO Periods and in Post-LIFO Periods
(Difference = Treatment - Control)
Variable
and Period

Wilcoxon
Z*

Sign Test
Z*

Positive
Rank Sum
(# Pos.
Ranks)

Negative
Rank Sum
(# Neg.
Ranks)

Statistic
Statistic
(Signif.)
(Signif.)
Physical Inventory Growth [Ave( log EU)] PreLIFO
-1.65 (.0496)
-1.10 (.1357)
875 (29)
1403 (38)
EUMs
EUAs ..
-1.67 (.0471)
-1.10 (.1357)
871 (29)
1407 (38)
Post-LIFO
1716 (46)
562 (21)
EUMs
3.60 (.0001)
3.05 (.0011)
EUAs
3.56 (.0002)
3.30 (.0005)
1709 (47)
569 (20)
Variability of Physical Inventory Growth [SD( log EU)]
Pre-LIFO
-1.34 (.0896)
-1.10 (.1357)
924 (29)
1354 (38)
EUMs
-1.37 (.1499)
EUAs.
-0.86 (.1949)
973 (30)
1305 (37)
Post-LIFO
-1.32 (.0937)
-1.10 (.1357)
928 (29)
1350 (38)
EUMs
-0.45 (.3264)
-0.12 (.4522)
1067 (33)
1211 (34)
EUAs ..
Ratio of Average Physical Inventories to Average Sales [Ave(EU)/ Ave(Salesd]
Pre-LIFO
-0.61 (.2709)
1076 (31)
-0.39 (.3470)
1202 (36)
EUMs
EUAs.
-0.37 (.3562)
-0.61 (.2709)
1080 (31)
1198 (36)
Post-LIFO
EUMs
1.38 (.0837)
0.61 (.2709)
1360 (36)
918 (31)
EUAs.
1.40 (.0809)
0.61 (.2709)
1363 (36)
915 (31)
Average Difference Between LIFO- and FIFO-based COGS [Ave(COGSDIF)]
Pre-LIFO
1.74 (.0407)
1.83 (.0336)
1418 (41)
860 (26)
Post-LIFO
1646 (47)
632 (20)
3.17 (.0008)
3.30 (.0005)
Ratio of Average COGSDIF to Average Sales [Ave(COGSDIF)/Ave(Sales)]
Pre-LIFO
0.09 (.4652)
-0.61 (.2709)
1153 (31)
1125 (36)
Post-LIFO
2.37 (.0090)
1.59 (.0559)
1518 (40)
760 (27)

Number
of Firm
Pairs

67
67
67
67
67
67
67
67
67
67
67
67
67
67
67
67

t Based on observations from period spanning six years prior to and up to six years after LIFO
adoption date.
* Standard normal deviate. (One-tail significance.)
JOINT TESTS OF THE ANTICIPATIONS AND

INCENTIVES

HYPOTHESES

To control for history threat factors (like, for example, recessions),

definitive tests of the Anticipations and Incentives hypotheses must be
based on observed changes in treatment firm attributes between the pre
and post-LIFO periods relative to changes in the attributes of their
control group counterparts. While the comparisons presented in tables 7
and 8 can provide some evidence on these relative changes, a more direct
approach is to compare pre- and post-LIFO ratios of attributes of paired
treatment and control group firms. Table 9 presents the results of
Wilcoxon and sign test comparisons based on five ratio measures (in each
case Treatment over Control) which provide joint35 tests of the Antici
pations and Incentives hypotheses: Average of logs of Ratios of
EUs (hereafter Ratio 1) is a measure of the relative sizes of the
paired treatment and control firms' physical inventories. Average of
Changes in
35

Statistically significant differences (in the right directions) for these ratio measures
between the pre- and post-LIFO periods are consistent with both hypotheses.

INVENTORY COSTING AND INVENTORY POLICY

263

TABLE 9
Wilcoxon and Sign Test Comparisonst Between Pre-LIFO and Post-LIFO Ratios
Which Relate Jointly to the Anticipation and Incentives Hypotheses (Difference=
Pre-LIFO - Post-LIFO)
Variable
and Sample

Wilcoxon

Sign Test

Z*

Z*

Statistic
(Signif.)

Statistic
(Signif.)

Positive
Rank Sum
(# Pos.
Ranks)

Negative
Rank Sum
(# Neg.
Ranks)

Number
of Firm
Pairs

1. Average Physical Inventory Ratio (Treatment over Control) {Ave[log(EUr/EUc)]}

Sample 1

EUMs
EUAs .

-3.14 (.0008)
-3.22 (.0006)

-2.44 (.0073)
-2.44 (.0073)

1799 (40)
1774 (40)

3766 (65)
3791 (65)

105
105

Sample 2
EUMs
-1.81 (.0350)
-1.34 (.0901)
849 (28)
1429 (39)
67
EUAs
-1.84 (.0331)
-1.34 (.0901)
845 (28)
1433 (39)
67
2. Average of Changes in Physical Inventory Ratios (Treatment over Control) { Ave[C1 log( E Ur/EUr:) ]}

Sample 1
EUMs
EUAs

-2.81 (.0025)
-2.87 (.0021)

-2.63 (.0043)
-2.63 (.0043)

1904 (39)
1886 (39)

3661 (66)
3679 (66)

105
105

Sample 2

EUMs
-3.40 (.0003)
-2.81 (.0025)
594 (22)
1684 (45)
67
EUAs
-3.41 (.0003)
-2.81 (.0025)
593 (22)
1685 (45)
67
3. Ratio of Variabilities of Physical Inventory Growth (Treatment over Control) [SD(C1 log E Ur)/SD(C1
log EUc)]

Sample 1
EUMs
EUAs

Sample 2

0.98 (.1636)
1.15 (.1259)

0.68 (.2483)
1.46 (.0721)

3089 (56)
3141 (60)

2476 (49)
2424 (45)

