© Costing and Control of Materials

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Costing and ControlCosting and Controlof Materialsof Materials


MaterialsMaterials

Materials are the basic input that are transformed into finished goods in the production process.

Materials costs based on relationship with finished goods, can be broken down into direct

and indirect costs.


Control of MaterialsControl of Materials

Accounting for materials in a manufacturing company usually involves two activities.

(1) Purchase of Materials (2) Issue of Materials

(i) Purchase

Requisition

(ii) Purchase order

(iii) Receiving Materials

(i) Periodic Inventory

System

(ii) Perpetual Inventory

System


1. Purchase Requisition

Purchase is initiated through a purchase requisition.

Total costApproved b y…………………………..

Total Unit priceDescriptionCatalogue numberQuantity

Department/Individual making request……………..

Order date …………. Delivery date requested……………..

NumberAvon Company Ltd

Purchase Requisition

Figure 1: Purchase Requisition


After the requisition has been approved, the purchasing department places order.

Order date…………………

Date delivery requested by………………

Payment terms………………..

Total costApproved b y…………………………..

Total Unit priceDescriptionCatalogue numberQuantity

Supplier………………….

Address……………………

Delivery terms……………….

NumberAvon Company Ltd

(full address)

Purchase Order

Figure 2: Purchase Order

2. Purchase Order


Quantities and condition on receipt of goods are noted by the receiving department on a Receiving Report as shown in Figure 3.

Approved signature…………

TotalUnit priceDescriptionCatalogue numberQuantity

Purchase order number……………

Date received……………..

Supplier ……………….

Number Avon Company Ltd

Receiving Report

Figure 3: Receiving Report

3. Receiving of Materials


Storing and IssuanceStoring and Issuance of Materials of Materials

The basic accounting records of any inventory system are the documents required to authorise and record materials movements in/out of the store, namely, stocks/stores/materials ledger cards, bin cards and materials requisition note.

Stock/Stores/Materials Ledger Cards

They show quantities on order, expected delivery dates and quantities reserved/required for work to be processed. They show the account number; description/type of material; location; unit measurement; minimum and maximum quantities to carry; details about the materials received; issued and balance.


Bin CardBin Card

Bin card shows quantities of each type of material received, issued and on hand.

quantityQuantity

Code number………….

Unit number ………..

Bin card ………….

ReferenceReference

Check Balance quantity

IssueReceivedDate

Stores ledger number…………

Date received…………………

Description ……………….

Avon Company Ltd

Bin Card

Figure 4: Bin Card


Materials Requisition Note/Form Materials Requisition Note/Form

Total Units costJob numberDescriptionQuantity

Approved by …………….

Date issued ………….

Issued to ……………

Date requested ……………..

Department requesting ……………

Requisition number………………..

Materials Requisition Form

Figure 5: Materials Requisition Note

The issuance of materials is authorised by means of a materials requisition form prepared by the production

manager/departmental supervisor.


Periodic Inventory SystemPeriodic Inventory System

Periodical inventory system involves physical count of materials on hand at periodical intervals to

arrive at the ending inventory.

Exhibit 1: Cost of Materials Issued

Materials inventory-opening

+ Purchases

= Materials available for use

– Materials inventory-closing (based on physical count)

= Cost of materials issued


Perpetual Inventory SystemPerpetual Inventory System

Perpetual inventory system shows both cost of materials issued and ending materials

inventory directly.


Recording/Accounting for Recording/Accounting for Material CostMaterial Cost

When a perpetual inventory system is used to account for materials inventory, a subsidiary ledger records

card is maintained.

Inventory Record Card

Item………. Description…………….

Received Issued Balance

Date Quantity Amount Date Quantity Amount Date Quantity Amount

Figure 6: Inventory Record Card


The use of perpetual inventory system also involves physical count of materials on hand, at least once a year, in order to check for

possible loss or shrinkage due to theft or spoilage.

If the physical count does not match with the balance in the inventory record cards, the book figures are adjusted upward/downward to

reflected the actual count.

Journal Entries: The purchase and issue of materials (direct as well indirect) are journalised as follows:

(i) When materials are purchased:

Direct Materials Inventory A/c Dr

To Cash/Accounts Payable (credit purchases)

Indirect Material Inventory A/c Dr

To Cash/Accounts Payable A/c (credit purchase)

(ii) Issue of direct materials for production:

Work-in-process Inventory A/c Dr

To Materials Inventory A/c

(iii) Issue of indirect materials for production:

Factory Overhead Control A/c Dr

To Materials Inventory A/c


Adjustment for Discrepancies Adjustment for Discrepancies

Physical count of materials under the perpetual inventory system may not tally with the inventory record cards (stores ledger). The discrepancy

may result from: (a) Unavoidable reasons (b) Avoidable reasons

(a) When book inventory is more than the physical inventory and the shortage is normal:

Factory Overheads Control A/c Dr

To Stores Ledger Control A/c

(b) When the shortage in physical inventory is due to non-recording of inventory shortage:

Work-in-process Control A/c Dr


In both the above situations, in the stores ledger, an entry for both quantity and value is recorded in the Issue Column and a reduction is made in the Balance Column.


