Determining the cost of the units transferred out of a department and those remaining in ending inventory is essentially an allocation process. Because costs can change over time, a cost flow assumptions must be adopted. The common cost flow assumption used for work in process inventory is average costing and fifo costing.
Fifo costing will be used here for illustrative purposes. (The average cost flow assumption is illustrated in the appendix to this chapter.) Next, because units of product in the ending work in process inventories are not completed-at least with respect to some cost elements-them the number of equivalent units, rather than physical units, must be computed for each cost element. An equivalent unit is the amount of a resource (such as materials, labor, or overhead) that is required to complete one unit of product. For example, if three units of the product in ending inventory each had one-third of the materials required to complete the product, the total amount of materials used for the three units would be equal to the amount of materials required to complete one unit of product (3 physical units ×1/3 complete = 1 equivalent unit of materials). Because these units are hypothetical units rather than physical units, they are referred to as equivalent units.