What is inventory?
Inventory is the term that describes the total number of goods on hand and available for sale.
In the world of accounting, this definition is expanded to include material that travels through the three stages of production—raw goods, work in progress, and finished goods.
The expanded accounting definition is compliant with the GAAP methods of accounting and is used to ensure that the assets of a company are accurately valued.
A Deeper Look at Inventory
GAAP stands for Generally Accepted Accounting Principles and represents a set of universal accounting practices that standardize corporate reporting. When corporate accounting conforms to a single universal standard it is much easier to catch errors, communicate finances, and compare firms.
Additionally, standardized accounting makes it harder for bad actors to use “creative accounting practices” to hide debt, skirt the law, or inflate the value of their businesses.
Inventory is an asset and as such is reported in the current asset section of a company’s balance sheet. However, because the change in inventory is a component in the cost of goods sold calculation (COGS), costs associated with inventory are reported on the income statement.
Cost of Goods Sold
The cost of goods sold is the cost of the products (finished goods) that a business has sold. It is an expense that is matched with the revenue from sales. When subtracted from net sales, the result is gross profit.
Cost of goods sold is easily calculated using the formula below.
Inventory Cost Flow Assumptions
Cost flow assumptions describe the way in which costs are removed from inventory and added to the cost of goods sold summary.
This process is referred to as an assumption because it may not literally represent the physical movement of goods—rather it is a standardized reporting system.
As an example, let’s use an inventory of ten items with different amounts of the items having different costs, as shown below.
Using cost flow assumptions when one of the items is sold, regardless of which cost group it belonged to, the cost that was recorded as removed from inventory and reported to cost of goods sold calculations would be dictated by the cost assumption rules.
This concept will make much more sense as we explore different cost flow assumption models.
There are three key inventory cost flow assumptions: FIFO, LIFO, and average. FIFO stands for “first in, first out.” LIFO means “last in, first out,” and the average cost flow assumption model uses the average cost of inventory for cost reporting.
Using the first in, first out cost flow assumption, the oldest cost—the inventory that arrived first—is also the first one to be deducted. If our ten-item inventory example is arranged by age from left to right (meaning the three items with a cost of $109 arrived first) then no matter which item is physically sold, $109 is the cost recorded for COGS calculation.
Using the last in, first out cost flow assumption means that the most recent cost is the one used. Under a LIFO assumption model, no matter which item was physically removed, the cost of $114 would be recorded for COGS calculation.
Using an average cost assumption model, the removal of any of the items in our example inventory would be recorded at the average cost of all units. In this case the average cost is $111.30.
Why Use Cost Flow Assumptions?
In a world where the prices of goods and services remained stable there would be no need for cost flow assumptions. In our world, however, inflation, price fluctuations, discounts, and markups can mean that over the course of a reporting period the cost for the same product can change.
If our example inventory took place over the course of a year, how would the company know which costs corresponded to which sales? The FIFO model assumes that the cost is matched to the selling price of the item (not necessarily the physical sale). The LIFO model assumes that the cost is matched to the sale. Many companies use the LIFO method because FIFO cost flow assumptions can inflate the value of inventory.