Economic Order Quantity (EOQ):

Economic order quantity (EOQ) is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the materials at the optimum level and at the minimum cost.

In other words, the economic order quantity (EOQ) is the amount of inventory to be ordered at one time for purposes of minimizing annual inventory cost.

The quantity to order at a given time must be determined by balancing two factors: (1) the cost of possessing or carrying materials and (2) the cost of acquiring or ordering materials. Purchasing larger quantities may decrease the unit cost of acquisition, but this saving may not be more than offset by the cost of carrying materials in stock for a longer period of time.

The carrying cost of inventory may include:

Interest on investment of working capital
Property tax and insurance
Storage cost, handling cost
Deterioration and shrinkage of stocks
Obsolescence of stocks.
Formula of Economic Order Quantity (EOQ):
The different formulas have been developed for the calculation of economic order quantity (EOQ). The following formula is usually used for the calculation of EOQ.




A = Demand for the year
Cp = Cost to place a single order
Ch = Cost to hold one unit inventory for a year
* = ×


Example:
Pam runs a mail-order business for gym equipment. Annual demand for the TricoFlexers is 16,000. The annual holding cost per unit is $2.50 and the cost to place an order is $50.

Calculate economic order quantity (EOQ)

Calculation:




Underlying Assumptions of Economic Order Quantity:
The ordering cost is constant.
The rate of demand is constant
The lead time is fixed
The purchase price of the item is constant i.e no discount is available
The replenishment is made instantaneously, the whole batch is delivered at once.

Re-order Level or Ordering Point or Ordering Level:


Definition and explanation:

This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels. Order points are based on usage during time necessary to requisition order, and receive materials, plus an allowance for protection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to the lead time usage quantity plus the safety stock quantity.

Formula of Re-order Level or Ordering Point:
The following two formulas are used for the calculation of reorder level or point.

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time ]

The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided. When safety stock is provided then the following formula will be applicable:

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time + Safety stock ]

Minimum Limit or Minimum Level of Stock:

The minimum level or minimum stock is that level of stock below which stock should not be allowed to fall. In case of any item falling below this level, there is danger of stopping of production and, therefore, the management should give top priority to the acquisition of new supplies.

Formula:
Minimum level or minimum limit can be calculated by the following formula:

[ Minimum limit or level = Re-order level or ordering point – Average or normal usage × Normal re-order period ]

Or the formula can be written as:

[ Minimum limit or level = Re-order level or ordering point – Average usage for Normal period ]

Maximum Level or Maximum Limit of Stock:

The maximum stock limit is upper level of the inventory and the quantity that must not be exceeded without specific authority from management. In other words, the maximum stock level is that quantity of material above which the stock of any item should not normally be allowed to go. This level is fixed after taking into account such factors as: capital, rate of consumption of materials, storage space available, insurance cost, risk of deterioration and obsolescence and economic order quantity.

Formula:
Maximum level or maximum limit can be calculated by the help of following formula:

[Maximum limit or level = Re-order level or ordering point – Minimum usage × Minimum re-order period + Economic order quantity]

Danger Level of Materials or Inventory Stock:

When danger level is reached, the try is made to purchase materials from the nearest possible source or place so that the workers and plant and machinery may not remain idle due to shortage of materials supplies.

Formula:
Danger level can be calculated by the help of the following formula:

[ Danger level = Average daily requirement × Time required to get emergency supply ]

Basic inventory decisions and EOQ

At the very basic level any firm faces two main decisions concerning the management of inventory: When should new stock be ordered and in what quantities? With regard to the order quantity, which minimises inventory related costs, we are familiar with the classical EOQ (economic order quantity) model. This remains the basic inventory model even when it is not applicable in real life business situations in most cases.

In inventory related literature, the answer to the question of when to order is given with reference to the ROP (reorder point), the point at which the replenishment order should be initiated so that the facility receives the inventory in time to maintain its target level of service. The ROP can be defined in terms of units of days or in units of inventory. In the static and deterministic model, the ROP is the simple multiplication of the number of lead days and the daily demand. It means that every time the inventory falls to the ROP level, an order must be initiated. And the order quantity is given by the EOQ model which is based on cost minimisation.




Figure 4.1 A simple deterministic inventory model based on fixed demand and fixed lead time

You are aware that the EOQ quantity is the balance between order and holding costs attached with the inventory. The order cost is made up of fixed and variable costs, whereas the holding cost consist of costs of insurance, taxes, maintenance and handling, opportunity costs and costs of obsolescence.

