7 3.2: Cost Flow Assumptions Business LibreTexts

As well, for goods that are similar and interchangeable, this method may most closely represent the actual physical flow of those goods. However, the costs of the goods in inventory does not have to flow the way the goods flowed. This means the bookstore can remove the oldest copy of its three copies from inventory but remove the cost of its most recently purchased copy. In other words, the goods can flow using first in, first out while the costs flow using last in, first out. This is why accountants refer to the cost flows as cost flow assumptions.

Businesses will refer to this as rotating the goods on hand or rotating the stock. FIFO, LIFO, average are assumptions because the flow of costs out of inventory does not have to match the way the items were physically removed from inventory. Companies can use the specific cost method only when the purchase date and cost of each unit in inventory is identifiable. For the most part, companies that use this method sell a small number of expensive items, such as automobiles or appliances. Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption.

What Is Inventory Costing?

Every time a purchase occurs under this method, a new weighted average cost per unit is calculated and applied to the items. Conversely, dramatic changes in inventory costs over time will yield a considerable difference in reported profit levels, depending on the cost flow assumption used. Thus, the accountant should be especially aware of the financial impact of the inventory cost flow assumption in periods of fluctuating costs.

Each item would have a separate serial number and could not be substituted for another item. The weighted average cost per unit multiplied by the number of units remaining in inventory determines the ending value of inventory. Subtracting this amount from the cost of goods available for sale equals the cost of goods sold.

Accounting Principles I

If a manager wanted to manipulate the current period net income, he or she could do this very easily using this method by simply choosing which items to sell and which to retain in inventory. Lower cost items could be shipped to customers, which would result in lower https://www.bookstime.com/blog/budgeting-for-nonprofits cost of goods sold, higher profits, and higher inventory values on the statement of financial position. Because of this potential problem, this technique should be applied only in situations where inventory items are not normally interchangeable with each other.

Therefore, many companies in the United States use LIFO even if the method does not accurately reflect the actual flow of merchandise through the company. The Internal Revenue Service accepts LIFO as long as the same method is used for financial reporting purposes. If Zapp Electronics uses the last‐in, first‐out method with a perpetual system, the cost of the last units purchased is inventory accounting allocated to cost of goods sold whenever a sale occurs. Therefore ending inventory consists of 50 units from beginning inventory and 50 units from the October 10 purchase. The last‐in, first‐out (LIFO) method assumes the last units purchased are the first to be sold. This method usually produces different results depending on whether the company uses a periodic or perpetual system.

Cost of Ending Inventory

Companies that use the periodic system and want to apply the same cost to all units in an inventory account use the weighted average cost method. The weighted average cost per unit equals the cost of goods available for sale divided by the number of units available for sale. Since the specific cost of each unit is known, the resulting values for ending inventory and cost of goods sold are not affected by whether the company uses a periodic or perpetual system to account for inventory. Check the value found for cost of goods sold by multiplying the 350 units that sold by their per unit cost. In times of rising prices, LIFO (especially LIFO in a periodic system) produces the lowest ending inventory value, the highest cost of goods sold, and the lowest net income.

Generally, the units are physically removed from inventory by selling the oldest units first. Therefore, the physical units of product are flowing first in, first out. Companies want to get the oldest items out of inventory and keep the most recent (freshest) ones in inventory.

Material Price Variance

For Zapp Electronics, the cost of goods available for sale is $ 7,200 and the number of units available for sale is 450, so the weighted average cost per unit is $ 16. The cost flow assumption does not necessarily match the actual flow of goods (if that were the case, most companies would use the FIFO method). Instead, it is allowable to use a cost flow assumption that varies from actual usage. For this reason, companies tend to select a cost flow assumption that either minimizes profits (in order to minimize income taxes) or maximize profits (in order to increase share value). The first‐in, first‐out (FIFO) method assumes the first units purchased are the first to be sold. In other words, the last units purchased are always the ones remaining in inventory.

• This approach tends to yield average profit levels and average levels of taxable income over time.
• Therefore, the physical units of product are flowing first in, first out.
• In other words, the goods can flow using first in, first out while the costs flow using last in, first out.
• A company may use different cost flow assumptions for different major inventory classes, but these choices should still be applied consistently.
• This means the bookstore can remove the oldest copy of its three copies from inventory but remove the cost of its most recently purchased copy.