CHAPTER 4: MATERIAL CONTROL I y y Material cost forms a significant part (approx.

60% to 65%) of the cost of the end product. Hence, this cost needs careful planning and control which ensures: y Continuous supply of raw materials for uninterrupted production y Desired quality is maintained at reasonable cost y Investment in inventory is at minimum level i.e. unnecessary blockage of funds is avoided.

Hence, the following are some key questions pertaining to materials management: I. II. III. IV. V. I. When to order? Various levels How much to order Economic Order Quantity How much to charge pricing of materials issue How to keep a check inventory control Material losses cause and treatment WHEN TO ORDER

Timing of the purchase is important in order to achieve objectives like avoiding overstocking, ensuring that the material is ordered at right time and also avoiding shortage of materials. a. Maximum Level : A level beyond which inventory is not allowed to rise. Purpose is to avoid overstocking. It is fixed like this: Reorder level+ Reorder Quantity period) (Minimum Consumption * Minimum re-order

b. Minimum Level: Inventory is not allowed to fall beyond this limit. Purpose is to avoid shortage of raw materials. It is calculated like this: Reordering level-(Average/Normal consumption * Normal Re-order period) c. Reorder Level: This level is fixed for deciding the time of placing an order. If the stock of materials reaches this level, fresh order is placed so that by the time the material is procured, the level of material may fall up to minimum level but not below that. This level is fixed in the following manner:

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Maximum consumption * Maximum re-order period OR Minimum level + Consumption during time lag period or lead time d. Average Level: (Maximum level + Minimum Level)/2 e. Danger Level: Generally this level is kept below the minimum stock level situations like stock-out. It is fixed like this: Re-order level (Average consumption * re-order period) in order to avoid panic

II.

HOW MUCH TO ORDER

There are costs attached to the ordering quantity. These costs are of two types, the first is the ordering cost and the other one is the carrying cost. Ordering cost is the cost of placing an order. These costs include costs like handling and transportation costs, stationery costs, costs incurred for inviting quotations and tenders etc. The more is the frequency of order, the more are these costs. On the other hand, there are certain costs that are called as carrying costs. The cost of carrying the inventory is the real out of pocket cost associated with having inventory on hand, such as warehouse charges, insurance, lighting, losses due to handling, spoilage, breakage etc, and another important component of carrying cost is the amount of interest lost due to the investment in the inventory. Carrying costs will go on increasing if the quantity of material in inventory goes on increasing. Both, the carrying costs and the ordering costs are variable costs, however their behavior is exactly opposite of each other. If orders are more frequent, ordering costs will go on increasing but as the material ordered will be in less quantity, the carrying costs will decrease. On the other hand, if number of orders are reduced, the quantity per order will increase and the carrying cost will increase. The ordering cost will come down due to reduction of number of orders. In this situation, the most desirable quantity to be ordered is that quantity at which both, the ordering costs and carrying costs will be at minimum. This quantity is called as Economic Order Quantity . This quantity can be calculated with the help of the following formula: EOQ = 2*A*O C Where,

A= Annual consumption units during the year

O= Cost of placing an order C = carrying cost per unit per annum III. HOW MUCH TO CHARGE? PRICING OF MATERIAL ISSUES

The following are the various methods which can help in determining the price of the material issued to the production department from stores department. There is a need for these methods as the same type of material may have been purchased in different lots, at different times, at different prices: 1. COST PRICE METHODS: a. Specified Price For pricing materials which can be identified with any specific job. Generally charged at actual purchase price. b. First-In-First-Out (FIFO) Based on the assumption that the material that was bought first will be used first in production. c. Last-In-first-Out (LIFO) Based on the assumption that the material that was bought last will be used first in production. d. Highest-In-First-Out (HIFO) Based on the assumption that the costliest material will be used first in production generally used in monopoly products or cost-plus contracts. e. Base Stock A certain minimum stock of a material is always maintained at original cost and the portion of stock above that minimum stock will be priced at any other suitable manner. 2. AVERAGE PRICE METHODS: a. Simple Average Average of prices ignoring quantities. b. Weighted Average Average of prices keeping in perspective the no, of units purchased/issued at that price. c. Periodic Simple Average Simple average for a specific period such as a month, a week etc & not every time the material is received.
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d. Periodic Weighted Average Weighted average for a specific period such as a month, a week etc & not every time the material is received.

e. Moving Simple Average Moving Simple average for more than one specific periods such as for 2 monts, 3 weeks etc. Calculated by dividing the total of periodic simple average of each such period by no. of such periods. f. Moving Weighted Average Moving Weighted average for more than one specific periods such as for 2 monts, 3 weeks etc. Calculated by dividing the total of periodic weighted average of each such period by no. of such periods.

3. NOTIONAL PRICE METHODS: a. Standard Price Price determined through a certain predetermined technical standard. Difference between standard and actual is transferred to the purchase price variance account. b. Inflated Price Includes carrying costs, losses due to evaporation etc. Aims to recover full costs of materials purchased. c. Market Price Priced at replacement price. It s the cost of the same type of materials in the market at any given time.

IV.