In your text

See Section 3.2.1 for a good discussion on the EOQ model.



The formula for EOQ or economic order quantity is well known:



Q is the order quantity per order.
K is the fixed set up cost which the warehouse incurs every time it places an order.
D is the demand per day.
h is the inventory carrying or holding cost per unit per day.

You will notice that your text highlights two important insights regarding the EOQ model. These are:

•Optimum order size is a good balance between the holding cost and the fixed order cost.
•Total inventory cost is related with order size, but the relationship is not very significant.
A discussion of the EOQ model would remain incomplete if the inherent assumptions on which the model is based are ignored. Bowersox (2001) explains that these major assumptions are:

•All demand is satisfied.
•The rate of demand is continuous, constant and known.
•Replenishment lead time is constant and known.
•There is a constant price of product that is independent of order quantity or time.
•There is an infinite planning horizon.
•There is no interaction between multiple items of inventory.
•There is no inventory in transit.
•There are no limits on capital availability.

The economic order quantity is a tool used in Operations Management to determine the most cost-effective purchase quantity. The variables within the formula are discussed in the article below.

The economic order quantity is used when goods or materials are purchased periodically.


The economic order quantity determines the appropriate number of product to order based on a number of different variables. The economic order quantity is the amount to purchase that will minimize the overall cost to the company. Small businesses do not have to compute this number on a regular basis, but understanding the logic behind the calculation can help your company make better purchasing decisions.

To begin, the different variables in the EOQ formula are; the annual demand of the product, the purchase cost per individual unit, the fixed cost per order, the order quantity and the holding cost of the product. By analyzing each of these variables, we can understand how it affects our purchasing habits and ultimately, our bottom line.

The annual demand for the product is an important piece to the puzzle. If it's a product that you use once or twice a year, you're probably not going to order it frequently or in large numbers. If it is a product that you use often, you may want to purchase in larger amounts to obtain a discount or arrange for frequent small deliveries with your supplier.

The purchase cost for individual unit is pretty straightforward. If an item cost thousands of dollars, we would expect to purchase it less frequently than an item that cost ten dollars. If the purchase price a unit increases, you may want to order it less frequently or wait until you have a customer commitment that requires the part.

The fixed cost per order is another key element, but it is often ignored in the purchasing process. Each time you place an order, it requires a fixed cost. You need to have an employee take the time to place the order. This may result from another employee taking the time to count the inventory and let your personnel know they need to order a product. Once an order is placed, there is the cost of tracking the order and receiving the order.

If these costs are high, you would want to order less frequently and in larger amounts. If your system is smooth, this fixed cost may be low and have a minimal impact on your purchasing habits.

The order quantity can be fixed or determined by your purchasing department. Sometimes lot sizes are fixed due to your supplier, and other times you have multiple pack sizes to choose from. If the order quantity is flexible, this is not too big of an issue. If the order quantity is large, depending upon your usage it can be costly to store. Understanding the order quantity versus your demand can greatly impact your purchasing decisions.

Finally, you need to consider the holding cost of the product. This can be difficult to calculate, especially for small businesses. The holding costs include the space the material is occupying as well as the labor to move it and count it in inventory. If your space is limited, your holding cost is high. As a result, you wouldn't want to have excess of a product that only gets used once or twice a year.

The EOQ formula can be easily found on the web. While it is not necessary for the small business to try and crunch these numbers, it is important that the small business understand the different variables and how they affect your company. If you understand the implications of the variables, you can find a nice balance that works best for your business.

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Gross Profit Analysis Part 2. Case Study

Gross Profit analysis of time sharing computer programs:

The senior system analysis of Tyrene, Inc. Bob Canedy, developed in his spare time three unique packages of computer programs: Package 1, inventory control; Package 2, sales analysis; Package 3; report preparation. After realizing their marketability, he struck out on his own, forming data-Pack Co., a computer time sharing service bureau. He rented an adequate computer and leased some data communication lines and terminals, then placed the packages on-line. Once operational, he planned to sell the use of his packages to industrial customers by the system-connect-hour, i.e., total time elapsing while the customer's terminal is directly connected to the central computer.

