Stock valuations using FIFO.

Maximising profit where there is a

Limiting Factor.

Author: Neil Hayden, Examiner Management Accounting Formation 2.


In process costing questions it is a standard procedure to state that stocks are valued on
the FIFO basis. Most candidates are aware that this means First In First Out. What is not
so certain is whether they understand the implications of this means of valuation.
Let us take an example: We will ignore losses.

Example 1

Stage 1 information

Materials 40,000
Labour 23,100
Overheads 14,500
Value of opening Work in Progress 4,900


Additional information

Units Material Labour Overheads
% completed % completed % completed
Opening work in progress 500 100 60 50
Transfer to stage 2 6,000 100 100 100
Closing work in progress 2,500 100 80 60


Equivalent units and valuations

Material Labour Overheads Total
Opening work in progress 500
units
0
(0% 500)
200
(40% 500)
250
(50% 500)
Started and finished
(6,000 500 Op W in P)= 5,500 5,500 5,500

5,500
Closing work in progress 2,500
units
2,500
(100%2,500)
2,000
(80% 2,500)
1,500
(60% 2,500)
Equivalent units 8,000 7,700 7,250
Costs NOTE 1 40,000 23,100 14,500
Cost per equivalent unit 5 3 2 10
Cost of opening W in P 4,900
Given
600
(3*200)
500
(2*250)
6,000
Started and finished 5,500*10 55,000
Closing stock 12,500
(5*2,500)
6,000
(3*2,000)
3,000
(2*1,500)
21,500


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NOTE 1
The costs which are used for the purposes of evaluating the value of equivalent units
completed during the period will include the following amounts:

1. Materials purchased during the period.
2. Labour and overheads for the period.
3. Transfers from the previous process stage (where this is relevant).
It does not include the cost of opening work in progress because this represents work
completed in the previous period. This is shown as a separate cost.

The transfer to the next stage is made up as follows:

1. The cost of opening work in progress (4,900) plus the cost of completing the
opening work in progress (600 +500)
2. The cost of work started and completed during the period (55,000)

It is evident from previous examinations where this aspect of process costing has
featured that students do not ensure that they fully understand the calculation and
evaluation of equivalent units.




Example 2.

Let us assume in Example 1 that the two batches of material had been purchased
i) 6,000 kilograms at 4.60 per kilogram: Estimated usage 5,000 kilograms
ii) 6,000 kilograms at 4.25 per kilogram: Estimated usage 4,000 kilograms.
Charge to production: 5,000*4.60 (23,000) +4,000*4.25 (17,000) =40,000.
Closing stock: 1,000* 4.60 (4,600) +2,000 at 4.25 (8,500) = 13,100

This calculation may be a reasonable estimate of what actually happened but it is not
consistent with the FIFO basis for the valuation of material. With FIFO you assume
that all of the earliest purchase is issued to production and when all of that is used then
you start utilising the next batch purchased. This applies even if the batches are in
different containers and are randomly issued to production from either container.
If there is more than one type of material (X and Y) FIFO will be applied separately to
each type.

FIFO is purely a basis for valuing stock and does not claim to record the actual
basis on which the stock is physically issued to production.


Valuation for Example 2 using the FIFO basis:
Charge to production: 6,000*4.60 (27,600) all of i) +
balance 3,000* 4.25 (12,750) = 40,350
Closing stock 3,000*4.25 = 12,750

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In both examples charge to production plus closing stock is equal to 53,100.
The revised statement of equivalent units would be as follows:

Material Labour Overheads Total
Opening work in progress 500
units
0
(% 500)
200
(40% 500)
250
(0% 500)
Started and finished
(6000 500 Op W in P)=
5,500
5,500 5,500

5,500
Closing work in progress 2,500
units
2,500
(100%2,500)
2,000
(80%
2,500)
1,500
(60%
2,500)
Equivalent units 8,000 7,700 7,250
Costs NOTE 1 40,350 23,100 14,500
Cost per equivalent unit 5.04375 3 2 10.04375
Cost of opening W in P 4,900
Given
600
(3*200)
500
(2*250)
6,000
Started and finished
5,500*10.04375
55240.625
Closing stock 12,609
5.04375*2,500
6,000
3*2,000
3,000
2*1,500
21,609

NOTES:
The highlighted figures are the changes resulting from the use of the FIFO basis.
You do not have to show the units of material. The value is sufficient.
For examination purposes figures would be rounded to 2 decimal places for the cost per
unit and the nearest for the total valuations.




Marginal Costing

The following example looks at how to maximise profits where there is a single limiting
factor. In this case production is restricted because of the scarcity of an input resource
(material, labour hours etc.) If there is more than one product being produced, a
decision has to be made about where to make the necessary cutbacks.

Toppers Ltd. makes two products Tops and Crowns.
Contribution per unit is Crowns 15 and Tops 12.
Material per unit is 5 kilograms for Crowns and 3 kilograms for Tops.
Possible maximum sales for each product are 1,500 units. This requires 12,000
kilograms. Total material available is 9,600 kilograms.
We will consider three options:
1. Produce 1,500 of Crowns (7,500 kilograms) and 700 of Tops (2,100 kilograms)
Total contribution is 1,500*15 (22,500) +700*12 (8,400) =30,900.
2. Produce 1,500 Tops (4,500 kilograms) and 1,020 Crowns (5,100 kilograms)
Total contribution 1,500*12 (18,000) +1,020*15 (15,300) = 33,300
3. Produce 1,200 Crowns (6,000 kilograms) and 1,200 Tops ( 3,600 kilograms)
Total contribution 1,200*15 (18,000) +1,200 *12 (14,400) = 32,400
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Option 2 produces the best result even though this produces the smallest number of
Crowns which has the highest contribution per unit produced and
the highest number of Tops which has the lowest contribution per unit produced.

Your natural instinct would be to concentrate on the product with the highest contribution
per unit produced which would be Option 1. The reason why this does not work is that
the contribution per unit of limiting factor (material) is the basis upon which the
order of priority is decided.

Top has a contribution of 3 per unit of material (15/5) whereas Top has a contribution
of 4 per unit of material (12/3). Therefore the priority is to maximise the production of
Tops as per Option 2.

In more complex situations other factors will be relevant which may involve mathematical
modelling. This is outside the scope of the Formation 2 Management Accounting
examination.

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