HOW TO KEEP A CHECK: METHODS OF INVENTORY CONTROL

Inventory Control: it is essential to take care of the material lying in the stock. Even though records are maintained in the stores regarding the receipts and issues, they should be periodically verified with the physical stock so that chances of errors and frauds are minimized. For inventory control, the following methods are used. A. Perpetual Inventory System: Perpetual Inventory system means continuous stock taking. Under this system, a continuous record of receipt and issue of materials is maintained by the stores department and the information about the stock of materials is always available. Entries in the Bin Card and the Stores Ledger are made after every receipt and issue and the balance is reconciled
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on regular basis with the physical stock. The main advantage of this system is that it avoids disruptions in the production caused by periodic stock taking. B. ABC System: In this technique, the items of inventory are classified according to the value of usage. Materials are classified as A, B and C according to their value. Items in class A constitute the most important class of inventories so far as the proportion in the total value of inventory is concerned. The A items constitute roughly about 5-10% of the total items while its value may be about 80% of the total value of the inventory. Items in class B constitute intermediate position. These items may be about 20-25% of the total items while the usage value may be about 15% of the total value. Items in class C are the most negligible in value, about 65-75% of the total quantity but the value may be about 5% of the total usage value of the inventory. The principle to be followed is that the high value items should be controlled more carefully while items having small value though large in numbers can be controlled periodically. C. Just in Time Inventory: This is the latest trend in inventory management. This principle envisages that there should not be any intermediate stage like storekeeping. Material purchased from supplier should directly go the assembly line, i.e. to the production department. There should not be any need of storing the material. The storing cost can be saved to a great extent by using this technique. The benefits of Just in time system are as follows: y Right quantities are purchased or produced at right time. y Cost effective production or operation of correct services is possible. y Inventory carrying costs are eliminated totally. y The stores function is eliminated and hence there is a considerable saving in the stores cost. y Losses due to breakage, wastage, pilferage etc are avoided. D. VED Analysis: This analysis divides items into three categories in the descending order of their criticality as follows. V stands for vital items and their stock analysis requires more attention. The reason is that if these items are not available, the resulting stock outs will cause heavy losses due to stoppage of production. Thus these items are required to be stored adequately to ensure smooth operation of the plant. E means essential items. Such items are considered essential for efficient running but without these items, the system will not fail. Care must be taken to see that they are always in stock.

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D stands for desirable items, which do not affect production immediately but availability of these items will lead to more efficiency and less fatigue. Thus VED analysis can be very useful to capital intensive process industries. As it analyses items based on their importance and it can be used for those special raw materials which are difficult to procure. E. FSND Analysis: Age of the inventory indicates the duration of inventory in the organization. It shows the moving position of inventory during the year. This analysis divides the items of inventory into four categories in the descending order of their usage rate as follows. y F stands for fast moving items and stocks of such items are consumed in a short span of time. Stock of fast moving items must be observed constantly and replenishment orders be placed in time to avoid stock out position. y N means normal moving items and such items are exhausted over a period of time, i.e. say one year. The order levels and quantities for such items should be on the basis of a new estimate of future demand to minimize the risks of a surplus stock. y S indicates slow moving items, existing stock of which would last for two years or so. These items must be reviewed carefully before eliminating them. y D stands for dead stock which means that there will not be any further demand for the same. It is necessary to identify these items and if there cannot be any alternative use for the same, should be eliminated.

V.

MATERIAL LOSSES

Material Losses: One of the main reason of rising material costs is the loss of material in the production process. It is of paramount importance that there should be rigid control over the material losses failing which it will be very difficult to keep the material costs in check. The material losses can be categorized as given below: 1. Waste: - Waste is a loss of material either in stores or in production due to reasons like evaporation, chemical reaction, shrinkage, unrecoverable residue etc. Wastages may be visible or invisible. In cost accounting, the wastage is divided into the following categories. Normal Wastage: - This wastage is such that it cannot be avoided. It is inherent in any production process. The normal wastage is normally estimated in advance and included in the material cost. In other words, the good units should bear the cost of normal wastage. Abnormal Wastage: - Any wastage over and above the normal wastage is the abnormal wastage. In other words it is more than the standard wastage. The cost of the abnormal wastage is not charged to the production, but it is written off to the Costing Profit and Loss Account. 2. Scrap: - Scrap is a residual material resulting from a manufacturing process. It has a recovery value and is measurable. The treatment of scrap in cost accounts is normally as per the following details:

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If the value of scrap is negligible, the good units should bear the cost of scrap and any income collected will be treated as other income. If the value of scrap is considerable and identifiable with the process or job, the cost of scrap will be transferred to job account and any realization from sale of such scrap will be credited to the job or process account and any unrecovered balance in the scrap account will be transferred to the Costing Profit and Loss Account. If scrap value is quite substantial and it is not identifiable with a particular job or process, the amount will be transferred to factory overhead account after deducting the selling cost. This will reduce the cost of production to the extent of the scrap value. 3.Spoilage:- Spoilage is the production that fails to meet quality or dimensional requirements and so much damaged in manufacturing operations that they are not capable of rectification and hence has to withdraw and sold off without further processing. Rectification can be done at a cost which may not be economic. If the spoilage is within limits, it is called as normal spoilage and anything exceeding this limit is called as abnormal spoilage. The accounting treatment of spoilage is as follows: The cost of normal spoilage is spread over to the good production by charging either to the specific production order or to the product overheads. The cost of abnormal spoilage is charged to the Costing Profit and Loss Account. 4. Defectives:- The defectives are part of production units which do not confirm to the standards of quality but can be rectified with additional application of materials, labor and/or processing and made it into saleable condition either as firsts or seconds depending upon the characteristics of the product. The accounting treatment of defectives is the same like that of spoilage. The cost of normal defectives is spread over the good units and the cost of additional processing is charged to a particular department/process if it is identifiable with the same. If it cannot be identified, it is charged to factory overheads. Cost of abnormal defectives is charged to the Costing Profit and Loss Account.

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