Pricing of Material Issues
Cost Accounting Notes CBCS Pattern
Methods of Pricing of Material Issues
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.
- This method is simple to understand and easy to operate.
- The closing stock is valued at the current market price.
- Since issues are priced at cost, no profit or loss arises from pricing.
- This method is more suitable in times of falling prices.
- Deterioration and obsolescence can be avoided.
- When prices fluctuate, calculation becomes complicated. This increases the possibility of clerical errors.
- During the period of price fluctuations, material charged to jobs vary. Therefore, comparison between jobs is difficult.
- 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.
2. 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.
- Issues are based on actual cost.
- Issue price reflects current market price.
- Product cost will be based on current market price and hence will be more realistic.
- There is no unrealized profit or loss.
- Simple to operate if purchases are not many and prices are steady or rising.
- When prices are raising this method is helpful in preparation of quotation or estimates.
- This method involves considerable clerical work.
- Under felling price, issues are priced at lower prices and stocks are valued at higher rates.
- Stock of material shown in the balance sheet will not reflect market price.
- Due to variation in prices, comparison of cost of similar job is difficult.
- This method is not accepted by the income tax authorities.
3. 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.
- This method is simple to understand and easy to operate.
- It reduces clerical work.
- It is suitable when price are stable.
- It does not take into account the quantities purchased.
- The value of closing stock becomes unrealistic.
- Material cost does not represent actual cost price.
- When prices fluctuate, this method will give incorrect result.
4. 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.
- It gives more accurate results than simple average price because it considers both quantity as well as price.
- It evens out the effect of price fluctuations. All jobs are charged a average price. So, comparison between jobs is more easy and realistic.
- It is suitable in the case of materials subject to wide price fluctuations.
- It is acceptable to income tax authorities.
- Stock on hand does not represent current market price.
- When large numbers of purchases are made at different rates, the calculation is tedious. So, there are more chances of clerical error.
- With some approximation in average price, there will be profit or loss due to over or under charging of material cost to jobs.
5. Replacement Price (or Market Price) Method
Replacement price is a price at which materials issued can be replenished. Thus, it means the market price, because replenishment can be done by purchase at market price. Charging of issues at replacement price, therefore, requires the ascertainment of replacement price (i.e., market price) whenever an issue takes place. The value of stock after each issue is the value before issue minus the value of the issue at replacement price. The method may be supported on the ground that, material cost of a job or work order should represent the current market price.
6. Standard Price method
Under this method all factors that may affect price are considered and standard material price for the materials is generally fixed before the actual purchase. Materials issued are valued at that standard price. The factors usually considered for establishing standard price are – (a) Apprehended changes in price due to possible changes in market conditions. (b) Amount of discount that may be available from the suppliers depending upon the quantity to be ordered. (c) Expenses relating to purchase i.e., freights and carriage, customs duty, godown expenses, packing, handling etc.
If there is any difference between the standard price and the actual price of purchase, the difference is called material variance. When the variance is due to difference between standard rate of purchase and the actual rate of purchase, such variance is called rate variance. If the variance is due to difference between total actual material cost and total standard material cost, there being no difference in rates, the variance is called usage variance. Variance may be worked out either at the time of actual purchase or at the end of accounting period. The variance is analysed into causative reasons and its recurrence is prevented by suitable measures.
Advantages of standard price method:
- Efficiency of the purchase department can be revealed.
- The method is easy to apply, because all issues are charged at a standard price.
- The method can be used in any industry, even if standard costing method is not applied there.
- The method helps to exercise control on material cost by setting the standard price, which may be called the price that should be.
Disadvantages of standard price method:
- The issues are not charged of actual cost.
- There may be profit or loss on materials.
- A very low or high standard price may spoil the purpose for which it is set.
- Since price depends upon a number of unknown variable factors it is difficult to fix a reliable standard price.