Here is an overview of the cost flow assumptions:

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In order to put this principle in context, let’s take a simple example and apply each of the four examples in turn. We’ll assume that NewCo Sporting Goods has decided to start selling baseball bats in October, starting with a model called the Slugger, and that the company made three purchases, listed in the table below. Notice that the cost of each bat is different for each purchase.

Say at the end of the year you have 12 bats left in stock, according to your physical count, and that for simplicity’s sake, you have decided to use the periodic method of accounting for inventory, where you wait until the end of the year to compute COGS. You have the following information:

• Beginning inventory was zero because this is your first year in business.
• You purchased three different “lots” of baseball bats, 43 in total, with a total cost of $520.
• There are 12 bats in ending inventory.

What cost do you assign to those 12 bats? The answer is, it depends on the cost flow assumption used.

Let’s take a quick look at each cost flow assumption using the periodic method, and then we’ll apply what we have learned to the perpetual method.

1. Specific Identification

Technically, the specific identification method of assigning costs to items in inventory isn’t an assumption because it is a direct assignment of the cost of the item purchased to the item. Assume that when each bat came in, we put a sticker on it. Green for the $10 bats, red for the $12 bats, and blue for the $15 bats. We look at the 12 bats in ending inventory and specifically identify which ones are left. We find two green bats, six red bats, and four blue bats.

Because we identified the exact cost of each bat, we can calculate the cost of ending inventory precisely. Two green bats at $10 each, plus six red bats at $12 each, and four blue bats at $15 each makes the total cost of ending inventory equal $152 using the historical cost principle and the specific identification cost-flow method.

Assume each bat sold for $20. We had 43 bats. There are 12 left, so we sold 31 bats at $20 each for total sales of $620. We’ll assume no discounts, no returns or allowances, and no freight in. Here is our calculation of gross profit on bats:

Another way to look at this is we sold 8 of the $10 bats, 19 of the $12 bats, and 4 of the $15 bats. What is the total cost of bats sold? $80 + $228 + $60 = $368.

2. Weighted Average

A “straight” or unweighted average would be ($10 + $12 + $15) / 3 = $12.33, which actually gives each price equal weight. However, we bought a lot more bats at $12 than at the other price points, so we should give those bats more weight. We do that by multiplying the price (our cost) by the units, which we have already done in the table above to get Total Purchases. Divide that number by total units, and we get the weighted average cost:

$520.00 / 43 units = $12.09.

Not a radical difference in this case, but for a bigger business, the effect of using the wrong calculation would be magnified.

There are 12 units in ending inventory at an average cost of $12.09 for a total ending inventory cost of $145.12.

3. First-in, First-out (FIFO)

First-in, First-out (FIFO) could also be called “last in still here.” The first purchases we made are assumed to be the first items sold, so the most recent purchases are the ones left in ending inventory. In this case, we would assume that the 12 bats left in our store at the end of the year were the eight we bought on the 15th of December and four of the bats we bought on the 15th of November.