CHAPTER 3 RAW MATERIALS

Objectives:

Understand different methods in solving inventoriable cost.

Learn the different methods in solving inventory cost

PRICING OF RAW MATERIALS:

Several methods are used for pricing inventories used in production. The important ones are:

∙ First-in first-out(FIFO)method

∙ Last-in first-out(LIFO)method

∙ Weighted average cost method

∙ Standard cost(price)method

FIFO METHOD:

This method assumes that the order in which materials are received in the stores is the order in
which materials are issued from the stores. Hence, the material which is issued first is priced on
the basis of the cost of material received earliest, so on and so forth.

The advantages of this method seemed to be:

1. The pricing of material is perhaps consistent with the practice of issuing oldest material first
followed in many manufacturing organization.

2. The value of material in stock is fairly closed to the current cost.

The disadvantages of this method are:

1. Issue of material at different prices complicates stores accounting.

2. Comparison of job cost becomes difficult when similar jobs may be charged with different
prices for the same material.

3. In this period of rising prices, the charge to production is low. This tends to inflate reported
profits, increase tax burden & push up dividends-as a consequence, the firm is sapped
financially.
MODULE INVENTORY MANAGEMENT AND CONTROL
LIFO METHOD:

This method is the opposite of FIFO method: It assumes that the material which is acquired last
is issued first. Hence material issues are priced on the basis of the cost of most recent material
purchases.

The advantages associated with this method are:

1. The cost of production reflects the current cost of materials better.

2. In a period of rising prices, reported profits are depressed, dividends are kept low, & working
capital is conserved.

The disadvantages of this method are:

1. Issue of material at different prices complicates stores accounting.

2. The pricing of materials is not consistent with the commonly followed practice of issuing the
oldest material first.

3. Comparison of job cost becomes difficult when similar jobs may be charged for the same
material at different prices.

WEIGHTED AVERAGE COST METHOD:

Under this method, material issues are priced at a weighted average cost of materials in stock.
To get an up-to-date weighted average cost figure, a new weighted average cost is calculated
each time a delivery is received.

The merits of this method are: It tends to smooth out price fluctuations. It provides a fairly
acceptable figure for stock values. The limitations of this method may be the tedium involved in
calculating the weighted average cost each time a new delivery is obtained.

Example of LIFO vs. FIFO

In the tables below, 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.

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MODULE INVENTORY MANAGEMENT AND CONTROL
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 P8 each for a P8,
000 valuations. 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 P10 P10,00

0

Feb 1,000 P12 P12,00

0

Mar 1,000 P15 P15,00

0

3,000 = Total
Purchased

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

MARCH

Item LIFO FIFO Average

Cost

Sales = 3,000 units @ P20 each P60,000 P60,000

P60,000

Beginning Inventory 8,000 8,000 8,000

Purchases 37,000 37,000 37,000

Ending Inventory 8,000 15,000 11,250

COGS P37,000 P30,000

P33,750

Expenses 10,000 10,00 10,000

0

Net Income P13,000 P20,000

P16,250

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MODULE INVENTORY MANAGEMENT AND CONTROL
COGS Valuation

∙ Under LIFO, COGS was valued at P37, 000 because the 3,000 units that were purchased

most recently were used in the calculation or the January, February, and March
purchases (P10, 000 + P12, 000 + P15, 000).

∙ Under FIFO, COGS was valued at $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 P8, 000) + (1,000 units for P10, 000 or Jan.) + (1,000 units
for P12, 000 or Feb.)

∙ The average cost method resulted in a valuation of P11, 250 or ((P8, 000 + P10, 000 +

P12, 000 + P15, 000) / 4).

Below are the Ending Inventory Valuations:

∙ Ending Inventory per LIFO: 1,000 units x P8 = P8, 000. Remember that the last units in

(the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.

∙ Ending Inventory per FIFO: 1,000 units x P15 each = P15, 000. Remember that the first

units in (the oldest ones) are sold first; therefore, we leave the newest units for ending
inventory.

∙ Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x

15)] / 4000 units = P11.25 per unit; 1,000 units X P11.25 each = P11, 250. Remember
that we take a weighted average of all the units in inventory.

WEIGHTED AVERAGE VS. FIFO VS. LIFO: EXAMPLE

Consider this example: Say you have a furniture store and you purchase 200 chairs for
P10/unit. The next month, you buy another 300 chairs for P20 each. At the end of an accounting
period, assume you sold 100 total chairs. The weighted average costs, using both FIFO and
LIFO considerations are as follows:

Example: 200 chairs @ P10 = P2, 000. 300 chairs @ P20 = P6, 000. Total number of chairs =
500

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MODULE INVENTORY MANAGEMENT AND CONTROL
Weighted Average Cost: Cost of a chair: P8, 000 divided by 500 = P16/chair. Cost of Goods
Sold: P16 x 100 = P1, 600. Remaining Inventory: P16 x 400 = P6, 400

FIFO: Cost of goods sold: 100 chairs sold x P10 = P1, 000. Remaining Inventory: (100 chairs x
$10) + (300 chairs x P20) = P7, 000

LIFO: Cost of goods sold: 100 chairs sold x P20 = P2, 000. Remaining Inventory: (200 chairs x
P10) + (200 chairs x P20) = P6, 000

STANDARD PRICE (COST) METHOD:

Under this method a standard price is predetermined. When materials are purchased the stock
amount is debited with the standard price. The difference between the actual price & standard
price is carried to a variance account. Material issued is charged as per the standard price.

The advantages of this method are: (i) All material issued are priced identically. The possibility
of jobs using the same material being charged with different cost-a problem with the FIFO or
LIFO method does not exist. (ii) Stock accounting is fairly simplified. There is no need for
specific prices attributable to specific issues of materials. The short comings of this method are:
(i) determining the standard price may be somewhat difficult, particularly when prices tend to
increase somewhat unpredictably or are characterized by wide fluctuations. (ii) The issue of how
variance should be treated may be thorny.

🖰 For more information refer to the link provided:

https://courses.lumenlearning.com/boundless
accounting/chapter/valuing-inventory/

❖ To know more information about - CHAPTER 3-Inventory Assumptions

PLEASE CLICK THE LINK: https://youtu.be/9ruxEEf_xZM

❖ To know more information about - CHAPTER 3-FIFO LIFO Weighted Average Examples
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 MODULE INVENTORY MANAGEMENT AND CONTROL

References

https://www.sciencedirect.com/topics/engineering/raw-material-price

https://www.investopedia.com/terms/r/rawmaterials.asp

https://evsmetal.com/2015/05/the-impact-of-raw-materials-pricing-

on.html
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