Inventory cost flow assumptions
For most trading companies, inventories flow in and out at different periods and the costs to purchase inventories normally differ for each purchase. Unless inventory items can be specifically identified (for example large items that are specially priced), we need to create cost assumptions to reduce the manual work of tracking the costs of sold and unsold inventories.
The four main cost flow assumptions that are summarized below are discussed in detail in the subsequent section.
| Cost flow assumption | Description |
| Specific identification | Actual costs of high-value items are individually tracked and matched to each sale; no flow assumption is needed. |
| First in, first out (FIFO) | This is a method that assumes that the earliest purchases are the first ones sold regardless of the actual flow of goods. |
| Last in, first out (LIFO) | This is a method that assumes that the latest purchases are the first ones sold regardless of the actual flow of goods.
LIFO is prohibited under IFRS. |
| Weighted average method | This is a method that assumes that the cost of the sold and unsold goods should be averaged. |
Specific identification method
Under the specific identification method, the actual cost of each individual inventory item sold is matched directly to the revenue generated from that specific item.
Unlike FIFO, LIFO, and the weighted-average method, specific identification does not rely on assumptions about the order in which costs flow. Instead, the company tracks the exact cost assigned to each individual unit of inventory.
This method is most appropriate when:
- inventory items are high-value
- each item is distinct and uniquely identifiable
- it is practical to track the cost of each individual unit
Examples include car dealerships, real estate companies, jewelry stores, and sellers of specialized machinery.
The following summary will be helpful in understanding the impacts of this method in the balance sheet and income statement:
| Financial statement | Account | Costs included |
| Balance sheet | Ending inventory | The actual costs of the specific inventory items that remain unsold at the end of the period are capitalized as ending inventory. |
| Income statement | Cost of goods sold (COGS) | The actual costs of the specific inventory items sold during the period are expensed as cost of goods sold. |
Because actual costs are assigned directly, this method provides the most precise matching of costs and revenues. However, it is generally impractical for companies that sell large volumes of homogeneous goods, such as grocery stores or fuel stations.
First in, first out (FIFO)
Under the FIFO assumption, the oldest inventories are first sold regardless of what batch of inventory was actually delivered to the customer upon the sale.
Since companies track inventory purchases per batch, each batch of purchases has different costs.
Under FIFO, companies do not track which batch the sold inventory was coming from but only track the number of units sold. We then determine the cost of the sold units through the FIFO assumption. FIFO is best applied to inventories that are high-volume, low value and homogeneous.
The following summary will be helpful in understanding the impacts of FIFO in the balance sheet and income statement:
| Financial statement | Account | Costs included |
| Balance sheet | Ending inventory | The costs of the latest purchases during the period are capitalized in the balance sheet as ending inventory. |
| Income statement | Cost of goods sold (COGS) | The costs of the beginning inventory (when fully sold) and the costs of the earliest purchases are expensed as COGS. |
Since prices of each batch of purchases vary, FIFO’s effect on the balance sheet and income statement depends on whether prices are rising or falling. The comparison table at the end of the average cost section below lays out the effects of FIFO, weighted average, and LIFO side by side.
Last in, first out (LIFO)
Under the LIFO assumption, the latest inventory purchases are first sold regardless of what batch of inventory was actually delivered to the customer upon the sale.
Like FIFO, LIFO tracks only the number of units sold, not the batch they came from, and suits the same high-volume, homogeneous inventories.
The following summary will be helpful in understanding the impacts of LIFO in the balance sheet and income statement:
| Financial statement | Account | Costs included |
| Balance sheet | Ending inventory | The costs of the beginning inventory and the costs of the earliest purchases are capitalized in the balance sheet as ending inventories. |
| Income statement | Cost of goods sold (COGS) | The costs of the latest purchases are expensed as COGS |
Since prices of each batch of purchases vary, LIFO’s effect also depends on the price trend - see the comparison table after the average cost section below.
Average cost method
Under the weighted-average method, the ending inventory and COGS are valued using an average cost during the period.
The average cost to be used is dependent on whether the system being used by the company is periodic or perpetual, which will be discussed in detail in the next chapter. The average cost method under the perpetual inventory system is called the moving average method. The average method generally attempts to create a balance between the FIFO and LIFO cost flow assumptions:
The table below summarizes how each method affects ending inventory, COGS, and net income when purchase prices are rising or falling. Weighted average always falls between FIFO and LIFO.
The following table compares FIFO, weighted average, and LIFO under rising and falling prices, for ending inventory, cost of goods sold, and net income.
| Price trend | Measure | FIFO | Weighted average | LIFO |
|---|---|---|---|---|
| Rising prices | Ending inventory | Highest | Middle | Lowest |
| Rising prices | COGS | Lowest | Middle | Highest |
| Rising prices | Net income | Highest | Middle | Lowest |
| Falling prices | Ending inventory | Lowest | Middle | Highest |
| Falling prices | COGS | Highest | Middle | Lowest |
| Falling prices | Net income | Lowest | Middle | Highest |
Example: FIFO, weighted average, and LIFO with rising prices
A company buys one unit for $10, then a second unit for $14. It then sells one unit.
- FIFO COGS: the first unit purchased ($10) is sold, so COGS = $10 and ending inventory = $14.
- LIFO COGS: the last unit purchased ($14) is sold, so COGS = $14 and ending inventory = $10.
- Weighted-average COGS: the average cost per unit is , so COGS = $12 and ending inventory = $12.
Answer: FIFO COGS = $10, weighted-average COGS = $12, LIFO COGS = $14.
In a period of rising prices, LIFO’s higher COGS lowers taxable income, which lowers cash taxes paid and increases cash flow. A U.S. company that uses LIFO for tax purposes must also use it in its financial statements - this is known as the LIFO conformity rule. FIFO, on the other hand, reports a more current inventory value on the balance sheet, while LIFO matches current costs against current revenue on the income statement.