Accountancy/Cost Flow Assumptions

Cost Flow Assumptions

• Cost flow assumptions affect the more important Income Statement and less important Balance Sheet
• Assume that the most recent cost is most relevant cost

Specific Identification

• Keeps track of the cost of each, specific good sold

The Good

• Perfect matching of costs of goods to goods sold

The Bad

• Often impossible or too costly
• Allows manipulation by management

FIFO

• First-In-First-Out
• Assigns first costs incurred to COGS (Cost of Goods Sold) on the Income Statement

The Good

• Disallows manipulation by management
• Cost flow agrees with ideal, physical flow of goods
  • Counter-Argument – Agreement of cost flow and ideal, physical flow of goods is not important

The Bad

• Uses the least relevant cost for the Income Statement
• Underestimates or overestimates cost of goods sold if prices are rising or falling, respectively

LIFO

• Last-In-First-Out
• Assigns last costs incurred to COGS on the Income Statement

The Good

• Disallows manipulation by management
• Uses the most relevant cost for the Income Statement

The Bad

• Underestimates or overestimates cost of goods sold if prices are falling or rising, respectively
• Cost flow disagrees with ideal, physical flow of goods
  • Counter-Argument – Agreement of cost flow and ideal, physical flow of goods is not important

Weighted Average

• Assigns average cost incurred to COGS on the Income Statement

The Good

• Disallows manipulation by management
• Better estimation of the cost of goods sold than FIFO or LIFO if prices are rising or falling

The Bad

• Tends to ignore extreme costs of inventory
• There is no theoretical reasoning for using this method

Notes

• 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; in the weighted average system, in the perpetual system, each sale moves the weighted average, so it is a moving weighted average for each sale, whereas in the periodic system, it is only the weighted average of the cost the beginning inventory, the sum cost of all the purchases, less the cost of the inventory , divided by the sum of the beginning units and the total units purchased.