Contents:

 Meaning

 Methods of Pricing Material Issues

 First in First out (FIFO) Method

 Last in First out (LIFO) Method

 Simple Average Method

 Weighted Average Method

 Solved Example of different Methods

 Conclusion
Meaning:
Materials purchased are kept in stores and issued to different jobs or work
orders. These jobs or work orders are charged with the cost of materials issued to
them. This is called pricing of material issues.
Prices paid for purchases made at different times may be different. While
issuing these materials, it is essential to consider the price at which it should be
charged to jobs or work orders.
There are different methods of pricing materials issues. The selection of a
proper method of pricing of material issues depends on many factors.
1) Nature of business.
2) Frequency of purchase of materials
3) Durability of stock
4) Length of inventory turnover period
5) Range of price fluctuations etc.
Methods of Pricing Material Issues:
Some important and mostly used methods of pricing of material issues are as
follows.

First in First out (FIFO) Method:

This method of pricing the issues is based on the assumption that the
materials purchased and received first in store are issued first to the job. It means the
materials are issued in the order in which they are received. The price of the earliest
lot of purchase is taken first and when that is exhausted, the price of the next lot of
purchase is adopted and so on. In other words, the materials are issued at the oldest
cost price. The closing stock is valued at latest or current price.
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 method 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.
This method is suitable when prices are falling. It is also useful if
transactions are few and prices of material remain stable. In case of perishable
materials this method is best applicable.

Advantages:
The following are the advantages of FIFO method.
i) It is simple to understand and easy to operate.
ii) It is based on logical and sound principle that materials are issued in
order of purchase.
iii) The closing stock is valued at a more recent price.
iv) Materials are priced at actual cost hence no unrealised profit or loss
arises.
v) Deterioration and obsolescence can be avoided by exhausting oldest
materials at the time of issue.
Disadvantages:
This method suffers from the following disadvantages.
i) The calculation becomes difficult and complicated when purchases
are made very frequently at different prices.
ii) Issue price does not reflect current market price.
iii) Cost of production tends to be high during the period of falling
prices.
iv) The pricing of material returns is difficult.
v) Cost comparison between two similar job becomes difficult when
issues are priced differently.

Last in First out (LIFO) Method:

This method is exactly opposite of FIFO method. It is based on the assumption
that the material purchased and received last in store are issued first to the job.
Under this method the cost of last lot of materials purchased is used for pricing
the material issues. Thereafter the price of next earlier lot is taken and so on. In other
words, the materials are issued at the latest cost price.
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.
The closing stock of materials are valued at the oldest cost price. In case of
a rising price LIFO method is suitable because material is issued at current price.
Advantages:

The following are the advantages of LIFO method.

i) It is simple to operate and easy to understand.

ii) It is appropriate for matching cost and revenue.
iii) Closing stock will be valued at earlier price and will not,
therefore, show unrealised profit.
iv) It shows real income in times of rising prices.
v) It is good method of avoiding tax.

Disadvantage:
The main disadvantages of LIFO method are as follows.
i) Calculations become complicated when rates of receipts are highly
fluctuating.
ii) Closing stock are not valued at current market price. It is valued at
unreal and outdate cost.
iii) The stocks require to be adjusted during falling prices.
iv) Due to variation of prices, comparison of cost of similar job is not
possible.
v) This method is not useful in case of perishable materials.
vi) Inventories may be depleted due to unavailability of materials to the
point of consuming inventories valued 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.
Simple Average Method:
Under this method materials are issued at the average price of materials on
hand on the date of issue. The simple average price is calculated dividing the
total of all rates of material in hand by the number of rates.
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.
The lot which is exhausted, based on FIFO method is excluded in
computing the average.
Rate of Issue = Total of Different Rates/ No. of Rates
This method is useful when the materials are received in uniform quantities
and purchase prices are normally stable.

