Elements of Costing

Lesson 2: Costing Materials

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The Four Main Topics of this Lesson

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The Cost of a Product

When working out the cost of a product we usually calculate three elements:

● Labour costs● Material costs● Overheads (or expenses)

In this lesson we will be thinking more about the cost of each item produced, whether a unit of production in a manufacturing business or a product sold in the services industry such as a hotel room or a place on an archery course in a leisure centre.

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Direct and Indirect Costs

We said in the first lesson that labour costs may be direct or indirect depending on whether they are directly linked to the production of an item or service or not.

The workers’ pay on a production line that produces computer screens is clearly a direct labour cost. We can calculate how many hours are worked, and how many computer screens are produced, and then calculate what labour cost should be allocated to each computer screen.

Let’s say that there are thirty workers on a production line that produces computer screens. In an hour, the workers produce 20 computer screens.

If the workers are each paid £10 per hour then 30 times £10 = £300 to produce 20 screens.

So each screen has labour costs of:

£300 divided by 20 = £15 per screen.

Note that overtime premiums are not normally a direct cost but are regarded as an indirect cost, so we will ignore them for the purposes of this calculation.

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Inventory Valuation Methods

The cost of materials would be fairly straightforward if we were to buy an exact amount of materials for a short production run. We would have no materials in stock before the production run started and we would have no materials left at the end of the production run. So the cost of the materials will be the amount that we paid for the exact amount of materials used.

Realistically speaking, there is always something left and, if we are producing a product on a regular basis, we will make regular purchases of the raw materials required for the production of the product.

So to calculate the cost of each unit of production in a given period of time, we need to understand the cost of the raw materials used in that period of time to produce a given amount of units.

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Inventory Valuation Methods (cont.)

Most organisations hold some inventories (or stock) and the way it is valued is important to understanding the cost of materials used in production at any given time.

We normally value inventories at cost, i.e. what we paid for the goods. However, we may have a quantity of the same item for which we have paid different amounts.

For example, we may have bought 100 widgets for £1.20 each, used 80 and still have 20. Then we buy another 100 widgets for £1.26 each and use another 70 widgets leaving us with 50 widgets. What is the value of the 50 widgets that we have left? Well, we could say that they are all valued at £1.26 each, or £1.20 each or some sort of average price.

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Inventory Valuation Methods (cont.)

In other words we could value the goods assuming that:

● The first goods that we bought are the first to be used, known as First In First Out or FIFO.

● The last goods that we bought are the first to be used, known as Last in First Out, or LIFO, or

● We take an average valuation of the goods that we have, known as Average Cost or AVCO

We’ll look at each method in turn.

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FIFO: First In, First Out

The simplest method is FIFO which values the inventory based on what we have left, assuming that the first items bought are used up first - like we all do with food.

So we bought 100 widgets @ £1.20, andUsed 80 widgets @ £1.20 which left 20 @ £1.20

Then, we bought another 100 widgets @ £1.26 so then we have a total of 120 widgets valued at the two different costs.

When we then issued another 70 widgets to the production line, we would have issued the 20 @ £1.20 first and then the remaining issue of 70-20 = 50 widgets will be costed @ £1.26.

The value of the materials issued to production would be 100 @ £1.20 + 50 @ £1.26 = £183.

The value of the remaining inventory in the warehouse would be 50 @ £1.26 = £63.

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LIFO: Last In, First Out

The next method that we will look at is LIFO or Last In First Out, which assumes that the most recently bought items are used up first - as if we just help ourselves from the top of the pile.

Let’s run through the calculations again using LIFO.

We started off by buying 100 widgets @ £1.20. We then used 80 @ £1.20 which left 20 @ £1.20.We bought another 100 widgets @ £1.26 so then we had a total of 120 widgets valued at the two different costs. When we then issue another 70 to the production line, things start to look a little different depending on your costing system. In FIFO we would issue the 20 @ £1.20 first and then the remaining issue of 50 widgets @ £1.26.

In LIFO, however, we leave the 20 @ £1.20 in stock and take all 70 items from the higher priced batch, the batch bought at £1.26 per item.

The value of the materials issued to production would then be 80 @ £1.20 + 70 @ £1.26 = £184.20.

The value of the remaining inventory in the warehouse would be 20 @ £1.20 and 30 @ £1.26 = £61.80.

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LIFO (cont.)

The effect of this method of valuing inventory is to minimise the value of the inventory in the warehouse and maximise the value of the materials used in production.

Over time this will reduce profit and reduce the value of the assets of the company. It doesn’t really give a true picture of the company’s assets and as such is not accepted as a suitable method of stock valuation for the purposes of preparing the company accounts.

While you need to know how it works so that you can recognise the method, you must not use LIFO in practice.

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The last method that we will look at is AVCO or Average Cost, which calculates an average value of the items in stock each time a new delivery is received, and then applies that to the units issued to the production line. Let’s run through the calculations using AVCO.

Remember we bought 100 widgets @ £1.20. We then used 80 @ £1.20 which left 20 widgets @ £1.20. We then bought another 100 widgets @ £1.26, so that we had a total of 120 valued at the two different costs.

What we will do now is calculate the total value and average it out. So the 20 widgets @ £1.20 work out at £24. We have added 100 @ £1.26 so the total value is £24 + £126 = £150. When we issue the next 70 to the production line, we will take an average valuation:

£150 divided by the 120 widgets is £1.25 per widget. So we would cost the 70 widgets @ £1.25 each.

The total value of the materials issued to production would then be the original 80 @ £1.20 + the second batch of 70 @ £1.25, which equals £183.50. The value of the remaining inventory in the warehouse would be 50 @ £1.25 = £62.50. This method of valuation is particularly useful for items which cannot be clearly separated, for example oil, or coal.

AVCO: Average Cost

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Inventory Valuation Methods Compared

Let’s have a look at the three methods side by side.

FIFO gave us a final inventory valuation of £63.LIFO gave us a final inventory valuation of £61.80.AVCO gave us a final inventory valuation of £62.50.

Those differences do not seem much, but scale them up and they become significant.

We are also required to show our accounts as accurately as possible, and stock valuation is included in Financial Accounting Statements such as the Statement of Financial Position and of Profit or Loss so we must adhere to the accounting standards.

The purpose of the accounting standards is to ensure that accounts are a true and fair reflection of the finances of the business, so we must choose the stock valuation method that is most appropriate for our inventory - and continue to use the same method in each accounting period.

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Recap

In this lesson, you have learnt about the following topics:

● Direct and Indirect Costs● Stock valuation methods:

○ LIFO (Last In, First Out)○ FIFO (First In, First Out)○ AVCO (Average Cost)