In the process of establishing profitable sales prices, Candey decided to project costs for the first year. Using processing information provided by the computer sales representative, he allocated the total cost to the packages as follows:

Computer Rental ($56,000) Other Common Costs ($14,000)
Package (1)

Core Requisitions (000s Bits) % of Total Core Requisitions CPU* Hrs
System Connect Hrs (2)
% of Total CPU to System Connect Hrs. Weighted Average [4 × Col. (1) - Col. (2)] - 5 Common Cost Traceable Cost Total Cost
1 80 60% 0.18 10% 50% $35,000 $10,000 $45,000
2 33 25 0.90 50 30 21,000 14,000 35,000
3 20 15 0.72 40 20 14,000 6,000 20,000
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total 133 100% 1.80 100% 100% $70,000 $30,000 $100,000
====== ====== ====== ====== ====== ====== ====== ======

*Central Processing Unit

Working from expected costs, Canedy computed the desired markup for each of the packages. Since he knew that the useful lives of the programs were only a few years, he decided to recoup the investment in time that he had spent on developing the programs by using that criterion in computing a sales price, as follows:

Package Workdays Spent in Developing Programs (1)
% of Total Development Projected Sales (Hrs.) (2)
Hourly Cost (Per unit) Unit Markup
(1) × (2) Unit Sales Price Total Sales (Hrs. × Sales Price)
1 27 15% 900 $50 $7.50 $57.50 $51,750
2 108 60 1,000 35 21.00 56.00 56,000
3 45 25 500 40 10.00 50.00 25,000
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total 180 100% 2,400 $132,750
======== ======== ======== ======== ======== ======== ========




After the first year of operation, Data-Pack's income statement appeared as follows:

Sales:
Package 1: 1,200 hrs. @ $53 $63,600
Package 2: 900 @ 58 52,200
Package 3: 700 @ 46 32,200
------------- $148,000
Cost of goods sold: Common Traceable Total
Package 1: $40,000 $14,000 $54,000
Package 2: 24,000 12,000 36,000
Package 3: 16,000 5,000 21,000
----------- 111,000
-------------
Operating income $37,000
======

Although the firm exceeded planned profits by $4,250, it was evident that changes in demand for the packages and changes in costs and sales prices made this gain only coincidental.

Required:

A gross profit analysis to determine the effects of the demand and fluctuating prices on sales revenue, so that a new price for the most profitable package can be established.

Solution:
Analysis of Sales Price and Sales Volume Variance
Package 1 Package 2 Package 3
Actual sales $63,600 $52,200 $32,200
Actual sales hours × budgeted unit sales price
#1: 1,200 hrs. × $57.50
69,900
50,400
35,000
------------ ------------ ------------
Sales price variance $5,400 unfav. $1,800 fav. $2,800 unfav.
======== ======== ========
Actual sales × budgeted unit sales price $69,000 $50,400 $35,000
Budgeted sales 51,750 56,000 25,000
------------- ------------- -------------
Sales volume variance $17,250 fav. $5,600 unfav. $10,000 fav.
======== ======== ========

Analysis of Cost Price and Cost Volume Variance:
Package 1 Package 2 Package 3
Actual cost of goods sold $54,000 $36,000 $21,000
Actual sales hours × budgeted hourly unit cost
#1: 1,200 hrs. × $50
60,000
31,500
28,000
------------- ------------- ---------
Cost price variance $6,000 fav. $4,500 unfav. $7,000 unfav.

Actual sales hours × Budgeted hourly unit cost $60,000 $31,500 $28,000
Budgeted cost 45,000 35,000 20,000
------------ ------------ ---------
Cost volume variance $15,000 unfav. $3,500 fav. $8,000 unfav.
======= ====== ======

Recapitulation of Sales Price Variance, Sales Volume Variance, Cost Price Variance, and Cost Volume Variance:
Sales Price Sales Volume Cost Price Cost Volume
Package 1 $ 5,400 U* $17,250 F** $ 6,000 F $15,000 U
Package 2 1,800 F 5,600 U 4,500 U 3,500 F
Package 3 2,800 U 10,000 F 7,000 F 8,000 U
---------- ---------- ---------- ------
Net variance $6,400 U $21,650 F $8,500 F $19,500 U
======= ======= ======= =======
* Favorable
** Unfavorable

Combining the net favorable sales volume variance of $21,650 with the net unfavorable cost volume variance of $19,500 leads to a net favorable volume variance of $2,150 that can be further analyzed into the sales mix variance and final sales volume

Gross Profit Analysis (GP Analysis): Part 1

Gross profit is the difference between the cost of goods sold and sales.

Since the adherence of the actual to the budgeted or standard gross profit figure is highly desirable, a careful analysis of unexpected changes in gross profit is useful to a company's management. These changes are the result of one or a combination of the following.

