Difference between FIFO and Average costing method under Process Costing System

The basic difference between the two methods concerns the treatment of opening work in process inventory. The averaging method adds opening work in process inventory costs to materials, labor, and factory overhead costs incurred during a period. Unit costs are determined by dividing these costs by equivalent production figures. Units and costs are transferred to the next department as one cumulative figure. The FIFO method retains opening work in process inventory cost as a separate figure. Costs necessary to complete the opening work in process units are added to this total cost. The sum of these two cost totals is the figure at which these units are transferred to the next department. Units started and finished during the period have their own unit cost which is usually different from the completed unit cost of units in process at the beginning of the period. Unfortunately, the true costs are averaged out in the next department, resulting in a loss of much of the value associated with the use of the FIFO method.

If the FIFO method is used, units lost during a period must be identified as to whether they came from units in process at the beginning or from units received during the period. Also, in computing equivalent production figures in FIFO costing, the degree of completion of both opening and closing work in process inventories must be considered. 

The disadvantage of FIFO costing is that if several unit cost figures are used at the same time, extensive detail is required within the cost of production report which can lead to complex procedures and even inaccuracy.

Whether the extra details yield more representative unit costs than the average costing method is debatable, especially in a firm using a process cost system where production is continuous and more or less uniform, and appreciable fluctuations in unit costs are not expected to develop. Under such conditions, the average costing method leads to more satisfactory cost computations.