MATERIALS

HOW DO THE MATERIALS ARE PURCHASED

1. THE STORES DEPARTMENT WOULD FIRST REQUEST THE MATERIALS USING A PURCHASE REQUISITION FORM
2. THE PURCHASING DEPARTMENT WOULD THEN SOURCE A SUITABLE SUPPLIER FOR THE MATERIALS
3. THE PURCHASING TEAM WOULD THEN ORDER THE GOODS FROM THE EXTERNAL SUPPLIER USING A PURCHASE ORDER
4. ONCE THE WAREHOUSE HAS RECEIVED THE GOODS, THEY WILL CONFIRM DELIVERY OF GOODS RECEIVED.
5. FINALLY , THE FINANCE TEAM WOULD PROCESS THE PAYMENT FOR THE MATERIALS USING AN INVOICE .

MATERIAL INVENTORY ACCOUNT

Material is an asset which is debited to the material inventory account.

Any transactions that

 increase the asset’s value are debited to the inventory account,
 decrease the asset’s value are credited to the inventory account.

Opening inventory is a debit balance in the materials control account.

MATERIAL CONTROL ACCOUNT

Movements of materials (buying materials, moving them from stores to produc on or back from produc on to stores) are
recorded in the materials control account

JE FOR THE MATERIALS

 INVENTORY CONTROL
Inventory is one of the highest costs for many organisations. Any organisation with inventory will
undertake checks to ensure that the items they think are in their stores are there. It also allows staff to
check if there has been any damage to the inventory.

Inventory control is managing the

o amount of each item and
o knowing where it is.
o recording inventory received and issued and
o iden fying any damage or obsolescence.
STOCK TAKING
Stocktaking is one way in which organisa ons check inventory. It involves physically coun ng
the materials held and checking the figures against records detailing how many materials the
organisa on should have.
There are two methods of stocktaking:
Periodic: Materials in the inventory are counted once a year.
Con nuous: Materials are checked regularly throughout the year

• When materials are received in a company’s

RECORDING warehouse, they will be stored until the production
OF department needs them. The inventory for
different materials will be recorded on ledgers
INVENTORY within the computerised accounting system

Inventory Discrepancies
Any difference between book inventory (the stores ledger) and monitoring inventory (a
physical stocktake) should be inves gated.
A company must also ensure that it has adequate controls in place to minimise differences
between physical inventory counts and book inventory. These differences are known as
discrepancies.
Inventory checks may reveal discrepancies between how much of an item is in inventory and
the amount shown in the inventory records.

Reason for discrepancy Control

The quantity of goods delivered differs from what is All inventory should be counted as it is
shown on the delivery note. received and signed off.

The actual quantity of inventory issued to production Inventory issued to production should be
differs from that shown in the records. carefully counted and signed off.

Production returned excess inventory without any All movements of inventory should be
documentation. recorded.

Security mechanisms and regular inventory

Theft of inventory by employees. checks will prevent this.

Inventory is damaged or obsolete and thrown away Damaged or obsolete items should be
without being documented. recorded
 FIFO AND LIFO

FIFO assumes that the inventory purchased LIFO assumes that the inventory purchased
first is sold first. first is sold last.
Materials in stock at the end of a period are Materials in stock at the end of a period are
valued using the most recent prices paid to valued using the oldest unit prices paid to
suppliers. suppliers.

FIFO LIFO

Goods sold Oldest first Newest first

Closing
inventory valued
at Latest prices Oldest price
PRACTICE QUESTION

Compute the value of issues and closing inventory for May using FIFO and LIFO.
Weighted Average Methods (CWA and PWA)
CWA PRACTICE QUESTION
PWA PRACTICE QUESTION

Step 1: CALCULATE THE PWA PRICE PER UNIT

(Divide the sum of Total value of receipts and opening balance with their respec ve units)

Step 2: CALCULATE THE VALUE OF THE CLOSING INVENTORY

(PWA price per unit mul plied by CL inventory voices)
Step 3: CALCULATE THE VALUE OF ISSUES
(PWA price per unit mul plied with the units of issues)
 MAnAgIng InvEnToRy
Inventory Costs and Control
Inventory Costs
Companies hold stock to ensure sufficient supply to meet customer demand and prevent
produc on delays. They will need to manage the costs of inventory.

Inventory cost Description

The price paid for inventory.

Includes the price paid and any applicable taxes and charges.

Total purchase cost for the period = Units purchased in the period × Unit
purchase price
Purchase cost

Costs incurred for ordering inventory

Includes transport and administration costs.

Ordering cost for the period = Number of orders in period ×Cost per order
Ordering cost

Costs incurred for holding inventory.

Includes storage, finance costs, security, insurance, obsolescence, deterioration,
spoilage, theft, etc

Holding cost for the period = Average inventory held for the period × holding cost
per unit for the period
Holding cost

Costs are incurred if inventory is unavailable.