(c) In case of inventory gain, that is, when the stores ledger balance is less than the physical inventory (inventory overages), reverse adjusting entries of (a) and (b) above are passed. In the stores ledger, an entry for quantity and value both is recorded in the Received Column and addition is made in the Balance Column.

(d) The above adjustments are made when the inventory shortage/overage is normal and is expected in the normal course of business operations. If the loss is abnormal/due to unusual circumstances such as fire, theft, sabotage, the proper treatment is to transfer it to costing profit and loss account:

Costing Profit and Loss A/c Dr


Abnormal loss is considered a non-manufacturing loss, and is taken as a period charge against income of the current accounting period.

(e) If the discrepancies are slight, the balance of the stores ledger may be accepted for inventory verification and accounting purposes. No adjustment is required in such a situation.


Inventory Control TechniquesInventory Control Techniques

(i) ABC Analysis

(i) ABC Analysis

(ii) Economic Order Quantity

(ii) Economic Order Quantity

(iii) Reorder-Point

(iii) Reorder-Point

(iv) Safety Stock(iv) Safety Stock


ABC Analysis

The first step in the inventory planning/control process is the classification of different types of inventory to determine

the type and degree of control required for each.

The ABC system is a widely-used classification technique for the purpose. On the basis of the cost involved, the various

items are classified into three categories:

(i) A, consisting of items with the largest investment.

(ii) C, with relatively small investments, but fairly large number of items.

(iii) B, which stands mid-way between category A and C.

Category A needs the most rigorous control, C requires minimum attention, and B deserves less attention than A but

more than C.


Economic Order Quantity (EOQ)

The second key inventory problem relates to determination of the size/quantity of inventory which would be acquired. This is

the order quantity problem.

Stated with reference to cost perspective, EOQ refers to the level of inventory at which the total cost of inventory comprising

(i) order/setup cost, and (ii) carrying costs is the minimum.

Carrying Costs are cost associated with the maintenance/holding of inventory.

Ordering Costs are costs associated with acquisition of/placing order for inventory.


Solution

Inventory Cost for Different Order Quantities

1. Size of order (units)

2. Number of orders

3. Cost per order

4. Total ordering cost (2 × 3)

5. Carrying cost per unit

6. Average inventory (units)

7. Total carrying cost (5 × 6)

8. Total cost (4 + 7)

1,600

1

Rs 50

50

1

800

800

850

800

2

Rs 50

100

1

400

400

500

400

4

Rs 50

200

1

200

200

400

200

8

Rs 50

400

1

100

100

500

100

16

Rs 50

800

1

50

50

850

Example 1

A firm’s inventory planning period is one year. Its inventory requirement for this period is 1,600 units. Assume that its acquisition costs are Rs 50 per order. The carrying costs are expected to be Re 1 per unit per year for an item.

The firm can procure inventories in various lots as follows: (i) 1,600 units, (ii) 800 units, (iii) 400 units, (iv) 200 units, and (v) 100 units. Which of these order quantities is the economic order quantity?

Working Notes

(i) Number of orders = Total inventory requirement/ Order size, (ii) Average inventory = Order size/2


Mathematical (Short-cut) Approach

The economic order quantity can, using a short-cut method, be calculated by the following equation:

EOQ = 2 AB/C

Where A = Annual usage of inventory in units,

B = Buying cost per order,

C = Carrying cost per unit per year.

√

Using the facts in Example 1, find out the EOQ by applying the short-cut mathematical approach.

EOQ =2 × 1,600 × 50

= 400 units.1√


Reorder PointReorder PointThe re-order point is that level of inventory when a fresh order

should be placed with suppliers. It is that inventory level which is

equal to the consumption during the lead time or procurement time.

Re-order level = (Daily usage × Lead time) + Safety stock.

Minimum level = Re-order level – (Normal usage × Average delivery

time).

Maximum level = Reorder level – (Minimum usage × Maximum delivery

time) + Re-order quantity.

Average stock level = Minimum level + (Re-order quantity)/2.

Danger level = (Average consumption per day × Lead time in days for

emergency purchases).


Safety StockSafety Stock

The safety stock are the minimum additional inventory which serve as a safety margin to meet an unanticipated

increase in usage.

The first step is to estimate the probability of being out of stock, as well as the size of stock-out.

Stock-out costs are costs associated with the shortage (stock-out) of inventory.

After the determination of the size and probability of stock-out, the next step is the calculation of the stock-out cost.

