The following points highlight the top two methods of pricing materials. The methods are: 1. Based On Cost Price 2. Average Price Method.
Pricing Materials: Category # 1.
Based On Cost Price:
(a) Specific Price Method:
Under this method the specific price of materials issued to a particular job is charged to the job. This method is used where materials are purchased specifically for a job work order.
(b) First-in-First-out (FIFO):
Under this method materials purchased first are to be issued first. Materials from the second lot will be issued only when the first lot is completely exhausted. Under this system of materials pricing the production or job is charged with earlier cost or cost of the earlier consignment. The idea behind this method is to sell the oldest units first and maintain a current inventory representing the most recent purchase.
1. FIFO represents an approximation of the specific identification of unit costs, so, this method has an advantage that the management has little or no control over the selection of units in order to influence recorded profits.
2. This method has also the advantage of not being influenced by the arbitrary or whimsical choices of customers. As a result, valuation of inventory and cost of goods manufactured are consistent and realistic.
3. It also provides an appropriate base for comparisons among different firms in the same industry and among several years.
4. This method is very simple and easy to understand.
5. An objective of FIFO is the presentation of closing inventory at the most recent costs in the Balance Sheet which may be assumed to approximate replacement costs. When the inventory turns over rapidly, the stock valuation under this method will reflect current prices unless prices change considerably after the recent purchases.
6. It is useful where transactions are not too many and prices of materials, are fairly steady.
This method may suitably be used for bulky materials with high unit prices.
1. When consignments are received very frequently at varying prices, calculations become complicated and cumbersome.
2. For one requisition for supply of materials, more than one price may be adopted because two lots of different prices may be involved.
3. Though ending inventory closely represent the current cost, current production is matched with costs that date back in time. In case the prices rise rapidly the production cost is understated.
4. As the production cost does not match the current cost, revenue from sales will not produce enough income to cover the cost of raw materials used for production.
5. This method fails to achieve the objective of matching current costs with current revenues. It also fails to report separately the gains and losses from price changes.
(1) The size and cost of materials units are large;
(2) Materials can be easily identified as belonging to a particular purchased lot;
(3) Not more than two or three different receipts of materials are on hand at one time.
FIFO is most suitable for use where the materials are of comparatively high value and not in frequent demand. It is also appropriate where there are relatively few changes of purchase price, or where the ratio of number of issues to the number of receipts is not large.
The following is the summary of the receipts and issue of materials in a factory during January 1991:
Jan. 1 Opening balance 500 units @ Rs.25 per unit.
3 Issue 70 units
4 Issue 100 units
8 Issue 80 units
13 Received from supplier 200 units @ Rs.24.50 per unit
14 Returned to store 15 units @ Rs.24 per unit
16 Issue 180 units
20 Received from supplier 240 units @ 24.75 per unit
24 Issue 304 units
25 Received from supplier 320 units @ Rs.24.50 per unit
26 Issue 112 units
27 Returned to store 12 units @ Rs.24.50 per unit
28 Received from supplier 100 units @ Rs.25 per unit.
Work out on the basis of First-in-First-out.
There was a shortage of 5 units on 15th and another on 27th of 8 units.
(c) LIFO Method (Last in First out):
Under this method, materials that are purchased last are issued to the production first. The cost of the last lot of materials received is used to price requisitions until the lot is exhausted. This method of materials pricing ensures that materials are issued at current cost. Thus, the inventory is valued at oldest costs.
The very objective of this method is to match the current costs with current revenues. This method has gained popularity because it eliminates the reporting of gains and losses from the holding of inventories as the inventories are valued at earlier costs which is a conservative valuation for the purpose of Balance Sheet.
1. It is a method of pricing material issued to production which is systematic and realistic.
2. It provides a better matching of current costs with current revenues.
3. This method is simple to operate and is useful when the transactions are not too many.
4. In case 6f sharp price fluctuations this method minimizes unrealized gains and losses from holding inventories.
5. Income is reported only when it is available for distribution as dividends.
6. Price changes over the business cycle do not result in the reporting of unrealized gains or losses arising from the holding of the initial and increasing amount of inventory.
7. In times of rising prices, this method of pricing materials issues helps in showing lower profit because the production or job is charged with increased price. The lower profit reduces tax burden. As long as the prices of materials do not decline, the tax benefit remains but if the tax rates go up, the tax saving facility will be eliminated with higher tax rates.
1. One of the principal objections to LIFO is that the value of the inventory shown in the balance sheet reflects prices of some past period which is meaningless in the context of current conditions.
2. The computation of working capital ratio and other financial ratios become useless since the valuation of inventory is dependent on the level of prices in the year the LIFO method was adopted.
3. For pricing a single requisition, more than one price has frequently to be adopted.
4. This method adjusts income only for price changes of materials and only for price changes since the last purchase. From this point of view, as a method of solving price- level problem, LIFO is incomplete.
