The various methods of pricing issues of materials may be grouped under three broad categories. They are: 1. At Cost Methods 2. Average Cost Methods 3. Notional Price Methods.
This method takes into account the price of materials at which they are bought for the purpose of valuing them at the time of issues.
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The following methods are considered under this head:
A. Specific Cost Method:
This method of pricing material issues is adopted where special type of material are bought for the exec ution of a job or a contract. The materials to be issued to jobs are identified with the invoices prices and if any handling and inspection costs are incurred such expenses are also included to constitute issue prices.
The materials which are thus priced is commonly known as special materials as they specifically purchased at the instance of customers. Thus, under this method, the production is charged with the actual cost of materials. The inventory is also similarly valued at the actual cost.
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Advantages of Specific Cost Method:
Following are the main advantages of this method:
1. No calculations are involved for calculating issue prices of the cost of materials as in the case of other methods.
2. The production is charged with actual cost and therefore, production is neither undercharged nor overcharged.
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3. The closing stock of materials are also valued at actual cost and, therefore, we do not come across any un-realised profit or loss.
Disadvantages of Specific Cost Method:
The main disadvantages of this method are:
1. This method is not suitable in case of continuous manufacturing industries involving repetitive and frequent purchase of materials.
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2. As each job differ from other jobs a separate register is to be maintained for the issue of materials which involves more of clerical work.
3. If materials purchased are too frequent it becomes difficult to maintain their identity. Similarly, if issues are too frequent it becomes difficult to relate the materials to each and every job.
4. As this method depends on invoices non-receipt of an invoice will obstruct the issue procedure.
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This method is suitable only for job industries which carry out individual jobs against specific orders.
B. First-In-First Out (FIFO) Method:
This method is based on the assumption that materials which are purchased first are issued first. It uses the price of the first batch of materials purchased for all issues until all units from this batch have been issued. After the first batch is fully issued, the price of the next batch received becomes the issue price. When this batch is also fully issued, the price of the further next batch issued for pricing and so on.
In other words, the materials are issued at the oldest cost price listed in the stores ledger account and thus, the materials in stock are valued at the price of the latest price. However, an endeavour is made in this method that materials which run the risk of obsolescence are issued first.
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Advantages of FIFO Method:
The system has the following advantages:
1. It is based on a realistic assumption that materials are issued in the order of their receipts.
2. Materials are issued at actual cost and thus no unrealistic profit or loss arises from the operation of this method.
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3. This method is easy to understand and simple to operate.
4. The value of closing stock will reflect current market price.
5. If purchases are few and if the prices are of materials remain Stable the method will be simple to operate.
6. This method is useful when prices are falling.
7. It is a logical method because it takes into consideration the normal procedure of utilising first those materials which are received first.
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This method suffers from the following disadvantages:
1. It involves complicated calculations and hence increases the possibility of clerical errors.
2. For pricing one requisition more than one price has often to be taken.
3. When prices rise, the issue price does not reflect the market price as materials are issued from the earliest consignments.
4. In case of fluctuations in prices of materials, comparison between one job and the other job becomes difficult because one job started a few minutes later than another of the same nature may be issued at different prices.
5. During the period of falling prices cost of production tends to be high. This may lead to cancellation of prospective sales because of high quotation.
This method is most suitable in times of falling prices because the issue price of materials to jobs will be high while the cost of replacement of materials will be low. But in case of rising prices, this method is not suitable because the issue price of materials to production will be low while the cost of replacement of materials will be high.
This method is useful for materials which are subject to obsolescence and deterioration. In periods of rising prices, the FIFO method produces higher profits and results in higher tax liability because lower cost is charged to production. Conversely, in periods of falling prices, the FIFO method produces lower profits and results in lower taxes because they are derived from a higher cost of goods sold.
Impact of FIFO Method on Cost of Production:
Following are the impact of this method on cost of production:
1. Cost of production does not reflect the current market price of materials because purchase rates of the earliest and subsequent lots of purchases are adopted for issue purposes.
2. The cost of production is not accurate but only arbitrary especially when materials prices fluctuate widely. This is because cost of production consists of issue prices of different lots of purchases.
3. The cost of production is overstated and understated depending upon the situation of fluctuation in the prices of materials in the market.
Impact of FIFO Method on Inventory Valuation:
Following are the impact of this method on Inventory Valuation:
1. When materials prices increases, the value of stock is understated and when material prices decrease, the value of closing stock is overstated.
2. The total value of stock fluctuates with the rise and fall in the cost of materials. This distorts the valuation of the stock accurately.
