Question

What is the cost flow assumption and what is meant by the physical flow of goods? What relationship exists between cost flows and the physical flow of goods in a company. To place the proper valuation on inventory, a business must determine which costs should be included in inventory cost. Getting goods ready to sell should include what items?

Answer 1

flow assumptions?

The phrase cost flow assumptions often refers to the methods available for moving the costs of a company's products from its inventory to its 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, and average are cost flow assumptionsbecause the costs flowing out of inventory do not have to match the specific physical units being shipped. Let's illustrate this important point with a company that 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 ships the oldest unit (the unit with a cost of $40), it will expense via the cost of goods sold: $40 under FIFO, $44 under LIFO, or $42 under the average method. If the company ships the most recently purchased unit (the physical unit having a cost of $44), the inventory will be reduced and the cost of goods sold will be increased by: $40 under FIFO, $44 under LIFO, or the average of $42. In other words, the cost used to reduce the inventory and to increase the cost of goods sold was based on an assumed cost flow without regard to which physical unit was actually shipped.

Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption. The physical flow, the physical movement of goods and services, is the foundation of the circular flowmodel. The fundamental problem of scarcity is addressed by physically transforming scarce resources intogoods and services that are then used to satisfy wants and needs.The valuation methods are bookkeeping methods and must not be confused with the physical flow of inventory. As most goods deteriorate with age, the physical movement of goods will probably be organized in such a manner as goods received first are issued or sold first. It should be noted that this physical order of movement is likely to be followed by the majority of firms irrespective of the valuation method.