FIFO, LIFO & Weighted Average - Material Cost, Cost Accounting | Cost Accounting - B Com PDF Download

Issue of materials Materials issued from stores are debited to the jobs or work orders which received them and credited to the materials account. These jobs are debited with the value of materials issued to them. But what is the value of materials? Theoretically the value includes the invoice price less trade discount, the freight, cartage, octroi and insurance on incoming materials, expenses of purchase, receiving, storing and record keeping and carriage from the stores up to the process plant. However, in practice, it involves minute calculations for including all these expenses and is a big task compared to the benefit derived from it.

Moreover the price changes according to the market conditions and at any given time there will be stock of materials purchased at different times at different prices. Hence the problem as to at what price the materials should be issued?

There are many methods of pricing material issues. The most important being: FIFO, LIFO, simple and weighed average methods.

1) First in First Out (FIFO)

Under this method material is first issued from the earliest consignment on hand and priced at the cost at which that consignment was placed in the stores. In other words, materials received first are issued first. The units in the opening stock of materials are treated as if they are issued first, the units from the first purchase issued next, and so on until the units left in the closing stock of materials are valued at the latest cost of purchases. This method is most suitable in times of falling prices because the issue price of materials to jobs or work order will be high while the cost of replacement of materials will be low. But in case of rising prices this method is not suitable because the issue price of materials to production will be low while the cost of replacement of materials will be high. The following example will illustrate how issues of materials are valued under this method.

Advantages:
(i) Since materials issued for production are at the original cost, the inventory reflects the current market price,
(ii) Profit and Loss Account and the Balance Sheet satisfactorily represent the actual conditions,
(iii) When the price level is declining, the FIFO method shows a lower profit for income tax implications,
(iv) Next to the Average Cost Method, FIFO is the most commonly accepted basis of valuation of issue, and
(v) The method simplifies computation of the values of issues.

Demerits:
(i) When there are price-fluctuations FIFO method makes the cost of production fluctuating from period to period,
(ii) At the time of increasing price-level this method shows profit and inventory at higher figures which have unfavourable income tax implications.
Illustration: The following is a history of the receipts and issue of motives in a factory during February, 2004:

Issues are to be priced on the principles of FIFO. Stock verifier of the factory noted on 15th a shortage of 5kgs. Write out the complete Store ledger account in respect of the above motives for February, 2004. 

Solution.
 

Illustration 6: The received side of the Stores Ledger Account shows the following particulars:

Issues of material were as follows:

Jan. 4- 200 units; Jan.10- 400 units; Jan. 15- 100 units; Jan 19- 100 units; Jan.26- 200 units; Jan.30- 250 units. Issues are to be priced on the principle of “first in first out”. Write the Stores Ledger Account in respect of the materials for the month of January.

2) Last in First Out (LIFO)

Under this method, issues are priced in the reverse order of purchase i.e., the prices of the latest available consignment is taken. This method is suitable in times of rising prices because material will be issued from the latest consignment at a price which is closely related to the current price levels. Valuing material issues at the price of the latest available consignment will help the management in fixing the competitive selling prices of the products.

Advantages:

This method claims a few advantages:
(a) The issue will be priced at the market rate prevailing, more or less, near the date of issue. This has the advantage of ascertaining the cost at about the prevailing market price and the cost thus ascertained will enable the prices to be fixed on competitive basis.
(b) The principle of costing the goods at cost has not been given up.
(c) In case of rising prices the method has the advantage of showing a lower profit which may help in saving tax to some extent. It is not without reason that this method has come into use only when prices have been steadily rising.

Disadvantages:
(i) The disadvantages of this method are the same as those of the FIFO method, namely, excessive clerical labour and differing costs of similar jobs using similar materials.
(ii) Under this method the inventory is shown at the oldest market price and so does not reflect the current conditions,
(iii) Since the inventory value at the end of a period is out of date, large adjustment may be necessary, if the cost or market rule is applied.

Solution (Illustration 6)

Stores Ledger Account

Illustration 7: Prepare Stores Account on Last in First Out method assuming the same particulars as in Illustration 6:

3) Simple Average Method In this method, price is calculated by dividing the total of the prices of the materials in the stock from which the material to be priced could be drawn by the number of the prices used in that total. This method may lead to over-recovery or under-recovery of cost of materials from production because quantity purchased in each lot is ignored.

Advantages:
(a) It is simple to work out & apply.
(b) Issue price cannot be affected considerably by the fluctuations in prices of purchase.
(c) Average cost method is suitable for the condition when different lots of purchases get mixed up so that the identification is not possible.
(d) Where the quantity of each purchase is stable but the prices fluctuate, average cost method suits the condition.

Disadvantages:
(a) Profit or loss in material arises as total cost incurred usually does not become equal to the total charges.
(b) Frequent calculations of rates will be necessary in case of frequent purchases, thereby involving much clerical work. Average rate may have to be revised due to exhaustion of an existing stock even if no new purchase comes.
(c) Too much profit or loss on materials may be resulted from the method, when lots of purchases vary much in quantities.
(d) Due to fact that the identity of the materials disappeared in the store, the verification of closing stock figures becomes difficult.
(e) Absurd figures may be shown by the closing stock. The closing stock account may even show credit balance, in times of inflationary spiraling.
The simple average method can work well where:
(a) in each lot, there is standard quantity of purchase
(b) there is very mild fluctuation in prices.

Illustration 4:
From the details prepare stores ledger under simple average method.

Shortage of 40 kg on 16.12.2010 & another shortage of 40 kg on 26.12.2010 is found by the stock verifier.

Workings: Calculation of simple average price:-
For Issue on 8th Dec = (1.25+1.30)/2        = $ 1.275
For Issue on 10th Dec                                 = $ 1.30
For Shortage on 16th Dec = (1.30+1.35)/2 = $ 1.325
For Issue on 18th Dec                                  = $ 1.325
For Issue on 25th Dec = (1.35+1.40)/2        = $ 1.375
For Shortage on 26th Dec                            = $ 1.40
For Issue on 28th Dec                                  = $ 1.40

Eg:- 

1000 units purchased @ Rs.10

2000 units purchased @ Rs.11

3000 units purchased @ Rs.12

In this example, simple average price will be Rs.11 calculated as below:

4) Weighted Average Methods

In this method, price is calculated by dividing the total cost of materials in the stock from which the materials to be priced could be drawn by the total quantity of materials in that stock.

In the above example, the weighted average price is Rs.11.33 per unit calculated as follows:

In the periods of heavy fluctuations in the prices of materials, the average cost method gives better results because it tends to smooth out the fluctuations in prices by taking the average of prices of various lots in stock.

Advantages:
(a) The effect of price fluctuations on issue rates are smoothened effectively by the method.
(b) The rate continues in its application unless a new purchase arrives.
(c) Only if, in the calculation of the rates, mathematical approximation is made then profit or loss on materials arises.
(d) Simple & not too much clerical work is involved unless purchases are made frequently.
(e) Where both the price & quantity ordered fluctuate, this method suits the condition.

Disadvantages:
(a) The work of calculation of rates becomes considerable in case where a frequent purchase is made.
(b) The cost price (nor the market price) of the materials actually issued are not represented by the charges made to issues.
(c) Unless the rates are calculated correcting up to 4 or 5 places of decimal whenever necessary, profit or loss on materials may be created by the method.

Solution (Illustration 7) LIFO Method