Introduction
Inventory management plays a crucial role in determining the financial health of a company, particularly in industries where production processes are continuous and work in progress (WIP) inventories are common. Companies that engage in manufacturing often use process costing methods to allocate costs accurately between completed and partially completed units of production. One of the most commonly used methods for handling work in progress inventory and determining the cost of production is the FIFO (First In, First Out) method.
The FIFO method is particularly valuable for companies using process costing because it allows for an accurate calculation of equivalent units of production (EUP). This method assumes that the first units to be started in production are the first units to be completed. This characteristic makes the FIFO method useful in providing detailed information about both the work done on beginning inventory and the work done during the current period.
In this article, we will discuss how the FIFO method is used to find equivalent units in inventory management, its significance in process costing, and how it helps businesses allocate costs accurately.
1. What is the FIFO Method?
FIFO is an inventory valuation method that assumes the oldest inventory items are sold or used first. In the context of process costing, the FIFO method dictates that the first units to be started in a production process are the first to be completed. Therefore, the costs associated with beginning inventory are assigned separately from those incurred during the current period.
This method is widely used in manufacturing industries where production occurs in stages, and a large number of partially completed units exist at any given time. In such industries, calculating equivalent units of production (EUP) is critical to ensuring that costs are allocated accurately between completed and partially completed units.
Under the FIFO method, the following categories of production are accounted for:
- Units Completed: The units that have been finished during the period, which may include both the units that were started and completed during the period and the units that were in progress at the beginning of the period.
- Work Done on Beginning Inventory: The work completed on the units that were in process at the start of the period but were not fully finished. These units are assigned costs for the work done in the current period.
- Units Started and Completed in the Period: These are the units that were both started and completed within the current period.
- Ending WIP Inventory: The units that remain in process at the end of the period. These units are partially completed and require estimation of the percentage of completion.
2. Understanding Equivalent Units of Production (EUP)
The concept of equivalent units is fundamental to process costing, as it allows businesses to allocate costs to both completed units and partially completed units (WIP). Equivalent units represent the number of completed units that could have been produced given the amount of work done during the period. The process of determining equivalent units for each stage of production helps businesses allocate manufacturing costs, such as direct materials, labor, and overhead, accurately.
In a FIFO system, equivalent units are calculated separately for beginning inventory and units started and completed during the period. The basic formula for calculating equivalent units under FIFO is: {eq}\text{Equivalent Units} = \text{Units Completed} + (\text{Ending WIP Units} \times \text{Percentage of Completion}){/eq}
However, under FIFO, the equivalent units calculation includes the following steps:
- Units Started and Completed: The units that were both started and completed in the current period are assigned 100% completion for both materials and conversion costs.
- Work Done on Beginning Inventory: The FIFO method assigns the work done on beginning inventory to the current period. For example, if a unit was 40% complete at the beginning of the period, only 60% of the work will be counted in the current period to complete it.
- Ending WIP: The equivalent units for units in ending WIP inventory depend on the percentage of completion for direct materials and conversion costs.
3. Steps to Calculate Equivalent Units Using FIFO
The calculation of equivalent units in FIFO inventory method can be broken down into several steps. Here is an outline of how the process works.
