Would you match the \$100 cost with the selling price of the unit sold? (If so, you are assuming a FIFO cost flow.) Would you match the \$110 cost with the sale? (That’s the LIFO cost flow assumption.) If you would matched the average of \$105, you would be using the weighted-average cost flow assumption. The gross profit method of estimating ending inventory assumes that the percentage of gross profit on sales remains approximately the same from period to period. Therefore, if the gross profit percentage is known, the dollar amount of ending inventory can be estimated. First, gross profit is estimated by applying the gross profit percentage to sales.

• In a perpetual system, each time a sale is made the cost flow assumption identifies the cost to be reclassified to cost of goods sold.
• For a periodic system, the cost flow assumption is only applied when the physical inventory count is taken and the cost of the ending inventory is determined.
• Under the LIFO method, your COGS is based on your most recent inventory purchase.
• As you may also recall, GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements.
• It is also easier for management when it comes to bookkeeping, because of its simplicity.

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. 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.

## Normal Balance of an Account

Therefore, the physical units of product are flowing first in, first out. Companies want to get the oldest items out of inventory and keep the most recent (freshest) ones in inventory. Businesses will refer to this as rotating the goods on hand or rotating the stock. The last costs for the period remain in ending inventory; the first costs have all been transferred to cost of goods sold.

• For example, Lynn Sanders owns a small printing company, Printing Plus.
• This will always be true regardless of which inventory cost flow method is used.
• This allows analysts to readily compare firms using different cost flow assumptions.
• Assume merchandise inventory at December 31, 2021, 2022, and 2023 was reported as \$2,000 and that merchandise purchases during each of 2022 and 2023 were \$20,000.
• If this stance is adopted by other accounting frameworks in the future, it is possible that the LIFO method may not be available as a cost flow assumption.
• In other words, with the LIFO method, the oldest raw materials are kept or recorded in inventory longer while FIFO leaves the recently purchased materials in inventory.

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 https://accounting-services.net/bench-accounting-competitors-revenue-alternatives/ consistent throughout the accounting period. 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.

## Cost Flow Assumptions: A Comprehensive Example  