Material Issues Methods
1. (FIFO) First in First out
The FIFO flow concept is a logical one for a business to follow since selling off the oldest goods first reduces the risk of inventory obsolescence. Under this method, the earliest goods purchased are the first ones removed from the inventory account. This results in the remaining items in inventory being accounted for at the most recently incurred costs so that the inventory asset recorded on the balance sheet contains costs quite close to the most recent costs that could be obtained in the marketplace.
Advantages of FIFO Method
- FIFO method is that it is simple to understand and easy to operate.
- It is a logical method because it takes into consideration the normal procedure of utilizing first those materials which are received first. Materials are issued in order of purchases, so materials received first are utilized first.
- Under this method, materials are issued at the purchase price; so the cost of jobs or work orders is correctly ascertained so far as the cost of materials is concerned. Thus, the method recovers the cost price of the materials.
- This method is useful when prices are falling.
- Closing stock of materials will be valued at the market price as the closing stock under this method would consist of the recent purchases of materials.
2. Last In First Out (LIFO) Method
LIFO is another Material Issues method that is most commonly applied to an organization’s inventory valuation procedures. There are a lot of different valuation methodologies applied to inventory, and often management has to make a strategic decision to determine the most advantageous method to use. Under LIFO, the valuation is structured around the concept that the last unit of inventory received (the newest inventory) is the first unit of inventory used. Depending on the unit cost and timing of inventory transactions, the LIFO method can generate a number of tax benefits due to profitability impacts on the income statement.
Advantages of LIFO Method
- Like the FIFO method, this is simple to operate and is useful when transactions are not too many and the prices are fairly steady.
- Like FIFO, this method recovers costs from production because the actual cost of material is charged to production.
- Production is charged at the recent prices because materials are issued from the latest consignment. Thus, the effect of current market prices of materials is reflected in the cost of sales provided the materials are recently purchased.
- In times of rising prices, the LIFO method of pricing issues is suitable because materials are issued at the current market prices which are high. This method thus helps in showing a lower profit because of increased charge to production during periods of rising prices and lower profit reduces the burden of income-tax.
3. Average Cost Method
The average cost method is another material issues method, based on that all of the materials in the store are so mixed up that an issue cannot be made from any particular lot of purchases and, therefore, it is proper if the materials are issued at the average cost of materials in store.
Average Cost may be of two types:
- Simple Arithmetic Average and
- Weighted Arithmetic Average.
- Simple Average Price: A price which 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 the prices used in that total. (C.I.M.A.). A simple average price is calculated by dividing the total of unit purchase prices of different lots in stock on the date of issue by the number of prices used in the calculation and the number of different lots is ignored. This method may lead to over-recovery or under-recovery of the cost of materials from production because the quantity purchased in each lot is ignored.
- Weighted Average Price: A price which is calculated by dividing the total cost of materials in the stock from which the materials to be priced could be drawn by the total quantity of materials in that stock. The weighted average price takes into account the price and quantity of the materials in the store. In periods of heavy fluctuations in the prices of materials, the average cost method gives better results because it tends to smooth out fluctuations in prices by taking the average of prices of various lots in stock.
4. Inflated Price Method
There are some materials that are subjected to natural wastage. Examples are (1) material lost due to loading and unloading, and (2) timber lost due to seasoning. In such cases, the materials are issued at an inflated price (a price higher than the actual cost) so as to recover the cost of natural wastage of materials from the production.
5. Specific Price or Identification Method
It is one of the material issues methods that can be applied in situations where different purchases can be physically separated. Under this method, each item sold and each item remaining in the inventory is identified. The cost of specific items that are sold during a period is included in the cost of goods sold for that period and the cost of specific items remaining on hand at the end of a period is included in the ending inventory of that period.
6. Base Stock Method
The base stock method is a valuation technique for the inventory asset, where the minimum amount of inventory needed to maintain operations is recorded at its acquisition cost, while the LIFO method is applied to all additional inventory. This approach is not acceptable under generally accepted accounting principles.
7. Highest In First Out (HIFO) Method
This method is based on the assumption that the closing stock of materials should always remain at the minimum value; so the issues are priced at the highest value of the available consignments in the store. The method is not popular as it always undervalues the stock which amounts to creating a secret reserve. The method is mainly used in case of cost-plus contracts or monopoly products as it is helpful in increasing the price of the contract or products.