Then, the carrying cost should be calculated.

Finally, the carrying costs and the expected stock-out costs at each safety level should be added.

The optimum safety stock would be that level of inventory at which the total of these two costs is the lowest.


Un

its

of

inve

nto

ry

Stock outs

X

Y

Figure: 7

Average inventory

Lead time (4 days) Safety stock)

0

Safety stock usage during lead time delay

Reorder point (ROP)

Replenishment point

Maximum inventory level

Usage Rage

(slope)

2 4 6 8 10 12 14 16

320

240

200160

80

0

600

560

480

400

Days

Usage Rage

(slope)

With the withdrawal of raw material inventory from the store at the rate of 40 units per day, the balance of inventory stock declines to 360 units after 6 days [600 units – (40 units x 6 days)]. This level is the reorder point. If delivery is on time, the next replenishment point is reached at Day 10. On the 10th day the company has a maximum level of stock of 600 units. If, however, inventory is not received in time, the company has a safety stock of five days to fall back upon.

Figure 7 has been drawn to show clearly the interrelationship that exists among various concepts of inventory discussed so far. It serves the useful purpose of presenting an integrated picture at one place.

In the Figure, inventory of 400 units is delivered on Day 0. The company has the policy of maintaining a safety stock of 200 units. With the receipt of 400 units inventory on Day 0, the inventory level reaches 600 units (the maximum level).


Cost of InventoryCost of Inventory

The cost of inventory may be said to be composed of two elements: (i)

Inventory quantities determined on the basis of either physical count or

perpetual inventory records and (ii) Unit cost.

In general, the basis of inventory valuation is the “lower of cost or market”

or more appropriately “the lower of actual cost or replacement cost.”

Although replacement costs can be estimated for interim periods, and

adjustments made later on to reflect the conditions at the close of the year,

the market value can be known with certainty only at the close of the

accounting period.

As regards the actual cost, there are several elements associated with it.

They are: (i) Invoice cost, (ii) Freight charges and costs of buying, receiving

and storing, and (iii) Discounts-trade/quantity as well as cash.


Methods of InventoryMethods of Inventory

The proper costing of inventory is important from the point of view of the income determination

and asset measurement. The important inventory costing methods are:

FIFO MethodFIFO MethodWeighted

Average Method Weighted

Average Method

LIFO MethodLIFO MethodInflated Cost

Method Inflated Cost

Method


The FIFO method assumes that the inventory is consumed in chronological order, that is, items received first are

deemed to have been issued/consumed first and priced accordingly.

FIFO Method

According to the Weighted Average Method, the weighted average price of purchases and inventory is taken as the

basis for determining the cost of the inventory.

Weighted Average Method


Table 1 Inventory Valuation (FIFO Method)

Date Receipts Issues Inventory

Quantity Cost Value Quantity Cost Value Quantity

Cost Value

(1) (2) (3) (4) (5) (6) (7) (8) (9)

January191227February1016March31729April41823May1224June1030Total

1,000

1,000

2,000

2,000

4,000

2,000

2,000

3,000

2,00019,000

Rs 2.21

2.31

2.41

2.41

2.29

2.14

2.04

2.00

2.022.19

Rs 2,210

2,310

4,820

4,820

9,160

4,280

4,080

6,000

4,04041,700

2,000

4,000

4,000

4,000

1,000

1,000

16,000

Rs 2.10

2.10

2.10

@

2.40

2.40

Rs 4,200

8,400

8,400

9,340

2,400

2,400

35,140

10,00011,000

9,00010,000

6,0008,000

10,0006,000

10,000

12,0008,000

10,000

9,00012,000

11,00013,000

Rs 2.10———

---—

———

———

——

——

Rs 21,00023,21019,01021,320

12,92017,740

22,56014,16023,320

27,60018,26022,340

19,94025,940

23,54027,580

@ 1,000 2.21 2,2101,000 2.31 2,3102,000 2.41 4,8204,000 — 9,340


Table 2 Inventory Valuation (Average Cost Method)

Date Receipt Issue Inventory

Quantity Cost* Value Quantity

Cost** Value Quantity Cost** Value

(1) (2) (3) (4) (5) (6) (7) (8) (9)

January191227February1016March31729April41823May1224June1030Total

1,000

1,000

2,000

2,000

4,000

2,000

2,000

3,000

2,00019,000

Rs 2.21

2.31

2.41

2.40

2.29

2.14

2.04

2.00

2.02

Rs 2,210

2,310

4,820

4,800

9,160

4,280

4,080

6,000

4,04041,700

2,000

4,000

4,000

4,000

1,000

1,000

16,000

Rs 2.11

2.13

2.24

2.24

2.20

2.15

Rs 4,220

8,520

8,960

8,960

2,200

2,150

35,010

10,00011,000

9,00010,000

6,0008,000

10,0006,000

10,000

12,0008,000

10,000

9,00012,000

11,00013,000

Rs 2.102.112.112.13

2.132.20

2.242.242.26

2.242.242.20

2.202.15

2.152.13

Rs 21,00023,21018,99021,300

12,78017,600

22,40013,44022,600

26,88017,92022,000

19,80025,800

23,65027,690

* Actual** Average


The Inflated Cost Method takes into account normal material losses caused due to transportation, material handling

and storage losses.

