The average and FIFO process costing methods differ in that the average method

When it comes time for businesses to account for their inventory, businesses may use the following three primary accounting methodologies:

• Weighted average cost accounting
• Last in, first out [LIFO] accounting
• First in, first out [FIFO] accounting

Each of these three methodologies relies on a different method of calculating both the inventory of goods and the cost of goods sold. Depending on the situation, each of these systems may be appropriate.

Key Takeaways

• When it comes time for businesses to account for their inventory, they typically use one of three different primary accounting methodologies: the weighted average method, the first in, first out [FIFO] method, or the last in, first out [LIFO] method.
• The weighted average method is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit.
• The first in, first out [FIFO] accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time.
• The last in, first out [LIFO] accounting method assumes that the latest items bought are the first items to be sold.

Weighted Average

The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit. This is frequently the case when the inventory items in question are identical to one another. Furthermore, this method assumes a store sells all of its inventories simultaneously.

To use the weighted average model, one divides the cost of the goods that are available for sale by the number of those units still on the shelf. This calculation yields the weighted average cost per unit—a figure that can then be used to assign a cost to both ending inventory and the cost of goods sold.

While the weighted average method is a generally accepted accounting principle, this system doesn’t have the sophistication needed to track FIFO and LIFO inventories.

First In, First Out [FIFO]

The first in, first out [FIFO] accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time. When a business uses FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.

Last In, First Out [LIFO]

The last in, first out [LIFO] accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory. It should be understood that, although LIFO matches the most recent costs with sales on the income statement, the flow of costs does not necessarily have to match the flow of the physical units.

Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily, LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.

Weighted Average vs. FIFO vs. LIFO Example

Consider this example: Suppose you own a furniture store and you purchase 200 chairs for $10 per unit. The next month, you buy another 300 chairs for $20 per unit. At the end of an accounting period, let's assume you sold 100 total chairs. The weighted average costs, using both FIFO and LIFO considerations are as follows:

Process costing works well whenever relatively homogeneous products pass through a series of processes and receive similar amounts of manufacturing costs. A process is a series of operations performed on the product, such as mixing, molding, or packaging.

Job-order costing works well whenever products pass through a series of processes that deal out different amounts of manufacturing costs.

The manufacture of nearly any product requires three types of cost:

1. Direct materials
2. Direct labor
3. Manufacturing overhead

The job-order costing system is designed to trace costs to a job.

A process-costing system traces the costs to the process, instead of the job.

The same accounts are used in the process-costing system as in a job-order costing system with the excep tion of the number of Work-in-Process accounts. A different Work-in-Process account is required for each processing department.

The major differences between process costing and job-order costing are summarized as follows:

 

1. Homogeneous units pass through a series of similar processes.

1. Unique jobs are worked on during a time period.

2. Costs are accumulated by processing department.

2. Costs are accumulated by individual job.

3. Unit costs are computed by dividing the processing departments’ costs by output. In addition, output is measured in equivalent units, not in units produced.

3. Unit costs are determined by dividing the total costs on the job-order cost sheet by the number of units in the job.

4. The production report provides the detail
for the Work-in-Process account for each processing department.

4. The job-order cost sheet provides the detail for the Work-in-Process account.

A. Types of Processes

The product may flow through the processing departments in different ways including:

1. sequential processing—a method of process manufacturing in which units pass from one process to another in a sequential pattern and each unit is processed using the same series of steps.

 

2. parallel processing—Two examples of parallel processing are:

a. Two different products emerge from a common process, and then each flows through its own separate series of processes for completion.

 

b. The products flow through their separate series of processes and then eventually flow through a common department.

 

B. How Costs Flow through the Accounts in Process Costing

As raw materials are purchased, the cost of the materials is recorded in a Raw Materials inventory account.

As used, raw materials, direct labor, and manufacturing overhead are recorded in the Work-in-Process account.

When goods are completed, their cost is transferred from the Work-in-Process account to the Finished Goods account.

As goods are sold, their cost is transferred from the Finished Goods account to the Cost of Goods Sold account.

In process costing, each processing department has its own Work-in-Process account.

Costs transferred from a prior process to a subsequent process are called transferred-in costs.

Cornerstone 6-1: How to Calculate Cost Flows without WIP

• See Mowen and Hansen text for in-class, demo problems. 

2. THE IMPACT OF WORK-IN-PROCESS INVENTORIES ON PROCESS COSTING

A. Equivalent Units of Production

• Equivalent unitsof output is the expression of a processing department’s activity in terms of fully completed units.

  For example, two units that are 50 percent complete are the equivalent of one unit fully completed.

The percentage of completion is a subjective assessment. Basically, the production manager “eyeballs” ending inventory to come up with a rough estimate of completion.

• Work done on partially completed units in beginning work-in-process inventory represents prior period work. Manufacturing costs assigned to these units represent prior period costs.

Cornerstone 6-2: How to Calculate Equivalent Units of Production: No Beginning Work in Process

• See Mowen and Hansen text for in-class, demo problems. 

Cornerstone 6-3: How to Measure Output and Assign Costs: No Beginning Work in Process

• See Mowen and Hansen text for in-class, demo problems. 

B. Two Methods of Treating Beginning Work-in-Process Inventory

• Work done on partially completed units in beginning work-in-process inventory represents prior-period work. Two approaches used for dealing with prior period output and prior period costs found in beginning work in process are:

1. weighted average method: combines beginning inventory costs [prior period work] with costs from current period work.

