7.3.2: Cost Flow Assumptions

The issue of cost flow assumptions can become particularly important when prices of inventory inputs are changing. Consider a merchandising company that purchases inventory items on a continuous basis in order to fill customer orders. At any given point during the accounting period, the goods available for sale may consist of identical items that were purchased at different times for different costs. The question the accountant must answer is, which costs should be allocated to the current cost of goods sold and which costs should continue to be held in inventory? To answer this question, the accountant can choose from three possible methods:

• Specific identification
• Weighted average cost
• First in, first out

Specific Identification

This technique is theoretically the most correct way to allocate costs. Each unit that is sold is specifically identified, and the cost for that unit is allocated to cost of goods sold. This method would thus achieve the perfect matching of costs to the revenue generated. There are, however, some disadvantages to this method. First, unless items are easy to physically segregate, it may difficult to identify which items were actually sold. As well, although physical segregation may be possible, this method could be expensive to implement, as a great deal of record keeping is required. The second disadvantage of this method is its susceptibility to earnings-management techniques. If a manager wanted to manipulate the current period net income, he or she could do this very easily using this method by simply choosing which items to sell and which to retain in inventory. Lower cost items could be shipped to customers, which would result in lower cost of goods sold, higher profits, and higher inventory values on the statement of financial position. Because of this potential problem, this technique should be applied only in situations where inventory items are not normally interchangeable with each other. An example of this would be the inventory held by a car dealership. Each item would have a separate serial number and could not be substituted for another item.

Average Cost

This technique can be applied to either periodic or perpetual inventory systems by calculating the average of all goods available for sale and then allocating the average to both the quantity of goods sold and the quantity of goods retained in inventory. When this technique is applied to a perpetual inventory system, it is usually referred to as a moving average cost. An example of a moving average cost calculation is as follows:

The following transactions occurred in the month of May for PartsPeople Inc.

May 1		Opening inventory		300 units @ $3.00
May 3		Purchase		100 units @ $3.20
May 7		Purchase		200 units @ $3.25
May 11		Sale		150 units
May 22		Purchase		250 units @ $3.30
May 25		Sale		375 units
May 31		Ending inventory		325 units

Inventory and cost of goods sold would be calculated as follows:

Date	Purchase	Cost of	Balance	Moving	Balance of
		Goods Sold		Average1	Units
May 1			300 $3.00 =	$3.0000	300
			$900.00
May 3	100		(300 $3.00) +	$3.0500	400
	$3.20		(100 $3.20) =
			$1,220.00
May 7	200		(300 $3.00) +	$3.1167	600
	$3.25		(100 $3.20) +
			(200 $3.25) =
			$1,870.00
May 11		150 $3.1167	450 $3.1167 =	$3.1167	450
		= $467.50	$1,402.50
May 22	250		(450 $3.1167) +	$3.1821	700
	$3.30		(250 $3.30) =
			$2,227.50
May 25		375 $3.1821	325 $3.1821 =	$3.1821	325
		= $1,193.30	$1,034.20

The total cost of goods sold for the period is , and the ending inventory balance is $1,034.20. Under this approach, the average inventory cost is recalculated after each purchase, and this revised average cost is then used to determine the cost of goods sold when a sale is made. After a sale is made, the revised average cost becomes the new base amount for further inventory transactions until the next purchase occurs, and a new average is determined.

This method is often used due to its simplicity and reliability. It is very difficult for managers to manipulate income with this method, as the effects of rising or falling prices will be averaged over both the goods sold and the goods remaining on the balance sheet. As well, for goods that are similar and interchangeable, this method may most closely represent the actual physical flow of those goods.

A video is available on the Lyryx web site. Click Here to view the video.

A video is available on the Lyryx web site. Click Here to view the video.

