What are cost flow assumptions?

The phrase cost flow assumptions often refers to the methods available for moving the costs of a company's products from its inventory to its 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, and average are cost flow assumptions because the costs flowing out of inventory do not have to match the specific physical units being shipped. Let's illustrate this important point with a company that 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 ships the oldest unit (the unit with a cost of $40), it will expense via the cost of goods sold: $40 under FIFO, $44 under LIFO, or $42 under the average method. If the company ships the most recently purchased unit (the physical unit having a cost of $44), the  inventory will be reduced and the cost of goods sold will be increased by: $40 under FIFO, $44 under LIFO, or the average of $42. In other words, the cost used to reduce the inventory and to increase the cost of goods sold was based on an assumed cost flow without regard to which physical unit was actually shipped.

Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption.