The phrase cost flow assumptions relate to how costs are deducted from a business’s inventory and recorded as COGS. The most frequent cost flow assumptions in the United States are first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average. There are several methods for estimating ending inventory, including the retail inventory approach, and it is feasible to allocate costs to inventory based on the actual cost of every product which is a specific identification method.
Continue to read to understand deeply the inventory cost flow assumptions also the four types of these assumptions.
Definition Of The Inventory Cost Flow Assumptions
Cost flow assumptions are three strategies used by company owners in the United States to calculate for inventory and cost of goods sold (COGS). The cost a company pays for similar commodities may vary due to market fluctuations, volume discounts, or sales.
For instance, a bookshop may carry copies of “Harry Potter” on a frequent basis, but the publisher may give a volume discount if the bookstore places a large purchase in December. Raw material costs for manufacturing companies fluctuate often, owing to the unpredictable market for crude oil.
What Are 4 Inventory Cost Flow Assumptions Types?
Changes in the market’s pricing make it difficult to determine the cost of the specific things you sold, particularly when they appear identical. As a result, firms calculate inventory value using one of the following cost assumptions. Whether you utilize accounting software to maintain inventory or a periodic inventory management system, the cost flow assumption you choose has an influence on your company’s bottom line.
Inventory Cost Flow Assumptions: Specific Identification
Every time a purchase is made under this cost flow assumption, the real cost of the product is computed and paid as the cost of goods sold. This is ideal for things that are readily distinguished, have a significant value, and have a limited volume of sales. As an example, consider custom-made kitchen cabinetry.
Inventory Cost Flow Assumptions: Weighted Average Cost
This cost flow assumption contradicts the specific identification assumption. This cost flow assumption contradicts the specific identification method: All commodities of a specific sort are thought to be interchangeable, with the sole distinction being the price at which they are purchased. Cost discrepancies are caused by external variables such as inflation, an unexpected winter storm reducing food availability, and a spike in gasoline prices owing to OPEC’s reduction in the amount of oil produced.
All expenses are summed and divided by the total number of items purchased under the weighted average cost flow assumption. The number of sales at the end of the fiscal period is then multiplied by the average per unit price to calculate the cost of goods sold and ending inventory.
Inventory Cost Flow Assumptions: FIFO
The real flow of commodities is closely followed by this cost flow assumption. In other terms, the products acquired initially are presumed to be the first ones to be sold. This means that the cheapest inventory will be sold firstly, and the most expensive goods will be sold last, forming the ending inventory. Ending inventory includes goods acquired at the end of the fiscal year. This cost flow assumption makes logical sense since it corresponds to the regular real movement of products.
FIFO increases net profits since inexpensive older inventory is utilized to validate the current cost of sold products. However, the corporation will need to pay more taxes as its income rises. The FIFO method results in a higher ending stock value, lower cost of goods sold, and better net income during inflation. It is because when FIFO is used in an escalating market, the old stock removed first allows the pricier things on the balance sheet to be sold at a better price later.
Whenever a cost flow assumption must be established, this approach is employed. When it comes to manufacturing, when items reach the final phases of creation and inventory is sold, the cost of the goods must be specified as an expense. When using FIFO, the cost of the merchandise purchased first is determined first.
Inventory Cost Flow Assumptions: LIFO
For tax reasons, this cost flow assumption is constructed. However, according to tax law constraints, a corporation that utilizes this assumption for tax reasons must also utilize it for financial reporting. It does not correspond to real commodities flow. During periods of inflation, LIFO is utilized to postpone income tax bills. The products in stock at the beginning of the period are presumed to stay in the ending inventory under LIFO perhaps for decades. Undoubtedly, this does not take place!
LIFO is a way of deferring taxation until the “first” inventory is sold. If this happens, the reduced cost of items that depends on expenditures spent far earlier would result in more revenue and, thus, higher taxes on income. In other ways, taxes delayed in the past are now payable, providing no changes to tax legislation or rates.
LIFO necessitates extensive record maintenance and cautious procurement management. It also leads to highly overstated inventory values if utilized for an extended period of time and/or if there is considerable depreciation. It does, though, lead to considerable tax savings.
Take A Look At The Inventory Cost Flow Assumption Example
Suppose company A spends $100 on a gadget in January. It purchases a similar gadget for $200 in June and another similar gadget for $300 in September. The business sells a single gadget on December 10. It paid three different prices for the widgets, thus, what cost should it declare for its COGS?
Purchase order of company A for gadget
The cost flow assumption can be interpreted in different ways. As an example:
With the FIFO cost flow assumption, according to the first-in, first-out technique, the first thing bought is also the first product sold. As a result, the cost of products sold would be $100. Revenue would be higher under FIFO because this is the lowest-cost product in the scenario.
With the LIFO cost flow assumption, the latest-in, first-out strategy assumes that the most recent item acquired is also the most recent thing sold. As a result, the cost of items sold would be $300. Because this is the most expensive product in the example, earnings would be the smallest under LIFO.
With the specific identification cost flow assumption, you may physically determine which specific products are bought and then sold using the specified identification technique, so the cost flow flows with the real product sold. This is an unusual circumstance because most products are not uniquely recognizable.
With the weighted average cost flow assumption, the weighted average technique calculates the cost of products sold as the average of all three components, which is $200 in this example. This cost flow assumption produces a mid-range price and, thus, a mid-range revenue.
In conclusion, the inventory cost flow assumptions may not always correspond to the real movement of products. Alternatively, a cost flow assumption that differs from actual consumption is permissible. As a result, businesses prefer to choose a cost flow assumption that either reduces profits to decrease income taxes or maximizes revenues to rise share value.