2. first-in, first-out [FIFO] method: separates beginning inventory costs [prior period work] from costs of current period work.

Both the weighted average method and the FIFO method use the following general pattern to determine the cost of production:

1. Analysis of the flow of physical units
2. Calculation of equivalent units
3. Computation of unit costs
4. Valuation of inventories

a. Cost of units transferred out, and
b. Cost of units in ending work in process

5. Cost reconciliation

3. WEIGHTED AVERAGE COSTING

• The weighted average costing method combines the partially completed units in beginning work-in-process inventory with units produced in the current period to determine a weighted average equivalent units of production.
• Equivalent units of output using the weighted average method is calculated as:

  Units completed and transferred out*
  + Equivalent units of production in ending work in process
  = Equivalent production

  *Note that the weighted average method includes the partially completed units in beginning inventory with the units that were started and completed in the current period.

• The weighted average method also merges prior-period costs with current-period costs by adding manufacturing costs in beginning work in process to manufacturing costs incurred during the current period.
• The major advantage of the weighted average method is simplicity.

Cornerstone 6-4: How to Measure Output and Assign Costs: Weighted Average Method

• See Mowen and Hansen text for in-class, demo problems. 

A. Five Steps in Preparing a Production Report

Step One: Physical Unit Flow Analysis

Units to account for:

Units in beginning work in process
+ Units started during the period
= Total units to account for

Units accounted for:

Units completed and transferred out
+ Units in ending work in process
= Total units accounted for

Step Two: Calculation of Equivalent Units  [Weighted Average]

Units completed and transferred out
+ Units in ending work in process × Fraction complete
= Equivalent units of output

Step Three: Computation of Cost per Equivalent Unit

Costs to account for:

Beginning work in process
+ Costs added [incurred] during the period
= Total costs to account for

Cost per equivalent unit = Total costs to account for/Total equivalent units

Step Four: Valuation of Inventories

Costs accounted for:

Goods transferred out [unit cost × equivalent units]
+ Goods in ending work in process [unit cost × equivalent units]
= Total costs accounted for

Step Five: Cost Reconciliation

Compare total costs to account for with total costs accounted for to determine that they are equal.

Tip: When you are using the weighted average method, you should ask the following question when calculating equivalent units: “What is the percent of effort provided as of the end of the period on the units worked on during the period?” This way you know you are including some work performed last period in your calculations.

Cornerstone 6-5: How to Prepare a Physical Flow Schedule

• See Mowen and Hansen text for in-class, demo problems. 

Cornerstone 6-6: How to Prepare a Production Report: Weighted Average Method

• See Mowen and Hansen text for in-class, demo problems. 

4. MULTIPLE INPUTS AND MULTIPLE DEPARTMENTS

A. Multiple Inputs

• Equivalent units must be calculated for each category of manufacturing input.
• Equivalent units are calculated for:

  1. each type of material
  2. transferred-in costs [costs from prior departments, if any] and
  3. conversion costs

• For example, if ending work in process contained 1,000 units and materials were 100% complete but conversion was only 40% complete, equivalent units would be calculated as follows:

Equivalent units for materials = 1,000 × 100% = 1,000

Equivalent units for conversion = 1,000 × 40% = 400

A unit cost for materials and a unit cost for conversion would be calculated based upon the equivalent units for each. 

Cornerstone 6-7: How to Calculate Equivalent Units, Unit Costs, and Value Inventories with Nonuniform Inputs

• See Mowen and Hansen text for in-class, demo problems. 

B. Multiple Departments

Once the students understand how to treat different categories of inputs, extension to multiple departments is straightforward. Transferred‑in goods is simply an additional input category [a type of materials added at the beginning of the process]. Besides that, a cost of production report would be prepared for each department.

Cornerstone 6-8: How to Calculate the Physical Flow Schedule, Equivalent Units, and Unit Costs with Transferred-In Goods

• See Mowen and Hansen text for in-class, demo problems. 

5. APPENDIX: PRODUCTION REPORT—FIFO COSTING

This appendix goes through the production costing report using the FIFO method.

Tip: When you are using the FIFO method, you should ask the following question when calculating equivalent units: “What is the percent of effort provided during the period?” Here the emphasis is on the work performed during the period.

FIFO costing excludes the equivalent units and costs in beginning work in process [prior-period costs] from the current-period unit cost calculations.

Only current-period work and current-period costs are used to compute FIFO unit costs.

If the costs of the manufacturing inputs fluctuate from period to period, the FIFO method may be more useful for cost control, pricing decisions, and performance evaluation because the FIFO method concentrates on the current period’s activity.

What is the difference between FIFO method and weighted average method in process costing?

According to the Accounting for Management website, the main difference between the FIFO and weighted average method is in the treatment of beginning work-in-process or unfinished goods inventory. The weighted average method includes this inventory in computing process costs, while the FIFO method keeps it separate.

What is the difference between weighted average and FIFO process costing methods is the handling of the partially completed?

the FIFO method keeps these units, and their cost separate, while the weighted-average method adds the units and the cost to the units started and completed.

What is the difference between FIFO and moving average costing methods in valuing raw materials inventory?

In real world, generally price of the item rises over time, so products that come into inventory earlier have lower cost than newer ones. That's why using FIFO, valuation rate generally shows higher value compared to moving average, and hence higher gross profit and net income.

How does the weighted average cost method differ from the average cost method?

Average cost method is a simple inventory valuation method, especially for businesses with large volumes of similar inventory items. Instead of tracking each individual item throughout the period, the weighted average can be applied across all similar items at the end of the period.