Equivalent Units: FIFO and Weighted-Average Approach (Simple Example)

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In CPA Canada’s CFE, Core 2 and PM exams, you can expect to see complex management accounting (MA) topics tested. One example of such topic is equivalent units. Understanding how to calculate equivalent units is a fundamental concept, particularly in the context of process costing. This is often tested, particularly for the Core 2 multiple-choice questions (MCQs). Determining equivalent units are important in determining total units of production, but it also influences cost allocation decisions in manufacturing processes. In this article, you will see the comparison between FIFO and weighted average, with an easy to understand example.

What’s the point of process costing?

Process costing is used to figure out how much it costs to produce items that are very similar or identical, like chocolate bars or cans of soda. In this costing system, costs are tracked for each step, or “process,” in the production, and then the total cost is divided by the number of units produced. This way, we can find out the cost per unit. It’s useful for companies making large quantities of similar products because it helps them understand cost per item.

Something similar to process costing is job costing. While process costing tracks costs for huge number of identical products, job costing tracks costs for specific, individual jobs or orders, which are often unique. For example, building a custom piece of furniture or a unique construction project would use job costing. In this case, we would track the costs of materials, labor, and overhead for each specific job separately. Both methods help businesses understand and manage their production costs, but they are used in different situations based on the type of products being made.

How does process costing work?

Process costing works by tracking the costs of each step, totaling the costs, and dividing by the total number of items produced. This is called the Weighted Average method and there are other methods too (discussed below).

Example:

Imagine a company that makes chocolate bars. They have 3 main steps in their production process:

  1. Mixing ingredients
  2. Molding the chocolate into bars
  3. Packaging the bars

In process costing, the company tracks costs at each step. Let’s say in one month, the costs are as follows:

  1. Mixing ingredients: $1,000
  2. Molding: $800
  3. Packaging: $200

In that month, the company makes 10,000 chocolate bars. To find the cost per chocolate bar, they add up all the costs ($1,000 + $800 + $200 = $2,000) and then divide by the number of chocolate bars (10,000). So, the cost per chocolate bar is $2,000 ÷ 10,000 = $0.20.

This means it costs $0.20 to make each chocolate bar, and this helps the company understand their production costs and set their selling prices.

What’s Equivalent Units?

Equivalent units (EU) is a way to measure partially completed products as if they were fully completed. The reason we do it is because it helps to calculate the costs of products that are not yet finished at month-end or year-end. Without this, we can’t assign costs to products in different stages of completion, so we won’t know the true costs at period end.

For example, a factory is making chocolate bars and they have 200 bars that are halfway done at month-end. Instead of counting these as 200 incomplete bars, we use equivalent units to measure them. Since they are halfway done, it’s like having 100 fully completed chocolate bars. This helps the factory calculate costs more accurately for the partially finished products.

What’s FIFO and Weighted-Average?

FIFO (First-In, First-Out) and WA (Weighted-Average) are methods used to assign costs to units produced. FIFO assumes that the oldest costs are assigned to the units completed first. For example, for a factory is making chocolate bars, FIFO means the cost of the ingredients and labor from the beginning of the production period are used first to calculate the cost of the finished bars. This helps to track the flow of costs more accurately based on the production timeline. On the other hand, the Weighted-Average method blends all the costs together to find an average cost per unit. So, if the factory had different costs for chocolate bars at different times, the Weighted-Average method would add up all the costs and divide by the total number of bars produced to get a single average cost per bar. This makes it easier to calculate costs when there are many different costs over a period.

FIFO, WA, and EU are all tools used to calculate the cost of producing products. A company will choose either the FIFO or WA. Equivalent units help measure the production activity by converting partially completed products into an equivalent number of fully completed products. The FIFO method uses these equivalent units by assigning the oldest costs to the units completed first, which helps track costs in the order they were incurred. The Weighted-Average method, on the other hand, averages out all the costs over the period, using equivalent units to find a single cost per unit for both completed and partially completed products. Together, equivalent units and the chosen method (either FIFO or Weighted-Average) help companies accurately calculate production costs.

