Topic 4
Topic 4
OBJECTIVES
After studying this chapter, students should understand the following:
• The organization of the materials function
• Procurement procedures and the custody of materials
• Pricing of material issues (FIFO; WAC; FIFO ETC)
• Materials management methods
• The principles and application of the Economic Order Quantity (EOQ)
• Accounting for material costs – control accounts
COST ACCOUNTING FOR MATERIALS
The organisation of the materials function
1. Importance of Store-Keeping
• The cost of materials is one of the largest elements of cost. Proper storing
of materials is very important to prevent losses from damage, pilferage
and deterioration in quality of materials.
• The stores must, therefore, be properly organised and equipped for the
handling of raw materials.
• Ideal stock levels must be maintained for every item of raw material so
that the production departments get their required quantity of materials
in time, and excessive working capital is not unnecessarily locked up in
overstocking.
• Overstocking enhances the cost of production and hence should be
avoided. However, the store department should be under the control of a
technically qualified Store Officer.
COST ACCOUNTING FOR MATERIALS
2. Functions of a Store-Keeper:
• The Store keeper is a responsible person and should be placed in a high
position in the management hierarchy since he has to control the stores
from every point of view. He is expected to help the cost department for
its effective functioning.
• His duties and responsibilities are:
a) To receive the materials from receiving department.
b) To maintain proper records of stores.
c) To make arrangement for proper storage of materials and finished
goods.
d) To issue materials to production departments against proper and
authorised requisition.
COST ACCOUNTING FOR MATERIALS
His duties and responsibilities cont.
e) To keep an eye on different stock levels and issue purchase
requisition to the purchase department in time.
f) To report on waste, scrap and obsolete stock.
g) To prevent unauthorized persons from entering the stores.
h) Periodic comparison of physical stocks and book figures and to
reconcile the discrepancies, if any.
i) To keep stores clean, tidy.
j) To make suitable arrangement for maintenance and preservation of
the materials during storage.
COST ACCOUNTING FOR MATERIALS
Store-keeping includes the following activities:
1. Efficient and speedy issue of materials and tools to production
departments which is absolutely necessary for increased production.
2. Receipt of materials from goods reception and from production
departments.
3. Organising storage in logical sequences so as to ensure that all items can
be identified precisely and storage space is used economically and
effectively.
4. Organising stock checks either on a continuous or a periodic basis so as
to be able to provide accurate stock figures when required.
5. Protecting materials from damage and deterioration.
6. Securing the stores from pilfering, theft and fire.
COST ACCOUNTING FOR MATERIALS
Organisation of Stores:
In a large organisation the management is faced with the problem of
adopting the type of organisation of store:
Types of Stores:
a) Central Store.
b) Central Store with sub-stores.
c) Independent stores situated in various departments.
d) Central store indicates centralised buying and handling of stores.
COST ACCOUNTING FOR MATERIALS
Advantages of Stores:
a) It is economical because there is economy in floor space, office
overheads, stationery etc.
b) It ensures better control and supervision because of availability of
specialised knowledge and experience of stores staff.
c) Better lay-out is possible.
d) It facilitates inventory checks.
e) The amount of capital invested in stock is minimised.
f) Since all stores are located in one place, it becomes convenient to
control the physical stock balances more effectively.
COST ACCOUNTING FOR MATERIALS
Disadvantages:
a) It takes time to deliver materials to production departments if store
is situated at some distance from many departments. So it causes
inconvenience and delay.
b) There is a greater risk of loss by fire because of concentration of all
types of materials in one place.
c) There is increased transportation cost.
d) Breakdowns in transport in central store may cause production
stoppage leading to increased cost.
COST ACCOUNTING FOR MATERIALS
Procurement procedures and the custody of materials
Ordering and receiving materials
• Every movement of a material in a business should be documented
using the following as appropriate: purchase requisition; purchase
order; GRN; materials requisition note; materials transfer note and
materials returned note.
COST ACCOUNTING FOR MATERIALS
1. Purchase requisition
• The stores department issues a purchase requisition which is sent to
the purchasing department, authorising the department to order
further inventory.
• An example of a purchase requisition is shown below.
COST ACCOUNTING FOR MATERIALS
2. Purchase order
• The purchasing department draws up a purchase order which is sent to the
supplier. (The supplier may be asked to return an acknowledgement copy as
confirmation of their acceptance of the order.)