105
105

EUMs
1.26 (.1046)
0.86 (.1949)
1340 (37)
938 (30)
67
EUAs
1.31 (.0948)
1.34 (.0901)
1349 (39)
929 (28)
67
4. Ratio of Average Difference between LIFO- and FIFO-based COGS (Treatment over Control)
[Ave( COGSDIFr)I Ave( COGSDIFc)]
Sample 1
-1.95 (.0255)
-1.66 (.0485)
2172 (44)
3393 (61)
105
Sample 2
-1.46 (.0719)
-1.34 (.0901)
905 (28)
1373 (39)
67
5. Ratio
(Treatment
over
Control)
of Ratios of Average
COGSDIF
to Average
Sales
{[Ave( COGSDIFr)/ Ave(Salesr)]/[Ave( COGSDIFr:)/ Ave(Salesc)]}
Sample 1
-1.81 (.0351)
-1.85 (.0322)
2216 (43)
3349 (62)
105
Sample 2
-1.10 (.1358)
-1.10 (.1358)
963 (29)
1315 (38)
67

t Based on observations from period spanning six years prior to and up to six years after LIFO
adoption date.
* Standard normal deviate. (One-tail significance.)

logs of Ratios of EUs (hereafter Ratio 2) is a measure of the rate of

change in Ratio 1. Ratio of Standard Deviations of Changes in logs of
EUs (hereafter Ratio 3) is a measure of the relative variabilities of
inventory growth. Ratio of Average COGSDIFs (hereafter Ratio 4) is a
measure of the relative potential LIFO cash-flow benefits available to
the paired treatment and control group counterparts. Ratio of Ratios
of Average COGSDIFs to Auerage Sales (hereafter Ratio 5) is a
scaled version of Ratio 4 which controls for differences in paired firm sizes
across firm pairs.
The comparisons in table 9 (and those in tables 10 and 11) are based
on vectors of pre-LIFO minus post-LIFO differences where the attribute
ratio measures have been estimated over the periods spanning six years
prior and up to six years after the treatment firms' LIFO adoption dates.
Every comparison based on the five attribute ratios considered in table
9 provides results in the directions indicated by the Anticipations and
Incentives hypotheses, and all but a few portray highly significant differ-

264

GARY C. BIDDLE

TABLE 10
Wilcoxon and Sign Test Comparisonsi Between Pre-LIFO and Post-LIFO Average
Ratios Relating to the Anticipations Hypothesis (Difference= Pre-LIFO - Post-LIFO)
Variable
and Sample

Wilcoxon

Sign Test

Statistic
(Signif.)

Statistic
(Signif.)

Z*

Z*

Positive
Rank Sum
(# Pos.
Ranks)

Negative
Rank Sum
(# Neg.
Ranks)

6. Average Sales Ratio (Treatment over Control) {Ave[log(Salesr/Salesc)]}

Sample 1
-2.54 (.0056)
-1.46 (.0721)
1989 (45)
3576 (60)
Sample 2
-1.48 (.0694)
-0.37 (.3557)
902 (32)
1376 (35)
7. Average of Changes in Sales Ratios (Treatment over Control) {Ave[ log(Salesr/Salesc)J}
Sample 1
-1.80 (.0361)
-2.44 (.0073)
2220 (40)
3345 (65)
Sample 2
-2.09 (.0179)
-2.57 (.0051)
803 (23)
1475 (44)

Numb er
of Firm
Pairs
105
67
105
67

t Based on observations from period spanning six years prior to and up to six years after LIFO
adoption date.
* Standard normal deviate. (One-tail significance.)
TABLE 11
Wilcoxon and Sign Test Comparisonst Between Pre-LIFO and Post-LIFO Average
Ratios Relating to the Incentives Hypothesis (Difference= Pre-LIFO - Post-LIFO)
Wilcoxon
Variable
and Sample

Z*

Statistic
(Signif.)

Sign Test
Z*

Statistic
(Signif.)

Positive
Rank Sum
(# Pos.
Ranks)

Negative
Rank Sum
(#Neg.
Ranks)

Number
of Firm
Pairs

8. Average Ratio of Inventory to Sales Ratios (Ave {log[ ( E Ur/Sales61r) I ( E Uc/Saless1c)]})

Sample 1
E UMs
-1.87 (.0306)
-1.85 (.0322)
2197 (43)
3368 (62)
105
EUAs
-1.95 (.0257)
-1.66 (.0485)
2173 (44)
3392 (61)
105
Sample 2
EUMs
-0.93 (.1760)
-1.34 (.0901)
990 (28)
1288 (39)
67
EUAs
-0.99 (.1618)
-1.34 (.0901)
981 (28)
1297 (39)
67
9. Average Change in Ratio of Inventory to Sales Ratios (Ave{ log[(EUr/Saless1r)(EUc/Saless1c)]})
Sample 1
EUMs
-2.34 (.0098)
-2.44 (.0073)
2052 (40)
3513 (65)
105
EUAs
-2.50 (.0063)
-2.44 (.0073)
2002 (40)
3563 (65)
105
Sample 2
EUMs
-2.83 (.0023)
-2.32 (.0102)
686 (24)
1592 (43)
67
EUAs.
-2.84 (.0022)
-2.08 (.0188)
684 (25)
1594 (42)
67

t Based on observations from period spanning six years prior to and up to six years after LIFO
adoption date.
* Standard normal deviate. (One-tail significance.)

ences. The comparisons based on Ratio 1 indicate that the treatment

group firms held significantly larger physical inventories in the post
LIFO than in the pre-LIFO periods relative to their control group
counterparts, while the comparisons based on Ratio 2 suggest signifi
cantly higher relative rates of inventory growth. The comparisons based
on Ratio 3 suggest that the treatment firms had less variable rates of
inventory growth in the post-LIFO than in the pre-LIFO periods relative
to their control group counterparts, though the differences are not con
sistently significant across samples, tests, and EU measures. The com
parisons based on Ratio 4 indicate significantly higher Average COGS
DIFs for the treatment group firms in the post- than in the pre-LIFO
periods relative to their control group counterparts, though the compar
isons based on the scaled Ratio 5 version are only moderately significant
for Sample 2 firms. Overall, the results presented in table 9 strongly

