A number of methods are used for pricing material issues. Each method has its own advantages and disadvantages. As such, it is impossible to say which method is the best. Each organisation should choose a particular method best suited to it. While choosing a method, it is necessary to see that the method chosen is simple, effective and realistic.
At the same time, it is equally necessary to consider the effect of the method on production cost and inventory valuation. The following are the different methods of pricing the material issues:
1. First In First Out Method (FIFO)
According to this method the units first entering the process are completed first. Thus the units completed during a period would consist partly of the units which were incomplete at the beginning of the period and partly of the units introduced during the period. The cost of completed units is affected by the value of the opening inventory, which is based on the cost of the previous period. The closing inventory of work-in-process is valued at its current cost.
Advantages:
1. This method is simple to understand and easy to operate.
2. The closing stock is valued at the current market price.
3. Since issues are priced at cost, no profit or loss arises from pricing.
4. This method is more suitable in times of falling prices.
5. Deterioration and obsolescence can be avoided.
Disadvantages:
1. When prices fluctuate, calculation becomes complicated. This increases the possibility of clerical errors.
2. During the period of price fluctuations, material charged to jobs vary. Therefore, comparison between jobs is difficult.
3. During the period of rising prices, product costs are under stated and profits are overstated. This may result in payment of higher dividend out of capital.
Last In First Out Method (LIFO)
According to this method units last entering the process are to be completed first. The completed units will be shown at their current cost and the closing-work in process will continue to appear at the cost of the opening inventory of work-in-progress along with current cost of work in progress if any.
Advantages:
1. Issues are based on actual cost.
2. Issue price reflects current market price.
3. Product cost will be based on current market price and hence will be more realistic.
4. There is no unrealized profit or loss.
5. Simple to operate if purchases are not many and prices are steady or rising.
6. When prices are raising this method is helpful in preparation of quotation or estimates.
Disadvantages:
1. This method involves considerable clerical work.
2. Under felling price, issues are priced at lower prices and stocks are valued at higher rates.
3. Stock of material shown in the balance sheet will not reflect market price.
4. Due to variation in prices, comparison of cost of similar job is difficult.
5. This method is not accepted by the income tax authorities.
Simple Average Method
The simple average is determined by adding different prices of materials in stock and dividing the total by number of prices. Quantity purchased in each lot is ignored.
Advantages:
1. This method is simple to understand and easy to operate.
2. It reduces clerical work.
3. It is suitable when price are stable.
Disadvantages:
1. It does not take into account the quantities purchased.
2. The value of closing stock becomes unrealistic.
3. Material cost does not represent actual cost price.
4. When prices fluctuate, this method will give incorrect result.
Weighted Average Method:
This is an improvement over the simple average method. This method takes into account both quantity and price for arriving at the average price. The weighted average is obtained by dividing the total cost of material in the stock by total quantity of material in the stock.
Advantages:
1. It gives more accurate results than simple average price because it considers both quantity as well as price.
2. It evens out the effect of price fluctuations. All jobs are charged a average price. So, comparison between jobs is more easy and realistic.
3. It is suitable in the case of materials subject to wide price fluctuations.
4. It is acceptable to income tax authorities.
Disadvantages:
1. Stock on hand does not represent current market price.
2. When large numbers of purchases are made at different rates, the calculation is tedious. So, there are more chances of clerical error.
3. With some approximation in average price, there will be profit or loss due to over or under charging of material cost to jobs.