• Copies of the purchase order must be sent to the accounts department and the
storekeeper (or receiving department).
COST ACCOUNTING FOR MATERIALS
3. Quotations
• The purchasing department may have to obtain a number of
quotations if either a new inventory line is required, the existing
supplier's costs are too high or the existing supplier no longer stocks
the goods needed.
• Trade discounts (reduction in the price per unit given to some
customers) should be negotiated where possible.
COST ACCOUNTING FOR MATERIALS
4. Delivery note
• The supplier delivers the consignment of materials, and the
storekeeper signs a delivery note for the carrier.
• The packages must then be checked against the copy of the purchase
order to ensure that the supplier has delivered the types and
quantities of materials which were ordered. (Discrepancies would be
referred to the purchasing department.)
COST ACCOUNTING FOR MATERIALS
5. Goods received note (GRNs)
• If the delivery is acceptable, the storekeeper prepares a goods received note
(GRN), an example of which is shown below.
2. Holding costs
• If inventories are too high, holding costs will be incurred
unnecessarily. Such costs occur for a number of reasons.
• Costs of storage and stores operations
• Interest charges
• Insurance costs
• Risk of obsolescence
• Deterioration
COST ACCOUNTING FOR MATERIALS
3. Costs of obtaining inventory
• Clerical and administrative costs
• Transport costs
• Production run costs
4. Stockout costs
• The are costs of running out of inventory
COST ACCOUNTING FOR MATERIALS
Objective of inventory control
• The overall objective of inventory control is, therefore, to maintain
inventory levels so that the total of the following costs is minimised.
1. Holding costs
2. Stockout costs
3. Ordering costs
COST ACCOUNTING FOR MATERIALS
Inventory control levels
• Inventory control levels can be calculated in order to maintain
inventories at the optimum level. The three critical control levels are
reorder level, minimum level and maximum level.
1. Reorder level = maximum usage x maximum lead time.
2. Minimum level = reorder level–(average usage x average lead time)
3. Maximum level = reorder level + reorder quantity – (minimum
usage x minimum lead time)
4. Average inventory = safety inventory + ½ reorder quantity
COST ACCOUNTING FOR MATERIALS
Economic order quantity (EOQ)
• The economic order quantity (EOQ) is the order quantity which minimises
inventory costs. The EOQ can be calculated using a table, graph or formula.
• AC 207 students should be able to perform EOQ calculations and also that
you understand the overall purpose of the calculation, which is to minimise
overall inventory costs.
COST ACCOUNTING FOR MATERIALS
Economic batch quantity (EBQ)
• The economic batch quantity (EBQ) is a modification of the EOQ and
is used when resupply is gradual instead of instantaneous.
The above formula are not given in the exam so students should be
learnt buy heart.
COST ACCOUNTING FOR MATERIALS
Pricing of material issues
• The correct pricing of issues and valuation of inventory are of the
utmost importance because they have a direct effect on the
calculation of profit.
• Several different methods can be used in practice. (FIFO; WAC; FIFO
ETC)
COST ACCOUNTING FOR MATERIALS
1. FIFO assumes that materials are issued out of inventory in the order
in which they were delivered into inventory: issues are priced at the
cost of the earliest delivery remaining in inventory.
2. LIFO assumes that materials are issued out of inventory in the
reverse order to which they were delivered: the most recent
deliveries are issued before earlier ones, and issues are priced
accordingly.
3. AVCO calculates a weighted average price for all units in inventory.
Issues are priced at this average cost, and the balance of inventory
remaining would have the same unit valuation. The average price is
determined by dividing the total cost by the total number of units.
COST ACCOUNTING FOR MATERIALS
4.1 Example -First In First Out (FIFO)
Bike LTD purchased 10 bikes during January and sold 6 bikes, details of
which are as follows:
January 1 Purchased 5 bikes @ $50 each
January 5 Sold 2 bikes
January 10 Sold 1 bike
January 15 Purchased 5 bikes @ 70 each
January 25 Sold 3 bikes
As can be seen from above, the inventory cost under FIFO method relates
to the cost of the latest purchases, i.e. $70.