INVENTORY COSTING AND

265265265

INVENTORY POLICY

suggest that relative to their control group counterparts, the treatment

group firms exhibited changes in the patterns of their year-end physical
inventories between the pre- and post-LIFO periods consistent with the
tax-related cash-flow advantages of the LIFO method.
SOME

GRAPHICAL COMPARISONS

Most of the relationships established in tables 7, 8, and 9 are clearly

depicted in the following illustrations. Figure 1 traces the cross-sectional
averages of physical inventory levels (EUMs) for the treatment and
control group firms in Sample 1 relative to their (treatment firms') LIFO
adoption dates. Figure 2 provides similar tracings for firms from Sample
2.36 Both figures portray parallel trends in the average physical invento
ries of the treatment and group firms in the pre-LIFO periods. Since the
control group firms hold generally smaller inventories, this is consistent
with the somewhat higher rates of inventory growth found for them in
the pre-LIFO periods in tables 7 and 8. In the post-LIFO periods,
however, figures 1 and 2 both indicate that sharply smaller average
inventories were held by the control than by the treatment group firms.
The ratio plots in each figure indicate a marked increase in the average
levels of physical inventories held by the treatment group firms relative
to those held by the control group firms at the time the treatment firms
adopted LIFO. In figure 2 (which is based on a fixed sample of firms), the
absolute difference between the average inventories held by the two
groups continues to increase in each of the post-LIFO years.
The time-series patterns of average physical inventories observed in
figures 1 and 2 can be explained, in part, by referring to figures 3 and 4.
These trace Average Saless- for the same respective samples of firms. The
sales patterns also reveal parallel averages for the treatment and control
groups in the pre-LIFO periods, with marked differences arising in the
post-LIFO periods. Beginning in the LIFO adoption years of their treat
ment group counterparts, the control group firms in each figure exhibit
markedly smaller increases in Average Saless-. In contrast, the Average
Sales-. of the treatment group firms continue to increase over the post
LIFO periods.37 The ratio plots confirm these patterns. For the fixed
sample of firms considered in figure 4, the absolute difference between
the Average Salese- of the treatment and control group firms increases in
each of the post-LIFO years. Sales, of course, are an important determi
nant of desired inventory levels. If the paired treatment and control
group firms correctly anticipated different patterns of future sales, the
resulting differences in anticipated inventory patterns can largely explain
their respective LIFO-FIFO choices in their (treatment firms') LIFO
36
Corresponding time-series plots based on the E UA measures provided almost identical
:
patterns and, as a result, are not presented.
37
The declines in Average EUs and Average Saless- exhibited by both the treatment and
control groups in figures 1 through 4 in the years immediately following the LIFO adoption
dates are attributable to the 1974-75 recession.

266

GARY C. BIDDLE
J. '?

1, 1

1, 3

o.o
i e .u
J?,:o
------- - -------:
Year Relative
to LIFO
Adoption Year
(Year 0)

-o
-19
-18

:56,3

'*

- =;,

-15
-14

75,0

13,G

11:::.::;

1Jl ,J

:::i

.,

0Sample Size
(Firm Pairs)
32
37
45
46
30
71
01
ll9
91
96
'19
101
.L05
10:"1

Solid Line: Treatment Group

Broken Line: Control Group
Dotted Line: Ratio of Averages
(Treatment over Control)

' *';::.-.*

-17
-16

*-. r

-13
-12
-11
-10
-9
-8

..

*'.._.,.
*..

toe;

-/'
'

-4
-3
-1

J.O'.:i
105
105
1()'.j

105
102
1.(')0

. -------: - - -----: ------- ! -------: -------: ------- ! -- ------: --- -- - - !

0, 0
18, 8
37. 5
56, 3
75 .o
93.8
112,5
131.3
1'.i0-0
1.1

1, 3

1,5

(RATIO

SCALEl

FIG. 1.-Time-series plots of Average EUMs of Sample 1 firms (millions of 1967 dollars).

1.0

1.2

o.o

17,5

1. 4

1,6

35,0

52.5

(RATIO SCALE)
70,0

87.5

105,0

122t5

140,0

:-------:-------:-------:-------:-------:-------:-------:-------:

1964
19<'i5
1966
1967
1968
1969
1970
1971
19'72
1973
1974
1975
1976
1977
1978

Solid Line: Treatment Group:

Broken Line: Control Group :
Dotted Line: Ratio of
Averages (Treatment
Control)

.....

')

...

! ...

.;

* '.". . ....

.. ..,.
f

*:-------:-------:-------:-------:-------:-------.
:-------:------..,
17,5

0,0
1,0

35,0

1,4

70,0

1,6

8/

c:

,J

105.0

122,5

140,0

<RATIO SCALE>

FIG. 2.-Time-series plots of Average EUMs of those Sample 2 firms with data available
over the period 1964-78 (millions of 1967 dollars). (Sample size = 42 firm pairs.)

adoption years. Thus, figures 3 and 4 provide evidence clearly consistent

38
with the Anticipations hypothesis.
Figures 5 and 6 present plots of Average COGSDIFs for treatment and
control group firms from Samples 1 and 2, respectively. Prior to the mid1960s (approximately year -10 and before in figure 5), the treatment and
control groups exhibit Average COGSDIFs close to zero, indicating that
for both (on average) there were small cash-flow implications associated
ss A sufficient condition for the sales patterns in figures 3 and 4 to be consistent with the
Anticipations hypothesis is that the managers of the paired treatment and control group
firms forecast future sales with equal accuracy.

