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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