Material Pricing Methods

Material Pricing Methods

The following approaches of pricing are prevalent in the market and a firm may adopt any of them according to their suitability.

• First in First Out Method
• Last in First Out Method
• Highest in First Out Method
• Average Cost Method
• Weighted Average Cost Method
• Periodic Average Cost Method
• Standard Cost Method
• Market Price

First in First Out Method

Under the first in first out (FIFO) method of pricing, the materials received first in the stores are issued first and accordingly the pricing is done. In other words, the materials received in the first batch, are first issued and only after all the items are issued from the first batch, the next batch is used. Thus, the materials are issued at the old price under this method. Closing stock is valued at the latest price.

Following are the advantages of this method:

• It is the simple method of pricing the materials as the materials received are issued first at the old price.
  
  
• It facilitates storage of materials in the store in chronological order according to their period of holding.
  
  
• It is easy to maintain and also cost effective.
  
  
• This method of valuation is accepted under the standard accounting practices.
  
  
• It is based on realistic and logical assumptions where materials received first are issued first.

However, this method has the following limitations:

• Since the materials are priced at the old price, it does not reflect the current market price and the cost of production is relatively lower.
  
  
• It is practically very difficult to segregate the material in the store in order of their receipts at store. There are more possibilities of getting old and new materials mixed.
  
  
• When price of raw materials rise in the market, the cost of production is underestimated.
  
  
• In practice, more than one price are used to price the materials as some of the items may be issued from the old stock while remaining from the new stock. In that case, materials issued at one time will have different prices.
  
  
• When material price changes frequently, it is difficult to maintain accurate pricing strategy

This method of pricing materials provides higher profits to the firm as lower cost of material is charged. This also results in lower pricing of the product. The firm is also required to pay higher taxes on account of higher profits.

Last in First Out Method

Under the last in first out (LIFO) method of pricing, the materials received last are issued first. Therefore, materials issued carry the latest cost of material acquisition. In practice, the stores department issues materials from the latest stock received and price accordingly and once that is finished, the materials are issued from earlier last received stock. The materials issued are at the latest actual costs and closing stock valuation is on the oldest price.

Following are the advantages of this method:

• The materials are priced at the current market price. The product carries the latest cost and therefore a realistic price.
  
  
• It is also simple to operate.
  
  
• This method provides a hedge against price rise.
  
  
• It does not carry any unrealized profits or loss.

The accounting standards do not allow this method of valuation for financial reporting.

Following are the limitations of this method:

• Often, more than one price mechanism is adopted while issuing materials from the stores.
  
  
• Physical flow material has no relationship with the pricing. It means materials can be issued from the earlier stocks.
  
  
• The closing stock is valued at the oldest price.

In the inflationary conditions, profit will be lower to the firm and consequently the tax liability will also be lower.

Highest in First Out Method

In the highest in first out (HIFO) method, the materials where prices are highest are issued first. It is not important that when these materials were purchased. The concept behind this approach is that, in increasing and inflationary market, the cost of material is immediately absorbed into the product cost to cover the risk of inflation.

Since the material is issued at the highest prices, the product costs also increases. However, this may affect the product to gain competitive prices in the market. Therefore, this is not a practical approach of material pricing.

Average Cost Method

Under this method, the materials are issued at the average price of the material purchased. A simple average cost is taken of all the materials purchased in the past, irrespective of the quantities and time to purchase.

Suppose the materials are purchased in five batches at prices of Rs. 17, 18, 19, 20 and 21, the average price in this case will be Rs. 19 per unit. All the materials will be issued at this price. This method is very simple but practically it is not considered as it only considers the price and not the quantity of the materials purchased. This method is useful when prices indicate a moderate increase and fluctuations are not very wide.

Weighted Average Cost Method

In the weighted average cost method, we consider both the prices as well as the quantities of the materials purchased. The weighted average is arrived at by dividing the cumulative amount by the cumulative quantity purchased at the time of issue of the materials. The materials are priced based on the weighted average cost. This can be explained through the following example: Suppose there are four invoices of materials that are purchased at the prices given in Table.

The weighted average cost will be as follows: The material from the stores for subsequent issue will be priced at Rs. 11.33 per unit. Since the process of material issue is ongoing, the weighted average price at any time will be based on the balance of quantity of material and the rate of the material.

The advantages of this method are as follows:

• It considers the price fluctuations and smoothen the effect of price change.
• This is more suitable where price fluctuations are higher.
• The material price is recalculated with each batch of new purchase.
• There are no unrealized profits or losses under this method.

Price (Rs.)	Quantity	Total	Cumulative Cost
10	1,000	10,000	10,000
11	1,400	15,400	25,400
12	1,200	14,400	39,800
12	1,500	18,000	57,800
Total	5,100	57,800	11.33

Following are the limitations of this method:

• The material issue price is not the current price.
  
  
• Where purchases are very frequent, this method becomes complicated and tedious.
  
  
• The prices paid in the past on very higher side are reflected in the average price.

Periodic Average Cost Method

In this method, the average cost is calculated on the basis of the materials received in particular time period rather than calculating the simple or the weighted average cost every time the material is received. The average may be calculated for the entire period. The average price may be arrived as follows: Average price = Cost of opening stock + Total cost of materials received for all batches during the period divided by number of units in opening stock + Total number of units received during the period.

Standard Cost Method

Under this method, the materials are priced at a pre-specified standard price determined for the issue of materials. If there is a difference between the actual purchase price and the standard price, the same is adjusted to the profit and loss account. The standard cost is pre-determined cost which is set based on certain standards and past trend.

It can be an effective method as the responsibility for difference between the actual price of material procured and the standard price of the material is fixed on the purchase department. However, a review of the prices in the market and the accordingly revision of standard cost is very much required.

Market Price

This method is also known as the replacement cost method. Under this method, materials are priced at the cost currently existing in the market as of the date of issue of the materials. The material can be identical. The replacement price can be explained in terms of the price of replacing the material at the time of issue of the materials. In practice, this method is applicable as it considers the hypothetical price which is not paid at the time of issue or receipt of the materials.

It may also have accounting problems. There is no standard rule as which of the methods should be used for pricing of materials. The firm may specifically choose any material pricing method as suited to it. However, method of production process, nature of material used by a firm, frequency of purchases, economic batch quantity, accounting practices acceptable in valuation of inventory, etc., are the considerations a firm may look into while considering material pricing policy.

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