The Average Cost Flow Assumption is an accounting principle that stipulates that the cost of inventory should be based on the average cost of the goods purchased during the period. This means that the cost of goods sold (COGS) will be based on the average cost of the inventory on hand during the period. This assumption is used in order to make the financial statements more accurate and to provide a better representation of the company's financial position.
How does a company determine what cost flow assumption they should use?
There are three common cost flow assumptions used in accounting: first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average. In general, companies use the cost flow assumption that results in the lowest income tax liability.
The FIFO method assumes that the first goods purchased are the first ones sold. The advantage of this method is that it more closely resembles the actual physical flow of inventory. The disadvantage is that it may not match up with the actual economic order in which the goods are sold, and it may result in a higher income tax liability.
The LIFO method assumes that the last goods purchased are the first ones sold. The advantage of LIFO is that it matches up with the actual economic order of the sales, and it may result in a lower income tax liability. The disadvantage is that it does not necessarily match the physical flow of inventory, which can make it difficult to keep track of.
The weighted average method assumes that the cost of goods sold is equal to the weighted average of the costs of all the goods in inventory. The advantage of this method is that it is relatively simple to calculate. The disadvantage is that it does not match up with either the physical flow or the economic order of the sales, and it may result in a higher income tax liability.
Why do we use cost flow assumptions?
There are three primary cost flow assumptions used in accounting: first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average. Each of these methods flow costs differently and, as a result, can create different values for ending inventory and cost of goods sold on the income statement.
The FIFO method flows costs in the order in which they were incurred, with the assumption that the first items purchased are the first items sold. The LIFO method flows costs in the reverse order, assuming that the most recent items purchased are the first items sold. The weighted average method assigns costs to inventory based on the average cost of all goods available for sale during the period.
The choice of cost flow assumption can have a significant impact on a company's financial statements. For example, assume a company has the following inventory at the beginning of the year:
Item 1: 10 units @ $5 per unit
Item 2: 20 units @ $4 per unit
During the year, the company purchases the following additional inventory:
Item 1: 30 units @ $6 per unit
Item 2: 40 units @ $5 per unit
If the company uses the FIFO method, the cost of goods sold would be calculated as follows:
10 units @ $5 per unit + 20 units @ $4 per unit = $150
The ending inventory would be calculated as follows:
30 units @ $6 per unit + 40 units @ $5 per unit = $330
If the company uses the LIFO method, the cost of goods sold would be calculated as follows:
30 units @ $6 per unit + 40 units @ $5 per unit = $300
The ending inventory would be calculated as follows:
10 units @ $5 per unit + 20 units @ $4 per unit = $150 Under Which method of cost flows is the inventory assumed? The inventory is assumed to be flowing under the FIFO method of cost flows. What is a cost flow assumption? A cost flow assumption is an accounting method used to assign the cost of inventory to the items sold. The three most common cost flow assumptions are first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average.
Which cost flow assumption generally results in the highest?
Of the three cost flow assumptions (LIFO, FIFO, and weighted average), LIFO generally results in the highest inventory value on the balance sheet. This is because LIFO assumes that the most recent items purchased are the first ones sold, so the newest and most expensive items are still considered to be in inventory.