Inventory Cost Flow Assumptions

Inventory Equation

The inventory equation is used to calculate the cost of goods sold (COGS). It also helps show the flow of inventory throughout the period.
When a business acquires and sells inventory in the course of its operations, keeping up with inventory is extremely important. The inventory equation, shown below, facilitates that.
The components of this equation represent the flow of inventory as goods are bought and sold. The beginning inventory balance (goods on hand) represents the inventory that is currently on hand from a prior period. When looking at this from the beginning of the calendar year 2018, which is at the end of 2017, the company still had an amount of goods in their inventory account. The ending inventory amount from the prior period automatically becomes the beginning inventory amount in the current period. Now, in the current period, it is discovered that the amount on hand is not enough to meet the current needs. Therefore, the company will purchase more goods. The sum of the beginning inventory plus the purchases made during the period equals the goods available for sale. The goods available for sale represents the total amount of goods or inventory that is available to sell to the company's customers.

The next section of the equation represents the split of how the items must be categorized at the end of the period. If the items were sold and are no longer in the company's possession, then they show up in the cost of goods sold category. The Cost of Goods Sold account ($5,000 in the example below), an expense account, is directly related to the Inventory account because when goods are sold, the entry also includes a debit to cost of goods sold as well as a credit to inventory. This shows that the goods have been removed from the company's inventory and are now showing as a cost to the company on the balance. Therefore, it should be noted that inventory is held as an asset on the balance sheet until it is sold. Once inventory is sold, it comes out of the asset account and becomes an expense, via cost of goods sold.

COGS and Inventory as Asset

Date Description Debit Credit
Mar. 31 Cost of Goods Sold $5,000
      Inventory $5,000
To record the cost portion of the sale

However, if the items were not sold, they would remain in inventory and show up in the ending inventory number. This equation can be written linearly to allow for traditional algebraic reordering to solve for any of the unknown numbers.

Algebraic Versions of the Inventory Equation

If solving for COGS Cost of Goods Sold = Beginning Inventory + Purchases − Ending Inventory
If solving for Ending Inventory Ending Inventory = Beginning Inventory + Purchases − Cost of Goods Sold
If solving for Beginning Inventory Beginning Inventory = Ending Inventory + Cost of Goods Sold − Purchases
If solving for Purchases Purchases = Ending Inventory + Cost of Goods Sold − Beginning Inventory

Valuing Inventory Costs and Cost Flow Assumptions

A uniform system of valuing inventory costs is essential to maintain fairness and measurability in periods of cost increases and inflation. Four inventory cost flow assumptions or methods are used for valuation: specific identification; first in, first out (FIFO); last in, first out (LIFO); and weighted average.
One of the primary misconceptions regarding valuing inventory costs is that the physical inventory purchased first will be the inventory that is sold first. However, it is important to separate the physical flow of inventory from the flow used for cost flow assumptions. In an ideal world, costing out inventory would be that simple. However, when a company is purchasing millions of goods and services in a given period, it is impossible to track the cost for one particular good from the purchase of that item through to the sale of that item. For example, Company ABC has 15 identical units in its inventory with varying costs paid for those goods.

Inventory Valuation Cost Flow Assumptions

The flow of cost is not the same as the physical flow of inventory. The inventory valuation cost flow assumptions were adopted to simplify this process when goods are identical and nonperishable. Thus, the physical order of sales is not considered.
The point of the inventory valuation cost flow assumptions is that when the goods are actually sold, the company does not have to keep track of which goods are being sold. Because these goods are identical and assumed to be nonperishable when sold, the physical order does not matter. For example, when Company ABC sold 5 units of its inventory on any date, the units had been selected physically from the warehouse in any order, though they may have been purchased at different times.

Administratively, it would be very difficult to keep up with the cost of the goods if the company had to record the sale of each item individually. This is why cost flow assumptions are used. Instead of keeping up with the physical flow of inventory, the company simply makes assumptions about the flow of costs, which significantly increases the efficiency and effectiveness of the process. The physical inventory is only relevant to maintain the total number of units. However, inventory cost flow assumptions determine the assignment of costs to those units. The inventory cost flow assumptions help accountants and businesses address issues that arise when identical merchandise units are purchased at different unit costs. When the items are sold, it is necessary to calculate the costs using one of the common inventory cost flow assumptions or inventory costing methods—specific identification; first in, first out (FIFO); last in, first out (LIFO); and weighted average.