Changes in sales prices of the products.

Changes in volume sold.
a. Changes in number of physical units sold.
b. Changes in the types of products sold, often called the product mix or sales mix.

Changes in cost elements, i.e., materials, labor, and overhead costs.

Procedures for analyzing gross profit:
The determination of the various causes for an increase or decrease in gross profit is similar to the computation of standard cost variances, although gross profit analysis is often possible without the use of standard costs or budgets. In such a case, prices and costs of the previous year, or any year selected as the basis for the comparison, serve as the basis for the calculation of the variances. When standard costs and budgetary methods are employed, however, a greater degree of accuracy and more effective results are achieved.

Gross Profit Analysis Based on the Previous Years Figures
Gross Profit Analysis Based on Budgets and Standard costs
Discussion Questions and Answers about Gross Profit Analysis
Gross Profit Analysis Solved Problems
Gross Profit Analysis Case Study

Uses of Gross Profit Analysis:

The gross profit analysis based on budgets and standards costs depicts the weak spots in the year's performance. Management becomes able to outline the remedies that should correct the situation. The planned gross profit is the responsibility of the marketing as well as the manufacturing department. The gross profit analysis brings together these two major functional areas of the firm and points to the need for further study by both of these department. The marketing department must explain the changes in the sales prices, the shift in the sales mix, and the decrease in units sold, while the production department must account for the increase in cost. To be of real value, the cost price variance should be further analyzed to determine variances for materials, labor, and factory overhead.

Gross Profit Analysis Based on the Previous Year's Figures:




As the basis for illustrating the gross profit analysis using the previous year's figures, the following gross profit section of a company's operating statements for 19A and 19B are presented.

19A
19B
Changes

Sales (net)
Cost of goods sold
Gross profit
$120,000
$100,000
----------
$20,000
=======
$140,000
$110,000
---------
$30,000
=======
+$20,000
+$10,000
----------
+$10,000
=======



In comparison with 19A, sales in 19B increased $20,000 and costs increased $10,000, resulting in increase in gross profit of $10,000.

Additional data taken from various records indicate that the sales and the cost of goods sold figure can be broken down as follows:

19A Sales
19A Cost of goods sold

Product Quantity Unit Price Total Unit Cost Total
X 8,000 Units $5.00 $40,000 $4.000 $32,000
Y 7,000 Units $4.00 $28,000 $3.500 $24,500
Z 20,000 Units $2.60 $52,000 $2.175 $43,500
---------- ----------
$1,20,000 $1,00,000
======= =======
19B Sales
19B Cost of goods sold

Product Quantity Unit Price Total Unit Cost Total
X 10,000 Units $6.60 $66,000 $4.00 $40,000
Y 4,000 Units $3.50 $14,000 2.50 $14,000
Z 20,000 Units $3.00 $60,000 2.80 $56,000
-------- -------
140,000 110,000
====== =====

In analyzing the gross profit of the company, the sales and cost of 19A are accepted as the basis (or standard) for all comparisons. A sales price variance and a sales volume variance are computed first., followed by the computation of a cost price variance and a cost volume variance. The sales volume variance and cost volume variance are analyzed further as a third step, which result in the computation of a sales mix variance and a final sales volume variance.

Calculation of sales price and sales volume variance:
The sales price and sales mix variances from the above data are calculated as follows:

Actual 19B sales $140,000
Actual 19B sales at 19A price:
X: 10,000 units @ $5.00 $50,000
Y: 4,000 units @ $4.00 $16,000
Z: 20,000 units @ $2.60 $52,000
------- $118,000
-------
Favorable sales price variance $22,000
=======
Actual 19B sales at 19A price $118,000
Total 19A sales (used as standard) $120,000
------
Unfavorable sales volume variance $2,000
======

Calculation of Cost Price and Cost Volume Variance:
The cost price and and cost volume variances are calculated as follows.

Actual 19B cost of goods sold $110,000
Actual 19B sales at 19A cost:
X: 10,000 units @ $4.000 $40,000
Y: 4,000 units @ $3.500 $14,000
Z: 20,000 units @ $2.175 $43,500
--------- $97,500
---------
Unfavorable cost price variance $12,500
========
Actual 19B sales at 19A cost $97,500
Cost of goods sold in 19Aused as standard $100,000
---------
Favorable cost volume variance $2,500
========

The result of the preceding computations might explain the reason for the $10,000 increase in gross profit.