5. This method as a procedure for matching current costs and revenues is not perfect in the sense that unless both purchases and sales occur regularly in even quantities, the revenues will not be matched with the current costs at the time of sale particularly if prices and costs change rapidly.
6. During falling prices, issues are priced at lower rates and inventory is shown at higher rate which requires adjustments for showing the stock on the principles of valuation of stock at the ‘lower of the cost and market price’.
Hendriksen suggests that LIFO is considered to be appropriate when:
(1) The inventory consists of basic and homogeneous goods;
(2) These goods form a substantial part of the cost of the final product sold;
(3) The inventory is large in relationship to the total assets of the firm;
(4) The inventory turnover is slow; and
(5) Changes in raw materials prices tend to be reflected quickly in the prices of the finished product.
The use of LIFO is advocated by those who follow the principle that cost should be related as closely as possible to current price levels. This method of pricing materials has considerable advantages in a period of rising prices as it puts sales and cost of sales on the same footing and automatically eliminates the windfall profit that would otherwise be shown.
Advocates of this plan claim that the profits shown tend to be more stable and the resulting accounting information provides a better guide to the management.
(d) Highest in First out (HIFO):
Under this method materials purchased at highest price are issued first. This will have the effect of pricing materials issued at the highest price and inventory valuation is made at the lowest possible prices. This method has not gained popularity. It is mainly used in case of monopoly products.
Pricing Materials: Category # 2.
Average Price Method:
(a) Simple Average Method:
This method of pricing materials is based on the principle that materials are to be issued to production or job on an average price of two previous receipts regardless of their quantity. The average price is adopted for pricing issues till another consignment of materials is received.
A new average rate is computed after every receipt. Average price is calculated by dividing the total of the prices of the materials in the stock from which the material to be priced could be drawn by the number of prices used in the total.
The issue price is determined as follows:
Issue Price = Unit prices of materials in stock/Number of prices
(i) It is easy to calculate the price at which the issues are to be made.
(ii) Simplicity is another advantage of this method.
(iii) A particular purchase at higher or lower rate does not disturb the price to a great extent because the particular difference in the price is averaged out.
This method suffers from the following disadvantages:
(i) Material cost does not represent the actual cost price
(ii) Since the identity of individual material price is lost, the closing stock figure cannot be verified.
(iii) This method does not consider the quantities of materials held in stock.
(iv) During the period of frequent rise in prices, the value of closing stock may show a credit which is not at all realistic.
This method can suitably be adopted where materials are received in uniform quantities. If the quantity varies widely, the simple average of prices will lead to erroneous costs.
From the following particulars find out the value of closing stock when materials are issued under simple average method:
Notes: Issue rate on 4th and 6th Feb. (Rs.5 + Rs.6) 2 = Rs.5.50
Issue rate on 25th Feb. (Rs.6 + Rs.6.50) -r 2 = Rs.6.25
(b) Weighted Average Method:
According to I.C.M.A. “A price which is calculated by dividing the total cost of materials in the stock from which the materials to be priced could be divided by the total quantity of materials in that stock”.
Thus, the weighted average price takes into account both the price and quantity of the materials in store.
1. The method is logical, rational and consistent as it absorbs the cost of materials while determining the average for pricing material issues. Weightage is given to both quantity and price to bring about consistency and uniformity.
2. This method recovers the cost of materials from production.
3. Under this method materials are issued at a price as near to the market price.
4. It is considered to be the best especially when prices fluctuate considerably.
5. Closing inventory represents the average cost price of materials in hand.
1. When there is too much change in the prices of materials, simplicity and convenience are lost.
2. Since an average price is not based on actual price incurred, pricing of materials does not become realistic.
Weighted Average Method Comprises of:
(I) Base Stock Method:
Under this method a certain minimum stock of a material is always carried and is priced at the original cost, generally at the lowest purchase price. The portion of stock above this level is issued and priced either under FIFO or LIFO method. This method works well in tanning, and mining industries.
This method of pricing materials has the following advantages:
1. The work of valuing inventory is simplified because base or normal stock values are fixed.
2. Unrealized profits are eliminated.
3. Inventories are consistently shown in balance sheet at conservative values.
1. Balance Sheet shows misleading picture of working capital as inventories are under stated.
2. Profit and Loss Account shows a misleading profit since it fails to recognise gains and losses on inventories.
3. This method of pricing materials is not recognised by the Income-tax Authorities.
(II) Highest-in-first-out Method:
Under this method it is assumed that highest priced materials are issued first. When the whole lot of highest priced materials are exhausted, the next-lot of materials purchased at next higher price should be used for pricing the issue. Thus, the inventory value of materials is kept at the lowest possible price. This method has no practical use.