Specific Identification

The first and easiest inventory cost flow assumption is specific identification. Under the specific identification inventory method, the cost of the unit sold is explicitly stated with each purchase. This method of inventory valuation is usually reserved for high-priced and highly specialized items. An example of a company that might use specific identification is an automobile dealer. Having merchandise at such a high cost, automobile dealers, who rely on serial numbers and specific identifiers for their products, would be inclined to cost each item at their specific cost. Also, though some of the items may be identically made, many automobile dealers tailor their cars to the needs and desires of each of their customers, making them highly specialized.

Specific Identification Illustration

Unlike the other cost flow systems, specific identification does not follow any specific pattern or assumptions. The difference between yellow and green units designates the specialized difference between otherwise identical products.
In this example, the physical flow of the items would match the cost flow of those items. However, most companies are not able to sustain this practice and must use one of the other cost flow assumptions to value their inventory.

First In, First Out (FIFO)

The first in, first out (FIFO) inventory method is based on the assumption that the units purchased first are sold first, therefore leaving the most recently purchased units in ending inventory. The flow of costs under the FIFO method typically follows what is considered a traditional way to think of how goods flow. The first units that are purchased, from a physical flow perspective, would be the first units that would be deemed to be sold. A great example of this is perishable goods. Bread and milk expire very quickly. Therefore, when cycling in new units, it's important to sell the older ones first. While the flow of costs never follows the physical flow of goods, the thought process can be the same.

First In, First Out (FIFO) Illustration

In this illustration, under the first-in, first-out (FIFO) method of inventory valuation, the first goods purchased in yellow, or "first in," would also be the first goods sold, or "first out." If the 5 units in yellow are sold, then by default, the 10 units in green will make up the ending inventory.

Last In, First Out (LIFO)

The last in, first out (LIFO) inventory method is based on the assumption that the units purchased more recently are sold first, therefore leaving the units purchased first in ending inventory. The flow of costs in the LIFO method typically goes against the normal way that people think about costs. Why would a company use the most recent costs first? Think about the gasoline industry. With constant fluctuations in the cost of a barrel of oil, the gasoline industry's prices change to keep up with the ever-changing market. Therefore, for conservative and matching purposes, these companies will elect to use the LIFO method of inventory valuation to reflect these changes. By using LIFO in this case, they ensure that their income statement reflects the true profit for a given period.

Last In, First Out (LIFO) Illustration

Under the last-in, last-out (LIFO) method of inventory valuation, the last-or more recent-goods purchased (yellow units) would be the first goods sold.
Unlike the FIFO method, the LIFO method starts with costs from the bottom. In the illustration, the units in yellow illustrate the 5 units that would be sold if using the LIFO cost flow assumption. Given that the units in yellow are the ones sold, the units in green will make up the ending inventory at the end of the period.

Weighted Average

Under the weighted average inventory method, the carrying value of a unit of inventory is based on the weighted average cost of inventory purchases. The cost of units sold and the units in ending inventory are valued using weighted averages of the purchase costs. The flow of costs in the weighted average method is simplified by averaging the costs of the units. In the following illustration, the same information is provided. However, instead of using the costs of the products acquired, a formula is used to determine an average cost that will be used to calculate both the cost of goods sold and the ending inventory.

Cost Flow Illustration

Under the weighted average method of inventory valuation, the total cost and the total number of units available are averaged together to create one amount (cost per unit) to use in calculating cost of goods sold and ending inventory.
Company ABC sells 5 items on 4/25/18. The total cost is determined for each purchase. Once the total cost is determined for each purchase, those numbers are totaled to arrive at the total cost of all purchases. This total cost is then divided by the total units available, at which time the weighted average cost per unit is determined. In this case, the costs range from $1.25/unit up to $1.55/unit. However, the weighted average cost per unit is $1.46/unit. Because this is an average of the costs, it should always fall between the highest and the lowest cost.

Once the weighted average cost per unit has been calculated, this rate would be used to determine the cost of goods sold. If 5 units were sold, then multiply the rate, $1.46, by the units to arrive at the total cost of goods sold, $7.30. The remaining 10 units would remain in ending inventory, and the same rate would be applied to determine their value.