What Are Cost Flow Assumptions in Accounting?

Cost flow assumptions are the methods a business uses to assign costs to inventory as it moves from purchased to sold. These are referred to as assumptions because the accounting method chosen does not need to align with the actual physical movement of inventory. The selected method directly determines how two important figures are calculated: the Cost of Goods Sold (COGS) on the income statement and the value of the remaining ending inventory on the balance sheet.

The Four Primary Cost Flow Assumptions

The specific identification method tracks the actual cost of each individual item in inventory from purchase to sale. This approach is practical only for businesses dealing with unique, high-value goods, such as art galleries or custom automobile manufacturers. Because it ties costs directly to the specific item sold, it is the most accurate method, but its tracking requirements make it impractical for companies with large volumes of similar products.

First-In, First-Out (FIFO) operates on the assumption that the first units purchased are the first ones to be sold. This can be visualized like the milk section in a grocery store, where employees rotate stock to sell the oldest cartons first. Under FIFO, the costs of the earliest inventory purchases are the first to be moved to the Cost of Goods Sold account when a sale occurs.

Last-In, First-Out (LIFO) is the opposite of FIFO and assumes the most recently purchased items are sold first. An analogy for this method is a hardware store’s bin of nails, where a customer takes from the top. Consequently, the costs associated with the most recent inventory purchases are recognized as the Cost of Goods Sold. This approach is often used for non-perishable goods.

The weighted-average cost method smooths out the effects of price changes by calculating a single average cost for all similar items in inventory. This average is computed by dividing the total cost of all goods available for sale by the total number of units available. The resulting weighted-average cost per unit is then applied to both COGS and ending inventory. This method is useful for companies that sell large quantities of indistinguishable items, like gasoline or grains.

Calculating Cost of Goods Sold and Ending Inventory

To understand how these assumptions work in practice, consider a company with the following inventory purchase record for a period where it sells 30 units. The company starts with 10 units at $5 each, then purchases 20 units at $6 each and 15 units at $7 each. The goal is to determine the Cost of Goods Sold (COGS) and the value of the 15 units in ending inventory.

First-In, First-Out (FIFO) Calculation

Under FIFO, we assume the first units purchased are the first ones sold. To find the COGS for the 30 units sold, we start with the oldest costs: the 10 beginning units at $5 ($50) and the next 20 units at $6 ($120). The total COGS is $170. The ending inventory consists of the most recently purchased items, the 15 units at $7 each, for a value of $105.

Last-In, First-Out (LIFO) Calculation

Using the LIFO method, we assume the last units purchased are the first sold. For the sale of 30 units, the COGS calculation starts with the most recent costs: 15 units from the last purchase at $7 ($105) and 15 units from the next purchase at $6 ($90). This results in a total COGS of $195. The ending inventory is valued using the oldest costs, including 10 units at $5 ($50) and 5 units at $6 ($30), for a total value of $80.

Weighted-Average Cost Calculation

The weighted-average method requires calculating an average cost per unit. First, find the total cost of all goods available for sale: (10 $5) + (20 $6) + (15 $7) = $275. With a total of 45 units, the weighted-average cost is approximately $6.11 per unit. The COGS for the 30 units sold is $183.30 (30 $6.11), and the ending inventory of 15 units is valued at $91.65 (15 $6.11).

Financial Statement and Tax Implications

The choice of a cost flow assumption directly impacts a company’s reported profits and tax obligations, especially in an environment of changing prices. In a period of rising prices, as seen in the previous example, LIFO results in the highest Cost of Goods Sold ($195). This higher expense leads to lower reported gross profit and, consequently, lower net income and a lower income tax liability.

Conversely, during the same inflationary period, FIFO produces the lowest Cost of Goods Sold ($170). This results in a higher reported gross profit and net income, which leads to a higher income tax liability. The choice also affects the balance sheet; FIFO reports a higher ending inventory value ($105), while LIFO reports a lower value ($80).

A consideration for businesses in the United States is the LIFO conformity rule. This IRS regulation stipulates that if a company uses LIFO for tax reporting, it must also use LIFO for its financial reporting to shareholders. This rule prevents companies from showing high profits to investors while simultaneously reporting low profits to the IRS to reduce taxes.

Factors in Selecting a Cost Flow Method

The economic environment is a factor in selecting a method. While the previous section detailed the effects of inflation, companies also consider deflationary periods. In times of falling costs, FIFO might be chosen to achieve a better tax outcome by matching lower costs to revenue.

The nature of the inventory also guides the decision. For businesses with perishable goods like food or items with a risk of obsolescence like electronics, the physical flow of goods aligns with the FIFO method. For industries with non-perishable items, such as raw materials, LIFO can be a practical choice.

Regulatory standards are also a factor. In the United States, Generally Accepted Accounting Principles (GAAP) permit all four methods. However, International Financial Reporting Standards (IFRS), used in many other countries, prohibit the use of LIFO. This makes FIFO and weighted-average the common methods for global comparability.