267
2672

GARY C. INVENTORY
BIDDLE
COSTING
AND INVENTORY POLICY
1,1
1, 3
1,S
(f<ATIO '3CAl_E,
6 7 2 6 7:o.o
2 6 7 :no.o 440.0 550.0 .,,,o.o
o . 2110.0
;,70.0
o,io.oSample
: ------ -:

: ----- - - : -------: -------: ---- -----:

Size
(Firm Pairs)
26

Year Relative
-l'.)

to LIFO
Adoption Year
(Year O)

1,J
-1
-1,S
15
--1-1
-13

*.'*

-11
-10
-?
-ll

* ';.

!*

-5
-4

* .

-12

28
32
37
45

Solid Line:
Treatment Group
Broken Line:
Control Group
Dotted Line:
Ratio of Averages;
(Treatment over Control)
'

'*.'*':1s.

46
'.:iO
71

81
87
?1
'76
' ?9
101
105

*..

105
105
1()5

-.. ..
"'
----:-

1.i::,

1 o:
ioo

--

,:

_:J{),0

440.')

1. J

l,::i

<J:HfIO

'':"(i

1_,.!.

1),')

105
10.s
h'15

--:---- -5'.:'iO,O

(J,1),0

.:'70,0

SL'Hl.E)

FIG. 3.-Time-series plots of Average Saless- of Sample 1 firms (millions of 1967 dollars).
1, 0

1,2

1,4

o.o

90,0

180,0

1964
1965

(RATIO SCALE)
270.0

360.0

450.0

540,0

630,0

720.0

:-------:-------:-------:-------:-------:-------:-------:-------:

1966
1967
1968
1969
1970
1?71
1972
1973

*'

Solid Line: Treatment Group ;

Broken Line: Control Group
Dotted Line: Ratio of
over.

,t .

,, ...
t

-....
YearLI F O Adoption

.. .. ..

,...

1974
1975

1?76
1 ",'77
1978

':i

:-------:-------:-------:-------:-------:-------:-------:-------

0,0

90.0

180.0

270,0

1. 0

1, 2

1,4

(RriTIO

360,0

4'.30,0

540,0

630,0

720,0

SCALE)

FIG. 4.-Time-series plots of Average Sale861 of those Sample 2 firms with data available
over the period 1964- 78 (millions of 1967 dollars). (Sample size = 42 firm pairs.)

with LIFO-FIFO choices. Beginning in the mid-1960s, however, increas

ing rates of inflation produced consistently positive Average COGSDIFs
for both (indicating potential LIFO cash-flow advantages). The Average
COGSDIFs for the two groups are of similiar magnitudes until one year
prior to the LIFO adoption dates when a persistent difference
arises. This difference is consistent with the results of the previous
comparisons in suggesting that in the postadoption periods the
treatment group firms exhibited inventory patterns more conducive to
LIFO cash-flow advan tages than their control group counterparts.
While the patterns in figures 5 and 6 are clearly consistent with the
implications of the Anticipations and Incentives hypotheses, perhaps the
-50

-co

SCALED BY 1 ()**
1
o.o
50,0
100.0
150,0
200,0
250,0
300.0
350
------- -------: -------: -------: -------: -- -----: ------- :-------

,,ample Size
(Firu l'ai rs)
26

--19

}8

Year Relative
to LIFO
Adoption Year
(Year 0)

-10

-u

-le.')
-15

-14

-u

- 12
- lJ
-10
-'I
-1-1
-}

- 4

268
2682
:.! :
j

GARY C. INVENTORY
BIDDLE
COSTING AND
Soli
3:'
d
2
6
8
2
6
8
2
6
8
JI
Line
:
Trea
tmen
t
Grou
p
Brok
en
Lf.no
:
Cont
rol
Grou
p
:
-so

INVENTORY POLICY

45
-t(J

1 O'.S
105
10,:
100

50
71
ui
89
'11
'?6
9?
1(11
1()

10:i
10':'j
105
105
105

-------- ------- :--------:-------: -------:-------: -------- :---- ----:

o .o

so

100.0

130.0

200.0

250.0

300.0

350.0

FIG. 5.-Time-series plots of Average COGSDIFs of Sample 1 firms (millions of dollars).

-50,0

1964

0,0

SCALED BY 10**
50,0
100,0
150,0

200,0

::50, 0

300,0

350,0

-------:-------:-------:-------:-------:-------:-------:

1965

Solid Line: Treatment Group

Broken Line: Control Group
(LIFO Adoption Year= 1974)

1966
1967

1968

1969
1970
1'171

1972
19/3

1974

1975

197<'-:,

1?77
1?78
-50,0

-------:-------:-------:-------:-------:-------:-------:

0,0

50,0

100,0

150,0

200,0

250,0

300,0

350,0

FIG. 6.-Time-series plots of Average COGSDIFs of those Sample 2 firms with data

available over the period 1964- 78 (millions of dollars). (Sample size = 42 firm pairs.)

most striking aspect of the figures is the sheer size of the tax-related cash
flow consequences of the LIFO-FIFO choice. In both of the figures there
is indicated for the treatment group firms an Average COGSDIF of more
than $32 million in the LIFO adoption year. Multiplied by an approximate
corporate income tax rate of 48 percent, this implies a $15 million average
cash-flow difference between the LIFO and FIFO alternatives. For the
forty-two treatment group firms in figure 6 there is indicated a $33 million
average cash-flow difference over the five-year post-LIFO period. Even
more surprising is the fact that the forty-two control group firms depicted
in figure 6 voluntarily paid (on average) more than $11 million in
additional taxes in 1974 alone than they would have paid if they had
adopted LIFO that year for all of their inventories. Over the five
years
197 4- 78 these additional tax payments sum to more than $23 million (
on average) for each of the control group firms. Similar amounts are
implied for the control group firms in figure 5. The relative sizes of these
potential cash-flow differences can be assessed in figures 7 and 8. They
plot the