Inflated Cost Method

The LIFO method is based on the assumption that the cost of inventory is computed on the basis of the inverse sequence

of receipts.

LIFO Method


Table 3 Inventory Valuation (LIFO Method)

Quantity Cost Value

PART A

Straight LIFO:

Inventory (January 1)

Receipts

Total

Inventory (June 30)

Inventory (January 1)

Receipts (January 9)

(January 27)

(February 16)

Cost of inventory issued

10,000

1,000

1,000

1,000

13,000

10,000

19,000

29,000

13,000

—

—

—

—

_______

16,000

Rs 2.10

—

—

2.10

2.21

2.31

2.41

—

—

—

21,000

2,210

2,310

2,410

Rs 21,000

41,700

62,700

27,930

34,770


PART BAdditions at average cost: Inventory (January 1) Receipts Total Inventory (June 30) Inventory (January 1) Added Inventory


10,0003,000

13,000

10,00019,00029,00013,000

——

—16,000

2,102,19

2.102,19

21,0006,585

21,00041,70062,700

27,58535,115

PART CAdditional at FIFO cost: Inventory (January 1) Receipts TotalInventory (June 30) Inventory (January 1) Receipts (June 30) Receipts (May 24)


————

10,0002,0001,000

13,000

10,00019,00029,00013,000

————

16,000

2.10——

2.102.022.00—

21,0004,0402,000

—

21,00041,70062,700

27,04035,660

(Contd.)


Table 4 Inventory Valuation (LIFO Method—6 Years)

Quantity Rate Value

Opening inventory at cost—first year‘Closing inventory: First year—opening inventory First year’s additionsTotal Second year—first year’s opening First year’s additions Second year’s additionsTotal Third year—first year’s opening First year’s additionsTotal Fourth year—first year’s opening First year’s additions Fourth year’s additionsTotal Fifth year—remainder of first year’s opening Sixth year—remainder of first year’s opening Sixth year’s additionsTotal

10,000

10,0003,000

13,00010,0003,0002,000

15,00010,0002,000

12,00010,0002,0001,000

13,0009,0009,0001,000

10,000

Rs 2.10

2.102.31

—2.102.312.20

—2.102.31

—2.102.312.50

—2.102.102.60—

Rs 21,000

21,0006,930

27,93021,0006,9304,400

32,33021,0004,620

25,62021,0004,6202,500

28,12018,90018,9002,600

21,500


Implications of Different Inventory Implications of Different Inventory Valuation Methods Valuation Methods

When prices are stable, all inventory valuation methods give the same figure of cost,

When prices are rising, the LIFO produces the highest cost flow and the lowest inventory,

When prices are falling, the LIFO method produces the lowest cost and the highest inventory. The impact of FIFO is exactly opposite,

The LIFO and the FIFO methods are extremes and the weighted average method falls in between.

The implication of different inventory costing method is:


Table 5: Impact of Inventory Valuation on Cost Flows/Profits

LIFO with additions at

FIFO Average cost

LIFO Average FIFO

Beginning inventory

Rs 21,000 Rs 21,000 Rs 21,000 Rs 21,000 Rs 21,000

Add: Receipts 41,700 41,700 41,700 41,700 41,700

Total 62,700 62,700 62,700 62,700 62,700

Deduct: Ending inventory

27,560 27,690 27,930 27,585 27,040

Materials put into process

35,140 35,010 34,770 35,115 35,660

It is clear from the table that each method produces a different figure for the transfer of raw materials to work-in-process. Ultimately, when the goods are sold, the varying methods of inventory valuation will have their impact on cost of goods sold and, thus, on profits.


Just-IN TimeJust-IN Time

However, it is more than an approach to inventory

management. It is a philosophy of eliminating non-value-

added activities.

JIT, as an innovative manufacturing system, refers to

acquiring materials and manufacturing goods only as

needed to fill customer orders. Also called lean production

system, it is a demand-pull manufacturing system because

each component in a production line is produced as soon

as and only when needed by the next step in the production

line.


Financial Benefits

The benefits of JIT are in addition to lower carrying cost of

inventory, improved quality, reduced rework, faster

delivery and so on.

The measures of performance that managers use to evaluate

and control JIT are personal observations, financial,

and non-financial measures.

The effects of JIT on costing system are reduced overheads

and direct tracing of some indirect costs.

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© Costing and Control of Materials