This method suffers from the following disadvantages:
1. This method of pricing issues involves cumbersome calculations.
2. The cost of production is grossly overstated.
3. During a period of rising prices this method will be similar to LIFO method and during a period of falling prices it will be the same as the FIFO method.
4. Under this method comparison among similar jobs becomes a difficult exercise.
5. Inventory is shown on the Balance Sheet at a lower value and as such Balance Sheet fails to exhibit true financial position.
(III) Periodic Simple Average Method:
Under the method of Periodic Simple Average rate is calculated for a particular period and not whenever consignment is received. Thus, Periodic Simple Average is calculated by dividing the total of materials purchased during the accounting period during which the materials to be priced are used, by the number of prices used to calculate the average price.
Periodic Simple Average Price:
(i) This method is very easy to operate.
(ii) It smoothness out the price fluctuations of materials during a particular period.
(iii) This method can suitably be used in process industry.
(i) The costing of the product gets delayed since pricing is done at the end of the period.
(ii) This method, cannot be used suitably where each individual order must be priced at each stage up to completion.
(iii) It involves heavy clerical work.
(iv) A substantial profit or loss may arise only due to the use of this method.
(IV) Moving Simple Average Method:
Under this method, periodic simple average prices are further averaged. The moving simple average price is the average of the periodic simple average prices for a given number of periods. This price is computed by dividing the total of the periodic simple average prices of a given number of periods by the number of periods. The period chosen should cover the period in which the material is issued.
(i) This method is very useful where prices of materials are subject to constant price fluctuations.
(ii) High and low prices are removed from the computation and do not influence the average after six or seven months.
(iii) This method helps to stabilise the charges to work-in-process even during the period of frequent price fluctuations.
(i) It involves substantial clerical work
(ii) The value of closing stock may be under-valued or over-valued. When prices rise, the issue price worked out is lower than the periodic average prices for the period concerned and vice versa.
(V) Periodic Weighted Average Method:
Under this method weighted average price is calculated by dividing the total cost of material purchased during the accounting period, in which the material to be priced is used by the total quantity of material purchased during that period.
Thus, Periodic Weighted Average Price:
(i) It is easy to operate.
(ii) It can be used in process industry advantageously.
(iii) It eliminates the effect of price fluctuations.
(i) Under this method costing of materials issues gets delayed up to the end of the period.
(ii) This method of pricing issues of materials cannot be used in job order industry.
(iii) It involves lot of clerical work.
(iv) Under this method the value of closing stock will not correspond to the value of closing stock determined under conventional method of valuation of closing stock, i.e., market price or cost price, whichever is less.
(VI) Moving Weighted Average Method:
Under this method, price is calculated by taking the average of periodic weighted average prices i.e. total of periodic weighted average prices of a given number of periods is divided by the number of periods.
The advantages and disadvantages of this method are more or less similar to those of Simple Average Method excepting that this method considers not only the prices but also the quantity used during the related period. The use of this method of pricing issues of materials yields a very representative price for costing the material issues.
(VII) Standard Cost Method:
The price of issues for each item is pre-determined for a particular period taking into account all the factors that affect price, e.g., market trends, transportation costs etc. Standard prices are determined for each material. All issues are made at standard price. The standards are revised from period to period. The actual price is compared with standard price.
1. This method is easy to apply.
2. This helps to prepare material price variance account and material usage variance account.
3. The preparation of variance accounts help to determine the efficiency of material purchase department. The efficiency in the use of materials can also be measured.
4. Quick determination of selling prices is possible.
5. The use of this method results in reduction of clerical work.
1. This method does not conform to accepted accounting practices.
2. This method does not reflect the market price.
3. The fixation of standard cost is a difficult exercise as it requires a lot of effort and experience.
4. This method can effectively be used when standard costing system is in use.
(VIII) Choice of Method:
In a period of falling price, it is conservative to value on the FIFO or Average Method, as the older or more expensive items are then absorbed into cost first and the less expensive items are left in stock. This brings the inventory reasonably into line with the value which will be used for financial accounting purposes.
In a period of rising prices, the pricing methods based on cost tend to show inflationary profits which appear to be highly satisfactory, but may nevertheless conceal factory losses and inefficient production.
On the other hand, the pricing methods based on market value (LIFO) maintain a balance between material cost and selling price, but as the stock balances include goods at the earliest prices, the inventory is considerably undervalued.
The standard cost method can satisfactorily be operated in either a rising or a falling market as price fluctuations are automatically segregated into variance accounts. The variances may be written-off at the time of purchase or be held in suspense and charged to the Profit and Loss Account at the time if issue.
Other factors affecting the choice of method are:
(i) The nature of the business;
(ii) The relative number of issues compared with receipts;
(iii) The frequency with which prices change;
(iv) The proportion which raw materials bear to total cost;
(v) The necessity for maintaining uniformity within an industry;
(vi) Relative rate of stock turnover;
(vii) Customs and practices within the industry.