Favorable sales price variance $22,000
Favorable volume variance (net) consisting of:
Favorable cost volume variance $2,500
Less unfavorable sales volume variance $2,000
--------
Net favorable volume variance $500
--------
$22,500

Less unfavorable cost price variance $12,500
-------
Increase in gross profit 10,000
=====

Calculation of the sales mix and final sales volume variance:
The net $500 favorable volume variance is a composite of the sales volume and cost volume variance. It should be further analyzed to determine the more significant sales mix and final sales volume variances. To accomplish this analysis, one additional figure must be determined―the average gross profit realized on the units sold in the base (or standard) year. The computations is:

Total gross profit ÷ Total number of units sold

= $20,000 ÷ 35,000

= $0.5714

The $0.5714 average gross profit per unit sold in 19A is multiplied by the total number of units sold in 19B (34,000 units). The resulting $19,427 is the total gross profit that would have been achieved in 19B if all units had been sold at 19A's average gross profit per unit.

The sales mix and final sales volume variance can now be calculated:

Actual 19B sales at 19A sales price $118,000
Actual 19B sales at 19A cost $ 97,500
-------------
Difference $20,500
19B sales at 19A average gross profit $19,427
---------
Favorable sales mix variance $ 1,073
======
19B sales at 19A average gross profit $19,427
Total 19A sales (used as standard) $120,000
Cost of goods sold in 19A (used as standard) 100,000
--------- 20,000
---------
Unfavorable final sales volume variance $573
======

Recapitulations of Variances:
The variances identified in the preceding calculations are summarized below:

Gains
Losses

Gain due to increased sales price $22,000
Loss due to increased cost $12,500
Gain due to shift in sales mix $1073
Loss due to decrease in units sold
$573
--------- ---------
Total $23073 $13073
Less $13073
---------
Net increase in gross profit
$10,000
=======


Gross Profit Analysis Based on Budgets and Standard Costs:




As the basis for illustrating the analysis of gross profit using budgets and standard costs, three financial statements for a company are presented:

The budgeted income statement prepared at the beginning of the period
The actual income statement prepared at the end of the period.
An income statement prepared at the end of the period on the basis of actual sales at budgeted sales prices and at standard costs.
Statement 1:
Income Statement (Budgeted)

Product Units Sales Cost Gross Profit
Unit price Amount Unit cost Amount Per unit Amount
A 6,000 $15.00 $90,000 $12.00 $72,000 $3.00 $18,000
B 3,500 $12.00 $42,000 $10.00 $35,000 $2.00 $7,000
C 1,000 $10.00 $10,000 $8.75 $8,750 $1.25 $1,250
------- ------- -------- ------- ------- ------- --------
10,500 $13.52* $142,000 $11.02* $115,750 $2.50* $26,250
===== ===== ===== ===== ===== ===== =====
*Weighted average


Statement 2:
Income Statement (Actual)

Product Units Sales Cost Gross Profit
Unit price Amount Unit cost Amount Per unit Amount
A 5,112 $16.00 $81,792 $13.98 $71,466 $2.02 $10,326
B 4,208 $12.00 $50,496 $9.72 $40,902 $2.28 $9,594
C 1,105 $9.00 $9,945 $8.83 $9,757 $0.17 $188
------- ------- -------- ------- ------- ------- --------
10,425 $13.64* $142,233 $11.71* $122,125 $1.93* $20,108
===== ===== ===== ===== ===== ===== =====
*Weighted average


Statement 3:
Income Statement (Actual units at budgeted prices and costs)

Product Units Sales Cost Gross Profit
Unit price Amount Unit cost Amount Per unit Amount
A 5,112 $15.00 $76,680 $12.00 $61,344 $3.00 $15,338
B 4,208 $12.00 $50,496 $10.00 $42,080 $2.00 $8,416
C 1,105 $10.00 $11,050 $8.75 $9,669 $1.25 $1,381
------- ------- -------- ------- ------- ------- --------
10,425 $13.26* $138,226 $10.85* $113,093 $2.41* $25,133
===== ===== ===== ===== ===== ===== =====
*Weighted average


According to statement 1, the company expected a gross profit of $26,250, based on an estimated production of 10,500 units and an average gross profit of $2.50 per unit. As shown in statement 2, the company actually made a gross profit of only $20,108, or $1.93 per unit. Statement 3 Indicates that the average gross profit for the actual units sold would have been $2.41 per unit if the budgeted sales price and costs per unit had been achieved.

