Method of Pricing of Material Issues

When materials are issued to production department, a difficulty arises regarding the price at which materials issued are to be charged. The same type of material may have been purchased in different lots at different times at several different prices. This means that actual cost can take on several different values and same method of pricing the issue of materials must be selected.

There are numerous methods of pricing issues. They may be classified as follows:

I. Cost Price Methods	II. Average Price Method	III. Notional Price Methods
(a) Specified Price	(a) Simple Average	(a) Standard Price   (i) Current Standard (ii) Basic Standard
(b) First-in First-out (FIFO)	(b) Weighted Average	(b) Inflated Price
(c) Last-in First-out (LIFO)	(c) Periodic Simple Average	(c) Market Price   (i) Replacement Price (ii) Realisable Price
(d) Highest-in First-out (HIFO)	(d) Moving Simple Average
(e) Base Stock	(e) Moving Weighted Average

Cost Price Methods

• Specified Price (Identifiable) Method: Sometimes materials are purchased to be utilized in a particular job or issues can be identified with a particular receipt. In these cases, the actual purchase price can be charged. This method can be adopted when prices are stable or when the materials are covered by price control orders. This method has limited application only.
• 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. 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 purchases. It should be noted that the assumption of FIFO is only for accounting purpose i.e. the physical flow of materials need not necessarily be in the order of the flow of cost, though normally materials would be expected to move out of stock on approximately a FIFO basis because oldest stocks are usually used up first.

Example

Receipts

20th Oct. 500 kgs. @ 5.00 per kg.

23rd Oct. 250 kgs. @ 5.50 per kg.

Issues

25th Oct. Issue of 600 kgs. will be valued as follows:

500 kgs. @ 5 per kg.

100 kgs. @ 5.50 per kg.

Advantages:

• It is a good inventory management system since the oldest units are used first and inventory consists of the latest stock.
• It is logical.
• It is easy to understand and operate.
• It facilitates inter-firm and intra-firm comparisons.
• Valuation of inventory and cost of finished goods is consistent and realistic.

Disadvantages

• The cost of production is not linked to the current prices.
• If prices are rising, production cost is understated. But if stock turnover rate is high, the inventory will reflect current prices. The effect of current market prices is not revealed in issues when prices are rising.
• It does not present the true picture when many lots are purchased at different prices. The calculation becomes complicated.
• The pricing of material returns is difficult.
• High inflation creates problems in replacing used materials; this aspect is not dealt with in FIFO.
• Usually more than one price has to be adopted for a particular issue.
• Cost comparisons between two batches of production become difficult when issues are priced differently.

Last-in First out (LIFO) Method

The principle adopted is that the materials used in production are from the latest purchase. The inventory is priced at the oldest costs. As the method applies the current cost of materials to the cost of units, it is also known as the replacement cost method. It is the most significant method in matching cost with revenue in the income determination procedure.

Example

Assuming the same facts as given under FIFO, the issues will be valued as follows:

250 kgs. @ 5.50 per kg.

350 kgs. @ 5.00 per kg.

Advantages

• It is simple and useful when transactions are few.
• It is a good method of avoiding tax.
• It is a systematic method. It matches current costs with current revenues in a better way.
• It reveals real income in times of rising prices.
• It minimizes unrealized inventory gains and losses and tends to stabilize reported operation profits especially when the industry is prone to sharp price fluctuations.

Disadvantages:

• When rates of material receipts are highly fluctuating, the method becomes complicated.
• More than one price may have to be adopted for an issue.
• Cost of different batches varies greatly, making inter-firm and intra-firm comparison difficult.
• The stocks require to be adjusted during falling prices.
• Unless purchases and sales occur in equal quantities the current costs cannot be easily matched with current revenue.
• The company can time the purchases to cause high or low costs thus changing reported income at will.
• Existing profit sharing and bonus can be affected by an accounting change. Employees will have difficulty in understanding the cause for these changes.

• Highest-in First-out (HIFO) Method: The principle adopted is that costliest materials are issued first; Inventory is valued at the lowest possible price. The method requires detailed records. It is mainly used for monopoly products or cost plus contracts. When stocks are undervalued, a secret reserve is created.
• Base Stock Method: A certain minimum stock of a material is always carried and is priced at the original cost (usually at the lowest purchase price). The portion of stock above this level is issued and priced under any one of the methods.

The disadvantages of this method are that the stock may be undervalued and hence the computation of return on capital will not be reliable.

Average Price Methods

Simple Average Method: The simple average is the average of prices ignoring the quantities involved. It can be used when the prices are normally stable and the stocks purchased are in equal quantities or the stock value is small. It is calculated by dividing the total rates of materials by the number of rates of prices. A new average is worked out after every receipt.

