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 | This is a method where the costs of high-value inventory items are individually tracked. When an inventory is sold, the company is able to identify the specific costs related to the sold inventory, which makes this assumption easy to apply when asked in an exam question. |
| 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 to be used 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
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)
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, it is important to understand the impact of FIFO when market prices of the inventories are either rising or falling, when compared to the LIFO assumption, which is covered in the next section.
In a period of rising prices:
- Balance sheet: FIFO ending inventory is higher since the latest prices are rising
- Income statement: FIFO cost of goods sold is lower since they are based on earlier purchases with lower prices. This results in higher net income because COGS is an expense item with an opposite impact.
In a period of falling prices:
- Balance sheet: FIFO ending inventory is lower since the latest prices are falling
- Income statement: FIFO cost of goods sold is higher since they are based on earlier purchases with higher prices. This results in lower net income because COGS is an expense item with an opposite impact.
Last in, first out (LIFO)
Since companies track inventory purchases per batch, each batch of purchases have different costs. Under LIFO, just like 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 units sold through the LIFO assumption. LIFO is best applied to inventories that are high-volume, low value and homogeneous.
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, it is important to understand the impact of LIFO when market prices of the inventories are either rising or falling, when compared to the FIFO assumption, which was covered in the previous section.
In a period of rising prices:
- Balance sheet: LIFO ending inventory is lower since this is based on the oldest costs
- Income statement: LIFO cost of goods sold is higher since they are based on latest purchases with higher prices. This results in lower net income because COGS is an expense item with an opposite impact.
In a period of falling prices:
- Balance sheet: LIFO ending inventory is higher since this is based on the oldest cost
- Income statement: LIFO cost of goods sold is lower since they are based on latest purchases with lower prices. This results in higher net income because COGS is an expense item with an opposite impact.
Average cost method
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.