The flow of costs is the path taken by costs as they move through a business. The concept is most applicable to a manufacturing firm, where costs are first incurred when raw materials are purchased. The flow of costs then moves to work-in-process inventory, where labor, machining, and overhead costs are added to the cost of the raw materials. Once the production process is complete, the costs move to the finished goods inventory classification, where the goods are stored prior to sale. When the goods are eventually sold, the costs move to the cost of goods sold. During this process flow, the costs are initially recorded in the balance sheet as assets, and are eventually flushed out at the point of sale and shifted to the cost of goods sold section of the income statement.
The flow of costs concept also applies to the cost layering system being used to record inventory. In the first in first out (FIFO) system, the cost of those inventory items that were acquired first are charged to expense when goods are sold; this means that only the cost of the most recently-acquired goods are still recorded in inventory. In the last in first out (LIFO) system, the cost of those inventory items that were acquired last are charged to expense when goods are sold; this means that only the cost of the oldest goods are still recorded in inventory.
The flow of costs concept is less applicable in a services firm, where most costs are incurred and charged to expense at the same time.