Inventory represents all the finished goods or materials used in production that a company has possession of. GAAP allows for last in, first out (LIFO), first in, first out (FIFO), or average cost method of inventory valuation. On the other hand, International 23 of the best accounting events to attend in 2020 Financial Reporting Standards (IFRS) do not allow LIFO because it does not typically represent the actual flow of inventory through a business. Most businesses adopt a cost flow assumption because it’s too laborious to track each item individually.

Financial statements are expected to be easily comparable from one accounting period to the next to make life simpler for investors. While the weighted average method is a generally accepted accounting principle, this system doesn’t have the sophistication needed to track FIFO and LIFO inventories. Read on to find the answers to any lingering questions you may have about cost flow assumptions. If this stance is adopted by other accounting frameworks in the future, it is possible that the LIFO method may not be available as a cost flow assumption.

Cost Flow Assumptions

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. Most small businesses choose the LIFO method for tax savings, which results in higher operating cash flow for your business. The FIFO cost of a hammer sold at Harry’s on April 1 is $15 ($1,500 January order / 100 units). The LIFO cost of a hammer sold at Harry’s on April 1 is $20 ($2,000 March order / 100 units). Each of these three methodologies relies on a different method of calculating both the inventory of goods and the cost of goods sold. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.

For a company selling heavy equipment, specific identification would likely make the most sense, as each item would be unique with its own serial number, and these items can be easily tracked. Choosing among weighted average cost, FIFO, or LIFO can have a significant impact on a business’ balance sheet and income statement. Businesses would select any method based on the nature of the business, the industry in which the business is operating, and market conditions. Decisions such as selecting an inventory accounting method can help businesses make key decisions in relation to pricing of products, purchasing of goods, and the nature of their production lines. If you’re looking for a cost flow assumption that smooths your product costs over time, the weighted average cost method is the best choice. Also called the average cost method, it creates an average unit cost that results in a per-unit cost that remains consistent throughout the accounting period.

1. Whether you use accounting software to track inventory or only count inventory by hand with a periodic inventory system, your choice in cost flow assumption has a bottom-line impact on your business.
2. Businesses would select any method based on the nature of the business, the industry in which the business is operating, and market conditions.
3. The specific identification method isn’t a cost flow assumption because you’re perfectly matching your inventory costs with your inventory sales.

This particular accounting technique is generally adopted when tax rates are high because the costs assigned will be higher and income will be lower. Average cost flow assumption is also called “the weighted average cost flow assumption.” The FIFO method assumes that the oldest inventory units are sold first, while the LIFO method assumes that the most recent inventory units are sold first. LIFO better matches current costs with revenue and provides a hedge against inflation. This motivation must be considered carefully, however, as income will be affected in opposite ways, depending on whether input prices are rising or falling. As well, although taxes could be reduced in any given year through the cost flow assumption made, this is only a temporary effect, as all inventory will eventually be expensed through cost of goods sold.

Average Cost Flow Assumption vs. FIFO vs. LIFO

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). Inventory cost flow assumptions (e.g., FIFO) are necessary to determine the cost of goods sold and ending inventory.

Given that the cost of inventory is premised on the most recent purchases, these costs are highly likely to reflect the higher inflationary prices. Another reason why businesses would use LIFO is that during periods of inflation, the LIFO method matches higher cost inventory with revenue. Also, through matching lower cost inventory with revenue, the FIFO method can minimize a business’ tax liability when prices are declining. Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily, LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.

Definition of Cost Flow Assumptions

This is achieved because the LIFO method assumes that the most recent inventory items are sold first. Businesses would use the weighted average cost method because it is the simplest of the three accounting methods. The first in, first out (FIFO) accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs over time.

What is the Weighted-Average Cost Flow Assumption?

Average cost method is a simple inventory valuation method, especially for businesses with large volumes of similar inventory items. Instead of tracking each individual item throughout the period, the weighted average can be applied across all similar items at the end of the period. That means that it is not possible to frequently chop and change inventory costing methods. Regular alterations are frowned upon and, when necessary, must clearly be highlighted in the company’s footnotes to the financial statements.

Companies have several methods at their disposal to roughly figure out which costs are removed from a company’s inventory and reported as COGS. This particular approach takes an average of the cost of items sold, leading to a mid-range COGs figure. Also, the weighted average cost method takes into consideration fluctuations in the cost of inventory. Average cost method uses a simple average of all similar items in inventory, regardless of purchase date, followed by a count of final inventory items at the end of an accounting period. Multiplying the average cost per item by the final inventory count gives the company a figure for the cost of goods available for sale at that point.

The weighted-average cost flow assumption is a costing method that is used to assign costs to inventory and the cost of goods sold. Under this approach, the cost of goods available for sale is divided by the number of units produced in the period to arrive at an average cost per unit. This amount is then assigned to the units sold in the period and the units remaining in stock.

Under the https://www.quick-bookkeeping.net/standard-cost-variance-analysis-how-it-s-done-and/, all of the costs are added together, then divided by the total number of units that were purchased. A further consideration would be the effects on the income statement and balance sheet. FIFO results in the inventory reported on the balance being reported at more current costs. As there is an increasing emphasis in standard setting on valuation concepts, this approach would result in the most useful information for determining the value of the company.