Example:

Assuming the facts given in FIFO the average will be:

(5 + 5.5)/2 =          5.25 Kg

Weighted Average Method: In this method, the total quantities and total costs are taken into account while calculating the average price. It is calculated after every purchase by adding the quantity received to the stock in hand and the cost of this purchase to the cost of stock in hand. The total cost is divided by the total quantity to arrive at the value. This method avoids price fluctuations and reduces the number of calculations and gives an acceptable figure for stock.

Example

The weighted average will be calculated as follows (with previously given data):

(5 x 500 + 5.5 x 100)/6000

= 5.083

Advantages

• It is logical and consistent.
• Changes in prices do not affect issues and inventory.
• The values reflect actual costs.

Disadvantages

• It involves considerable amount of clerical work.
• When prices change frequently, it is inconvenient and complex.
• As it is not the actual price, it is not realistic.

Periodical Simple Average Method

Some companies may price materials by taking average of the prices of all receipts during a period, e.g., a month, a week, etc. for the subsequent period. Only those prices – relevant to the period is taken into account. Purchases made during the period and closing stock are taken into account.

Example

The receipts during the month were at the rates of 5, 5.50, 6 and 4.50. The periodic simple average will be:

Total Prices of Materials        = 55.5064.50

Total Number of Prices          = 5.25

Disadvantages:

• Pricing of issues ignores heavy fluctuations in price during the current period.
• It is not an exact cost method.
• It involves heavy clerical work.

Periodic Weighted Average Method

The average price is calculated periodically and not every time the material is received. It is calculated by dividing the total value of materials purchased during a period by the total quantity purchased.

Example

If the total receipts during a month is 1,000 kg. Costing 25,000, the periodic weighted average will be

(25000)/1000

= 25 per Kg.

Advantages

• Clerical costs are reduced.
• It is useful in process costing.
• The issue price is not affected by short-term fluctuations.

Disadvantages

• At the end of the accounting period, heavy clerical work is involved.
• Violent fluctuations are ignored till the end of the period.
• Closing stock can be erroneously valued and nil stock may have a residual value.

Moving Simple Average Method

In this method, periodic simple average prices are further averaged. By dividing periodic average prices by the number of periods taken, the moving average is calculated. The period chosen should cover the period in which the material is issued.

The value of closing stock may be undervalued or overvalued. When prices are rising, the issue price worked out is lower than the periodic average prices for the period concerned and vice versa.

Moving Weighted Average Method

The material issue price is calculated by dividing the total of the periodic weighted average prices for a number of periods by the total number of such periods.

Notional Price Methods

Standard Price Method: The price of issues for each item is pre-determined for a stated period taking into account all the factors affecting price, e.g., market trends, transportation costs, etc. Standard prices are determined for each material. All issues and inventory are kept at the standard price. These should be revised from period to period.

Standard can be basic or current standard. The basic standard is fixed for long periods and it gives the ideal price. It assists forward planning. Current standard keeps costs of the products adjusted to prevailing trends in markets. Basic standard on the other hand, helps to study trends in production costs over a period. The difference between standard and actual is transferred to the purchase price variance account.

Advantages

It simplifies accounting as only quantities are recorded.

• As only one rate is adopted, inconsistency is avoided.
• It helps to determine purchase efficiency. If actual cost is more than the standard than there is unfavorable purchasing efficiency and vice versa.
• It is simple to operate.
• It provides stability to the costing system.

Disadvantages

• It does not reflect the actual or expected cost but only a target.

Inflated Price Method

Inflated price includes carrying costs, losses due to evaporation etc. It aims to recover full costs of materials purchased.

Market Price Method

Materials may be issued at the replacement price. The replacement price is the cost of the same type of materials in the market at any given time.

Advantages

• It measures results correctly and accurately as current revenues are matched against current costs.
• It differentiates between holding gains and operating gains.
• A realistic and competitive selling price can be determined.

Disadvantages

• In the absence of a market price, replacement price cannot be determined.
• As it is not based on actual cost, they may increase the confusion and complication in accounting.

The replacement price is used in respect of items used in manufacturing whereas the realizable price is used for items kept in stock.

The realizable price is useful for calculating the issue price of obsolete and slow-moving stores. If issues are priced at current market price, price reduced due to bulk purchases, are not reflected.

The market price method introduces elements of uncertainty and involves excessive classical labour to maintain records of latest prices for various items.

Selection of Material Pricing Method

The various methods of pricing issues have merits and demerits. The choice of any method depends on many factors which can be summarized as under

• The frequency of purchases.
• Price fluctuations and its range. Method of stock valuation.
• Customs and practices followed in the industry, whether uniform costing system is being followed.
• Stock turnover rate.
• Percentage cost of raw materials to total cost of products.
• Economic order quantity.
• Effect of pricing method on tax payable.
• The accuracy required and the accuracy which would be obtained.
• Clerical work involved.
• Costing system adopted.
• Traceability of issue to purchase lot.
• Frequency of receipts and issues.
• Whether standard costing system is adopted.
• The nature of business.
• The possibility of using different methods for different classes of items.