Advantages:
Following are the advantages of simple average method.
i) This method is easy to operate.
ii) It gives reasonably accurate results if prices are stable.
iii) It is a realistic costing method useful to management in analysing
operating results and appraising future production.
iv) It minimizes the effect of unusually high or low materials prices,
thereby making possible more stable cost estimates for future work.
v) It is practical and less expensive perpetual inventory system.

Disadvantage:
Following are the disadvantages of simple average method.
i) Materials are not priced at actual costs.
ii) It does not take into account the quantity of materials purchased.
iii) Verification of closing stock becomes difficult.
iv) When price and quantity of different lots are widely fluctuates, this
method gives incorrect result.

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 is 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.

Weighted Average Method:

This method gives due importance to quantity of material in stock.
Under this method issue price of material is calculated by dividing the value of
materials in stock by the quantities of material in stock
Rate of Issue = Value of material in stock/ quantities of material in stock
Weighted average rate is calculated each time when a fresh lot is
received. It remains the same till the next lot is received. Thus, issue price is
calculated at the time of receipt of material and not all the times of issue of
 material. This method is useful, where the purchase price and quantities of
material are widely different.
Advantages:
i) Easy to calculate and operate.
ii) Closing stock value is acceptable.
iii) When prices fluctuate considerably, it smooths out the fluctuations.
iv) This method is more logical than the simple average method.

Disadvantages:

i) The issues are not priced at current market price.

ii) Issue price of materials does not represent actual cost price and
therefore a profit or loss may arise.
iii) It involves considerable amount of clerical work.

Example 1:(FIFO Method)

Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as
follows:
January 1 Purchased 5 bikes @Rs.50 each
January 5 Sold 2 bikes
January 10 Sold 1 bike
January 15 Purchased 5 bikes @ 70 each
January 25 Sold 3 bikes
The value of 4 bikes held as inventory at the end of January may be
calculated as follows:

The sales made on January 5 and 10 were clearly made from purchases on 1st
January. Of the sales made on January 25, it will be assumed that 2 bikes relate
to purchases on January 1 whereas the remaining one bike has been issued from
the purchases on 15th January. Therefore, the value of inventory under FIFO is
as follows:
 Date Purchase Issues Closing Inventory

Units Rs. /Units Total Units Rs. /Units Total Units Rs. /Units Total

Jan 1 5 50 250 - - - 5 50 250

Jan 5 - - - 2 50 100 3 50 150

Jan 10 - - - 1 50 50 2 50 100

Jan 15 5 70 350 - - - 5 70 350

Jan 15 - - - - - - 7 - 450

Jan 25 - - - 2 50 100 - - -

- - - 1 70 70 4 70 280

As can be seen from above, the inventory cost under FIFO method relates to
the cost of the latest purchases, i.e., Rs.70.

An Example of LIFO Calculation:

Assume a product is made in three batches during the year. The costs and
quantity of each batch (in order of when they are produced) are as follows:

 Batch 1: Quantity 2,000 pieces, cost to produce Rs.8,000

  Batch 2: Quantity 1,500 pieces, cost to produce Rs.7,000
 Batch 3: Quantity 1,700 pieces, cost to produce Rs.7,700

Total produced: 5,200 pieces. Total cost: Rs.22,700. The average cost to
produce one piece: Rs.4.37.

Next, calculate the unit costs for each batch produced.

 Batch 1: Rs.8,000/2,000 = Rs.4

 Batch 2: Rs.7,000/1,500 = Rs.4.67
 Batch 3: Rs.7,700/1,700 = Rs.4.53

To determine the cost of units sold, under LIFO accounting, you start with
the assumption that you have sold the most recent (last items) produced first and work
backward.

Let's say 4,000 units were sold during the year. Using LIFO, you assume
that Batch 3 items were sold first. Thus, the first 1,700 units sold from the last batch
cost Rs.4.53 per unit. That's a total of Rs.7,701.