269
2692

269

INVENTORY COSTING AND INVENTORY POLICY

GARY C. BIDDLE
SCALED
0

-vs ---------;

F<Y

10**

to:---=:---;---==;----;

-20

Year Relative
to LIFO
Adoption Year
(Year O)

S..11:1ple Size

:'.;;o (F'Lrm

Pairs)

-19

Solid Line:
Treatnent Group
Broken Line: Control Gr oup

-18
-17
-16
-15
-14
-13

71
01
O(J

--12
-11

'/6

10
'I

-u

101
10:,
10'.,
10:;
lO!j

6
-5
-4
:5

o;

10'.,
i

-1

o-.

l 05

1 d::

100
-1

: ---------

-75, 0

-------: ---------: -------: ---- - -- : ----- -- : -------: ------7s.o

rso .o
22:i.o
300.0
375,o
450.0
s:;;.o

0, 0

FIG. 7.-Time-series plots of average ratios of COGSDIFs to Sales for Sample 1 firms.

o.o

75,0

SCALED BY 10**

150,0

300,0

375.0

450.0

525.0

600.0

:-------:-------: -------:-------:-------:-------:-------:-------:

1 ?t,4
19l,5

Solid Line: Treatnent Group

Broken Line: Control Group
(LIFO Adoption Year= 1974)

19<',6

.t 967
l 9l,8
1969
19?0
I. : J
19'/2
l 973
1 "? 74

- -------

1. '!O''\

1 oo;- I,
l s>:
1? .?U

u
0

:-------:-- ----:-------:---- --:-------:-----/ =,; ()

l.'..iO.

JOO

()

.,,_: _,,w----

'.;;::.'_,,()

FIG. 8.-Time-series plots of average ratios of COGSDIFs to Sales for those Sample
2 firms with data available over the period 1964- 78. (Sample size = 42 firm pairs.)

average ratios of COGSDIFs to Sales for firms from Samples 1 and 2,

respectively. In their LIFO adoption years, the treatment group firms in
figure 7 exhibited, on average, COGSDIFs which were more than 4
percent of sales. Their control group counterparts exhibited, on average,
COGSDIFs to Sales ratios of more than 3 percent. The corresponding
values for the firms in figure 8 are 5 and 4 percent, respectively. The
average potential cash-flow differences expressed as percentages of sales
would be roughly half of the values indicated in figures 7 and 8. Figures
7 and 8 suggest, therefore, that the cash-flow implications of LIFO-FIFO
39
choices are not insignificant for most firms in relation to their sales.

39

The large spikes observed in figures 5 and 6 in the Average COGSDIFs for the LIFO
adoption years are in large part due to the high rates of inflation experienced in 1974. In
1974 the Wholesale Price Index for All Commodities increased by nearly 19 percent, more
than three times its average rate of increase over the previous five years.

INDEPENDENT TESTS OF THE ANTICIPATIONS AND INCENTIVES

HYPOTHESES

As outlined in Section 3, the Anticipations and Incentives hypotheses

represent conceptually separable explanations for ( certain) postLIFO adoption differences in the inventory properties of the paired
treatment and
control group
firms. Yet, precisely because either
hypothesis can be used to explain observed differences, empirical tests
based solely on inventory property differences (like those in table 9)
cannot be used to address the hypotheses independently. In the tests
presented below, sales have been introduced to facilitate this separation.
Implicit in these tests is the assumption that when making inventory
management decisions and LIFO-FIFO choices, managers will view
sales as an exogenously determined variable.
The Anticipations hypothesis suggests that when making their respec
tive LIFO-FIFO choices, the managers of the treatment and control
group firms forecast different future inventory patterns. An obvious basis
(given figures 3 and 4) for these differing forecasts is that the treatment
and control group firms anticipated different patterns of future sales."
Table 10 presents Wilcoxon and sign test results for pre- versus post
LIFO period comparisons based on two sales ratio (treatment over
control) measures: Average of logs of Ratios of Sales (hereafter Ratio 6)
is a measure of the relative levels of sales of the paired treatment and
control group firms. Average of Changes in logs of Ratios of
Sales (hereafter Ratio 7) is a measure of the rate of change in the
relationship between the sales of the paired treatment and control group
firms.
The tests based on Ratios 6 and 7 indicate that the sales of the
treatment group firms were larger and were growing faster in the post
than in the pre-LIFO periods relative to those of their control group
counterparts. (Only the sign test based on Ratio 6 for the Sample 2 firms
is not statistically significant at the 10 percent level.) The results
are consistent with the Anticipations hypothesis in suggesting that at
the time they adopted LIFO, the managers of the treatment group
firms anticipated future sales more conducive to LIFO cash-flow
advantages than did their control group counterparts.
The Incentives hypothesis suggests that the managers of the treatment
group firms would have responded to the tax-related incentives provided
by the LIFO assumption by altering inventory management policies. The
inventory model discussed earlier suggests that (during periods of infla
tion) they should have responded by increasing their inventories relative
to those of their control group counterparts. Table 11 presents the results
of Wilcoxon and sign test comparisons based on two inventory ratios
(treatment over control) which have been scaled by sales to control for
40

While an examination of inventory levels can also provide evidence on the Anticipa
tions hypothesis, management control of inventory levels means that results consistent with
the Anticipations hypothesis could also be explained by appealing to the Incentives
hypothesis.

INVENTORY COSTING AND INVENTORY POLICY

271

the influence of sales on desired inventory levels (and to control for any
systematic differences in size across firm pairs): Average of logs of Ratios
of EUs to Sales-, (hereafter Ratio 8) is a measure of the relative sizes of
the paired treatment and control firms' physical inventories expressed as
proportions of their sales. Average of Changes in logs of Ratios of EUs
to Sales. (hereafter Ratio 9) is a measure of the rate of change in Ratio
8.