The $6,142 difference between the budgeted gross profit and the actual gross profit is the result of changes in sales price, sales volume, sales mix, and costs. For example, on the basis of the budget, A is the most profitable product and C is the least profitable per unit. Due to variations in sales price and cost, B is actually the most profitable while C is the least profitable per unit. The dollar effect of such changes is shown by the calculation of the sales price, sales volume, cost price, cost volume, sales mix and final sales volume variances.

Calculation of sales price variance and sales volume variance:
Using the figures from the statements above, the sales price variance and sales volume variance for the company are calculated as follows:

Actual sales $142,233
Actual sales at budgeted price $138,226
-----------
Favorable sales price variance $4,007
=======
Actual sales at budgeted price $138,226
Budgeted sales 142,000
------------
Unfavorable sales volume variance $3,774
========

Calculation of Cost Price Variance and Cost Volume Variance:
Using the figures from the statements above, the cost price variance and cost volume variance for the company are calculated as follows:

Cost of goods sold - Actual $122,125
Budgeted cost of actual units sold $113,093
-----------
Unfavorable cost price variance $9,032
=======
Budgeted cost of actual units sold $113,093
Budgeted cost of budgeted units sold 115,570
------------
Favorable cost volume variance $2,657
========

Calculation of the Sales Mix and Final Sales Volume Variance:
In the above calculation two volume variances appear:

Unfavorable sales volume variance $3,774
Favorable cost volume variance $2,657
--------
Net unfavorable volume variance $1,117
=====

The net volume variance should be further analyzed to determine the sales mix and final sales volume variance. These variances are computed as follows:

Actual sales at budgeted prices $138,266.00
Budgeted cost of actual units sold 113,093.00
--------------
Difference $25,133.00
Budgeted gross profit of actual units sold
10,425 actual units × $2.50 budgeted gross profit per unit $26062.50
---------------
Unfavorable sales mix variance $929.50
=======
Budgeted gross profit of actual units sold $26062.50
Budgeted sales $142,000
Budgeted cost of budgeted units sold $115,750
------------- 26,250.00
---------------
Unfavorable final sales volume variance $187.50
========

Check:

Unfavorable sales mix variance $929.50
Unfavorable final sales volume variance 187.50
-----------
Net unfavorable volume variance 1,117.00
======

Recapitulation of Variances:

Gains Losses
Gain due to increased sales prices $4,007
Loss due to increased cost $9,032.00
Loss due to shift in sales mix 929.50
Loss due to decrease in units sold 187.50
---------------
Total $10,149.00
Less 4,007.00
---------------
Net decrease in gross profit $6,142.00
=======

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Controlling and Costing Materials Part 2

First In First Out (FIFO) - Materials and Inventory Costing Method:

Definition and Explanation:
The first in first out (FIFO) method of costing is used to introduce the subject of materials costing. The FIFO method of costing issued materials follows the principle that materials used should carry the actual experienced cost of the specific units used. The methods assumes that materials are issued from the oldest supply in stock and that the cost of those units when placed in stock is the cost of those same units when issued. However, FIFO costing may be used even though physical withdrawal is in a different order.

Advantages of First in First out (FIFO) Costing Method:
Advantages claimed for first in first (FIFO) out costing method are:

Materials used are drawn from the cost record in a logical and systematic manner.
Movement of materials in a continuous, orderly, single file manner represents a condition necessary to and consistent with efficient materials control, particularly for materials subject to deterioration, decay and quality are style changes.
FIFO method is recommended whenever:

The size and cost of units are large.
Materials are easily identified as belonging to a particular purchased lot.
Not more than two or three different receipts of the materials are on a materials card at one time.
Example:
This example is based on the following transactions:

February
(1)Beginning balance: 800 units @ $6 per unit.
(4)Received 200 units @ $7 per unit.
(10)Received 200 units @ $8 per unit.
(11)Issued 800 units.
(12)Received 400 units @ $8 per unit.
(20)Issued 500 units.
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price.
(28)Received 600 units @ $9 per unit.

Calculation for the above transactions would be as follows:

FIFO Costing Method

February:
01. Beginning balance
800 units @ $6
$4,800
04. Received 200 units @ $7 $1,400
10. Received 200 units @ $8 $1,600 $7,800
11. Issued 800 units @ $6 $4,800
Balance
200 units @ $7 $1,400
200 units @ $8 $1,600 $3,000
12. Received 400 units @ $8 $3,200 $6,200
20. Issued 200 units @ $7 $1,400
300 units @ $8 $2,400 $3,800
Balance
300 units @ $8 $2,400
25. Returned to storeroom 100 units @ $8 $800
28. Received 600 units @ $9 $5,400 8,600
Balance
400 units @ $8 $3,200
600 units @ $9 $5,400 $8,600

Disadvantages or Limitations of FIFO Method
FIFO method is definitely awkward if frequent purchases are made at different prices and if units from several purchases are on hand at the same time. Added costing difficulties arise when returns to vendors or to the storeroom occur.

