Comparing the Weighted-Average and FIFO Methods

Consider the summary of the costs assigned to units completed and to units still in process under the weighted-average and FIFO process-costing methods in our example for March 2020:

The weighted-average ending inventory is higher than the FIFO ending inventory by $480, or 4.9% $\left(\$480÷ \$\text{9,800}=0.049,\hspace{0.17em}\text{or}\hspace{0.17em}4.9\%\right)$. This would be a significant difference when aggregated over the many thousands of products Pacific Electronics makes. When completed units are sold, the weighted-average method in our example leads to lower cost of goods sold and, therefore, higher operating income than the FIFO method. To see why, recall the data in Case 3: Process Costing With Some Beginning and Some Ending Work-in-Process Inventory. For the beginning work-in-process inventory, direct materials cost per equivalent unit is $80 and conversion cost per equivalent unit is $60. The cost per equivalent unit of work done during the current period is $72 for direct materials and $52 for conversion costs. The current-period costs could be lower because of lower prices of direct materials and conversion-cost inputs or as a result of process efficiencies resulting in smaller quantities of inputs being used per unit of output or both.

FIFO assumes that (1) all the higher-cost units from the previous period in beginning work in process are the first to be completed and transferred out of the process and (2) the ending work in process consists of only the lower-cost current-period units. The weighted-average method smooths out the cost per equivalent unit by assuming that (1) more of the lower-cost units from the current period are completed and transferred out and (2) some of the higher-cost units from beginning inventory are placed in ending work in process.

Managers use information from process-costing systems to make pricing and product-mix decisions and for managing costs. FIFO provides managers with information about costs per unit in the current and previous periods. Managers can use these data to adjust selling prices based on current conditions (for example, based on the $72 direct materials cost and the $52 conversion cost in March). Managers can also more easily evaluate the firm’s cost performance relative to a budget or the previous period. By focusing on the work done and the costs of work done during the current period, the FIFO method provides valuable information for these planning and control purposes.

The weighted-average method merges unit costs from different accounting periods, obscuring period-to-period comparisons. For example, the weighted-average method would lead managers at Pacific Electronics to make decisions based on the $75.60 direct materials and $54.40 conversion costs, rather than the $72 and $52 costs prevailing in the current period. Its advantage is that it is relatively easy to compute and results in a more-representative average unit cost when input prices fluctuate from month to month.

The weighted-average and FIFO methods result in materially different cost of units completed and operating income when (1) direct materials or conversion cost per equivalent unit differs significantly from period to period and (2) physical-inventory levels of work in process are large relative to total number of units transferred out of the process. As changes in unit costs and inventory levels across periods decrease, the difference in the costs of units completed under the weighted-average and FIFO methods also decreases.^*

When the cost of units completed under the weighted-average and FIFO methods differs substantially, which method should a manager choose? In a period of falling prices, as in the Pacific Electronics case, the higher cost of goods sold under the FIFO method will lead to lower operating income and lower tax payments, saving the company cash and increasing the company’s value. FIFO is the preferred choice, but managers may not make this choice. If the manager’s compensation, for instance, is based on operating income, the manager may prefer the weighted-average method, which increases operating income even though it results in higher tax payments. Boards and top managers must design compensation plans to encourage managers to take actions that increase a company’s value, for example, by rewarding after-tax cash flow in addition to operating income, to align decision making and performance evaluation.

Other factors can also affect the choice of a process-costing method. Suppose that by using FIFO and reporting a lower income, a company would violate its debt covenants (such as its debt to income ratio) resulting in its loans coming due. In this case, a manager may prefer the weighted-average income-increasing method even though it results in higher taxes to avoid being forced to repay its loans.

In a period of rising prices, the weighted-average method will decrease taxes because more of the higher costs of the current period will be included in cost of goods sold, lowering operating income. Readers familiar with the last-in, first-out (LIFO) method (not presented in this chapter) will recognize that with rising prices, the LIFO method reduces operating income and taxes even more than the weighted-average method.

We close with comments on the use of activity-based costing and standard costing in process costing. Each process—assembly, testing, and so on—can be considered a different (production) activity. However, no additional activities need to be identified within each process. That’s because products are homogeneous and, in contrast to job-costing environments, use the resources of each process in a uniform way. This uniform use of resources makes it easier to establish standard costs of products. The appendix illustrates the use of the standard costing method for the assembly department.