Process costing is the allocation of production costs to output units. The production process usually involves multiple stages and business units. The first-in first-out inventory valuation method assumes that the first items into inventory are the first items used in production. The weighted average cost is equal to the total cost of all inventory items divided by the number of units.
According to the Accounting for Management website, the main difference between the FIFO and weighted average method is in the treatment of beginning work-in-process or unfinished goods inventory. The weighted average method includes this inventory in computing process costs, while the FIFO method keeps it separate.
Costs for raw materials and conversions are proportionately allocated to equivalent units, which include finished and unfinished goods. Conversion costs include direct labor and factory overhead costs. For example, if 100 units of ending work-in-process inventory used 75 percent of the purchased raw materials and 60 percent of the conversion costs, then the equivalent units for process costing purposes are 75 units (100 x 0.75) and 60 units (100 x 0.60), respectively. If 100 additional units were completed and shipped to customers, then the equivalent units are 175 (100 + 75) and 160 (100 + 60) for raw materials and conversion costs, respectively.
The beginning work-in-process inventory is subtracted from the totals in the FIFO method. Continuing with the example, if the beginning work-in-process inventory consisted of 20 units, and it includes 100 percent of raw materials and 50 percent conversion costs, then the equivalent units are 20 (20 x 1.00) and 10 units (20 x 0.50), respectively. Therefore, the ending work-in-process inventory contains 55 (75 - 20) and 50 (60 - 10) equivalent units for raw materials and conversion costs, respectively. Therefore, using the FIFO method, the total equivalent units are 155 (100 + 55) and 150 (100 + 50), respectively.
Equivalent Unit Cost
The beginning inventory costs and additional costs incurred in a period are combined in the weighted average method. Continuing with the example, if the total raw material costs under the weighted average method are $1,250, then the equivalent unit raw materials costs are about $7.14 ($1,250 / 175). If the conversion costs are $3,500, then the equivalent unit conversion cost is about $21.88 ($3,500 / 160). Therefore, the total equivalent unit cost is $29.02 ($7.14 + $21.88).
Under the FIFO method, the beginning work-in-process raw materials and conversion costs are excluded. If these were $250 and $1,000, respectively, then the equivalent unit costs are about $6.45 [($1,250 - $250) / 155 = $1,000 / 155 = $6.45] and about $16.67 [($3,500 - $1,000) / 150 = $2,500 / 150 = $16.67]. Therefore, the total equivalent unit cost using the FIFO method is $23.12 ($6.45 + $16.67).
The raw materials and conversion costs are assigned to the completed and work-in-process units. To conclude the example, under the weighted average method, the completed unit cost is $2,902 (100 x $29.02), the work-in-process cost is about $1,848 [(75 x $7.14) + (60 x 21.88)] and the total cost is $4,750 ($2,902 + $1,848). In the FIFO method, the completed unit cost is $2,312 (100 x $23.12), the work-in-process cost is $1,188 [(55 x $6.45) + (50 x 16.67)] and the total cost is $3,500 ($2,312 + $1,188).
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.