What is the difference between the weighted average and FIFO method of process costing?

Weighted Average vs. FIFO vs. LIFO: An Overview

When it comes time for businesses to account for their inventory, businesses may use the following three primary accounting methodologies:

• Weighted average cost accounting
• Last in, first out (LIFO) accounting
• First in, first out (FIFO) accounting

Each of these three methodologies relies on a different method of calculating both the inventory of goods and the cost of goods sold. Depending on the situation, each of these systems may be appropriate.

Key Takeaways

• When it comes time for businesses to account for their inventory, they typically use one of three different primary accounting methodologies: the weighted average method, the first in, first out (FIFO) method, or the last in, first out (LIFO) method.
• The weighted average method is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit.
• The first in, first out (FIFO) accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time.
• The last in, first out (LIFO) accounting method assumes that the latest items bought are the first items to be sold.

Weighted Average

The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit. This is frequently the case when the inventory items in question are identical to one another. Furthermore, this method assumes a store sells all of its inventories simultaneously.

To use the weighted average model, one divides the cost of the goods that are available for sale by the number of those units still on the shelf. This calculation yields the weighted average cost per unit—a figure that can then be used to assign a cost to both ending inventory and the cost of goods sold.

While the weighted average method is a generally accepted accounting principle, this system doesn’t have the sophistication needed to track FIFO and LIFO inventories.

First In, First Out (FIFO)

The first in, first out (FIFO) accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time. When a business uses FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.

Last In, First Out (LIFO)

The last in, first out (LIFO) accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory. It should be understood that, although LIFO matches the most recent costs with sales on the income statement, the flow of costs does not necessarily have to match the flow of the physical units.

Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily, LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.

Weighted Average vs. FIFO vs. LIFO Example

Consider this example: Suppose you own a furniture store and you purchase 200 chairs for $10 per unit. The next month, you buy another 300 chairs for $20 per unit. At the end of an accounting period, let's assume you sold 100 total chairs. The weighted average costs, using both FIFO and LIFO considerations are as follows:

• 200 chairs at $10 per chair = $2,000. 300 chairs at $20 per chair = $6,000
• Total number of chairs = 500

Weighted Average Cost

• Cost of a chair: $8,000 divided by 500 = $16/chair
• Cost of Goods Sold: $16 x 100 = $1,600
• Remaining Inventory: $16 x 400 = $6,400

First In, First Out Cost

• Cost of goods sold: 100 chairs sold x $10 = $1,000
• Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000

Last In, First Out Cost

• Cost of goods sold: 100 chairs sold x $20 = $2,000
• Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000

Another acceptable method for determining unit cost under process costing is the first-in, first-out (FIFO) cost method.  Under the FIFO method, we assume any units that were not completed last period (beginning work in process) are finished before anything else is started.  The following table shows the differences between the weighted average method and the FIFO cost method:

We will look at each item individually as we discuss the steps of process costing.  Under either method, weighted average or FIFO, process costing consists of 5 steps:

1.  Physical Flow of Units
2.  Equivalent Units
3.  Cost per Equivalent Unit
4.  Assign Costs to Units Completed and Ending Work in Process Inventory
5.  Reconcile Costs

Physical Flow of Units

The physical flow of units is as follows under the weighted average method:

This is altered just slightly under the FIFO method as we must separate the items in units completed into Units Completed from beginning work in process and Units started and completed this period since under FIFO, we must finish anything from beginning work in process before we start something new.  Under the FIFO, we the physical flow of units would be documented as:

Just as in the weighted average method, the 2 Total Units figures must agree!

Equivalent Units of Production

Under the FIFO method, we will calculate equivalent units for 3 things:  Units completed from beginning work in process, units started and completed this period and units remaining in ending work in process.  This video will discuss the differences between the Weighted Average and FIFO methods for equivalent units (if you are comfortable with the weighted average method, skip to minute 4:06 to begin the discussion on the FIFO method).

Equivalent units for the period will be calculated as follows under FIFO (keep in mind, you may have different percent complete for materials, labor and overhead):

1.  Units from beginning work in process:  you want to complete this units, so how much MORE effort will be needed to finish these units.  You will calculate this as beginning work in process units x (100% – given % complete) to calculate the amount of additional work necessary to make the unit 100% complete.
2. Units started and completed this period:  take the units x 100% complete since they were started and completed they have received all of their materials, labor and overhead and will not receive any more since they are finished.
3. Units in Ending work in process:  just like with the weighted average method, we will take the ending work in process units x a given % complete.

To illustrate the computation of equivalent units under the FIFO method, assume the following facts (for simplicity we are using just one percent complete for materials, labor and overhead):

The physical flow of units would be (calculate units started and completed as units started 10,000 – units in ending work in process 5,000):

The equivalent production for the period would be:

Cost per Equivalent Unit

Under the weighted average method, we use beginning work in process costs AND costs added this period.  Under the FIFO method, we will only use the costs added this period.  This video will explain the differences between the two approaches.

The formula we will use for calculating cost per equivalent unit under the FIFO Method is:

Assign Costs

When we assign costs to units completed and transferred and units remaining in ending work in process under the FIFO method, we need the following items:

1.  Costs from beginning work in process:  these were the costs we started the period with or the unfinished items from the previous period (no calculation required — just bring over the costs from beginning work in process).  Remember, under FIFO, these are finished first so their costs must be passed along to completed units.
2.  Costs to complete beginning work in process:  you will take the Equivalent units calculated for completing beginning work in process x the cost per equivalent unit.  You will do this for materials, labor and overhead (or for conversion costs which is the both direct labor and overhead).
3. Costs of units started and completed:  you will take the equivalent units calculated for units started and completed x the cost per equivalent unit for materials, labor and overhead (or conversion).
4. The sum of these 3 will be the cost of units completed and transferred which is also known as cost of goods manufactured.  This amount is transferred to the next department or to finished goods and out of work in process for the units completed this period.
5. Cost of units remaining in ending work in process:  you will take the ending work in process equivalent units x the cost per equivalent unit for materials, labor and overhead (or conversion) just as we did under the weighed average method.  This amount rolls over to be the next period’s beginning work in process inventory.

This video will provide a demonstration of cost assignment under the FIFO method.

Reconcile Costs

Finally, something is the same under FIFO and Weighted Average.

We want to make sure that we have assigned all the costs from beginning work in process and costs incurred or added this period to units completed and transferred and ending work in process inventory.

First, we need to know our total costs for the period (or total costs to account for) by adding beginning work in process costs to the costs incurred or added this period.  Then, we compare the total to the cost assignment in step 4 for units completed and transferred and ending work in process to get total units accounted for.  Both totals should agree.

The cost reconciliation would be:

In the next page, we will do a demonstration problem of the FIFO method for process costing.

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