In addition to the above, the following factors have to be satisfied:

• The purchase cost is covered.
• The issue price reflects the market price,
• There is no significant variation in cost from period to period, and
• The system does not necessitate heavy adjustment at the time of valuing closing stock.

Illustration 1

From the following you are required to prepare a statement showing the issues made under LIFO method:

Date     Opening Balance 100 units at 10 each

1          Received 200 units at 10.50 each

2          Received 300 units at 10.60 each

4          Issued 400 units to Job A vide MR No. 3

6          Issued 120 units to Job B vide MR No. 4

7          Received 400 units at 11 each

10        Issued 200 units to Job C vide MR No. 5

12        Received 300 units at 11.40 each

13        Received 200 units at 11.50 each

15        Issued 400 units to Job D vide MR No. 6

Receipts	Issues	Balance
Date	P.o No.	Qty.	Rate	Amount	Date	M.R	Qty.	Rate	Amount	Qty	Rate	Amount
										100	10.00	1,000
1st		200	10.50	2,100						100	10.00	1,000
										200	10.50	2,100
2nd		300	10.60	3,180						100	10.00	1,000
										200	10.50	2,100
										300	10.60	3,180
					4th	3	(400)   300	10.60	3,180	100	10.00	1,000
						100	10.50	1050	100	10.50	1,050
					6th	4	(120)   100	10.50	1,050	80	10.00	800
							20	10	200
7th		400	11.00	4,400						400	11.00	4,400
					10th	5	200	11.00	2,200	80	10.00	800
12th		300	11.40	3,420						200	11.00	2,200
										80	10.00	800
										200	11.00	2,200
										300	11.40	3,420
13th		200	11.50	2,300						80	10.00	800
										200	11.00	2,200
										300	11.40	3,420
										200	11.50	2,300
										80	10.00	800
					15th	6	(400)   200	11.50	2,300	200	11.00	2,200
							200	11.40	2,280	100	11.40	1,140

CLOSING STOCK: 380 Units, Value: `4,140.

Illustration 2

Prepare a statement showing the pricing of issues, on the basis of (a) Simple Average, and (b) Weighted Average Methods from the following information pertaining to material ‘X’.

Date

1          Purchased 100 units @ 10.00 each.

2          Purchased 200 units @ 10.20 each.

5          Issued 250 units to Job A vide MR No.

10        Purchased 200 units @ 10.80 each

13        Issued 200 units to Job B vide MR No. 2

1 7       Purchased 300 units @ 10.50 each

18        Issued 200 units to Job C vide MR No. 3

20        Purchased 100 units @ 11.00 each.

25        Issued 150 units to Job D vide MR No. 4.

Receipts	Issues	Balance
Date	P.O No.	Qty.	Rate (Rs.)	Amount (Rs.)	Date	M.R No.	Qty.	Rate (Rs.)	Amount (Rs.)	Qty.	Amount (Rs.)
1st     2nd		100     200	10.00     10.20	1,000     2,040						100     300	1,000     3,040
7th   10th		300   200	10.50   10.80	3,150   2,160	5th             13th     18th	1             2     3	250             200     200	10+10.20 2           10.20+10.50+10.80 3   10.50+10.80	2,525             2,100     2,130	50     350   550   350     150	515     3,665   5,825   3,725     1,595
20th		100	11.00	1,100	25th	4	150	2         10.80+11.00 2	1,635	250   100	2,695   1,060

CLOSING STOCK: 100 Units, Value: 1,060.

Weighted Average Method

Receipts	Issues	Balance
Date	P.O No.	Qty.	Rate (Rs.)	Amount (Rs.)	Date	M.R No.	Qty.	Rate (Rs.)	Amount (Rs.)	Qty.	Rate (Rs.)	Amount (Rs.)
1st   2nd       7th   10th           20th		100   200       300   200           100	10.00   10.20       10.50   10.80           1,100	1,000   2,040       3,150   2,160           1,100	5th         13th   18th       25th	1           2   3       4	250           200   200       150	10.13           10.58   10.58       10.74	2,533.30           2,116.00   2,116.00       1,611.00	100   300   50   350   550   350   150   250   100	10.00   10.13   10.13   10.45   10.58   10.58   10.58   10.74   10.74	1,000.00   3,040.00   506.70   3,656.70   5,816.70   3,700.70   1,584.70   2,684.70   1,073.70

CLOSING STOCK: 100 Units, Value: 1073.70.

Rate = 3,040 = 10.13                           Rate = 5,816.70 = 10.58

300                                                      550

Rate = 3,656.70 = 10.45                      Rate = 2,684.70 = 10.74

350                                                      250