Typically the costs of materials used in manufacturing products are determined by two factors, the price paid for the materials and the quantity of materials used in production.
Materials Pricing Methods
The cost of material will normally be determined from the supplier’s invoice but often multiple ordering of the same goods can be charged at different prices. A decision needs to be made as to which price to use when goods are issued into production.
The following pricing methods exist for this purpose:
FIFO (first in, first out)
FIFO assumes that the issues into production will be made from the oldest stock available leaving the most recent purchases in stock.
An example of a business using FIFO would be dairy producing milk which is perishable.
LIFO (last in, first out)
LIFO assumes that the issues into production will be made from the newest stock available leaving the oldest purchases in stock.
An example of a business using LIFO could be a computer manufacturer who wants to use the most up-to-date processors in production.
AVCO (average cost or weighted average)
AVCO assumes that the issues into production will be made at an average price. This price is derived from taking the total value of the stock and dividing it by the total units in stock thus finding the average price per unit.
An example of a business using AVCO could be a builder’s merchant selling sand or a paint manufacturer.
The standard costing system is typically used because they provide important cost information for several purposes, including:
- Provide a prediction of the future costs used for decision making purposes. Standard costing consist of two costing systems, the traditional and activity-based costing system.
- Also it motivates employees by challenging them with achieving targets set.
- It also helps with setting budgets and evaluating manager’s performances.
- Also helps to identify the activities that did not go as planned and this will help managers identify the activities they have less control over.
Next in, First out
A inventory valuation technique that values productions at current market price. For example, Instead of using the cost at which the material was bought(historical cost), the replacement cost would be used.
This valuation techniques aims to ensure production cost are as accurate as possible according to the accounting period in which the material was consumed not when it was bought.