First in, First out (FIFO)

Another cost-flow choice companies can use is referred to as the first in, first out method, usually abbreviated as FIFO. This method allocates the oldest costs to goods sold first, with newer costs remaining in the inventory balance. Assume the same set of facts for PartsPeople Inc. used in the previous example. Under FIFO, each time a sale occurs, the oldest items are removed from inventory first. The calculation of costs and inventory amounts would be done as follows:

Date	Purchase	Sale	Balance	Balance of
				Units
May 1			300 $3.00 =	300
			$900.00
May 3	100 $3.20		(300 $3.00) +	400
			(100 $3.20) =
			$1,220.00
May 7	200 $3.25		(300 $3.00) +	600
			(100 $3.20) +
			(200 $3.25) =
			$1,870.00
May 11		150 $3.00 =	(150 $3.00) +	450
		$450.00	(100 $3.20) +
			(200 $3.25) =
			$1,420.00
May 22	250 $3.30		(150 $3.00) +	700
			(100 $3.20) +
			(200 $3.25) +
			(250 $3.30) =
			$2,245.00
May 25		(150 $3.00) +	(75 $3.25) +	325
		(100 $3.20) +	(250 $3.30) =
		(125 $3.25) =	$1,068.75
		$1,176.25

In this case, the total ending inventory balance of $1,068.75 is higher than the balance calculated under the moving average cost system. This makes sense, as FIFO inventory balances represent the most recent purchases, and in this scenario, input costs were rising throughout the month. This feature of FIFO is considered one of its strengths, as the method results in balance-sheet amounts that more closely represent the current replacement cost of the inventory. Also note that the total cost of goods sold of $1,626.25 \(\$ 450.00+\$ 1,176.25\) is lower than moving average amount. This also makes sense, as older costs, which are lower in this case, are being expensed first. This characteristic of FIFO is also one of its major drawbacks. The method of expensing older costs first means that proper matching is not being achieved, as current revenues are being matched to older costs. This method thus represents a trade-off common in accounting standards. A more relevant balance sheet results in a less relevant income statement. Moving average, on the other hand, averages out the differences between the balance sheet and income statement, resulting in some loss of relevance for both statements. As both methods are acceptable under IFRS and ASPE, management would have to decide which statement is more important to the end users and then choose a policy accordingly.

A video is available on the Lyryx web site. Click Here to view the video.

How to Choose?

When making an inventory cost flow assumption, what factors do managers need to consider? Generally, the cost flow assumption should attempt to reflect the actual physical flow of goods as much as possible. For example, a grocery retailer selling perishable merchandise may want to use FIFO, as it is common practice to place the oldest items at the front of the rack to encourage their sale first. Alternatively, consider a hardware store that sells bulk nails that are scooped from a bin. There is no way to identify the individual items specifically, and it is likely that over time, customers scooping out nails would mix together items stocked at different times. Weighted average costing would make the most sense in this case, as this would likely represent the real movement of the product. For a company selling heavy equipment, specific identification would likely make the most sense, as each item would be unique with its own serial number, and these items can be easily tracked.

A further consideration would be the effects on the income statement and balance sheet. FIFO results in the inventory reported on the balance being reported at more current costs. As there is an increasing emphasis in standard setting on valuation concepts, this approach would result in the most useful information for determining the value of the company. If profitability is more important to a financial-statement reader, then weighted average cost would be more useful, as more current costs would be averaged into income.

Income taxes may also be a consideration when choosing a cost flow formula. This motivation must be considered carefully, however, as income will be affected in opposite ways, depending on whether input prices are rising or falling. As well, although taxes could be reduced in any given year through the cost flow assumption made, this is only a temporary effect, as all inventory will eventually be expensed through cost of goods sold.

Whatever method is chosen, it should be applied on a consistent basis. It would be inappropriate for a company to change cost flow assumptions year to year, simply to achieve a certain result in net income. Once the cost flow assumption is determined, it should be applied the same way each year, unless there has been a significant change in circumstances that warrants a change. A company may use different cost flow assumptions for different major inventory classes, but these choices should still be applied consistently.

As a historical note, a further cost flow assumption, last in, first out (LIFO), was once available for use. This method took the most recent purchases and allocated them to the cost of the goods sold first. LIFO is now not allowed in Canada under IFRS or ASPE, but it is still used in the United States. Although this method resulted in the most precise matching on the income statement, tax authorities criticized it as way to reduce taxes during periods of inflation. As well, it was more easily manipulated by management and did not result in accurate valuations on the balance sheet. Canadian companies that are allowed to report under US GAAP may still use this method, but it is not allowed for tax purposes in Canada.