The results presented in table 11 based on Ratio 8 indicate that the

inventories of the treatment group firms were larger in the post- than in
the pre-LIFO periods relative to their control group counterparts, even
after controlling for the higher levels of treatment group sales noted in
table 10. The results based on Ratio 9 indicate that the inventory-to-sales
ratios of the treatment group firms were growing at faster rates in the
post- than in the pre-LIFO periods relative to their control group coun
terparts. All of the tests indicate high levels of statistical significance
except those based on Ratio 8 for the Sample 2 firms, and here the
significance levels are moderate. These results are consistent with the
Incentives hypothesis in suggesting that the managers of the treatment
group firms responded to the LIFO cash-flow incentives by increasing
their inventories by more, relative to their sales, than their control group
counterparts. Notice that the common assumption that inventories in
crease less than in proportion to sales would bias the tests against the
observed results.41
DISCUSSION

The preceding empirical results provide several checks on the validity

of the comparisons. The similarity of the test results based on Samples
1 and 2 suggests that the results (for Sample 1) cannot be attributed to
the pairing of firms with different industry classifications, different LIFO
adoption dates, or markedly different levels of sales. The similarity of the
results based on the alternate EU measures suggests that the results are
not sensitive to the use of monthly or annual price indexes in their
calculation, and a comparison of tables 7 and 8 suggests that the results
are not sensitive to differences in the periods over which the attribute
measures are estimated. The Wilcoxon and sign test procedures provide
almost identical implications for each comparison, while figures 1 through
8 provide graphical evidence consistent with these implications. In addi
tion, the results of the N oether test comparisons shown in Appendix
B confirm (at even higher levels of significance in most cases) the results
of the other tests, suggesting that the results are not highly dependent
on the choice of statistical procedures.
41

The "square root rule," for example, suggests that inventories will increase in
propor tion to the square root of sales (see Hadley and Whitin [1963]). Because the sales
of the treatment group firms
generally increased relative to their control group
counterparts in the post-LIFO periods, the square root rule suggests that Ratio 8 would
decrease between the pre- and post-LIFO periods.

272

GARY C. BIDDLE

The empirical results have revealed evidence consistent with each

of the implications of the Anticipations and Incentives hypotheses
except those concerning pre-LIFO differences. Since the arguments
suggesting pre-LIFO differences actually represent an extension of the
Anticipations hypothesis (see table 1), the absence of confirming
evidence in this case does not affect the previous conclusions. Moreover,
the generally insig nificant pre-LIFO differences found in tables 7
and 8 between the inventory properties of the paired treatment and
control group firms suggest that the sample selection procedures
succeeded in
identifying similar
treatment and control group
counterparts. The generally insignif icant pre-LIFO differences imply
that the managers' LIFO-FIFO choices were not greatly influenced by
their firms' previous inventory properties.
Implicit in the formulation of the Anticipations and Incentives hy
potheses and the derivation of their testable implications is the assump
tion that managers respond to the cash-flow implications of the LIFO
and FIFO alternatives. 42 Managers, of course, may respond to other
aspects of these methods when making LIFO-FIFO choices and subse
quent operating decisions. For example, the decrease (increase) in re
ported net income which accompanies most LIFO (FIFO) adoptions is
often cited as a negative (positive) aspect of these decisions (see, e.g.,
Coopers & Lybrand [1974] and Jannis and Johnson [1975]). However,
the empirical results presented above are uniformly consistent with the
implications based on the cash-flow assumption (and uniformly incon
sistent with the reported income argument), indicating more than insig
nificant explanatory power. Yet, the empirical results also raise some
important questions. If managers do recognize the cash-flow implications
of the LIFO and FIFO alternatives, why was LIFO not adopted
43
earlier and to a greater extent by the treatment group firms? Why
did the control group firms each voluntarily pay (on average) the tens of
millions of dollars in additional income taxes implied in figures 5 and 6?
What are the other factors influencing these LIFO-FIFO choices? Future
studies will, I hope, provide some answers.

8. Conclusions
This study has examined associations between properties of year-end
inventories and managers' choices among alternative inventory costing
methods. Through their role in the determination of taxable earnings,
these alternative methods (especially the LIFO and FIFO cost-flow
assumptions) can produce large differences in firms' cash flows. Moreover,
these cash flows depend, in part, on the levels of year-end inventories. It
has been suggested that managers respond to these cash-flow incentives
42
As noted in Section 3, a more general formulation of the Anticipations and Incentives
hypotheses would involve managers' responses to the incentives provided by the methods
without specifying that they be cash-flow incentives.
43
Only a few of the treatment group firms adopted LIFO for all of their inventories.

INVENTORY COSTING AND INVENTORY POLICY

273273273

when making choices among inventory costing methods and subsequent

inventory management decisions. The empirical results are consistent
with the following conclusions.
(1) Choices between LIFO and FIFO are influenced by managers'
forecasts of associated future cash flows. As noted above, several

previ ous studies of motives for and determinants of accounting choices

have concentrated on firm characteristics existing prior to and concurrent
with the accounting choices. Because LIFO-FIFO choices are
voluntary, it has been argued that managers will anticipate future
events in making these choices. While generally insignificant preadoption date differences were found between firms that adopted LIFO
and those that did not, the empirical results indicate significant
differences in the postadoption pe riods. These results emphasize the
importance of considering post- as well as prechoice factors in future
studies of motives for and determinants of voluntary accounting choices.
(2) Managers' decisions regarding year-end inventory levels are in
fluenced by the tax-related cash-flow incentives provided by the
LIFO and FIFO alternatives. The voluntary nature of the LIFO-FIFO

choice implies that managers can jointly consider changes in inventory

costing methods and changes in inventory management policies.
While this makes it difficult to identify changes in inventory
management policies which have been induced by costing method
choices, the empirical results provide evidence consistent with these real
effects. As implied by a one period model which considers LIFO-FIFO
tax incentives in optimal inventory order quantity decisions, the
empirical results suggest that the managers of firms that adopted
LIFO chose to hold larger inventories than their control group
counterparts.
(3) There are large cash-flow implications associated with choices
among alternative inventory costing methods. One of the most striking

empirical results is the sheer size of the differences between the cash
flows available to firms under the LIFO and FIFO alternatives. Even
more surprising is the finding that many firms have voluntarily paid tens
of millions of dollars in additional income taxes by continuing to use
FIFO rather than switching to LIFO. Although cash-flow incentives have
exhibited considerable power in explaining LIFO-FIFO choices and their
effects on subsequent management decisions, managers are clearly being
influenced by other factors as well.
APPENDIX A

