Product costing systems have been developed specifically for production processes. They are a management tool, which helps to determine the cost of producing every product. In recent years product costing practices have been improved, emphasizing quality, waste reduction, concentration on value-added activities and customer satisfaction. Product costing can provide valuable insights into performance through analysing products costs, productivity, material used, labour expenditures and special demands as well as help to decide which products to promote further and which should be redesigned or taken out of production.
LIFO (last in first out) costing method provides a means for evaluating stocks, assigning the cost of the “last in” item to the inventory. An alternative to LIFO is the average-costing-system. It does not differentiate between the first and last items, but calculates the average value for each unit. This method can be applied only when items in the stock are not distinguishable and do not deteriorate over time.
If LIFO is used in the cost of production report for Ajax Chemical Company, the per unit cost of the period is used for evaluation. In order to assign cost to the products transferred out, the number of units (maximum equal to the initial units) should be multiplied by the cost per unit. For Ajax, 5000 units transferred to finished goods is multiplied by the per unit price of $5.50 to obtain the cost of $27,500 to be transferred out. When the number of units, which should be transferred out, exceeds the number of starting units, a different unit cost should be used for the excess products. However, in practice strict adherence to this principle is not always followed. In Ajax, the end-of-period inventory is greater than the beginning of the period one, amounting to 4,000 and 2,000 respectively, therefore, only the cost of $5.50 should be used for the cost of production report.
When the weighted-average costing method is used, the per unit price of the goods transferred out is calculated as the average of the prices for the periods. Thus, cost per unit of materials is derived as , labour cost per unit is ,
while manufacturing per unit cost is . Summing up these values, we can obtain the per unit cost of the goods transferred out, which is $5.53 . It is then multiplied by the number of units transferred out (5,000) to get total cost of the goods transferred , $27,667. Therefore, the reported amount transferred to the finished goods, calculated with LIFO method will be less, then that for weighted-average method.
The end-of period inventory can be found as the difference between total cost to be considered for the period and the cost transferred out. The value of the goods transferred out can be calculated by adding the beginning-of-period inventory and the total manufacturing cost for the period, while subtracting the inventory remaining in the end of the period.
As compared to weighted-average method, LIFO has a number of differences in the reported values. Firstly, in an inflationary period, cost of sales on the report will be higher. This will lead to profit reduction and less inventory value. When the reporting period is characterized by deflation, the outcome of LIFO costing will be completely the opposite. Therefore, LIFO is often used for the sole purpose of tax reduction through lower profit reporting, while an internal system for control and measurement is used in the organization. The weighted-average method, on the other hand, allows getting a better picture of the inventory situation, without having to consider prices fluctuations and equalizing the inventory level.
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