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

Learning Objectives:

1. Define and explain FIFOmethod. 2. Give an example of FIFOmethod 3. What are advantages and disadvantages of fist in first out (FIFO) costing method? 1. 2. 3. 4.
Definition and Explanation of FIFO Method Advantages of First in First out-FIFO-Costing Method Example of FIFO Method Disadvantages or Limitations of FIFO Costing Method

Definition and Explanation:

The first in first out (FIFO)method of costing is used to introduce the subject ofmaterials costing. The FIFOmethod of costing issuedmaterials follows the principle that materials used should carry the actual experienced cost of the specific units used. The methods assumes thatmaterials are issued from theoldest 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 costingmethod are:

1. Materials used are drawn from the cost record in a logical and systematic manner. 2. Movement of materials in a continuous, orderly, single file manner represents a
condition necessary to and consistent with efficientmaterials control, particularly for materialssubject to deterioration, decay and quality are style changes.

FIFO method is recommended whenever:

1. The size and cost of units are large. 2. Materials are easily identified as belonging to a particular purchased lot. 3. Not more than two or three different receipts of the materials are on amaterials 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. Beginningbalance 04. Received 10. Received 11. Issued Balance 12. Received 20. Issued Balance 25. Returned to storeroom 28. Received Balance

800 units @ $6 200 units @ $7 200 units @ $8 800 units @ $6 200 units @ $7 200 units @ $8 400 units @ $8 200 units @ $7 300 units @ $8 300 units @ $8 100 units @ $8 600 units @ $9 400 units @ $8 600 units @ $9

$4,800 $1,400 $1,600 $1,400 $1,600 $3,200 $1,400 $2,400 $2,400 $800 $5,400 $3,200 $5,400

$7,800 $4,800 $3,000 $6,200 $3,800

8,600 $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.

Definition and explanation:

Issuingmaterialsat anaverage costassumes that each batch taken from the storeroom is composed of uniform quantities from each shipment in stock atthe dateof issue. Often it is not feasible to mark or label eachmaterialsitem with aninvoice pricein 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 ofmaterialscost. However,average costingmay be used even though the physical withdrawal is an identifiable order. Ifmaterialstend 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 costingmethodhas the following main advantages:

1. 2. 3.

It is a realistic costingmethoduseful to management in analyzing operating results and appraising future production. It minimizes the effect of unusually high or lowmaterialsprices, thereby making possible more stablecost estimatesfor future work. It is practical and less expensiveperpetual inventory system.

The average costingmethoddivides the total cost of allmaterialsof a particular classby the numberof units on hand to find the average price. The cost of newinvoicesare added to the total in thebalancecolumn; 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.Materialsare issued at the established average cost until a new purchase is recorded. Although a new average cost may be computed whenmaterialsare 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 bythe returnswill be absorbed.

Example:
February (1)Beginningbalance: 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 CostingMethodCalculation Illustrated 01. Beginningbalance 04. Received Balance 10. Received Balance 11. Issued Balance 12. Received Balance 20. Issued Balance Returned to storeroom Balance 800 units @ $6 200 units @ $7 1000 units 200 units @ $8 12,00 units 800 units @ $6.50 400 units 400 units @ $8 800 units 500 units @ $7.25 300 units 100 units 400 units $4,800 $1,400 $6,200 $1,600 $7,800 $5,200 $2,600 $3,200 $5,800 $3,625 $2,175 $725 $2,900

$6.20 $6.5 $6.5 $7.25 $7.25 $7.25

28. Received Balance

600 units @ $9 1000 units

$5,400 $8,300

$8.30

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

Learning Objectives:

1. 2. 3. 1. 2. 3. 4.

Define and explain last in first out (LIFO) method. Give an example of LIFO costing method What are advantages and disadvantages of LIFO method? Definition and explanation of LIFO method Example of LIFO costing method Advantages of Last in First Out method Disadvantages of Last in First Out Method

Definition and explanation:

Thelast in first out (LIFO) methodof costingmaterialsissued is based on the premise thatmaterialsunits 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. UnderLIFO procedures, the objective is to charge the cost of current purchases towork in processor other operating expenses and to leave the oldest costs in theinventory. Several alternatives can be used to apply theLIFO method. Each procedure results in different costs formaterialsissued and the endinginventory, 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 4. Received 10.Received 11. Issued 800 units @ $6.00 200 units @ $7.00 200 units @ $8.00 200 units @ $8.00 200 units @ $7.00 400 units @ $6.00 400 units @ $6.00 400 units @ $8.00 400 units @ $8.00 100 units @ $6.00 300 units @ $6.00 100 units @ $6.00 600 units @ $9.00 400 units @ $6.00 600 units @ $9.00 $4,800 $1,400 $1,600 $1,600 $1,400 $2,400 $2,400 $3,200 $3,200 $600 $1,800 $600 $5,400 $2,400 $5,400

$7,800

$5,400 $5,600 $3,800

Balance Received 20. Issued Balance 25. Returned to storeroom 28. Received Balance

$7,800 $7,800

The basic difference between the various applications of this costing method is the time interval betweeninventorycomputations. In this example of LIFO costing a newinventorybalance is computed after each receipt and each issue ofmaterials, with the endinginventoryconsisting 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 endinginventoryfrom the total of the opening balance plus the receipts, the endinginventorywould consist of: 800 units @ $6 on hand in the beginninginventory 200 units @ $7 from the oldest purchase, Feb. 4 1,000 units, LIFOinventoryat the end of February. $4,800 $1,400 ------$6,200 =====

Both procedures are appropriate applications of the LIFO method, even though the cost ofmaterialsused and the endinginventoryfigures differ. Such a difference does not occur inFIFO costing method. Regardless of the cost flow assumptions, this later procedure is particularly appropriate in process costing where individualmaterialsrequisitions are seldom used and thematerialsmove 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 chargesmaterialstowork in processfrom 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: Materialsconsumed 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. Unrealizedinventorygains and losses are minimized, and reported operating profits are stabilized in industries subject to sharpmaterialsprice 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 annualinflation rateincrease.

Disadvantages of the LIFO Costing Method:

The disadvantages or limitations of the last in first out costing method are:

1. 2.

3. 4. 5.

6.

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 theInternal Revenue Service(IRS) This is a "cost only" method with no right down to the lower of cost ormarketallowed 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. Shouldthe marketdecline below LIFO cost in subsequent years, thebusinesswould be at a tax disadvantage. When prices drop the only option may be to charge off the older (higher) cost by liquidating theinventory, 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 theinventoryreturns to its original level at the end of the year. Interim externalfinancial reportingprinciples impose a similar requirement wheninventoryis expected to be replaced by the end of the annual period. LIFO must be used infinancial statementsif it is elected for income tax purposes. However, forfinancial reportingpurposes, the lower of LIFO cost ormarketcan 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 ofmaterialsto 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 LIFOinventoryaccount. 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 theinventorytemporarily liquidated. When thisinventoryis replenished, the temporary allowance (credit) is removed and the goods acquired are placed ininventoryat their old last in first out cost. In standard number 411 "accounting for acquisition costs ofmaterials, " thecost accountingstandards 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 forgovernment contractsto 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.