A Model of Optimal Inventory Policies in the Presence of LIFO-FIFO

Tax Incentives
The following notations are used:

x = physical units in beginning inventory

y = physical inventory units procured (purchased or produced) during
the year

274

GARY C. BIDDLE

z = the decision variable which represents physical inventory units

available for sale (z = x + y)
c1 = unit cost (purchase or production input price) for all inventory
units procured during the year
r = unit selling price (r > C1)
h = unit holding cost per year (applied to year-end inventory)
s = unit stock-out cost
M = marginal corporate income tax rate (0 M 1)
J5 = a random variable representing annual demand (sales) of physical
inventory units.

It is assumed that: (Al) Excess demand is lost (i.e., no backlogging is

permitted). (A2) Demand is distributed with a known cumulative distri
bution function F. (A3) The initial physical inventory x is valued at a
uniform cost of c0 (i.e., beginning inventory consists of a single layer).
Given this notation and the foregoing assumptions, it follows that:
Revenues= r[min(z, D)]
$Purchases= C1Y = c1(z x) Holding costs= h(z - fJ)+
Stock-out costs= s(fJ - z)"
FIFO taxes = M { (r - co )min(x, J5)
+ (r - ci)min[z - x, (D LIFO taxes= M{(r - co)min(x, [D - (z + (r - ci)min(z - x, D)}.

-r n

r:

The FIFO tax expression can be simplified using the additional (reason
able) assumption that the firm will sell at least as many physical inventory
units as are held in its beginning inventory; that is, (A4) Physical
inventory turnover is greater than one (x < J5). This allows taxes arising
from holding gains realizations (the first term in brackets below) to be
separated from those arising from profits on the current year's purchases:

FIFO taxes= M{(c1 - co)x

(r - ci)min(z,

D)}. (Assumption (A4) also implies that F(x) = 0.)

The LIFO tax expression can also be rewritten to separate taxes
associated with sales of beginning inventory units from taxes arising from
sales of inventory units purchased during the current year:

LIFO taxes= M{(c1 - co)min(x, [D - (z - x)t)

D)}. Thus, the

only differences between the

(r - ci)min(z,

LIFO and FIFO tax

expressions
are in the terms related to holding gains realizations on beginning
inventory units (the first terms within the brackets).
Expressions for expected after-tax cash flows under FIFO (7TF) and
LIFO ( 'lTL) as functions of the units available for sale (z) can now
be written as follows:44
44
If inventory holding and stock-out costs are assumed to be tax deductible, h and s
would become (1 - M)h and (1 - M)s, respectively, in expressions (1) and
(2).

INVENTORY COSTING AND

275275275

'7TF(z)

INVENTORY POLICY

= rE[min(z, .D)] - c1(z - x)

- hE[(z - Dt] - sE[(.D - z)+]

- M{(c1 - co)x
= r

+ (r - c1)E[min(z, .D)]}

[1 - F(u)] du - c1(z - x)
00

- hf (z - u) dF(u) - s

- M{

(c1 - co)x

(r - c.)

(1)

(u - z) dF(u)

[1 - F(u)] du}

'7TL(z) = rE[min(z, .D)] - c1(z - x)

- hE[(z - .D)+] - sE[(.D - z)+}

- M{(c1 - co)E[min(x, [.D - (z x)t)]

+ (r - c1 )E[min(z, .D)]}
=

(2)

[1- F(u)] du - c1(z - x)

00

- hf (z - u) dF(u) - s

- M{ (c1 - co)[
+

(r - c.)

f,

(u - z) dF(u)

(u - z

+ x) dF(u) + x(l

- F(z))

[1 - F(u)] du}

To obtain the cash-flow-maximizing levels of units available for sale,

the derivatives of the expected profit expressions (with respect to z) are
set equal to zero:
[d7TF(z)]/dz = r[l - F(z)] - c1 - hF(z)

+ s[l - F(z)] = (1 -

M)(r - c.)

M(r - c1)[l - F(z)]

(3)

+s

- [r(l - M) + h + s + Mc1]F(z) =
45
0

45

The same expression for [d'7TF(z)]/dz is obtained without Assumption (A4). Thus, the
optimal order quantity derived for the FIFO case is not dependent on the assumption that
physical inventory turnover is greater than one. Assumption (A4) does, however, allow a
clearer illustration of the origins of the difference between optimal order policies under
FIFO and LIFO.

