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First In First Out (FIFO) | Inventory Cost Flows - YouTube
Channel: Accounting Stuff
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In this video we're going to cover an
Inventory Cost Flow Assumption
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FIFO
which means First In First Out.
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[Music]
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Hey there my name is James
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you're watching Accounting Stuff
and today we're continuing our
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how to account for inventory mini-series.
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There’s got to be a better name for it than that.
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So far we've covered
cost of goods sold and the
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perpetual and periodic inventory systems.
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If you missed either of those
you can find them linked up here
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and down there in the description.
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Today we're moving onto another
hotly requested topic
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Inventory Cost Flow Assumptions.
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By the way if you hear any squawking
there's a really noisy crow there.
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I've tried telling it to be quiet
but it won't listen to me.
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Anyway there are three
Inventory Cost Flow Assumptions
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that you should be aware of
FIFO, LIFO and AVCO.
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In this video we'll be doing FIFO.
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I'm going to show you a
4 step process to calculate
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cost of goods sold and
closing inventory using this method.
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So let's get into it.
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When do we need
Inventory Cost Flow Assumptions?
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Let's think back to our
inventory calculation from
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the previous video.
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Opening inventory plus additions
gives us cost of goods available for sale
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and when we subtract our cost of goods sold
from this we get our closing inventory.
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Now here's the thing
up until now we've assumed
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one constant cost price
across all of your inventory.
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But in reality this isn't always the case.
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Your opening inventory might have
cost you $2 per unit but your
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additions might have cost you $3 per unit.
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So your inventory on hand
or your cost of goods available for sale
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could be made up of a whole mix
of $2 and $3 units
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and when you get around to making a sale
you need to work out how much this cost
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needs to flow out of the
inventory account in your balance sheet
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into your cost of goods sold account.
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An expense account kept
in your income statement
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and also how much of this cost
should remain where it is
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in your closing inventory.
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To work this out you
can use Cost Flow Assumptions.
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Cost Flow Assumptions are rules
that help us estimate what
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these cost flows are.
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These are assumptions
so they don't necessarily reflect
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the reality of underlying transactions.
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There are three main types of
Cost Flow Assumption
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FIFO LIFO and AVCO
First In First Out
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Last In First Out
and the Average Cost method.
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In this video we're going to
concentrate on FIFO
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but I'll be covering LIFO
and AVCO in the near future as well
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so if you'd like to see that
remember to subscribe.
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Okay so FIFO…
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First In First Out
what's this all about?
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When you make a sale
using the FIFO method
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you make the assumption
that your oldest inventory
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is going to be sold first.
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Your oldest inventory is
what you bought first
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so you're going to imagine that
you sell it first every time.
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First In First Out.
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But how do you account for this?
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I think it's time for an example.
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Business is booming in the
window cleaning industry.
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Word of this catches your ears
and you decide to get into wholesale
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buying and selling and squeegees in bulk.
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Yeah that's what these are called.
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Squeegees!
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It's the beginning of November
and you have 220 Squeegees
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in your inventory
you bought these for $2 each.
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On November 5th you buy another
400 squeegees for $1,200
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and on November 12th
you sell 500 squeegees for $2,750.
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Question
what is your cost of goods sold
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and closing inventory for November
assuming that no other
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transactions have taken place
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and that you're using the FIFO
Cost Flow Assumption?
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First In First Out.
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To help you get to the bottom of this
I've put together four steps
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which we're going to run through now
but you can also find them
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on my cheat sheet.
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You can help support this channel by
buying it on my website
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I'll link to it down below.
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Step 1
Draw an inventory cost flow table.
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What on earth is that?
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It's a table made up of five columns
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date
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description
quantity
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cost per unit
and total cost.
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Okay Step 2
Enter what you know.
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Here's where we use
the information given to us to fill out
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as much of this table as possible.
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So let's do that.
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You began November with
220 squeegees which cost you $2 per unit.
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So on November 1st you had
an opening inventory made up of
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220 units which cost you $2 per unit.
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A few days later you bought
another 400 squeegees which
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cost you $1,200 in total.
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We'll add that to the table as well.
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On November 5th you made
additions of 400 units which
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cost you $1,200 in total.
