Cost flow assumptions are necessary because of inflation and the changing costs experienced by companies. If costs were completely stable, it wouldn’t matter how costs were flowed.
To illustrate the cost flow assumption, let’s assume that a company’s product had a cost of $100 at the start of the year, at mid-year the cost was $105, and at the end of the year the cost was $110. Which cost would you match with the sale of one item at the end of the year? Would you match the $100 cost with the selling price of the unit sold? (If so, you are assuming a FIFO cost flow.) Would you match the $110 cost with the sale? (That’s the LIFO cost flow assumption.) If you would matched the average of $105, you would be using the weighted-average cost flow assumption.
The cost flow assumption will also affect the inventory values. If you matched the $100 cost with the sale, the company’s inventory will have the higher costs. If you matched the $110 cost with the sale, the company’s inventory will have lower costs. The weighted-average cost would mean that both the inventory and the cost of goods sold would be valued at $105 per unit.
You must also realize that the cost flow assumption is independent of the physical flow of the products. This means you can rotate your company’s inventory (by selling its oldest units first) and yet flow the costs by using LIFO or weighted average.
Many U.S. companies have switched their cost flow assumption from FIFO to the LIFO because they were experiencing rising costs. By flowing the recent higher costs into the cost of goods sold on the income statement and tax return (and keeping the older lower costs in inventory), they are reporting a more realistic net income and less taxable income.
