Question

Explain in your own words:

What is a cost flow assumption?

Why would we use different cost flow assumptions?

Answer 1

Definition of Cost Flow Assumptions
The term cost flow assumptions refers to the manner in which costs are removed from a company's inventory and are reported as the cost of goods sold. In the U.S. the cost flow assumptions include FIFO, LIFO, and average. (If specific identification is used, there is no need to make an assumption.)

FIFO, LIFO, average are assumptions because the flow of costs out of inventory does not have to match the way the items were physically removed from inventory.

Example of Cost Flow Assumptions
To illustrate, let's assume that a company has four units of the same product in its inventory. The units were purchased at increasing costs and in the following sequence: $40, $41, $43, and $44. If the company physically removes and sells the oldest unit (the unit that had a cost of $40), the cost removed from inventory and reported as the cost of goods sold (COGS) will vary depending on the cost flow assumption:

Under the FIFO cost flow assumption, the oldest cost of $40 is removed from inventory and charged to COGS
Under the LIFO cost flow assumption, the most recent cost of $44 is removed from inventory and charged to COGS
Under the average cost flow assumption, the average cost of $42 is removed from inventory and charged to COGS
Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption.

Use different type of cost flow assumptions because there are many methods for valuation of inventory and also maintenance of inventory

If we follow fifo method of inventory maintenance then we need to follow one cost flow assumption.

in the same case if we follow lifo method of inventory maintenance then we need to follow another cost flow assumption.

Due to this type of reasons we use different type of cost flow assumptions.

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