3. The value of closing stock reflects current market price.
Impact of FIFO Method on the Profit:
The profit is unaffected by the overstatement in cost as this is compensated by a corresponding understatement in closing stock value and vice versa. However, as production cost of a particular product or job is distorted by a rise or fall in the material cost, consequently profit on such product or job will also fall or rise.
C. Last-In-First Out Method (LIFO Method):
This method operates in just reverse order of FIFO method. It is based on the assumption that the last materials purchased (just before the first issue of material) are the first materials issued. Thus, the price of the last batch of the materials purchased is used first for all issues until all units from this batch have been issued, after which the price of the previous batch of materials purchased is used. It should be noted that physical flow of materials may not conform to LIFO assumption.
Suitability:
This method is suitable in times of rising prices because materials will be issued from the latest consignment at a price which is closely related to the current price levels. Valuing material issues at the price of the latest available consignment will help the management in fixing the competitive selling prices of the products. This method was first introduced in U.S.A., during the Second World War to get the advantages of rising prices.
In period of rising prices, profit and tax liability under LIFO method would be lower than under FIFO method because cost will be charged at current prices which are at higher level. Conversely, in periods of falling prices, closing stock is valued at old prices which are at higher level and thus, profit would also be higher resulting in higher tax liability.
Advantages:
Following are the main advantages of this method:
1. This method is also quick and simple to operate particularly when prices are fairly steady.
2. Under this method, materials are charged to production at the latest prices paid.
3. Under this method, in times of rising prices, quotation of prices for company’s product will be safe and profitable.
4. This method like FIFO does not result in any unrealistic profit or loss.
5. This method is easy to operate where purchases are made less frequently.
6. Due to the effect of inflation in the cost of production, the reduced profit margin results in saving of tax.
Following are the disadvantages of LIFO Method:
1. Under this method, closing stock is valued at the old prices and does not represent the current economic value.
2. This method is not realistic as it does not conform to the physical flow of materials.
3. Like FIFO method, in this method as well the material cost of similar jobs may differ because materials were issued from different lots and thus, at different prices. It makes comparison difficult.
4. This method is cumbersome when prices are subject to frequent fluctuations.
5. For pricing a single requisition, more than one price has often to be adopted.
6. When prices fluctuate this method becomes complicated.
Impact of LIFO Method on Cost of Production:
Following are the effects of LIFO method on cost of production:
1. As the prices of the latest purchased materials are used for issue purpose, the issue price conforms to the current market prices. Consequently, the cost of production also reflects to the current market price.
2. In a rising market, cost of production is overstated and in a falling market the cost of production is understated.
Impact of LIFO Method on Inventory Valuation:
The value of closing stock does not reflect the current market price as all the rates of latest purchased materials are used for issue purposes. Thus, closing stock is valued at old rates but not at the current rates of materials.
Impact of LIFO Method on Profit:
1. The total profit will not get affected under this method because a rise in price may be compensated by a fall in prices over a period of time. However, profits of every product or job differ because of charging of different rates of materials to different products.
2. In period of rising prices, the higher rates of materials are charged to production, thereby inflating the cost of production. This results in a reduced margin of profit resulting in tax deduction.
D. Highest-In-First Out (HIFO) Method:
Under this method materials issued are charged at the rate of highest priced materials in stores. This highest rate is continued to be used until material at that highest price is exhausted, after which the next highest price is used. Thus, in HIFO method, the production absorbs the high cost of materials and closing stock is valued at lower rates.
The HIFO method has the advantage that in fluctuating market, the highest cost of materials is recovered first and inventory valuation is kept at the lowest which is tantamount to creating a secrete reserve. This method is not popular but is used ‘cost plus contracts’ with advantage.
Advantages:
The main advantages of this method are:
1. Under this method, the actual cost of materials issued is recovered from production, as materials are issued at actual cost price.
2. Under this method, as the cost of lots purchased at higher prices are issued first and are recovered first from production, closing stock is valued at lower prices.
This method suffers from the following drawbacks:
1. This method is difficult to operate, as it involves various calculations not only with regard to issues but also stock.
2. As closing stock is valued at lower prices, there results in under valuation of closing stock and creation of secrete reserves.
3. Comparison of costs becomes difficult.
Suitability:
This method is suitable for pricing of materials issued to cost plus contracts and monopoly products. But today, this method is not popular and it is not adopted widely.
Impact:
The impact of this method over cost of production is that cost is overstated. On profit, its impact is under statement of profit. On valuation of closing stock its impact is understatement of the value of stock and a hidden reserve is created in the valuation of stock.
E. Next-In-First-Out (NIFO) Method:
Under this method, the issues are priced at the purchased rates of materials which are yet to arrive. In simple words, the material rates which have been agreed upon by the supplier is used for issue purpose, though materials are not physically received. In this method, materials are issued at the price at which a new order has been placed and this price will hold good for all future issues until a next order is placed. As this method is somewhat complicated it is not normally adopted.
