Chapter 4 - Controlling and Costing Materials Inventory

Costing Problem
To illustrate the problem of costing materials inventory, assume that the materials ledger card shows unit prices of materials purchases
ranged from P100 to P175. Assume further that 150 units of materials are issued, and 25 units are on hand at the end of the month.
The problems which have to be resolved are:
a. What would be the value of the P150 units issued?
b. What would be the value of the 25 units on hand?
If other factors remain the same, the higher the ending inventory valuation, the lower the cost of goods sold resulting in greater profits or
smaller losses. On the other hand, the lower the ending inventory valuation, the higher the cost of goods sold, resulting in a smaller
profit and greater losses.

Inventory Costing Methods

When the inventory items are few and are not ordinarily interchangeable, specific identification technique may be used. Specific
identification of cost means that specific costs are attributed to identify items of inventory.
When there are large numbers of items of inventory that are usually interchangeable, perpetual inventory system is usually used. Under
the system, unit costs and total costs should be computed each time materials are received or issued. The primary basis of inventory
valuation is cost.
There are three methods to determine the cost of ending inventory to be reported These methods are as follows:
a. First in first out (FIFO) method – Under this method, the first materials purchased (the oldest or earliest) are the first
materials to be used. The materials on hand are therefore assumed to be the last one purchased.
b. Last in, first out (LIFO) method – Under this method, the last materials purchased (the most recent) are the first materials
(the most recent) are the first materials to be used. The materials on hand are assumed to be the first one purchased.
c. Moving average method – In this method, all costs are commingled and an average cost is computed with each new
purchase and assigned to materials issued and on hand.

Illustration: To illustrate the application of these methods, assume the following transactions relating to Material IJ-4, ink jet:
May 1: The beginning balance on hand is 150 units, costing P150 each.
6: 150 units are purchased under Purchase Order 08 at P155 each.
10: 180 units are issued for use per Requisition 10.
21: 150 units are purchased on Purchase Order 9 for P156.
23: 160 units are issued for use on Requisition 16.
25: 10 units are returned to the storeroom as noted on Returned Materials Report 3. These units had been issued on May 10 for use
on Requisition 10.

First in First Out Method

The materials
ledger card shows the transactions relating to Materials IJ-4 are recorded under the
FIFO method:
MATERIALS LEDGER CARD (FIFO Cost Method)
Material: Ink Jet Reorder Point: 150
Number: IJ-4 Reorder Quantity: 150
Date Ref. Received Issued Balance
Un its Price Amount Units Price Amount Units Price Amount
May 1 Bal. 150 150 22,500
6 PO-8 150 155 23,250 150 150 22,500
150 155 23,250
10 R10 150 150 22,500
30 155 4,659 120 155 18,600

21 PO-9 150 156 23,400 120 155 18,600

150 156 23,400
23 R16 120 155 18,600
40 156 6,240 110 156 17,160
25 RM3 (10) 155 (1,550) 10 155 1,550
110 156 17,160

Arguments in favor of the first in, first out method are that that it is easier and less costly to use because FIFO requires less record
keeping.; it reflects the actual physical flow of goods; and that the inventory shown in the balance sheet is more relevant because it
includes the most recent costs.¹
A strong argument against the first in, first out method is that it does not match current costs against current sales revenue, because
under this method, the ending inventory is priced at the most recent costs, resulting on the cost of goods sold to be priced at the oldest
costs. When the net income is computed, the cost of goods sold that is deducted from sales revenue does not include the most recent
costs.

Last In, First Out Method:

Using the same transactions for Material IJ-4, the Materials Ledger Card under the LIFO method is shown below:

MATERIALS LEDGER CARD (LIFO Cost Method)

MATERIAL: Ink Jet REORDER POINT 150

NUMBER: IJ 4 REORDER QUANTITY: 150

DATR REF. RECEIVED ISSUED BALANCE

UNITS PRICE UNITS PRICE AMOUNT UNITS PRICE AMOUNT

AMOUNT

May 1 Bal. 150 150 22,500

6 PO-8 150 155 23,500 150 150 22,500

150 155 23,250

10 R10 150 155 23,250

30 150 4,500 120 150 18,000

21 PO-9 150 156 23,400 120 150 18,000

150 156 23,400

23 R16 150 156 23,400

10 150 1,500 110 150 16,500

25 RM3 (10) 150 (1,500) 10 150 1,500

110 150 18,000

The major argument in favor of the last in, first out method is that the current costs are matched against current revenue, because the cost
of goods sold contains the most recent costs.
The argument against the LIFO is that it represents an unrealistic physical flow of goods.
Moving Average Method
Under this method, the units and cost of each new purchase are added to the balances already on hand when the purchase is received and
a new average cost per unit is computed. When materials are issued, they are charged out at this average cost until another purchase is
received or a return is recorded, when a new average cost per unit is computed.
MATERIALS LEDGER CARD ( Moving Average Method)

MATERIAL: Ink Jet REORDER POINT: 150

NUMBER: IJ – 4 REORDER QUANTITY: 150

DATE REF. RECEIVED ISSUED BALANCE

UNITS PRICE UNITS PRICE UNITS PRICE AMOUNT

AMOUNT AMOUNT

May 1 Bal. 150 150 22,500

6 PO-8 150 155 23,250 300 152.50 45,750

10 R10 180 152.50 27,450 120 152.50 18,300

21 PO-9 150 156 23,400 270 154.44 41,700

23 R16 160 154.44 24,710.40 110 154.44 16,988.40

25 RM3 (10) 152.50 (1,525) 120 154.27 18,512.40

One advantage of the moving average method is that it is relatively simple to apply, especially with computers. Moreover, the moving
average method produces inventory valuation that approximates current value if there is a rapid turnover of inventory.

The main argument against the moving average method is that there may be a considerable lag between the current cost and inventory
valuation since the average unit cost involves early purchases.

Philippine Accounting Standards (PAS) No. 2 (Inventories) prescribes the use of FIFO and the Moving Average Methods to compute the
cost of inventories. LIFO is no longer permitted under PAS 2.