Inventory Cost Flow Assumption
The inventory cost flow assumption is a method used by companies to calculate the cost of their inventory and the cost of goods sold (COGS). It determines the order in which costs are moved from inventory to cost of goods sold, which can have a significant impact on the company’s reported gross profit and income tax.
There are several different cost flow assumptions:
- First-In, First-Out (FIFO): This method assumes that the first goods purchased or produced are the first ones to be sold. This means that the cost of the oldest inventory is recorded in COGS, while the cost of the newest inventory remains on the balance sheet.
- Last-In, First-Out (LIFO): This method assumes that the last goods purchased or produced are the first ones to be sold. This means that the cost of the newest inventory is recorded in COGS, while the cost of the oldest inventory remains on the balance sheet.
- Average Cost (AVCO): This method averages the cost of all the goods available for sale during the accounting period and uses that average cost to calculate COGS and ending inventory.
- Specific Identification: This method is used when inventory items are uniquely identifiable (like cars, real estate, or custom-made goods). The cost of each specific item sold is recorded in COGS.
The choice of cost flow assumption can have a significant impact on a company’s financial statements, especially in times of inflation. FIFO results in lower COGS and higher gross profits when prices are rising, while LIFO results in higher COGS and lower gross profits. The choice between these methods can also have tax implications.
It’s important to note that the inventory cost flow assumption is just an accounting method and does not necessarily reflect the actual physical flow of goods. A company could use LIFO for accounting purposes even if the actual physical flow of its inventory follows the FIFO pattern.
In the United States, both GAAP and IRS regulations allow the use of FIFO, LIFO, and average cost. However, if LIFO is used for tax reporting, it must also be used for financial reporting (this is known as the LIFO conformity rule). International Financial Reporting Standards (IFRS), on the other hand, do not allow the use of LIFO.
Example of the Inventory Cost Flow Assumption
Let’s say you run a small electronics shop and you’ve purchased three similar gaming consoles over time at different prices due to changes in supplier costs:
- Gaming Console 1: Purchased for $200
- Gaming Console 2: Purchased for $220
- Gaming Console 3: Purchased for $240
Now, you sell one gaming console. The cost of goods sold (COGS) and the value of the remaining inventory will depend on the cost flow assumption you use:
First-In, First-Out (FIFO):
Assuming the first console you bought is the first one sold, your COGS will be $200 (the cost of the first console). Your remaining inventory will be valued at $220 + $240 = $460.
Last-In, First-Out (LIFO):
Assuming the last console you bought is the first one sold, your COGS will be $240 (the cost of the last console). Your remaining inventory will be valued at $200 + $220 = $420.
Average Cost (AVCO):
You would calculate an average cost of the consoles: ($200 + $220 + $240) / 3 = $220. This average cost will be your COGS and also the cost assigned to each console remaining in inventory. So, your remaining inventory will be valued at $220 * 2 = $440.
Specific Identification:
If each console is distinguishable (maybe they are different models or editions), you can directly attribute the cost of the specific console sold to COGS. For example, if you sold Gaming Console 2, your COGS would be $220, and your remaining inventory would be $200 + $240 = $440.
This example simplifies the process and doesn’t account for multiple sales within an accounting period or other complexities, but it provides a basic understanding of how each inventory cost flow assumption can affect COGS and inventory values.
