Definition of 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 cost of goods sold. In the U.S. the cost flow assumptions include FIFO, LIFO, and average. (If specific identification is used, there is no need to make an assumption.)
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.
Example of Cost Flow Assumptions
To illustrate, let's assume that a company has four units of the same product in its inventory. The units were purchased at increasing costs and in the following sequence: $40, $41, $43, and $44. If the company physically removes and sells the oldest unit (the unit that had a cost of $40), the cost removed from inventory and reported as the cost of goods sold (COGS) will vary depending on the cost flow assumption:
- Under the FIFO cost flow assumption, the oldest cost of $40 is removed from inventory and charged to COGS
- Under the LIFO cost flow assumption, the most recent cost of $44 is removed from inventory and charged to COGS
- Under the average cost flow assumption, the average cost of $42 is removed from inventory and charged to COGS
Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption.