How to Use Cost Flow Assumptions in Your Business

Your business’s financials should be complete, accurate, and readily available.

It’s a balancing act to have accurate financials that don’t take months to create. While exact dollar amounts are preferred to estimates, some accounting areas allow approximate costs or account balances. Inventory accounting is one of them.

Overview: What are cost flow assumptions?

Cost flow assumptions refer to three methods that U.S. business owners use to account for inventory and cost of goods sold (COGS).

The price a business pays for the same goods may fluctuate because of changes in market prices, bulk discounts, or sales. For example, a bookstore might regularly stock copies of “The Polar Express,” but the publisher might offer a bulk discount when the bookstore makes a large order in December.

Manufacturing businesses see their raw materials costs change frequently, often due to the volatile crude oil market.

Changes in market price make it hard to identify the cost of the exact items you sold, especially when they look the same. That’s why businesses use one of three cost assumptions to estimate inventory value.

Whether you use accounting software to track inventory or only count inventory by hand with a periodic inventory system, your choice in cost flow assumption has a bottom-line impact on your business.

Cost flow assumption examples

U.S. businesses can use the following cost flow assumptions on their financial statements: last-in/first-out (LIFO), first-in/first-out (FIFO), and weighted average cost.

Say you’re the owner of Harry’s Hardware, a new hardware store that buys a particular hammer directly from the manufacturer. Each purchase order below is for 100 hammers:

The manufacturer ran a sale during the first two months of the year, bringing your unit cost down to $15 ($1,500 / 100 units).

Let’s calculate the cost of a hammer sold on April 1, when you have 250 hammers in stock.

Last-in/first-out (LIFO): Says the last items put on your shelves are the first ones sold. To calculate COGS with the LIFO method, use the per-unit cost from your most recent inventory purchase.

The LIFO cost of a hammer sold at Harry’s on April 1 is $20 ($2,000 March order / 100 units).

First-in/first-out (FIFO): Asserts that your oldest inventory items are the first ones to sell. Under the FIFO method, your COGS comes from the earliest purchase that you still have in your inventory.

Since the beginning of the year, Harry has purchased 300 hammers (three orders x 100 units) and still has 250 in inventory, meaning he’s sold 50 units. Under the FIFO cost flow assumption, all 50 units came from the January purchase order.

The FIFO cost of a hammer sold at Harry’s on April 1 is $15 ($1,500 January order / 100 units).

Weighted average cost: Blends the cost of your purchases to smooth out your COGS. The weighted average cost method uses the average cost per unit as your COGS.

Average Cost per Unit = Cost of Goods Purchased / Number of Units Purchased

To find the average cost of Harry’s hammers, find the total hammer purchase cost and divide by the number of units purchased.

The Weighted Average Accounting Cost is $16.67 [($1,500 + $1,500 + $3,000) / (100 + 100 + 100 units)]

How cost flow assumptions work

After the sale of inventory, your accounting software processes two transactions: one to record the sale and another to record the decrease to your inventory account.

No matter your cost flow assumption, the sale transaction always looks the same. If you sell a hammer for $40, your journal entry will look like this:

Replace cash with accounts receivable when the customer pays later.

Your choice in cost flow assumption determines the dollar amounts in the latter transaction. Take a look at each inventory accounting method and how it affects your business income.

LIFO method

Under the LIFO method, your COGS is based on your most recent inventory purchase. When product costs are rising, LIFO yields the highest COGS and the lowest pretax income, potentially lowering your business taxes. As prices decrease, LIFO does the opposite.

FIFO method

The FIFO method produces the lowest COGS and the highest pretax income when prices are rising. While you may pay more in small business taxes, you’re boosting your asset balance and business income. The opposite is true when prices are dropping.

Weighted average cost method

If you’re looking for a cost flow assumption that smooths your product costs over time, the weighted average cost method is the best choice. Also called the average cost method, it creates an average unit cost that results in a per-unit cost that remains consistent throughout the accounting period.

Frequently asked questions about cost flow assumptions

Read on to find the answers to any lingering questions you may have about cost flow assumptions.

Which cost flow assumption should I choose?

If you run a just-in-time inventory management system or purchase and sell your entire inventory in a given accounting period, your choice in cost flow assumption doesn’t matter.

Since all of your inventory purchases will end up in COGS by the end of the period, your choice in cost flow assumption does not affect your business’s financials.

Businesses that hold onto inventory for a while should choose a cost flow assumption that fulfills their priorities.

For businesses that don’t use accounting software to track inventory or sell only a few types of products, you’re better off using the weighted average cost method for its simplicity.

Most small businesses choose the LIFO method for tax savings, which results in higher operating cash flow for your business.

Can I change cost flow assumptions?

Short answer: Yes, but please don’t.

The most common change is from FIFO to LIFO: Business owners choose FIFO when they start their companies and later want to move to LIFO for tax savings.

It’s possible to change cost flow assumptions, but it requires the help of a CPA and a tax attorney to revalue your inventory and quantify the impact on your financial statements. And often, you can’t change methods again.

To change from FIFO to LIFO, business owners must fill out IRS Form 970.

Can’t I just track my inventory item by item?

Yes, and it’s called the specific identification method. It’s often used in businesses with easy-to-track inventories, such as antique shops.

The specific identification method isn’t a cost flow assumption because you’re perfectly matching your inventory costs with your inventory sales.

Most businesses adopt a cost flow assumption because it’s too laborious to track each item individually.

Don’t flow alone

If you’re starting your business and need to pick an inventory accounting method, talk to a professional. It’s a pain to change methods, and it has implications on your business’s tax liability and cash flow.