Dhanu,
I'm not a technical expert on MRP running, but I believe that as MRP runs, it uses the LLC to process demands one level at a time. If an item has the wrong LLC, it won't be planned at the correct level by MRP, so some demand could be missed or incorrectly interpreted. Maybe someone else can give a good example.
As far as what are actually the codes, I ran a short test to illustrate. I created items TEST1, TEST2 and TEST 3. Initially all three had a LLC of zero (0). Items TEST1 and TEST2 are Manufactured, while TEST3 is Purchased. I created a BOM for TEST1 which has as its single component 1 EA of item TEST2. After doing this, the LLC for TEST1 is now 1 and the LLC for TEST2 is 2. I then added a BOM for item TEST2 which has as its single component 1 EA of item TEST3. Now the LLC of item TEST3 is set to 3. Thus, the LLC mimics the level of hierarchy that an item has in any BOM's.