Cost Flow Assumptions
Inventory cost flow assumptions are necessary to determine the cost of goods sold and ending inventory. Companies make certain assumptions about which goods are sold and which goods remain in inventory (resulting in different accounting methodologies). This is for financial reporting and tax purposes only and does not have to agree with the actual movement of goods (companies typically choose a method because of its particular benefits, such as lower taxes) .
The only requirement, regardless of method is that: The total cost of goods sold plus the cost of the goods remaining in the ending inventory for financial and tax purposes is equal to the actual cost of goods available.
Characteristics of the specific identification method include:
- Keeps track of the cost of each, specific good sold
- Perfect matching of costs of goods to goods sold
- Often impossible or too costly and allows manipulation by management
Characteristics of the FIFO method include:
- Assigns first costs incurred to COGS (cost of goods sold) on the income statement
- Disallows manipulation by management and cost flow agrees with ideal, physical flow of goods, though the agreement of cost flow and ideal, physical flow of goods is arguably not important
- Uses the least relevant cost for the income statement and underestimates or overestimates the cost of goods sold if prices are rising or falling, respectively
Characteristics of the LIFO method include:
- Assigns last costs incurred to COGS on the income statement
- Disallows manipulation by management and uses the most relevant cost for the income statement
- Underestimates or overestimates cost of goods sold if prices are falling or rising, respectively and cost flow disagrees with ideal, physical flow of goods, though the agreement of cost flow and ideal, physical flow of goods is arguably not important
Characteristics of the weighted average method include:
- Assigns average cost incurred to COGS on the income statement
- Disallows manipulation by management and better estimation of the cost of goods sold than FIFO or LIFO if prices are rising or falling
- Tends to ignore extreme costs of inventory and there is no theoretical reasoning for using this method
LIFO and weighted average cost flow assumptions may yield different end inventories and COGS in a perpetual inventory system than in a periodic inventory system due to the timing of the calculations. In the perpetual system, some of the oldest units calculated in the periodic units-on-hand ending inventory may get expended during a near inventory exhausting individual sale. In the LIFO system, the weighted average system, and the perpetual system, each sale moves the weighted average, so it is a moving weighted average for each sale. In contrast, in the periodic system, it is only the weighted average of the cost of the beginning inventory, the sum cost of all the purchases, less than the cost of the inventory, divided by the sum of the beginning units and the total units purchased.