This method can be explained with the help of an example. Suppose, in stock there are two batches of materials, one at Rs. 45 and the other at Rs. 46. There is a further batch of materials on order at Rs. 48.50 which has not yet been received. If materials were to be issued now, these will be charged at Rs. 48.50. The main argument in favour of this method is that this is a more up-to-date replacement price than under LIFO method.
Advantages:
The chief advantage of this method is that, under this method, the materials cost charged to production comes very close to current market price.
Disadvantages:
The chief drawbacks of this method are:
1. Under this method calculations become difficult.
2. This method becomes impracticable, when the price of the next consignment ordered at the time of issue but not yet received is not known in advance.
3. Difficulty may also arise if the committed price of the next consignment ordered at the time of the issue, but not yet received is changed later at the time of actual delivery and payment for some reason or the other.
This method is, no doubt, a forward looking method. But it becomes impracticable in many cases, so it is rarely in use.
F. Base Stock Method:
The method is based on the contention that each enterprise maintains at all times a minimum quantity of materials in its stock. This quantity is termed as base stock. The based stock is deemed to have been created out of the first lot purchased and, therefore, it is always valued at this price and is carried forward as fixed asset.
Any quantity over and above the base stock is valued in accordance with any other appropriate method. As this method aims at matching current costs to current sales, the LIFO Method will be most suitable for valuing stock of materials other than the base stock. The base stock method has the advantage of charging out materials at actual cost.
The advantages of this method are:
1. This method ensures the maintenance of a certain minimum amount of stock for emergencies.
2. It ensures the full recovery of the actual cost of materials from production.
3. The work of valuation of stock in hand is simplified under this method.
4. As the base stock is valued at its original cost throughout and the stocks of other consignments are valued at their respective cost prices under this method, this method does not give rise to any profit or loss on stock valuation.
This method suffers from the following disadvantages:
1. This method cannot be used independently. It is required to be used jointly with any other method like FIFO or LIFO method.
2. Under this method stock is not valued at current market price.
3. Under this method calculations become tedious.
4. This method becomes complicated in case of price fluctuations.
5. Under this method, the materials cost charged to two similar jobs undertaken simultaneously may differ just because one job consumes materials issued from a lot purchased at a lower price, and the other job consumes materials issued from a lot purchased at a higher price.
This method is considered suitable under the following cases:
1. When there is the need of maintenance of base stock for emergencies.
2. When the objective is to charge the issue to production at current prices.
2. Average Cost Methods:
These methods are based on the assumption that when materials purchased in different lots are stored together, their identity is lost and, therefore, issues should be charged at an average price.
Basically average prices are of two types:
(A) Simple average and
(B) Weighted average
(A) Simple Average Method:
Simple average price is calculated by dividing total of unit purchase prices of different lots in stock by the number of prices used in the calculation. Unit prices of latest consignments are taken into account for this purpose. This method does not take into account the quantities of materials in stock while calculating the average.
Suppose, the following five lots of materials are in stock when material is to be issued:
1,000 units purchased @ Rs. 25
800 units purchased @ Rs. 30
500 units purchased @ Rs. 35
300 units purchased @ Rs. 38
200 units purchased @ Rs. 42
= 170/5 = Rs. 34
Advantages:
Following are the main advantages of this method:
1. It is a simple method,
2. This method smoothens out the variations in the material price.
3. Under this method, issue rate remains same until a fresh purchase is made. This reduces clerical work.
Disadvantages:
This method suffers from the following disadvantages:
1. It takes into account only the purchase prices but not the quantities.
2. Under this method, the issue prices do not conform the current market price. So we come across an element of unrealised profit or loss in every job.
3. Closing stock value also not conform to current market price. This distorts the balance sheet of the concern.
Simple average price is not to be followed because this method of calculating issue price does not recover the cost price of the materials from the production. In the above example – the purchase price of the material in stock is Rs. 86,300, (i.e., 1,000 x 25 + 800 x 30 + 500 x 35 + 300 x 38 + 200 x 42) whereas the recovery from the production according to simple average price method will be Rs. 95,200 (total quantity 2,800 units issued @ Rs. 34 per unit). Thus, there is over recovery of Rs. 8,900 (i.e., 95,200 – 86,300).
Suitability:
This method may be suitable when purchases are numerous and prices fluctuate within narrow limits. One it is not, generally, regarded as a good method.
(B) Weighted Average Price Method:
This methods gives due weight to the quantities held at each price when calculating the average price. Under this method the issue price is calculated by dividing the value of materials in hand by the number of units in hand. The average price to be charge to issue will continue to be the same until a new purchase is made which will necessitate computation of new average.