Includes price premiums for emergency supplies, lost sales revenue, and incentives
to retain dissatisfied customers.
Stockout cost
Obsolescence
Reduction in inventory value due to it becoming irrelevant to the organisation’s needs.
Eg: Holding stocks of tech products for extended periods, as they are eventually surpassed by new tech and
become less valuable.

Deteriora on
Reduction in inventory value due to degradation in its qualities.
Eg: fresh produce degrades rapidly after harvesting and would be unusable after a few days unless kept
fresh with refrigeration or further processing.

Obsolete and deteriorating inventory would eventually be discarded and written off

PRACTICE QUESTION

Computer Co uses 20,000 units of computer parts each year, and each unit costs $20. It
orders 5,000 units every time it places an order, and it costs $1,400 to place an order.
Computer Co holds an average level of inventory of 2,500 units. The holding cost is 10% of
the value of the average inventory held.
Calculate Computer Co’s costs of total inventory cost for the year, including
purchase, holding, and ordering costs

 Purchase costs for the year

Total purchase cost = total units purchased × Purchase price
Total purchase cost = 20,000 × $20
Total purchase cost = $400,000

 Holding cost
Holding cost = 10% × value of the average inventory held
Average inventory held = 2,500
Value of average inventory held = 2,500 × $20 = $50,000
Holding cost = 10% × $50,000 = $5,000
It costs Computer Co $5,000 to hold the stock of computer parts for a year.

 Ordering cost
Number of orders in a year = Demand / Order quantity
Number of orders in a year = 20,000 / 5,000 = 4 orders in a year
Computer Co will place 4 orders in a year, and each order will cost $1,400 per order.
Total ordering costs for the year = 4 × $1,400 = $5,600

 Total inventory costs for the year

Total purchase costs for the year = $400,000
Total ordering costs for the year = $5,600
Total holding costs for the year = $5,000
Total inventory costs for the year = $ (5,600 + 5,000 + 400,000) = $410,600
Buffer inventory
Buffer inventory is the minimum amount of inventory an organisa on should hold in stock to deal with an
unexpected rise in the demand for its products. Hence, it is some mes called safety stock or safety
inventory.

Just-in-Time
Holding inventory incurs expenses. It must be stored, financed, secured, and kept in good condi on.
Ordering 'just-in- me' (only when produc on is ready to use the materials) minimises inventory holding
costs.
• Produc on should only make as many units as can be sold.
• There will be no inventory of raw materials or finished goods.
• Smaller, more frequent deliveries are required at short no ce.
• A few dedicated suppliers deliver defect-free components just
in me when the parts are demanded on the produc on line.
However, this increases the risk of “stock-out”, where no inventory is available for produc on or sales.
To mitigate this risk, companies build robust, integrated relationships with their suppliers or diversify their
sources of supply.

Order Size
For example, it is often cheaper for organisations to buy materials in bulk (suppliers may offer a discount
on large orders). However, this can make holding costs more expensive, as there are more goods to store,
and they could become damaged or obsolete over time.
Stockout Costs
Another problem is the potential cost of running out of materials. If an organisation holds too much
inventory, it will have higher holding costs than it needs to. On the other hand, if it maintains too little
inventory, there is a risk of running out, known as a stockout.
Stockout costs include:
 Loss of sales during the stockout period
 Loss of reputation
 Customers switching to competitor products and continuing to buy from competitors in the future
 Cost of production stoppages (machinery and workers are idle)
 Extra ordering costs for urgent orders.

Balancing Inventory Costs

Balancing inventory costs is part of inventory control, which involves:
 Holding the right amount of inventory
 Valuing inventory issued and remaining
 Ordering goods
 Receiving and storing goods.

InvEnToRy ConTRoL: REoRdER LEvEL

 Organisations must pick an optimum amount of inventory to hold that minimises their overall cost.
 Maintaining an optimum inventory level minimises costs

Lead me – The wai ng me to receive goods a er placing an order.

Reorder Level Reord
 The inventory level held at which the company should place an order to minimise inventory
holding costs and stockout risk.
 When the reorder level is reached, it signals that it is me for a company to place a new order
with its suppliers.
 When an order is placed, there will be a gap between when the order is placed and when it is
delivered; this me gap is known as the lead me.
Reorder level

Re-order level = Maximum usage × Maximum lead time

The following data relate to Material P, which is held in the stores of LBR Co.
 Minimum daily usage 450 units
 Maximum daily usage 800 units
 Minimum lead time 5 days
 Maximum lead time 10 days.
Daily demand for Material P is constant.
Calculate the reorder level for Material P.