Average Costing Method--Materials and Inventory Costing:

Definition and explanation:
Issuing materials at an average cost assumes that each batch taken from the storeroom is composed of uniform quantities from each shipment in stock at the date of issue. Often it is not feasible to mark or label each materials item with an invoice price in order to identify the used units with its acquisition cost. It may be reasoned that units are issued more or less at random as for as the specific units and the specific costs are concerned and that an average cost of all units in stock at the time of issue is satisfactory measure of materials cost. However, average costing may be used even though the physical withdrawal is an identifiable order. If materials tend to be made up of numerous small items low in unit cost and especially if prices are subject to frequent changes.

Advantages of Average Costing Method:
Average costing method has the following main advantages:

It is a realistic costing method useful to management in analyzing operating results and appraising future production.
It minimizes the effect of unusually high or low materials prices, thereby making possible more stable cost estimates for future work.
It is practical and less expensive perpetual inventory system.
The average costing method divides the total cost of all materials of a particular class by the number of units on hand to find the average price. The cost of new invoices are added to the total in the balance column; the units are added to the existing quantity; and the new total cost is divided by the new quantity to arrive at the new average cost. Materials are issued at the established average cost until a new purchase is recorded. Although a new average cost may be computed when materials are returned to vendors and when excess issues are returned to the storeroom, for practical purposes, it seems sufficient to reduce or increase the total quantity and cost, allowing the unit price to remain unchanged. When a new purchase is made and a new average is computed, the discrepancy created by the returns will be absorbed.

Example:
February
(1)Beginning balance: 800 units @ $6 per unit.
(4)Received 200 units @ $7 per unit.
(10)Received 200 units @ $8 per unit.
(11)Issued 800 units.
(12)Received 400 units @ $8 per unit.
(20)Issued 500 units.
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price.
(28)Received 600 units @ $9 per unit.

Calculations for the above transactions would be as follows

Average Costing Method Calculation Illustrated

01. Beginning balance 800 units @ $6 $4,800
04. Received 200 units @ $7 $1,400
Balance
1000 units $6,200 $6.20
10. Received 200 units @ $8 $1,600
Balance
12,00 units $7,800 $6.5
11. Issued 800 units @ $6.50 $5,200
Balance
400 units $2,600 $6.5
12. Received 400 units @ $8 $3,200
Balance
800 units $5,800 $7.25
20. Issued 500 units @ $7.25 $3,625
Balance
300 units $2,175 $7.25
Returned to storeroom 100 units $725
Balance
400 units $2,900 $7.25
28. Received 600 units @ $9 $5,400
Balance
1000 units $8,300 $8.30

Last In First Out (LIFO) - Materials and Inventory Costing Method:

Definition and explanation:
The last in first out (LIFO) method of costing materials issued is based on the premise that materials units issued should carry the cost of the most recent purchase, although the physical flow may actually be different. The method assumes that the most recent cost (the approximate cost to replace the consumed units) is most significant in matching cost with revenue in the income determination procedure.

Under LIFO procedures, the objective is to charge the cost of current purchases to work in process or other operating expenses and to leave the oldest costs in the inventory. Several alternatives can be used to apply the LIFO method. Each procedure results in different costs for materials issued and the ending inventory, and consequently in a different profit. It is mandatory, therefore, to follow the chosen procedure consistently.

LIFO Costing Method Example:
This example is based on the following transactions:

February
(1)Beginning balance: 800 units @ $6 per unit.
(4)Received 200 units @ $7 per unit.
(10)Received 200 units @ $8 per unit.
(11)Issued 800 units.
(12)Received 400 units @ $8 per unit.
(20)Issued 500 units.
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price.
(28)Received 600 units @ $9 per unit.

