What Is Flow of Costs?
Flow of costs refers to the manner or path in which costs move through a firm. Typically, the flow of costs is relevant with manufacturing companies whereby accountants must quantify what costs are in raw materials, work in process, finished goods inventory, and cost of goods sold.
Flow of costs applies not only to inventory but also to factors in other processes to which a cost is attached, such as labor and overhead.
Understanding Flow of Costs
The process of the flow of costs begins with valuing the raw materials used in manufacturing. The flow of costs then moves to the work-in-process inventory. The cost of the machinery and labor involved in production are added as well as any overhead costs. The flow of costs next moves to the inventory stage where the finished goods are stored until they're sold. Following the sale of the goods, the flow of costs finally moves to cost of goods sold.
There are several methods for accounting for the flow of costs. These include LIFO (last in, first out), FIFO (first in, first out), specific identification, and weighted-average cost. For example, the costs of raw materials might vary over time, whereby some are higher in price than others. After the goods are sold, the company must account for the cost of goods sold by removing the items from inventory to COGS.
Under the FIFO method, the first raw material purchased would be moved from inventory and charged to COGS as an expense. Conversely, if the company used the LIFO method, the last unit of raw materials purchased would be moved from inventory and charged to COGS as an expense.
In other words, with the LIFO method, the oldest raw materials are kept or recorded in inventory longer while FIFO leaves the recently purchased materials in inventory. Companies must use the same cost flow calculations and assumptions.
U.S. GAAP (generally accepted accounting principles) financial reporting standards require that companies that use the LIFO method report the difference between that method and FIFO in a line item called LIFO reserve. This allows analysts to readily compare firms using different cost flow assumptions.
Example of Flow of Costs
For example, Ford Motor Company produces cars and trucks. The company has to purchase raw goods to manufacture the cars it sells, which marks the start of the cost of auto production. Next, there are the costs to pay employees to run the assembly line, which adds on to the cost of the raw materials. The cost to operate the machines and the costs associated with the building where the machines are located are also accounted for in the flow of costs.