 The next 1,500 units sold from Batch 2 cost Rs.4.67 per unit, for a total of
Rs.7,005.
 And the last 800 units sold from Batch 1 cost Rs.4 each, for a total of Rs.3,200.
 The total cost of the 4000 items sold is Rs.17,906.

The cost of the remaining 1200 units from the first batch is Rs.4 each for a
total of Rs.4,800. These units will start off the next year.

Differentiation of FIFO & LIFO

Simple Average Method:

1st time 500 units @ Rs. 3

2nd time 600 units @ Rs. 4
3rd time 200 units @ Rs. 2

Material issue with simple average method = total of unit cost of each purchase/ total
no. of units

= 3 +4+2/3 = Rs. 3

Weighted Average Method:

Formula for Weighted average

Let xi be the observations and wi be the weights of the observations; the formula of the
weighted average is given below.
¯¯¯x or W=w1x1 + w2x2 + w3x3 + …+ wn x nw1 + w2 + w3 + …wnx¯ or W =
w1x1 + w2x2 + w3x3 + … + wn x nw1 + w2 + w3 +… wn
This can also be written as:
¯¯¯x = ∑ni = 1wixi∑ni = 1wix¯= ∑I = 1nwixi∑I = 1nwi
Here,
x̄ or W = Weighted average
n = Number of terms to be averaged
wi = Weights applied to x values
xi = Data values to be averaged
In simple terms, we can write the above formula as:

WeightedAverage=
Sum of Weighted Terms Total Number of Terms Weighted Average = Sum of
Weighted Terms Total Number of Terms
To find the weighted term, multiply each term by its weighting factor, which is the
number of times each term occurs.

Solved Example
Example 1: A class of 25 students took a science test. 10 students had an average
score of 80. The other students had an average score of 60. What is the average score
of the whole class?
Solution:
Step 1: To get the sum of weighted terms, multiply each average by the number of
students that had that average and then add them up.
80 × 10 + 60 × 15 = 800 + 900 = 1700
i.e., Sum of weighted terms = 1700
Step 2: Total number of terms = Total number of students = 25
Step 3: Using the formula, 
WeightedAverage=SumofWeightedTermsTotalNumberofTermsWeightedAverage=Su
mofWeightedTermsTotalNumberofTerms
= 1700/25
= 68
Answer: The average score of the whole class is 68.

Stock turnover ratio

This ratio is a relationship between the cost of goods sold during a particular period of
time and the cost of average inventory during a particular period. It is expressed in
number of times. The Inventory turnover ratio indicates the number of times the stock
has been replaced during the period and evaluates the efficiency with which a firm is
able to manage its inventory. This ratio indicates whether investment in stock is within
proper limit or not.

Components of the Ratio:

Average inventory and cost of goods sold are the two elements of this ratio. Average
inventory is calculated by adding the stock in the beginning and at the end of the
period and dividing it by two. In case of monthly balances of stock, all the monthly
balances are added and the total is divided by the
number of months for which the average is calculated.

Formula of Stock Turnover/Inventory Turnover Ratio:

The ratio is calculated by dividing the cost of goods sold by the amount of average
stock at cost.

Inventory Turnover Ratio =

Cost of goods sold ÷ Average inventory at cost

Generally, the cost of goods sold may not be known from the published financial
statements. In such circumstances, the inventory turnover ratio may be calculated by
dividing net sales by average inventory at cost. If average inventory at cost is not
known then inventory at selling price may be taken as the denominator and where the
opening inventory is also not known the closing inventory
figure may be taken as the average inventory.

Example:

The cost of goods sold is 500,000. The opening stock is 40,000 and the closing stock
is 60,000 (at cost).

