Knowing how to calculate equivalent units of production is an important tool for those in the business and accounting world. When thinking about how goods are manufactured and sent in a finished form to their destination, there are a lot of steps. There are costs involved at each step, from starting production to mid-production to finished production.
TL;DR (Too Long; Didn't Read)
Knowing how to calculate equivalent units of production is an important tool in the business and accounting world. There are two ways to calculate this metric, known as the weighted average method or the first-in, first-out method.
Accountants use the term equivalent units to explain how costs are segmented between items that are still in production versus items that are in completed form. Many items are in continuous production, so without some way to calculate equivalent units, it would be difficult to determine how much money was tied up in production costs. Incomplete work must be accounted for on a regular basis so that a value can be placed on the incomplete work.
There is a simple formula that is used to calculate the equivalent units of production for those partially completed units. This formula not only applies to materials that are in continuous production, but also to labor costs and overhead costs.
Let’s say a parts maker is supposed to make 1,000 parts. At the end of the first quarter, there are 500 completed parts and 300 parts that are still in process. The parts maker’s best estimate is that these additional 300 parts are 50 percent completed. These parts are only half done, so they can’t be counted as finished parts, but the costs involved in making them need to be accounted for. If a report was created, it would indicate that there are 1,150 equivalent units of production.
Calculate Equivalent Units of Production
Here’s the formula:
The number of partially completed units x percentage of completion = equivalent units of production
Plugging in the information that you have from the parts maker, there are 300 partially completed units. These 300 units are 50 percent completed.
300 x .5 = equivalent units of production
equivalent units of production = 150
These equivalent units are added to the 500 parts that are already done, and the total units of production come to:
500 + 150 = 650 equivalent units of production
Weighted Average Method to Calculate Equivalent Units of Production
The weighted average method to calculate equivalent units of production combines units and costs from the current period with units and costs from the prior period. The calculation is different for a weighted average. Here is the weighted average formula:
Total equivalent units for a cost component = A + B × C
A = units transferred out to the next department/finished goods
B = units in closing work in process
C = percentage of completion with respect to the relevant cost component
Using the formula given in the first section (Number of partially completed units × percentage of completion = equivalent units), the equivalent units of production are transferred to the next department of finished goods plus the equivalent units in the department's ending work-in-process inventory.
Total equivalent units = 650 equivalent units of production + 300 + .5
Total equivalent units = 800
Note that, in the weighted average method, beginning work-in-process inventory is ignored. When you use weighted averages, all work accomplished in prior periods is not factored into the equations.
First-in First-out (FIFO) Method of Calculating Equivalent Units of Production
The second method of calculating equivalent units of production uses a FIFO method or First-in First-out. Businesses will first sell the finished inventory that they first receive, followed by any inventory they receive later, hence first in, first out.
Use the following equation for FIFO:
Equivalent Units of Production = equivalent units to complete beginning inventory + units started and completed during the period + equivalent units in ending work in process inventory.
Equivalent units to complete beginning inventory = units in beginning inventory × (100 percent − percentage completion of beginning inventory).
The entire equation can be further simplified to:
Equivalent units of production = units transferred out + equivalent units in ending work in process inventory − equivalent units in beginning inventory.
Calculate the units of production from both materials and conversion. Using FIFO, you'll have two percentages to determine for beginning and ending inventory.
Equivalent units under FIFO method are calculated using more variables than the previous example:
Equivalent units for each cost component = (100% − A) × B + C + D × E
A = percentage of completion at the end of last period
B = units in opening work in process
C = units added/started and transferred out
D = percentage of completion of units in closing work in process
E = units in closing work in process
Here’s a walkthrough of the formula using our parts example if there are 1,000 parts in beginning production during the month of March. During that accounting period (March), let’s say that an additional 4,000 parts are added to production. During March, 3,000 parts are completed and moved out of production. Let’s say there were 2,000 parts completed at the end of the last accounting period and that the parts- in-process are 30 percent done. This leaves:
A = 2,000
B = 1,000
C = 4,000
D = 30%
1,000 (beginning production)+ 4,000 (added to production) – 3,000 (parts completed) = 2,000 parts in production.
E = 2,000
To use the FIFO method, only the percentage of beginning parts completed during the accounting period is used, along with the production costs incurred in completing those units. You can use the same method for calculating the overhead costs and materials if you know the percentage of completion of each pricing factor.
Since 2006, Vanessa has written for a variety of website development agencies and private clients on topics related to growth for new and underperforming businesses. Her work can be found in print publications and on websites such as Palo Alto Software and business accelerators and Chambers of Commerce in her state.