The inventory cost flow assumption states that the cost of an inventory item changes from when it is acquired or built and when it is sold. Because of this cost differential, management needs a formal system for assigning costs to inventory as they transition to sellable goods.
For example, ABC International buys a widget on January 1 for $50. On July 1, it buys an identical widget for $70, and on November 1 it buys yet another identical widget for $90. The products are completely interchangeable. On December 1, the company sells one of the widgets. It bought the widgets at three different prices, so what cost should it report for its cost of goods sold? There are a multitude of possible ways to interpret the cost flow assumption. For example:
- FIFO cost flow assumption. Under the first in, first out method, you assume that the first item purchased is also the first one sold. Thus, the cost of goods sold would be $50. Since this is the lowest-cost item in the example, profits would be highest under FIFO.
- LIFO cost flow assumption. Under the last in, first out method, you assume that the last item purchased is also the first one sold. Thus, the cost of goods sold would be $90. Since this is the highest-cost item in the example, profits would be lowest under LIFO.
- Specific identification method. Under the specific identification method, you can physically identify which specific items are purchased and then sold, so the cost flow moves with the actual item sold. This is a rare situation, since most items are not individually identifiable.
- Weighted average cost flow assumption. Under the weighted average method, the cost of goods sold is the average cost of all three units, or $70. This cost flow assumption tends to yield a mid-range cost, and therefore also a mid-range profit.
The cost flow assumption does not necessarily match the actual flow of goods (if that were the case, most companies would use the FIFO method). 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).
In periods of rising materials prices, the LIFO method results in a higher cost of goods sold, lower profits, and therefore lower income taxes. In periods of declining materials prices, the FIFO method yields the same results.
The cost flow assumption is a minor item when inventory costs are relatively stable over the long term, since there will be no particular difference in the cost of goods sold, no matter which cost flow assumption is used. Conversely, dramatic changes in inventory costs over time will yield a considerable difference in reported profit levels, depending on the cost flow assumption used. Thus, the accountant should be especially aware of the financial impact of the inventory cost flow assumption in periods of fluctuating costs.
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.
Note that the LIFO method is not allowed under IFRS. If this stance is adopted by other accounting frameworks, it is possible that the LIFO method may not be available as a cost flow assumption over the long term.