Answer:

Reorder level = maximum usage × maximum lead time

Reorder level = 800 × 10 = 8,000 units

Inventory Control: Other Control Levels

The reorder level may be used to calculate some other control levels for inventory.

Maximum Inventory level

Inventory held above this level is incurring excessive holding costs.

Maximum inventory level = reorder level + reorder quantity − (minimum usage × minimum lead time)

Average inventory level

The level of inventory is somewhere between the maximum and minimum inventory levels.

Average inventory level = buffer inventory + (order quantity / 2)

Minimum inventory level

There is a severe risk of stockout if the amount of inventory held is below this level.

Minimum inventory level = reorder level − (average usage × average lead time)
PRACTICE QUESTION FOR INVENTORY CONTROL LEVEL
The following information is available for a decorative component used in a cabinet design at Furniture Co:

Average usage 1,000 per day

Minimum usage 800 per day

Maximum usage 1,300 per day

Lead time for replenishment 5 to 15 days

Reorder quantity 20,000 units

Reorder Level
The level of inventory at which more should be ordered. This is to ensure there is enough inventory to supply
maximum production.

Reorder level = Maximum usage × Maximum lead time

Reorder level
= 1,300 × 15
= 19,500

Minimum Level
The inventory level indicates a high risk of stockout. Often used as the buffer inventory level.

Minimum Level = Reorder level − (average usage × average lead time)

Minimum level
= 19,500 − (1,000 × 10)
= 9,500

Maximum Level
The maximum level warns that inventory holding is too high and more expensive than necessary.

Maximum level = Reorder level + Reorder quantity − (Minimum usage × Minimum lead time)

Maximum level
= 19,500 + 20,000 − (800 × 5)
= 35,500

Average Level
The inventory level is midway between minimum and maximum levels.

Average level = Minimum level + (reorder quantity / 2)

Average level
= 9.500 + (20,000 / 2)
= 9,500 + 10,000
= 19,500
1. Reorder level
= Maximum usage × Maximum lead time
= 280 × 10
= 2,800

2. Minimum Level
= Reorder level − (average usage × average lead time)
= 2,800 − (200 × 9)
= 1,000

3. Maximum level
= Reorder level + Reorder quantity − (Minimum usage × Minimum lead time)
= 2,800 + 3,000 − (150 × 8)
= 4,600

4. Average level
= Minimum level + (reorder quantity / 2)
= 1,000 + (3,000 / 2)
= 1,000 + 1,500
= 2,500
There is a balance between the costs and benefits of ordering large amounts of inventory and
holding inventory:
 Inventory holding costs rise as the level of inventory rises, so
ordering smaller amounts from suppliers each me will reduce
holding costs
 Ordering costs rise as the number of orders rises, so placing fewer
but larger orders would reduce order costs

When annual demand is 10,000 and when we order a batch of 50, it will takes 200 no of orders. So rather
than ordering batch of 50 when we order a batch of 250 it will only take 40 no of orders, Hence the
ordering cost decreases as the no of orders reduces
Same as holding few units incurs less holding cost and as the level of inventory increases the holding cost
also increases.

Economic order theory finds the optimal balance between ordering costs (which increase with more
orders) and holding costs (which increase when more inventory is held due to large order sizes).
The Economic Order Quantity (EOQ) is the level of stock that minimises the total inventory holding
costs and ordering costs.
The EOQ can be estimated using a graph that shows the holding costs, ordering costs and total costs at
different activity levels. The estimated EOQ is the point at which the holding and ordering costs are equal.
Variable Description

CH Cost of holding one unit of inventory for one time period

Co Cost of placing one order

D Demand during period

PRACTICE QUESTION
Q1

Co = Cost of ordering = $50

D = Number of units demanded each year = 10,000
Ch = Cost of holding one unit of product for one year = 100

EOQ = 100

Q2 A car manufacturer sells 75,000 cars a year. Each vehicle needs five tyres. The cost of placing
one order for tyres is $10. The cost of holding a tyre in inventory for one year is $25.
What is the EOQ?

Q3 A manufacturing company has an EOQ of 1,000 for Component A. It uses 15,000 of these
components a year. The minimum inventory level is 4,000. The cost of holding one component
in inventory for a year is $0.60.
What is the total cost of holding inventory for the component for a year?

Q4 A company uses 65,000 units of raw material each year. It places orders in batches of 1,500,
which is its EOQ. The minimum inventory level is 2,000. The cost of holding one unit in inventory
for a year is $0.25.
What is the total cost of holding inventory for the component for a year?

Key Point

It’s crucial to ensure the period is consistent.

If the holding cost is expressed for a year, then demand should also be for a year
Economic Order Quantity with Discounts
Sometimes a supplier may offer an organisational discounts on the materials it buys based on the quantity
it orders.
Accepting a supplier’s discount will affect the purchase price of material and the ordering and holding
costs.
 The unit cost of purchasing materials from suppliers will fall
 The total cost of placing orders will also fall, assuming the size of each order increases
 The cost of holding materials will rise as the average inventory levels rise.

