Flow of Costs

REVIEWED BY WILL KENTON

Updated Sep 23, 2019

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.