How to Use Cost Flow Assumptions in Your Small Business

Specific identification achieves the exact matching of revenues and costs while weighted average accomplishes an averaging of price changes, or smoothing. The use of FIFO results in the current cost of inventory appearing on the balance sheet in ending inventory. The cost flow method in use must be disclosed in the notes to the financial statements and be applied consistently from period to period.

  1. This laborious requirement might make use of the average method cost-prohibitive.
  2. If the furniture sells for $15,000, you would receive $10,000 and the shop would keep the remaining $5,000 as its sales commission.
  3. The Weighted Average Cost method smooths out price fluctuations by averaging the cost of all inventory items available for sale during the period and assigning this average cost to both the cost of goods sold and the ending inventory.

All of the preceding issues are of less importance if the weighted average method is used. This approach tends to yield average profit levels and average levels of taxable income over time. Financial considerations are paramount when determining which method aligns best with a company’s strategic objectives. A company looking to defer taxes in an inflationary environment might lean towards LIFO, while one seeking to show stronger balance sheet health might prefer FIFO. Generally accepted accounting principles (GAAP), a common set of accounting principles, standards, and procedures that all public companies in the U.S. are required to abide by, champions consistency.

1 Inventory Cost Flow Assumptions

The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. 11 Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. 11 Financial’s website is limited to the dissemination of general information pertaining to its advisory services, together with access to additional investment-related information, publications, and links. As a case in point, the buyer of 10 ounces of gold does not care which lot the gold comes from, as long as all the gold is of the same quality. Nonetheless, the management of the hardware store is free to choose the FIFO method of pricing its inventories.

As an example, a change in consumer demand may mean that inventories become obsolete and need to be reduced in value below the purchase cost. This often occurs in the electronics industry as new and more popular products are introduced. Using the same information, we now apply the FIFO cost flow assumption as shown in Figure 6.9. Thus, the cost of the ending inventory is calculated as $2,640 and the cost of goods sold is $7,800. If the next year’s ending inventory falls below 600 units, the 100 units represented by the 24 January purchase would be included in the cost of goods sold before the 500 units represented by the beginning inventory. Therefore, the cost of the ending inventory consists of the cost of the items of the earliest purchases.

Calculations of Costs of Goods Sold, Ending Inventory, and Gross Margin, Last-in, First-out (LIFO)

For example, using the same purchase prices as above, under LIFO, the $15 goods would be the first considered sold. However, it may also result in an inventory valuation on the balance sheet that is significantly lower than market value if the older, less expensive inventory remains unsold. Explore the impact of inventory cost flow assumptions on financial accuracy and learn how to choose the right method for your business reporting. These estimates could be needed for interim reports, when physical counts are not taken. The need could be result from a natural disaster that destroys part or all of the inventory or from an error that causes inventory counts to be compromised or omitted.

Module 8: Inventory Valuation Methods

The method selected affects profits, taxes, and can even change the opinion of potential lenders concerning the financial strength of the company. When making an inventory cost flow assumption, what factors do managers need to consider? Generally, the cost flow assumption should attempt to reflect the actual physical flow of goods as much as possible.

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It’s a pain to change methods, and it has implications on your business’s tax liability and cash flow. Most businesses adopt a cost flow assumption because it’s too laborious to track each item individually. Changes in market price make it hard to identify the cost of the exact items you sold, especially when they look the same. That’s why businesses use one of three cost assumptions to estimate inventory value. Cost flow assumptions refer to three methods that U.S. business owners use to account for inventory and cost of goods sold (COGS). In addition to the practical problems of keeping track of the costs of the specific items in the inventory, there are theoretical problems with the specific identification method.

It takes less time and labor to implement an average cost method, thereby reducing company costs. The method works best for companies that sell large numbers of relatively similar products. Conversely, when prices fall (deflationary times), FIFO ending inventory account balances decrease and the income statement reflects higher cost of goods sold and lower profits than if goods were costed at current inventory prices. The effect of inflationary and deflationary cycles on LIFO inventory valuation are the exact opposite of their effects on FIFO inventory valuation. For example, assume that you sell your office and your current furniture doesn’t match your new building.

Using the previous data from Cerf Company, the cost of the ending inventory under LIFO is $2,410 and the cost of goods sold is $8,030. We will see, however, that when applying the FIFO method, the cost of the ending inventory is determined first, after which the cost of the goods sold is easily derived. The estimated ending inventory at June 30 must be $100—the difference between the cost of goods available for sale and cost of goods sold. Estimating ending inventory requires an understanding of the relationship of ending inventory with cost of goods sold.