Inventory Cost Flow Assumptions

Inventory Cost Flow Assumptions (specific identification; weighted average cost; FIFO; LIFO) are necessary to determine cost of goods sold and ending inventory. Note the word "assumption". Companies make certain assumptions about which goods are sold and which goods remain in inventory. This is for financial reporting and tax purposes only and does not have to agree with the actual movement of goods. The only requirement is: The total cost of goods sold plus the cost of the goods remaining in ending inventory for financial and tax purposes is equal to the actual cost of goods available. Cost flow assumptions are timing issues. I.e., over the life of the firm the total cost of goods sold for financial reporting and tax purposes must be equal to the total price paid for inventory. Cost Flow Assumptions: Weighted Average Cost This cost flow assumption is the exact opposite of the specific identification method: All goods of a certain type are assumed to be interchageable and the only difference is their purchase price. Price differences are due to external factors (for example, inflation; a sudden cold spell affecting availability of produce; an increase in the price of gasoline because OPEC reduces the amount of oil pumped. Under the weighted average cost flow assumption all costs are added and divided by the total number of units purchased. At the end of the accounting period, the number of units sold (left in inventory) is then multiplied by the average price per unit to determine cost of goods sold and ending inventory. Cost Flow Assumptions: Specific Identification Under this cost flow assumption each time a sale is made, the actual cost of the item is determined and charged as cost of goods sold. This is primarily appropriate in the case of items that can be clearly differentiated, have high value and sales low volume. E.g., custom built kitchen cabinets. Cost Flow Assumptions: FIFO (first-in; first-out) This cost flow assumption closely follows the actual flow of goods. In other words, the items purchased first are assumed to have been sold first. Goods purchased at the end of the accounting period remain in ending inventory. This cost flow assumption is logically appealing, since it follows the normal actual movement of goods. Cost Flow Assumptions: LIFO (last-in; first-out) This cost flow assumption was developed for tax purposes. However, because of tax law requirements, if a company uses this assumption for tax purposes it must also use it for its financial statements. It does not coincide with the actual movement of goods. LIFO is used during inflationary times to defer income tax payments. Under LIFO the goods in inventory at the beginning of the period is assumed to remain in the ending inventory (perhaps for decades). Obviously, this does not actually happen! Remember, this is an assumption only. LIFO is a method to defer taxes until the "beginning" inventory is sold (either because the company changes to a different method or because it has not replenished its inventory of the particular goods or class of goods). If this event occurs, the lower cost of goods (based on costs incurred at a much earlier time) will result in higher income and correspondingly higher income taxes. In other words, the taxes deferred during earlier times will now become payable, assuming there have been no changes in tax law/rates. LIFO requires significant record keeping and careful management of purchases. It also results in significantly understated inventory values (assets) if it has been used for a significant length of time and/or if there is significant inflation. However, it results in significant tax savings (cashflow!). Problems associated with LIFO (and solutions) In addition to the record keeping requirements (and resulting costs) mentioned above, a major potential problem is the possibility of "involuntary LIFO liquidation" of inventory. This may result from unexpected high sales volume at the end of the accounting period. One way to avoid this is to carefully manage purchases. Another, popular, method is "inventory parking". Under this approach an inventory purchase is made on paper, but the inventory is not actually delivered. The "seller" agrees to repurchase the goods at a slightly higher price after the financial statement date. This is considered acceptable for tax purposes, but not for financial accounting. A second cause of involuntary LIFO liquidation is a change in the inventory mix. (If tastes change, there is no point in maintaining an inventory of record players, if the market demands CD players, for example).