276

GARY C. BIDDLE

= r[I

[d1rL(z)]/dz

- F(z)] - c1 - hF(z)

+ s[l - F(z)] - M(r - c1)[l - F(z)]

+ M[F(z) - F(z - x)](c1 - co)
= [d1rF(z)]/dz + M[F(z) - F(z - x)](c1 - co)

(4)

= 0.
By inspection, (3) and (4) reveal that if c1 = co, M = 0 or x = 0, the
cash flow-maximizing levels of inventories (available for sale) will be the
same under LIFO and FIFO. These implications are consistent with
earlier observations concerning the conditions under which cash-flow
46
differences will arise.
The second-order conditions can be verified by examining the second
derivatives of the expected cash-flow expressions with respect to z:

+ Mrf(z)

- Mci{(z)

(5)

= -rf(z) - hf(z) - sf(z) + Mrf(z) - Mcof(z)

(6)

[d 1rF(z)]/dz

[d 1rL(z)]/dz

-r/(z) - hf(z) - sf(z)

- M(c1 - co)f(z - x)
where f is the density function of D. By inspection, it is clear that (5)
is less than or equal to zero, thus assuring that the solution to (3) is
a maximum. A sufficient condition for (6) to be less than or equal to
zero
is for c1 co. Thus, increasing input prices assures that the solution
to
(4) is also a maximum. (It is also clear that c1 can be less than co and (6)
still be negative depending on the values of the other parameters.)
Solving expression (3) yields the profit-maximizing level of inventory
units available for sale under FIFO. This can be written in closed form
as:
1
zF = F- {[(1 - M)(r - c.) + s]/[r(l - M) + h + s + Mc1]}.
(7)
By inspection, it is clear that if holding costs (h) increase, the optimal
inventory level under FIFO will decrease, and if per-unit revenues (r) or
stock-out costs (s) increase, the optimal inventory level will increase.
Although a closed form expression for optimal available inventory is not
possible for the LIFO case (z "), an inspection of expression (4) yields
identical conclusions about the effects of h, r, ands on z':
A comparison of expressions (3) and (4) also reveals that under condi
tions of inflation (c1 >
co):
[d1rL(z)]/dz > [d1rF(z)]/dz.

47

46

lt can also be noted that co does not appear in expression (3). This implies that the
optimal order policy under FIFO does not depend on either the costs assigned to beginning
inventory units or to the change in inventory input prices between the previous and current
periods. In a multiperiod setting, Cohen and Pekelman [1979] have shown that the FIFO
optimal order quantity likewise does not depend on past inventory costs, but there does
arise a term which depends on anticipated inventory input prices in the upcoming period.
47
By assumption (A4), [F(z) - F(z - x)];;::: 0.

INVENTORY COSTING AND INVENTORY POLICY

277

Since under these conditions both expected cash-flow expressions ((1)

and (2)) are concave, this implies that z': > zF; that is, during inflation
the cash-flow-maximizing level of inventory available for sale (and, there
fore, of expected year-end inventory) would be higher under LIFO than
under FIFO. Under conditions of input price deflation (c1 < co):
[d'7TL(z)]/dz

< [d'7TF(z)]/dz

and, therefore, lower inventories would be held under LIFO than under
FIFO; that is, z': < zF (regardless of whether expression (2) is strictly
48
concave). These conclusions are consistent with earlier suggestions (and
traditional notions) that a firm using LIFO would have greater incentives
to avoid inventory declines during periods of rising input prices and
greater incentives to allow inventories to decline during periods of falling
input prices.
Under the LIFO assumption in a multiperiod setting, units of beginning
inventory (x) may be assigned input prices which prevailed more than
one period in the past. The presence of these "old" prices may influence
LIFO inventory policies, since they can generate large holding gains
realizations if these units are sold. It is possible to illustrate this effect in
the present one-period model by noting the effect of changes in co on
optimal order quantities. Since co does not appear in the expression
for z" (Expression (7)), it does not affect inventory policies under FIFO.
The input price assigned to beginning inventory units does appear,
however, in expression (4), indicating that it does affect optimal
inventory levels under LIFO. A decrease in c0 will lead to an increase
in d1TL(z) / dz and thus (by concavity) to an increase in z". Similarly, an
increase in c0 would lead to a decrease in z': (I.e., if y = d'7TL(z)/dz,
then dy/dc0 < 0 and azL /ac0 < 0.) Thus, if co is "adjusted" to reflect
the existence of older LIFO layers and the prices assigned to these
layers reflect the current
trend in input prices (i.e., the relationship between C1 and co), then the
optimal order quantity under LIFO will be adjusted upward in the case
of rising and downward in the case of falling input prices relative to the
FIFO case.

48
Assuming continuity, d1rL(z)/dz is globally concave since d1rL(z = 0)/dz = (1 - M)(r
- c.) + s > 0 and limz-+oo d1r(z)/dz = -c1 - h < 0. Because with C1 < co, d1rL(z)/dz <
d1rF(z)/dz, any maxima of 1rL must be at a lower z than the maxima of 1rF.

278

GARY C. BIDDLE

APPENDIX B
Noether Test Comparisons Between Pre-LIFO and Post-LIFO Ratios
for Those Sample 2 Firm Pairs with Five Years of Post-LIFO Data
Availability*
(Comparison= Pre-LIFO versus Post-LIFO)
Variable

Reference to
Corresponding
Wilcoxon and
Sign Test
Results

Table 9
log(EUT/EUc)
EUMs
EUAs
!).. log(EUT/EUc)
Table 9
EUMs
EUAs
logtSales-v'Salese)
Table 10
Table 10
!).. log(Salesr/Salesc)
Table 11
log[ (EUr/Sales51r) /(EUc/SaleSG1c)]
EUMs
EUAs
!).. log [(EUr/Sales67T) /(EUc/Sales51c)]
Table 11
EUMs
EUAs
* Two-sample test for randomized blocks based on rank sums as proposed by

Noether Z**
Statistic
(Significance)

-2.76 (.0029)
-2.97 (.0015)
-2.88
-2.59
-2.12
-2.62

(.0020)
(.0048)
(.0170)
(.0044)

-1.48 (.0694)
-1.51 (.0655)
-1.45 (.073&)
-1.36 (.0869)

Noether (1967, pp. 4143]. The use of a sample with equal numbers of pre- and post-LIFO observations (both five years)
provides for a consistent and unbiased test (see Noether (1967, p. 43)). The sample size in each

comparison is fifty-one firm pairs.

* * Standard normal deviate. Sign indicates direction of difference; a negative (positive) sign indicates
larger post-LIFO (pre-LIFO) observations. (One-tail significance.)

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