What’s conversion costing and WIP?

Conversion costing is the cost spent to turn raw materials into finished products. For example, in the case of chocolate bars, conversion costing means the cost for mixing, molding, and packaging. Work In Progress (WIP) are the products that are still being made and not finished yet. In the case of chocolate bars, WIP means the bars that are partially made and not ready to be sold.

Full Example

Let’s imagine a chocolate bar manufacturing company.

  • Beginning Inventory: At the start of the month, the company has partially finished chocolate bars. These bars are 70% complete in the process (mixing, molding, and packaging) and have all the necessary materials (100% complete for materials like cocoa, sugar, and milk).
  • Ending Inventory: By the end of the month, the company has some chocolate bars that are still in the production process. These bars are 20% complete in terms of the conversion process and have all the necessary materials.
  • Units Started: During the month, the company starts production on 200,000 chocolate bars.
  • Transferred Out: By the end of the month, 160,000 chocolate bars are fully completed and moved out of the production line to be ready for sale.
  • Ending Inventory: There are 90,000 chocolate bars still in production at the end of the month.

In CPA Canada exams, this information would be presented like this:

The requirement is to determine equivalent units (EU).

Solving under FIFO:

FIFO separates the cost of current work, and work in beginning inventory. It also assumes all beginning WIP are transferred out first (i.e. FIFO is first-in, first-out). This means that the ending WIP is what was started in the current month.

Under FIFO, the approach would be:

  • Step 1: If we started 200k units this period, and transferred out 160k units, with 90k units left in ending inventory, this means we had beginning inventory of 50k units (160k units transferred out + 90k units in ending inventory – 200k started this period). This also means 250k units were worked on during this period (160k units transferred out + 90k units in ending inventory). Because 100% of materials are used at the beginning of the process in FIFO, 0% of materials need to be added to complete the beginning inventory. For conversion costs, only 70% is added at the beginning, which means 30% is needed to complete beginning inventory. Think of this as what you have left to do, or what is left to complete the inventory.
  • Step 2: Now we need to determine the units started and completed. This means that these units are 100% completed with respect to conversion and material costs. If we started with 50k units in beginning inventory, these units would have been transferred out first as part of FIFO. Since we transferred out 160k units, this would leave 110k units that were started and transferred out in addition to the beginning inventory.
  • Step 3: For ending inventory, you will take the ending inventory units, and multiply them by their corresponding percentage of completion. This will become your beginning inventory for the next period.

For total EU, this is the sum of the beginning inventory, the units started and completed, and the units still in the ending inventory. The answer is 200K EU for materials, and 143K for CC.

We format our answer in CPA Canada exams like this:

Solving under WA:

Weighted average takes the units completed during the period and adds it to your ending WIP.

  • Step 1: Identify the units completed (transferred out) – Units being transferred out are transferred with both material and conversion costs. This would be 160,000 for both.
  • Step 2: Identify the ending WIP – For materials, there is 100% completion, and with 90,000 units in ending inventory, this would be 90,000 units for materials. However, there is still work to be done on these units, as conversion costs are only 20% complete. Using the WA method, we don’t specifically know which units are complete, so the 20% will be applied to the full 90,000 units.

For total equivalent units, this is the sum of the units transferred out, with your ending inventory. The answer would be 250K EU for materials, and 178K for CC.

We format our answer in CPA Canada exams like this:

Conclusion

Both FIFO and WA methods calculate equivalent units to determine the total units of production. The specific calculation differs in terms of how ending work in process inventory is treated: FIFO focuses on the partially completed units in ending WIP inventory separately, while the WA method combines all units completed and in process to calculate an average cost per equivalent unit.

Extra resources

Extra resources are available in Gevorg’s CPA review programs.