Introduction to Inventory Cost Flow Assumptions Financial Accounting

Companies also select a cost flow assumption to specify the cost that is transferred from inventory to cost of goods sold (and, hence, the cost that remains in the inventory T-account). For a periodic system, the cost flow assumption is only applied when the physical inventory count is taken and the cost of the ending inventory is determined. In a perpetual system, each time a sale is made the cost flow assumption identifies the cost to be reclassified to cost of goods sold. During inflationary periods, companies that apply LIFO do not look as financially healthy as those that adopt FIFO. Eventually this recommendation was put into law and the LIFO conformity rule was born. If LIFO is used on a company’s income tax return, it must also be applied on the financial statements. Conversely, dramatic changes in inventory costs over time will yield a considerable difference in reported profit levels, depending on the cost flow assumption used.

• Changing cost flow assumptions can have a significant impact on a company’s Financial Statements.
• The flow of cost is not the same as the physical flow of inventory.
• This problem will carry through several chapters, building in difficulty.
• For example, taxpayers who encounter high medical costs or casualty losses are entitled to a tax break.
• The goods available for sale represents the total amount of goods or inventory that is available to sell to the company’s customers.
• Together, the net effect is an addition of $146 million ($1,886 million less $1,740 million) in computing cost of goods sold for 2008.

The method utilized to assign costs to inventory and COGS can have a big bearing on a company’s key financials, reported profitability, and tax obligations. Inventory represents all the finished goods or materials used in production that a company has possession of.

Which of the following is the most common cost flow assumption used in the costing inventory?

At the beginning of September, Webworks had 19 keyboards costing $100 each and 110 flash drives https://accounting-services.net/ costing $10 each. Webworks has decided to use periodic FIFO to cost its inventory.

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. This is also used as a method for business management, as well.

What are some common mistakes companies make when it comes to cost flow assumptions?

The term cost flow assumptions refers to the manner in which costs are removed from a company’s inventory and are reported as the COGS. In the U.S., the common cost flow assumptions are First-in, First-out , Last-in, First-out , and average.

However, as the previous statistics point out, this requirement did not prove to be the deterrent that was anticipated. For many companies, the savings in income tax dollars more than outweigh the problem of having to report numbers that make the company look a bit weaker. Recognize that three cost flow assumptions are particularly popular in the United States. For this retail store, the following financial information is reported if FIFO is applied. Two shirts were bought for ($50 and $70) and one shirt was sold for $110. However, an examination of the notes to financial statements for some well-known businesses shows an interesting inconsistency in the reporting of inventory . When the LIFO method is used, it is important to maintain separate layers of costs of ending inventory.

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Average cost flow assumption is a calculation companies use to assign costs to inventory goods, cost of goods sold , and ending inventory. An average is taken of all of the goods sold from inventory over the accounting period and that average cost is assigned to the goods. As purchases and sales are made, costs are assigned to the goods using the chosen cost flow assumption. This information is used to calculate the cost of goods sold amount for each sales transaction at the time of sale. These costs will vary depending on the inventory cost flow assumption used. As we will see in the next sections, the cost of sales may also vary depending on when sales occur.

Each time this figure is found by dividing the number of units on hand after the purchase into the total cost of those items. For example, at point D, the company now has four bathtubs. One cost $110 while the other three were acquired for $120 each or $360 in total. Total cost was $470 ($110 + $360) for these four units for a new average of $117.50 ($470/4 units). That average is then used until the next purchase is made. The applicable average at the time of sale is transferred from inventory to cost of goods sold at points A ($110.00), B ($117.50), and C ($126.88) below.

Why do companies use inventory cost flow assumptions?

If Zapp Electronics uses the last‐in, first‐out method with a perpetual system, the cost of the last units purchased is allocated to cost of goods sold whenever a sale occurs. Therefore ending inventory consists of 50 units from beginning inventory and 50 units from the October 10 purchase. Measures the average number of days that a company takes to sell its inventory items; computed by dividing average inventory for the period by the cost of inventory sold per day. As seen in the periodic inventory formula, beginning inventory is added to purchases in determining cost of goods sold while ending inventory is subtracted. With the LIFO figures reported by Safeway, $1,886 million was added in arriving at this expense and then $1,740 million was subtracted. Together, the net effect is an addition of $146 million ($1,886 million less $1,740 million) in computing cost of goods sold for 2008. The expense was $146 million higher than the amount of inventory purchased.