Steps to Approach
STEP 1: Calculate total inventory costs using EOQ
STEP 2: Calculate total inventory costs using discounted order quan ty
STEP 3: Compare total inventory costs of EOQ and discounted order quan ty

CONCLUTIONS:

 If EOQ costs > discounted order quan ty costs, it is cost-effec ve to accept the
discount offered by the supplier.
 If EOQ costs < discounted order quan ty costs, it is cost-effec ve to order using EOQ

Example
Glass Co uses sand in its production process at a rate of 200,000 units per year. Its supplier, Sand Co,
has offered a discount of 5% if the company buys their sand in batches of 500 units at a time. The
company has accepted the discount. Each unit of sand costs $40 before the discount.
It costs $5 to hold one unit of sand for a year and $200 to place an order for sand.
Calculate the total inventory cost for the year of taking up the discount.

Answer:
 Total purchase costs
200,000 × 0.95 × $40 = $7,600,000 per year
The 0.95 value calculates the purchase costs with a 5% discount (100% − 5% = 95% = 0.95).

 Total holding costs

Average inventory level = 500/2 = 250 units.
Total holding costs = 250 × $5 = $1,250 per year

 Total ordering costs

Number of orders = 200,000/500 = 400 a year
total cost of orders = 400 × $200 = $80,000 per year

 Total inventory costs

The total inventory cost for the year is $(7,600,000 + $1,250 + $80,000) = $7,681,250
 Economic Batch Quantity
Batch costing involves producing a specific quantity of a product at
a time (batches). Companies that use batch costing will use
Economic Batch Quantity (or EBQ) calculations to decide how
many items should be produced in each batch.

When a batch is produced, it usually requires a machine to be set up for that production batch.
This is called a MACHINE SET-UP COST. Therefore, the more batches produced, the higher the
machine set-up costs.
The number of items in a batch will also affect holding costs.
o Larger batch sizes will produce more items that must be held in stores. Holding
costs will therefore be higher with larger batch sizes.

o Smaller batch sizes will produce fewer items that require storage space before being
sold. This results in lower average stock levels and lower holding costs

Economic Batch Quantity =

EBQ = Size of batch

Co = Cost of setting up a batch production run
D = Number of units to be produced for the period
Ch = Cost of holding one unit of product for the period
R = Production rate for the period

Example
Glass Co produces glass in batches. Production is at a rate of 1,000 units each week, and the
factory is open for 50 weeks a year. The weekly demand for glass is 800 units. Setting up the
machine for a production run costs $4,500 for each batch. The cost of holding one unit of glass in
stock for one year is $15.
Calculate the economic batch quantity for Glass Co.

Answer:
Co = $4,500
D = Annual demand rate = weekly demand rate × number of weeks
D= 800 × 50 = 40,000
Ch is the cost of holding one unit of glass for one year, which is $15 (this is the same as in the EOQ
model)
Ch = $15
R = Annual production rate = weekly production rate × number of weeks
R = 1,000 × 50 = 50,000
R = 50,000
Applying the EBQ formula;
EBQ = 10,954

Example

EOQ and EBQ compared

With the EOQ, there is an immediate re-stocking of inventory.

However, with the EBQ, inventory is re-stocked gradually each time a batch is produced.
The main things to note about the EBQ equation are:
 Co is the cost of setting up a machine for a batch run (compare this to the cost of placing an
order in the EOQ formula)

 A figure for ‘R’ must be calculated if it is not given. ‘R’ is the annual production rate and is not in
the EOQ equation.

Summary
 Companies hold stock to ensure sufficient supply to meet customer demand and prevent
production delays. They will need to manage the costs of inventory.

o Purchase cost
o Ordering cost
o Holding cost

 Another problem is the potential cost of running out of materials. If an organisation holds too
much inventory, it will have higher holding costs than it needs to. On the other hand, if it
maintains too little inventory, there is a risk of running out, known as a stockout.
 When the reorder level is reached, it signals that it is time for a company to place a new order
with its suppliers.

 The Economic Order Quantity (EOQ) is the level of stock that minimises the total inventory
holding costs and ordering costs.

 Compare total inventory costs for EOQ and the discounted order quantity:
o If EOQ costs > discounted order quantity costs, it is cost-effective to accept the
discount offered by the supplier.
o If EOQ costs < discounted order quantity costs, it is cost-effective to order using EOQ.

 Batch costing involves producing a specific quantity of a product at a time (batches). Companies
that use batch costing will use Economic Batch Quantity (or EBQ) calculations to decide how
many items should be produced in each batch.