Comparing First In, First Out Method and Weighted Average Costs
An accountant can calculate the cost component and number of equivalent units in two ways: using the first in, first out method (FIFO) or using the weighted average method. There are trade-offs associated with each method. Calculating the value of equivalent units through the use of the weighted average method is simpler than using FIFO. However, FIFO has the advantage of being more accurate in identifying current period costs.
In business, the first in, first out (FIFO) inventory method means that a company assumes that the first items it makes are the first items it sells. Even if a company ships later products first for some reason, the assumption from an accounting perspective is that the chronologically oldest items ship out before newer ones do. FIFO calculations help a business figure out how much it will cost to buy new raw materials. This type of calculation is especially important during times of inflation, when the costs of raw materials may rise sharply.
If the accountant chooses the first in, first out inventory method (FIFO) to calculate the value of equivalent units, then they use only the costs spent during the current period. This means that the accountant would not include costs spent in the prior period that is work in process (WIP) for the processing department in calculating the costs of the inventory.
For example, consider an ending work in process inventory for the previous period of 100 units that was 45% complete for both materials and conversion costs. Under FIFO, only 55 units would be considered in the calculation for the current period. FIFO assumes the work in process inventory from the previous period is among the first pieces transferred out to the next processing department when considering costs.
In contrast, the weighted average method of calculating the inventory value of equivalent units includes the cost of all units that were involved in production during the period. Costs from both the previous period and the current period are included in the calculation. When using the weighted average method, the accountant includes in the calculation the number of units of production during the period.
Let's use the same example that we used for the FIFO method, with 100 units at 45% complete for the previous ending work in process inventory. An accountant using the weighted average method would not try to exclude prior period costs. Under the weighted average method, the accountant would include all 100 units in the calculation for equivalent unit costs. This approach requires that the cost spent in the prior period to be assigned to the partially completed units.
Calculation of Weighted Average Costs
The calculation of inventory costs is part of completing a managerial product cost analysis and providing the inventory amount on the balance sheet. A manufacturing firm using process costing can calculate equivalent units cost by using the weighted average method to arrive at work in process (WIP) inventory costs. To complete the equivalent units calculation using the weighted average method, the accountant starts by determining the number of units that the processing department worked with during the period. This calculation involves adding the number of units of work in process from the previous period to the number of units started into production during the period. From this figure, the accountant subtracts the number of units transferred out, which provides the number of units in the ending work in process inventory.
To get the number of equivalent units in the ending work in process inventory, the accountant multiplies the total quantity of units by the percentage of units completed. It is common for the number of equivalent units of direct materials to differ from the equivalent units for conversion costs.
Because the work in process inventory value that is determined is included in the financial statements, it must be consistent with generally accepted accounting principles (GAAP), which are the rules and standards adopted by the Securities and Exchange Commission that companies must follow when reporting financial information. The weighted average calculation provides a value acceptable under GAAP.
GAAP gives investors, the government, and the public a better idea of what a company is producing and how much it is profiting because almost all companies follow GAAP. GAAP is a standard for financial information communicated externally, but it does not apply to managerial accounting work. Therefore, managerial accountants need to know what GAAP requires, but it does not figure in most of their calculations.
The unit cost, or the amount of money needed to produce one item, is what the accountant calculates to determine the total value of inventory. Companies use this figure for ending work in process inventory and for inventory transferred out of the processing department. The accountant calculates the unit costs for direct materials and conversion costs separately.The accountant adds costs for direct materials in the beginning work in process inventory to the costs for units started into production during the period. Then the accountant divides this total cost by the equivalent units for direct material to get the unit cost of material. The accountant calculates the conversion costs in the same way. The value of ending work in process inventory is the cost per unit multiplied by the number of equivalent units in ending work in process inventory. The accountant does this separately for direct material and conversion costs. These separate calculations are necessary because direct materials are typically added 100% to the product at the beginning of each process, while the conversion costs start at 0% and increase as the product is worked on. After calculating the direct material and conversion costs, the accountant adds the totals together to arrive at the value of ending work in process inventory. The equivalent unit quantity for inventory transferred out of the department will be the same number for both direct material and conversion costs.