- Explain and show how to compute and apply costs on equivalent units using the First-In-First-Out (FIFO) method [SLIDE 1] We have discussed the weighted-average method for equivalent units and how all units and costs are treated the same. We will now look at the FIFO method for equivalent units. FIFO is considered to be a more accurate measure of cost than weighted-average. While the calculations in weighted-average and FIFO appear to be similar, there are significant differences in the two methods. Those differences are:
  1. The computation of equivalent units
  2. The way in which the costs of beginning inventory are treated
A distinctive feature of the FIFO process-costing method is that work done on beginning inventory before the current period is kept separate from work done in the current period. Costs incurred and units produced in the current period are used to calculate cost per equivalent unit of work done in the current period. In contrast, equivalent-unit and cost-per-equivalent-unit calculations under the weighted-average method merge units and costs in beginning inventory with units and costs of work done in the current period. Let's look at how to calculate equivalent units and assign cost to those units using the FIFO method. [SLIDE 2] Remember in the previous lesson on the weighted-average method, the basic concept for calculating equivalent units is: Equivalent units = Number of physical units × Percentage of completion All units (beginning and new units started) were blended together and costs from the prior and current period were added together to find the cost per unit. In the first-in, first-out (FIFO) process-costing method, we assign the cost of the previous accounting period's equivalent units in beginning work-in-process inventory to the first units completed and transferred out of the process. Next, we assign the cost of equivalent units worked on during the current period first to complete beginning inventory, next to started and completed new units and finally to units in ending work-in-process inventory. The FIFO method assumes that the earliest equivalent units in work in process are completed first. In the FIFO method, we treat beginning inventory differently. Let's review the FIFO method to see in more detail how equivalent units are determined and costs assigned. [SLIDE 3] The steps in calculating equivalent units for the weighted-average method and the FIFO method are the same except for the fact that we have to separate beginning work in process units and costs, from units started in the period and remaining at the end of the period. The same four steps used in calculating equivalent units in weighted-average are also used in the FIFO method for calculating equivalent units and assigning cost. The only difference is to separate the beginning work in process units from the current units. The steps are:
  1. Summarize the physical flow of units and compute the equivalent units for direct materials, direct labor, and overhead.
  2. Summarize the costs to be accounted for (separated into direct materials, direct labor, and overhead). Direct labor and overhead are combined as conversion costs.
  3. Calculate the cost per equivalent unit.
  4. Use the cost per equivalent unit to assign costs to (1) completed units transferred out and (2) units in ending WIP inventory.
The formula used to calculate equivalent units in production using the FIFO method is as follows: Equivalent units of production = Equivalent Units to complete beginning work in process inventory + Units started and completed during the period + Equivalent units in ending work in process inventory This will all make more sense as we work through an example. [SLIDE 4] In the FIFO method, the units and cost are separated for the prior and current period. Let's look at an example of calculating the equivalent units for a processing department of Sample Company. Assume the following facts for the accounting period of February: Using this information, we determine that there are 63,700 physical units to account for in this period. In step two, we determine the equivalent units of production, which is needed in order to compute the direct materials and conversion costs for the month. We know that the beginning inventory for work in process is 6,200 partially completed units that were 100% complete on direct materials and 60% complete on conversion costs. The remaining 40% of their conversion costs was incurred as they were completed in the period. Our equivalent units for the conversion costs is 2,480 units. We calculated this by taking the 6,200 and multiplying by the 40% to get the equivalent units. We know that 57,500 units were started but only 52,500 were completed during the period and incurred 100% of both direct materials and conversion costs, so equivalent units were 52,500. We know that we have 5,000 in ending work in process that are 100% complete in direct materials and 45% complete in conversion costs, so the equivalent units are 5,000 for direct materials and 2,250 for conversion costs (5,000 multiplied by 45%). Remember, we cannot account for cost on units that are not 100% complete. The units in beginning work in process inventory plus the units started into production must equal the units in ending work in process inventory plus the units completed and transferred out. In equation form, this is: Units in beginning work in process inventory + Units started into production or transferred in = Units in ending work in process inventory + Units completed and transferred out Now that we know our equivalent units of production we are ready for step 3: accounting for cost and step 4: computing cost per equivalent unit. [SLIDE 5] In process costing for equivalent units, we have direct materials and conversion costs to assign to equivalent units of production. Now that we have figured out our equivalent units; we can use them to figure out the cost that needs to be transferred to the next processing department or finished goods and what needs to remain in work in process for the given period. In our example, we have beginning inventory cost in work in process of $41,540 ($20,150 in direct materials and $21,390 in conversion cost). Our current period costs for the 57,500 units added is $510,238 ($189,750 in direct materials and $320,488 in conversion cost). This gives us a combined total work in process inventory cost for the period of $551,778 ($209,900 in direct materials and $341,878 in conversion cost). In the weighted-average method, the units and cost were blended together for both the prior and current period. In the FIFO method, the direct materials costs and conversion costs for the current period are divided by their respective units of equivalent production to arrive at the cost per equivalent unit. Prior period costs attached to units in beginning inventory are not included in these computations because the FIFO costing method uses a separate costing analysis for each accounting period. The FIFO method treats the costs of beginning inventory separately, in Step 5. Using our formula for cost per equivalent units, we get total cost per equivalent unit of $8.90, which consists of $3.30 per unit cost of direct materials ($189,750 divided by 57,500 equivalent units) and $5.60 per unit of conversion cost ($320,488 divided by 57,230 equivalent units). The next step in the FIFO method is to assign costs to completed and partially completed units to record costs on the accounting ledgers for the period. [SLIDE 6] When we assign cost using the FIFO method, we have to compute the cost of the units in beginning work in process inventory that were completed and transferred first. In our example, we show that the costs transferred for beginning work in process includes the $41,540 in direct materials and conversion costs from the prior period. The remaining conversion cost for completing the 6,200 units in beginning inventory is calculated by using the 2,480 equivalent units and multiplying by the current month cost per equivalent unit of $5.60 to get $13,888 to complete the units carried over from January. Each of the 52,500 units started and completed in February cost $8.90 to produce. Their combined cost of $467,250 is added to the $41,540 and $13,888 of costs required to produce the 6,200 units from beginning inventory to arrive at the total of $522,678 that is transferred to the Finished Goods Inventory account. The entry resulting from doing the process cost report for February is:
DebitCredit
Finished Goods (or Work in Process)$522,655
Work in Process$522,655
All costs remaining in work in process inventory account after the cost of goods manufactured has been transferred out represent the costs of the units still in production at the end of February. The balance of $29,100 in the ending work in process inventory is made up of $16,500 of direct materials costs (5,000 units multiplied by $3.30 per unit) and $12,600 of conversion costs ((5,000 multiplied by 45%) multiplied by $5.60 per unit).