COST ACCOUNTING FOR MATERIALS
4.2 Example - Last In First Out (LIFO)
Date Purchase Issues Inventory
Units $/Units $ Total Units $/Units $ Total Units $/Units $ Total
Jan 1 5 50 250 5 50 250
Jan 5 2 50 100 3 50 150
Jan 10 1 50 50 2 50 100
Jan 15 5 70 350 5 70 350
Jan 15 7 450
Jan 25 3 70 210 2 50 100
2 70 140
4 240
As can be seen from above, LIFO method allocates cost on the basis of
earliest purchases first and only after inventory from earlier purchases
are issued completely is cost from subsequent purchases allocated
COST ACCOUNTING FOR MATERIALS
4.3 Example - Average Cost Method (AVCO)
Date Purchase Issues Inventory
Units $/Units $ Total Units $/Units $ Total Units $/Units $ Total
Jan 1 5 50 250 5 50 250
Jan 5 2 50 100 3 50 150
Jan 10 1 50 50 2 50 100
Jan 15 5 70 350 5 70 350
Average Cost of Inventory 7 64.286 450
Jan 25 3 64.286 192.858 4 64.286 257.144
As can be seen from above, AVCO method allocates cost on the average
cost of purchases during the period. Average cost of inventory changes
every time a purchase is made at a different price.
COST ACCOUNTING FOR MATERIALS
FIFO Valuation Method
Advantages of FIFO Valuation Method Disadvantages of FIFO Valuation Method
FIFO helps maintaining records of inventory in natural way i.e. It can get clumsy, complex and difficult to manage the
recording is done in the same order as units are bought or inventory and respective prices of each batch if entity
produced therefore much easier to understand and relate. places many order for goods that have fluctuating price.
Thus prone to more errors as well.
FIFO best fits the situation where entity holds inventory that has As cost of goods sold is based on the oldest inventory
fast turnover and converts quickly thus revenue and costs are from based on prices that may no longer relevant for analysis
related periods conducted after the end of the period
As ending inventory value is based on most recent purchases For costing decisions, the cost of sales value is not
therefore, value is much better reflection of market prices of similar reliable especially under inflationary economies.
product prevailing at period end date
Records each batch of inventory bought with respective cost thus The effect of inappropriate cost of sales figure is amplified
management can ascertain inventories issued and held in if entity buys inventory in the beginning of the period for
warehouse are from which batch. the whole period especially if prices fluctuate
significantly.
Widely accepted by regulatory authorities and standards including Matching principle requires the revenue and costs to be
IFRSs and GAAPs. IAS 2 accepts this method matched and reported in the same period
COST ACCOUNTING FOR MATERIALS
LIFO Valuation Method
Advantages of LIFO Valuation Method Disadvantages of LIFO Valuation Method
It is appropriate for matching cost and revenue. Inventory valuation does not reflect the current
prices and therefore are useless in the context
of current conditions.
Simple to operate and easy to understand. Due to variation of prices, comparison of cost of
similar job is not possible.
Facilitates complete recovery of material cost. Calculations become complicated and
cumbersome when rates of receipts are highly
fluctuating.
Most suitable when prices are rising. LIFO involves considerable clerical work.
COST ACCOUNTING FOR MATERIALS
AVCO Valuation Method
Advantages of AVCO Valuation Method Disadvantages of AVCO Valuation Method
It significantly simplifies calculation and record keeping and Cost of ending inventory determined under AVCO
can easily process even if entity has high frequency of method may be significantly different from the
inventory ordering prices prevailing for similar products at such date
It is ideal when it comes to goods that cannot be separated If entity is using cost plus pricing strategy to price
or it is impossible to distinguish one batch of goods from its products, then every time new purchase is
the other for example, earth produce like oil, wheat, iron made at a different rate than previous it will cause
ore e.t.c price to change as well.
AVCO is widely accepted method for inventory valuation Under AVCO method each batch loses its identity,
and it is also permitted under numerous accounting thus it may become hard to correctly value the
standards and guidelines e.g. IFRSs permit use of AVCO items where age of unit plays an important role
method.
Cost of sales calculation will be much more consistent and The average cost calculation often give cost per
less affected by prices changes under AVCO method as unit in long decimals that are rounded for record
compared to FIFO and LIFO purposes. The long decimals end up huge.
COST ACCOUNTING FOR MATERIALS