This method is more scientific than the simple average method. It also reduces the number of calculations to be made as the old overage will continue till fresh supply of material is obtained. It is frequently used and under normal circumstances gives the best results. But under this system on account of approximation being used while calculating the average price, a profit or loss on issue of materials may arise.
Advantages:
The chief advantages of this method are:
1. This method recovers the total cost of the materials from total production.
2. It is quite suitable for the pricing of materials subject to wide price fluctuations.
3. It evens out sharp fluctuations in prices of materials.
4. As all jobs or works are charged at the average price, comparison of similar jobs becomes easy and reliable.
5. It is easy to operate, in the sense that a new issue price is to be calculated only when a new purchase is made and not at the time of every issue.
6. Under this method, the closing stock represents fair value.
7. This method gives more accurate results than the simple average price method, as it takes into account both the unit prices and the quantities of different materials purchases.
Disadvantages:
This method suffers from the following disadvantages:
1. The average price is required to be calculated to four or five decimal places, if accuracy is required, this makes the calculations tedious.
2. As the issues are not priced at actual cost, there may be profit or loss on the issue of materials.
3. Under this method, the closing stock does not represent current market value.
Suitability:
In spite of the above drawbacks, this method is, generally, considered to be the best for pricing the issues of materials which are subject to wide fluctuations.
3. Notional Price Methods:
A. Standard Price Method:
Standard price is a pre-determined price which is fixed for a definite period, such as a year. It takes into account factors like probable trend of prices over that period, market conditions, discounts, etc. Thus, standard price is a notional price and not the actual cost price. Standard prices are fixed for each item of material and where prices of materials fluctuate heavily.
Standard prices should be fixed for a short period and revised as and when required. Under this method, all receipts are posted in the ledger account at actual cost and issued are priced at standard price. The difference between actual and standard prices is transferred to material price variance account, the ultimate balance of which is transferred to costing profit and loss Account.
Advantages:
The chief advantages of this method are:
1. It is simple and easy to work.
2. Under this method, the material cost for a work or production order can be fixed in advance.
3. It is a tool for measuring the purchase efficiency.
4. It facilitates fair comparison of the cost of two similar jobs undertaken.
Disadvantages:
The main drawbacks of this method are:
1. This method deviates from the costing principle, in the sense that the issue is not valued at the cost price.
2. It results in profit or loss on material issues.
3. In times of heavy fluctuations in material prices, it is very difficult to fix the standard price. In such cases, the standard price is required to be calculated only for a short period, and it has to be corrected frequently.
This method is suitable only for industries where standard costing is in operation.
B. Market Price Methods or Replacement Price Method:
Replacement price method is also known as market price method. Replacement price is the price at which materials would be replaced, i.e. market price on the date of issue. This method is used when it is designed to reflect current prices in cost. It is most suitable for business that buys large quantities of materials well in advance of requirements to take advantage of cheap prices the benefit of which is not desired to be passed on to the customer.
Following are the chief advantages of this method:
1. As far as calculations are concerned, it is simple to operate.
2. The material cost of the product reflects the current market price.
3. This method indicates the buying efficiency. If the replacement price charged to the materials issued to production is more than their purchase price, there is said to be efficient purchase of materials. On the other hand, if the replacement price charged, he the materials issued to production is less than their purchase price, buying is supposed to be inefficient.
This method suffers from the following drawbacks:
1. This method involves the maintenance of up-to-date list of prevailing market prices. But it is not easy to maintain such a list.
2. It deviates from the costing principle, in the sense that issues are not priced at actual cost.
3. As issues are not priced at actual cost under this method, there may be profit or loss on the issue of materials.
4. Though issues are at current market prices, inventory valuation is not at current market prices.
This method is suitable for giving tenders or quotations, because quotations should reflect the latest competitive market prices as far as materials are concerned.
C. Inflated Price Method:
This method is adopted for pricing the issues of materials which are subject to normal or natural wastage due to evaporation, shrinkage, climate conditions, breaking the buck, etc. Under this method, materials are issued to production at an inflated price so as to provide for the natural or normal wastage.
For example – if 100 kgs of particular material are purchased at Rs. 180 and out of the purchase only 90 kgs can be normally used, the other 10 kgs being normal wastage, issues to production will be priced at Rs. 180/90, Rs. 2 per kg to cover the normal loss of 10 kgs.
Advantages:
The main advantage of this method is that it ensures the full recovery of the actual cost of materials from production.
Disadvantages:
The chief drawback of this method is that the stock is not valued at the current market price.
Suitability:
This method is suitable only for pricing issues of materials which are subject to natural, normal losses due to evaporation, shrinkage, etc.