The primary difference between the FIFO method and the average method of process costing lies in the treatment of the cost of beginning work in process inventory. In the FIFO method, the cost of the beginning work in process inventory is kept separate from the cost of production of the current period.
When determining the FIFO cost of unit completed and transferred to next department (process) or to finished goods, the cost of the beginning work in process inventory and the cost necessary to complete the beginning work in process units are added together. The sum of these two costs is the cost assigned to the units in the beginning work in process inventory that are transferred out. Units started and completed during the period are assigned a cost on the basis of costs incurred during the period for the equivalent units produced during the period.
In the FIFO method each department is regarded as a separate accounting unit. Thus, the application of the FIFO method in practice is modified to the extent that subsequent departments usually combine all transferred-in costs into one amount, even though they could identify and separately account for the costs relating preceding department’s beginning inventory ant those relating to the preceding department’s units started and completed during the period.
The average method of process costing may be simpler to use than the FIFO method, primarily because the beginning work in process inventory is averaged in as a part of the current production. In the average method, the beginning work in process inventory costs are combined with current production costs even though some of the production was begun prior to the current period. When equivalent units are determined, work done on the beginning inventory in a preceding period is regarded as if it were done in the current period. Unit costs are determined by dividing the sum of the beginning work in process and the cost of current production costs by the equivalent units produced, including the units in the department’s beginning work in process inventory. The cost of all units transferred out of a department during a period is the product of the number of units completed multiplied by the average cost.