The various methods of Costing like FIFO, LIFO and Weighted Average Inventory used in Accounting are explained below:
FIFO - First in First out
Under this method ,for the purpose of pricing the issue it is assumed that material received first are issued first and charges are made at the corresponding costs. In other words issue takes place in the order of receipts. Here the identity of material is not required. In fact the material received last may be issued first (i.e. in case of materials placed in heaps it cannot be expected that materials from bottom shall be issued).In FIFO the earlier purchases shall be exhausted earlier (as per assumption) and the stock will represent later purchases.
Thus in a condition of falling price, higher cost shall be consumed by production and there will be lower replacement cost. The opposite shall happen in a condition of rising prices.
In FIFO Materials shall be charged at cost.So, there will be no difference between total cost and total charges. In condition of falling price the method will give better result and the value of closing stock will more or less correspond to market price. But in the condition of rising prices the method proves that lower costs are absorbed by production and higher cost are represented by closing stock. Replacement of stock will involve more money.
LIFO - Last in First Out
Under this method, for the purpose of pricing the issues, it is assumed that latest receipts are issued first. The identity of material is immaterial. Physically any purchase may be issued first according to convenience.
For the purpose of pricing it is always assumed that latest purchases are issued first. However in condition of rising prices the charge to production, under this method, will be more or less at current market price while the stock will represent earlier low prices.
In LIFO cost of material charged to jobs will represent more or less the current market prices and the closing stock will represent earlier low prices and hence there will be no unrealized profit in financial accounting.
This method will give better result where profits fluctuate during periods of changing price levels and there will be no difference between total cost incurred and total charges made.
But in the condition of falling prices the method will mean lower charge to production and higher value of closing stock. Two jobs may be charged at different rates (depending on the availability of stock) thereby rendering any comparison of cost unreliable. In condition of rising prices the value of closing stock shall have no influence of the current market conditions on it.
Weighted Average Inventory
In weighted Average inventory method the total value (at cost) of materials in stock at the time of issue is divided by the total quantity of materials in stock to obtain the weighted average rate .In this method both rates and their corresponding quantities are given emphasis, because the value at cost is obtained by multiplying the quantity by the rate. This rate will be used until some fresh purchase comes.
The method effectively smoothen the effect of price fluctuation. Profit and loss on material arises only if mathematical approximation is made to the calculation of rates.
Weighted Average Rate=uv+u1v1+u2v2+u3v3
Where v, v1, v2, v3 are corresponding rates of purchases u,u1,u2,u3
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