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In an inventory cost flow table you want
to leave an empty row beneath
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every addition or sale.
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This is where your subtotals
are going to go.
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Your goods available for sale
or your closing inventory
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after the final transaction.
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It'll become clear why in a moment.
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Okay finally on November 12th
you sold 500 squeegees for $2,750.
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So on November 12th
you sold 500 units which needs
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to be negative because
you no longer own these squeegees.
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The sale reduced your
inventory on hand and
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you sold these for $2,750
so we'll deduct that here…
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Hold up, wait…
we can't do that.
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You sold 500 squeegees for $2,750.
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This is the revenue that you made
not what these squeegees
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actually cost you.
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So we can't enter the $2,750
into your total cost of goods sold
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we'll have to work this one out.
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We're also going to need to work out
your closing inventory
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at the end of the month
on November 30th.
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Which brings us on to Step 3
It's time to fill in the blanks.
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There are a couple of things
to be aware of when filling out
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a cost flow table under FIFO.
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We'll need to calculate the
cost per unit of your
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opening inventory and additions
but you can ignore the cost per unit
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of your goods available for sale
goods sold and closing inventory.
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We'll start off by calculating
the total cost of your opening inventory.
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You began the month holding 220 units
which cost you $2 per unit
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220 multiplied by $2 is $440
Next up we have to work out
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the cost per unit of your additions.
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You bought 400 units costing you
a total of $1,200.
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$1,200 divided by 400 units is $3 per unit.
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That's quite an increase from
the cost per unit of your opening inventory.
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Something to bear in mind when picking
Inventory Cost Flow Assumptions.
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But more on that soon.
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Now we'll take some subtotals
to work out your goods available for sale.
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220 units plus 400 units is
620 units available for sale
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and $440 plus $1,200 is $1,640
your total cost of goods available for sale.
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Remember I said that under FIFO
we can keep the cost per unit
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of your goods available for sale
and goods sold blank.
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That means we can move on to working
out your total cost of goods sold.
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Here's where FIFO comes in.
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First In First Out.
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You sold 500 units but what did it cost you?
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Well under FIFO the first units
you bought in are the first to be sold.
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You had an opening inventory
of 220 units which cost you $2 per unit
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but you still need to sell
another 280 units to reach 500.
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The next 280 units come from your
additions which cost you $3 per unit.
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So here's our workings
220 units multiplied by $2 is $440
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and 280 units multiplied by $3 is $840
440 plus 840 is $1,280
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this is your total cost of goods sold.
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Nice work!
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That was the hard part
now let's take some totals to find out
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your closing inventory on November 30th.
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620 minus 500 gives you 120 units
and 1,640 minus 1,280 gives you $360
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your total cost of closing inventory.
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Step 4
Calculate your total cost of goods sold
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and your closing inventory.
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Well like I said the hard part is over.
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Your total cost of goods sold
for the month can be calculated
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by adding up your
cost of goods sold for each sale.
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Here you've only made one sale
so your total cost of goods sold
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for November is $1,280 and the
total cost of your
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closing inventory is $360.
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The inventory cost flow table
makes it easy for us to work these out
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and if any of this looks
familiar to you it's because
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it mirrors the inventory calculation
that we had up earlier.
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So why would you choose
the FIFO method?
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Well it's one of the easiest
Cost Flow Assumptions to use in practice
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and in an inflationary economy
where prices are rising
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the cost of your inventory might be
going up like it did in this example.
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So choosing FIFO can make
your profits look bigger because
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you're matching your current revenues
against your older
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cheaper cost of goods.
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Revenue less cost of goods sold
is gross profit and as you can see
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in this example
your gross profit calculated under FIFO
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is larger than your
gross profit calculated using
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the LIFO or AVCO methods.
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But as a business owner this
isn't necessarily a good thing.
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High profits can mean high taxes
which can negatively impact
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your cash flow.
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So if possible is worth considering
the Last In First Out
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or Average Cost methods.
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In my next two videos
we'll explore these.
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You can subscribe to
Accounting Stuff so you
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don't miss out on those videos.
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I'll drop both of them in the playlist over here
as soon as they're done.
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Like I said I've created a
Cost Flow Assumptions Cheat Sheet
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which you can find here as well.
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See you soon.
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