The reported figure that changes is the cost of the ending inventory. According to LIFO, the last costs are transferred to cost of goods sold; only the cost of the first four units remains in ending inventory. Periodic FIFO. In a periodic system, the cost of the new purchases is the focus of the record keeping. At the end of the period, the accountant must count and then determine the cost of the items held in ending inventory. When using FIFO, the first costs are transferred to cost of goods sold so the cost of the last four bathtubs remain in the inventory T-account.

However, the LIFO conformity rule joins these two at this one key spot. Most companies keep their books on a FIFO or weighted average cost basis and then apply a LIFO adjustment, so the switch to an alternative method should not be a big issue in a mechanical sense. However, the reason most companies apply the LIFO costing method relates to U.S. tax law.

• And that same sentiment would probably exist in the United States except for the LIFO conformity rule.
• However, instead of using the costs of the products acquired, a formula is used to determine an average cost that will be used to calculate both the cost of goods sold and the ending inventory.
• It also helps show the flow of inventory throughout the period.
• Because ending inventory for one period becomes the beginning inventory for the next, application of a cost flow assumption does change that figure also.
• For large organizations, such transactions can take place thousands of times each day.

Under the perpetual system, the first‐in, first‐out method is applied at the time of sale. The earliest purchases on hand at the time of sale are assumed to be sold. Check the value found for cost of goods sold by multiplying the 350 units that sold by the weighted average cost per unit. For Zapp Electronics, the cost of goods available for sale is $ 7,200 and the number of units available for sale is 450, so the weighted average cost per unit is $ 16. The resulting turnover figure indicates the number of times during the period that an amount equal to the average inventory was sold. The larger the turnover number, the faster inventory is selling. Inc. recognized cost of goods sold for the year ending February 28, 2009, as $34,017 million.

Without any replacement of the inventory, the cost of the gasoline bought in 1972 for $0.42 per gallon is shifted from inventory to cost of goods sold in 2010. Instead of the normal profit margin of $0.15 per gallon or $1,500 for ten thousand gallons, the company reports a gross profit of $2.28 per gallon ($2.70 sales price minus $0.42 cost of goods sold). That amount does not reflect the reality of current market conditions. The average cost flow assumption assumes that all units are identical, even though that not might always be the case.

Notice in Figure 6.2.6 that the number of units sold plus the units in ending inventory equals the total units that were available for sale. This will always be true regardless of which inventory cost flow method is used.

3 Problems with Applying LIFO

LIFO has been applied over the years so that the inventory is reported at the 1972 cost of $0.42 per gallon. In the current year, gasoline cost $2.55 per gallon to buy and is then sold to the public for $2.70 per gallon creating a normal gross profit of $0.15 per gallon. That is the amount of income that a station is making at this time. Average cost flow assumption is a calculation companies use to assign costs toinventorygoods, cost What are cost flow assumptions? of goods sold , and ending inventory. 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. But our economy seems more complicated; prices tend to rise, which means the choice of accounting method can dramatically affect company profit.

It is literally impossible to analyze the reported net income and inventory balance of a company such as ExxonMobil without knowing the cost flow assumption that has been applied. General Journal Date Account/Explanation F Debit Credit Accounts Receivable 10.00 Sales 10.00 To record credit sale at a selling price of $10 per unit. Cost of Goods Sold 3.25 Merchandise Inventory 3.25 To record the cost of the sale. Perpetual inventory incorporates an internal control feature that is lost under the periodic inventory method. Losses resulting from theft and error can easily be determined when the actual quantity of goods on hand is counted and compared with the quantities shown in the inventory records as being on hand. It may seem that this advantage is offset by the time and expense required to continuously update inventory records, particularly where there are thousands of different items of various sizes on hand. Companies that apply LIFO often hope decision makers will convert their numbers to FIFO for comparison purposes.