Calculate inventory turnover ratio

Calculation:
Inventory Turnover Ratio (ITR) = 500,000 / 50,000*
= 10 times
This means that an average one dollar invested in stock will turn into ten times in sales

Significance of ITR:

Inventory turnover ratio measures the velocity of conversion of stock into sales.
Usually a high inventory turnover/stock velocity indicates efficient management of
inventory because more frequently the stocks are sold; the lower amount of money is
required to finance the inventory. A low inventory turnover ratio indicates an
inefficient management of inventory. A low inventory turnover implies over-
investment in inventories, dull business, poor quality of goods, stock accumulation,
accumulation of obsolete and slow moving goods and low profits as compared to total
investment.

The inventory turnover ratio is also an index of profitability, where a high ratio
signifies more profit; a low ratio signifies low profit. Sometimes, a high inventory
turnover ratio may not be accompanied by relatively high profits. Similarly a high
turnover ratio may be due to under-investment in inventories.

It may also be mentioned here that there are no rule of thumb or standard for
interpreting the inventory turnover ratio. The norms may be different for different
firms depending upon the nature of industry and business conditions. However the
study of the comparative or trend analysis of inventory turnover is still useful for
financial analysis.

Days Sales in Inventory

Indicates the length of time that it will take to use up the inventory through sales.

Ending Inventory
Cost of Goods Sold ÷ 365

This is a financial measure of a company's performance that gives investors an idea of

how long it takes a company to turn its inventory (including goods that are work in
progress, if applicable) into sales. Generally, the lower (shorter) the DSI the better, but
it is important to note that the average DSI varies from one industry to another.
Another Example of LIFO vs. FIFO

we use the inventory of a fictitious beverage producer called ABC

Bottling Company to see how the valuation methods can affect the outcome of a
company’s financial analysis.

The company made inventory purchases each month for Q1 for a total of
3,000 units. However, the company already had 1,000 units of older inventory that
was purchased at Rs.8 each for an Rs.8,000 valuation. In other words, the beginning
inventory was 4,000 units for the period.
The company sold 3,000 units in Q1, which left an ending inventory balance of 1,000
units or (4,000 units - 3,000 units sold = 1,000 units).

ABC CO. — MONTHLY INVENTORY PURCHASES

Month Units Purchased Cost / Each Value

Jan 1,000 Rs.10 Rs.10,000

Feb 1,000 Rs.12 Rs.12,000

Mar 1,000 Rs.15 Rs.15,000

3,000 = Total Purchased

ABC CO. — INCOME STATEMENT (SIMPLIFIED), JANUARY—MARCH

Item LIFO FIFO Average Cost

Sales = 3,000 units @ Rs.20 each Rs.60,000 Rs.60,000 Rs.60,000

Beginning Inventory8,000 8,000 8,000

Purchases 37,00037,00037,000

Ending Inventory 8,000 15,00011,250

COGS Rs.37,000 Rs.30,000 Rs.33,750

Expenses 10,00010,00010,000

Net Income Rs.13,000 Rs.20,000 Rs.16,250

COGS Valuation

Under LIFO, COGS was valued at Rs.37,000 because the 3,000 units
that were purchased most recently were used in the calculation or the January,
February, and March purchases (Rs.10,000 + Rs.12,000 + Rs.15,000).
 Under FIFO, COGS was valued at Rs.30,000 because FIFO uses the
oldest inventory first and then the January and February inventory purchases. In other
words, the 3,000 units comprised of (1,000 units for Rs.8,000) + (1,000 units for
Rs.10,000 or Jan.) + (1,000 units for Rs.12,000 or Feb.). The average cost method
resulted in a valuation of Rs.11,250 or ((Rs.8,000 + Rs.10,000 + Rs.12,000 +
Rs.15,000) / 4).

CONCLUSION:

Inventory is an essential part of a company; whether it is parts or equipment

everything must be accounted. There are many inventory methods available, but the
most popular methods are: FIFO or LIFO. The FIFO method is first-in, first-out
whereas LIFO is last-in, first out. Each method contains advantages and disadvantages
that affect inventory maintenance, affect net income, and financial statements. It is up
to management to decide which inventory methods is best suited for their company.