1. The Need for Cost Flow Assumptions
When a business buys identical inventory items at different prices throughout the year, it is often impossible to track which specific item was sold. Accountants use cost flow assumptions to assign values to sold and remaining items.
2. First-In, First-Out (FIFO) Methodology
  • Assumption: The oldest inventory items purchased are assumed to be sold first.
  • Impact:
    • Balance Sheet: Closing inventory is valued at the most recent purchase prices, reflecting current market costs accurately.
    • Income Statement: During periods of rising prices (inflation), FIFO uses older, lower costs for COGS, which leads to higher reported profits.

3. Weighted Average Cost (AVCO) Methodology
  • Assumption: A new average unit cost is calculated either continuously (after every purchase) or periodically (at the end of the month/year).

“Weighted Average Unit Cost” = “Total Cost of Inventory Available for Sale”/”Total Number of Units Available for Sale”

  • Impact: This method smooths out price fluctuations, resulting in a profit figure and inventory value that sit between the FIFO and LIFO extremes.
  • Note: The Last-In, First-Out (LIFO) method is explicitly forbidden under international standards (IFRS), though it is permitted under US GAAP.
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