Cost-flow assumptions govern the way in which accountants recognize inventory expenses and assign direct costs to individual sales. Accountants can choose from among several cost-flow assumption methods when recognizing their inventory expenses, including FIFO (First In, First Out) and LIFO (Last In, First Out). No single cost-flow assumption method is inherently better than the others; the best method to use depends on your specific business, inventory types and sales processes. The LIFO method is best suited to a smaller range of businesses than other types, but it can be highly useful in specific situations.
As the name implies, the LIFO method of cost-flow assumption assigns the last, or most recent, purchase costs to current sales, regardless of what each sold item actually cost. Businesses can experience fluctuations in product costs over time due to a range of factors, including inflation and changes in suppliers. As a simple example of how LIFO works, imagine a company buys five units of inventory at $10, then buys five more units at $11. Under the LIFO method, the first five units of inventory sold would be assigned the $11 cost, then the remaining units would be assigned the $10 cost, assuming no new purchases had been made in the meantime.
The LIFO method can be advantageous for financial reporting purposes when product costs have been decreasing. When LIFO assigns lower recent costs to sold items which were actually bought at higher prices, the reported profitability on individual sales increases. However, using LIFO does not actually increase real-world profits, since assigning different costs does not change what a company truly paid for specific batches of inventory.
Using LIFO can slightly skew the numbers to make profit figures more attractive in current periods in cases of falling product costs, but companies must still deal with the older, higher costs at some point, which can actually make their financial situation look worse than it really is in the future. Also, if product costs rise over time, profit figures on paper can decrease under LIFO, the same way decreasing costs cause paper profitability to increase.
At first glance, LIFO does not seem to mirror the actual flow of goods in most businesses. There are a variety of industries, however, in which the flow of inventory is accurately reflected by the LIFO method. Consider lumber and gravel yards, for example, who may pile newer batches of inventory directly on top of older batches, pulling the newer, topmost layers off first for customers. In these cases, assigning the most recent purchase costs to sales can present a realistic picture of gross profitability.
As mentioned, accountants have a number of alternatives to choose from when assigning product costs. The FIFO method works the opposite of LIFO, assigning the first, or oldest, product costs to current sales. The weighted average method uses a running average of inventory on hand to calculate an average cost to assign to all sales until a new purchase is made, at which time the average is recalculated. The specific ID method is used for expensive, fairly heterogenous product categories with low-volume sales, such as automobiles and yachts, where each inventory item can be assigned its own unique cost figure.
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