Step 1: Calculate the Equivalent Units for Units Completed
The first step is to calculate the number of units that have been fully completed during the period. This includes the units that were both started and completed during the period, as well as the units from the beginning inventory that were completed during the period. {eq}\text{Units Started and Completed} = \text{Units Completed} – \text{Units in Beginning Inventory}{/eq}
Step 2: Calculate the Equivalent Units for Work Done on Beginning Inventory
Next, you need to determine the equivalent units for the work done on the units in beginning inventory during the current period. This requires calculating how much work was completed on these units during the period. {eq}\text{Equivalent Units for Beginning Inventory} = \text{Units in Beginning Inventory} \times (100\% – \text{Percentage of Completion at Beginning of Period}){/eq}
For example, if there were 1,000 units in beginning inventory that were 40% complete with respect to direct labor, the equivalent units for labor would be: {eq}1,000 \, \text{units} \times (100\% – 40\%) = 600 \, \text{equivalent units}{/eq}
Step 3: Calculate the Equivalent Units for Ending WIP
The final step involves calculating the equivalent units for the units still in process at the end of the period. The degree of completion for these units must be estimated, and only the work completed during the current period is included in the equivalent unit calculation. {eq}\text{Equivalent Units for Ending WIP} = \text{Ending WIP Units} \times \text{Percentage of Completion}{/eq}
For example, if 2,000 units are in ending WIP and are 50% complete with respect to conversion costs, the equivalent units for conversion costs would be: {eq}2,000 \, \text{units} \times 50\% = 1,000 \, \text{equivalent units}{/eq}
Step 4: Total Equivalent Units Calculation
After calculating the equivalent units for the beginning inventory, units started and completed, and ending WIP, you sum them up to obtain the total equivalent units for both direct materials and conversion costs. {eq}\text{Total Equivalent Units} = \text{Units Started and Completed} + \text{Equivalent Units for Beginning Inventory} + \text{Equivalent Units for Ending WIP}{/eq}
4. Example of FIFO Inventory Method for Finding Equivalent Units
Let’s now apply the FIFO method for equivalent units calculation with a detailed example.
Example Details:
- Units in Beginning WIP Inventory: 1,000 units (40% complete for direct materials and 30% complete for conversion costs).
- Units Started in the Period: 8,000 units.
- Units Completed: 7,500 units.
- Units in Ending WIP Inventory: 1,500 units (50% complete for direct materials and 20% complete for conversion costs).
- Total Costs Incurred: $100,000 for direct materials and $50,000 for conversion costs.
Step 1: Units Started and Completed
{eq}\text{Units Started and Completed} = 7,500 \, \text{units} – 1,000 \, \text{units (Beginning Inventory)} = 6,500 \, \text{units}{/eq}
Step 2: Equivalent Units for Beginning Inventory
For direct materials (40% complete at the beginning of the period): {eq}\text{Equivalent Units for Direct Materials (Beginning Inventory)} = 1,000 \, \text{units} \times (100\% – 40\%) = 600 \, \text{units}{/eq}
For conversion costs (30% complete at the beginning of the period): {eq}\text{Equivalent Units for Conversion Costs (Beginning Inventory)} = 1,000 \, \text{units} \times (100\% – 30\%) = 700 \, \text{units}{/eq}
Step 3: Equivalent Units for Ending WIP
For direct materials (50% complete): {eq}\text{Equivalent Units for Direct Materials (Ending WIP)} = 1,500 \, \text{units} \times 50\% = 750 \, \text{units}{/eq}
For conversion costs (20% complete): {eq}\text{Equivalent Units for Conversion Costs (Ending WIP)} = 1,500 \, \text{units} \times 20\% = 300 \, \text{units}{/eq}
Step 4: Total Equivalent Units
- Direct Materials:
{eq}\text{Total Equivalent Units for Direct Materials} = 6,500 \, \text{units} + 600 \, \text{units} + 750 \, \text{units} = 7,850 \, \text{units}{/eq}
- Conversion Costs:
{eq}\text{Total Equivalent Units for Conversion Costs} = 6,500 \, \text{units} + 700 \, \text{units} + 300 \, \text{units} = 7,500 \, \text{units}{/eq}
5. Advantages of FIFO Method for Finding Equivalent Units
- Accurate Cost Allocation: FIFO provides a more precise allocation of costs by distinguishing between the work done on beginning inventory and the work done in the current period.
- Clearer Reflection of Current Costs: FIFO ensures that the current period’s costs are attributed to the units started and completed in the same period, providing an accurate reflection of current production costs.
- Better Financial Reporting: FIFO is often preferred by companies looking for more transparent reporting, as it provides clear insights into the costs associated with the beginning inventory and current production.
6. Conclusion
The FIFO method for calculating equivalent units is an essential tool for businesses involved in continuous or process manufacturing. By distinguishing between the work done on beginning inventory and the work done in the current period, FIFO ensures that costs are allocated fairly and accurately. This method provides companies with valuable insights into their production costs, helping them make informed decisions regarding pricing, budgeting, and efficiency improvements. While the calculation of equivalent units using FIFO can be complex, its benefits in terms of accurate
cost allocation and financial transparency make it a valuable method in process costing systems.