Calculations for the above transactions would be as follows

LIFO COSTING METHOD
February:
1. Beginning balance
800 units @ $6.00
$4,800

4. Received 200 units @ $7.00 $1,400
10.Received 200 units @ $8.00 $1,600 $7,800
11. Issued 200 units @ $8.00 $1,600
200 units @ $7.00 $1,400
400 units @ $6.00 $2,400 $5,400
Balance
400 units @ $6.00 $2,400
Received 400 units @ $8.00 $3,200 $5,600
20. Issued 400 units @ $8.00 $3,200
100 units @ $6.00 $600 $3,800
Balance
300 units @ $6.00 $1,800
25. Returned to storeroom 100 units @ $6.00 $600
28. Received 600 units @ $9.00 $5,400
$7,800

Balance
400 units @ $6.00 $2,400

600 units @ $9.00 $5,400
$7,800


The basic difference between the various applications of this costing method is the time interval between inventory computations. In this example of LIFO costing a new inventory balance is computed after each receipt and each issue of materials, with the ending inventory consisting of 1,000 units valued at $7,800. If, however, a physical rather than a perpetual costing procedure is used, whereby the issues are determined at the end of the period by ignoring day to day issues and by subtracting total ending inventory from the total of the opening balance plus the receipts, the ending inventory would consist of:

800 units @ $6 on hand in the beginning inventory
200 units @ $7 from the oldest purchase, Feb. 4

1,000 units, LIFO inventory at the end of February. $4,800
$1,400
-------
$6,200
=====


Both procedures are appropriate applications of the LIFO method, even though the cost of materials used and the ending inventory figures differ. Such a difference does not occur in FIFO costing method.

Regardless of the cost flow assumptions, this later procedure is particularly appropriate in process costing where individual materials requisitions are seldom used and the materials move into process in bulk lots, as in floor mills spinning mills, oil refineries, and sugar refineries. The procedure also functions smoothly for a company that charges materials to work in process from month end consumption sheets which provide the cost department with quantities used.

Advantages of Last In First Out (LIFO) Method:
The advantages of the last in first out method are:

Materials consumed are priced in a systematic and realistic manner. It is argued that current acquisition costs are incurred for the purpose of meeting current production and sales requirements; therefore, the most recent costs should be charged against current production and sales.

Unrealized inventory gains and losses are minimized, and reported operating profits are stabilized in industries subject to sharp materials price fluctuations.

Inflationary prices of recent purchases are charged to operations in periods of rising prices, Thus reducing profits, resulting in a tax saving, and therewith providing a cash advantage through deferral of income tax payments. The tax deferral creates additional working capital as long as the economy continues to experience an annual inflation rate increase.

Disadvantages of the LIFO Costing Method:
The disadvantages or limitations of the last in first out costing method are:

The election of last in first out for income tax purposes is binding for all subsequent years unless a change is authorized or required by the Internal Revenue Service (IRS)
This is a "cost only" method with no right down to the lower of cost or market allowed for income tax purposes. Furthermore, the IRS requires that when last in first out is adapted an adjustment must be made to restore any previous right downs from actual cost. Should the market decline below LIFO cost in subsequent years, the business would be at a tax disadvantage. When prices drop the only option may be to charge off the older (higher) cost by liquidating the inventory, however, liquidation for income tax purposes must take place at the end of the year. According to IRS regulations, liquidation during the fiscal year is not acceptable if the inventory returns to its original level at the end of the year. Interim external financial reporting principles impose a similar requirement when inventory is expected to be replaced by the end of the annual period.
LIFO must be used in financial statements if it is elected for income tax purposes. However, for financial reporting purposes, the lower of LIFO cost or market can be used without violating IRS LIFO conformity rules.
Record keeping requirements under this method, as well as FIFO, are substantially greater than those under alternative costing and pricing methods.
Inventories may be depleted due to unavailability of materials to the point of consuming inventories costed at older or perhaps the oldest prices. This situation will create a miss matching of current revenue and cost, sometimes companies using this costing method counteract this problem by establishing an allowance for replacement of the LIFO inventory account. Cost of goods sold is charged with current cost. The allowance account is credited for the access of the current replacement cost over the LIFO carrying cost for the inventory temporarily liquidated. When this inventory is replenished, the temporary allowance (credit) is removed and the goods acquired are placed in inventory at their old last in first out cost.
In standard number 411 "accounting for acquisition costs of materials, " the cost accounting standards board "CASB" precludes the use of LIFO except when applied currently on a specific identification basis. As a result, the use of this method, when an annual LIFO adjustment is made, is ruled out for government contracts to which CASB regulations apply.
The decision to adopt the last in first out method has had increased appeal in the last few years, due to an accelerated rate of inflation; however its adoption should not be automatic. Long range effects as well as short term benefits must be considered.

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