Unit 3

Costing and Control

of Materials
COSTING AND CONTROL OF
MATERIALS

Control of Materials

Cost of Inventory and

Costing methods

Just-in Time
Inventory/Production
Materials

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 Materials
Accounting for materials in a manufacturing
company usually involves two activities.
(1) Purchase of Materials (2) Storing and issue Accounting for Issue of
Materials

1. Purchase (i) Bin card (i) Periodic

Requisition -PR Inventory
System
(ii) Stores ledger
1. Purchase order -PO cards (ii) Perpetual
Inventory
System
2. Receiving (i) Material requisition
Materials-GRN note - MRN
(ii) Materials returned
report
1. Purchase Requisition

Purchase is initiated through a purchase requisition.

2. Purchase Order
After the requisition has been approved, the purchasing
department places order.
 3. Receiving of Materials

Quantities and condition on receipt of goods are noted by the

receiving department on a Receiving Report as shown
Storing and Issuance
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 Card
Bin card shows quantities of each type of material
received, issued and on hand.
Materials Requisition Note/Form

The issuance of materials is authorised by means of a materials

requisition form prepared by the production
manager/departmental supervisor.
Periodic 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
Opening Stock+ Purchases
= Materials available for use
– Closing stock (based on physical count)
= Cost of materials issued
Perpetual Inventory System

Perpetual inventory system shows both cost of

materials issued and ending materials
inventory directly.
Recording/Accounting for Material
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

Inventory Control Techniques

(i)
(i) ABC
ABC (ii)
(ii) Economic
Economic
Analysis
Analysis Order
Order Quantity
Quantity

(iii)
(iii) Reorder-
Reorder- (iv)
(iv) Safety
Safety Stock
Stock
Point
Point
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.
ABC Analysis
Problem 1: A firm uses 7 different items in
its inventory. The average number of each of
these items held, along with their unit cost ,
is listed below.
Item Nos. Avg. No. of Avg. Cost per
units in unit –Rs.
inventory
1 20,000 60.80

2 10,000 100.40

3 32,000 11.00

4 28,000 10.28

5 60,000 3.40

6 30,000 3.00

7 20,000 1.30
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.
Economic Ordering Quantity
Economic order of quantity
EOQ is the size of lot to be purchased which is economically viable.
Cost of managing the inventory is made up of two parts:-
1. Ordering Costs or Buying cost
2. Carrying costs
The ordering lot size which will minimize the Ordering cost as well as
carrying cost is EOQ
 EOQ=√(2AB/C)
Where , A = Annual consumption in rupees
 B =Buying cost or Cost of placing an order
C= Carrying cost of one unit
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?
Given,
Annual demand A=1600 units,
Buying cost B=Rs50 per order,
Carrying cost C= Rs1 per unit, per annum

EOQ = √ 2 AB/C

Where A = Annual usage of inventory in units,

B = Buying cost per order,
C = Carrying cost per unit per year.

√
2 × 1,600 × 50
EOQ = = 400 units.
1
Inventory Cost for Different Order Quantities
1. Size of order (units) 1,600 800 400 200 100

2. Number of orders 1 2 4 8 16

3. Cost per order Rs 50 Rs 50 Rs 50 Rs 50 Rs 50

4. Total ordering cost (2 × 50 100 200 400 800

3)
1 1 1 1 1
5. Carrying cost per unit
800 400 200 100 50
6. Average inventory (units)
800 400 200 100 50
7. Total carrying cost (5 × 6)
850 500 400 500 850
8. Total cost (4 + 7)
Working Notes
i. Number of orders = Total inventory requirement / Order size
ii. Average inventory = Order size / 2
Reorder Point
The 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 consumption × Lead time) + Safety stock.

Problem2: Annual demand for Product Alpha is 40000
units, cost of ordering is Rs200 per order and carrying
cost is Rs100 per unit per annum. The following data
with respect to ordering product alpha were given. Find
out EOQ and fix stock levels
Given,
Annual demand, A=40000 units
Buying cost, B= Rs200 per order
Carrying cost, C=Rs100 per unit per annum

EOQ=√(2AB/C)
=√(2x40000x200/100)
=√160000
=400 units
 Determination of stock level

Reorder level:
Reorder level
= Maximum Consumption x Maximum reorder period
=90x10=900 units
Maximum Level:
Maximum Level
= Reorder level + reorder quantity – (Minimum Consumption x Minimum
reorder period)
=900+400-(30x5)=1150
Determination of stock level

Minimum level:
Minimum stock Level
= Re order level – (Normal consumption x Normal reorder period)
= 900-(50x7)=550 units
Average stock level:
Average Stock level
= Minimum stock level + ½ of reorder quantity
=550+1/2(400)=750
Safety 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.
Calculate 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.
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).

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
Cost 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.”
Methods 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
FIFO Method
Method LIFO
LIFO Method
Method

Weighted
Weighted
Average
AverageMethod
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)
January
1 10,000 Rs 21 Rs 2,10,000
9 1,000 Rs 22.1 Rs 22,100 11,000 — 2,32,100
12 2,000 Rs 21 Rs 42,000 9,000 — 1,90,100
27 1,000 23.10 23,100 10,000 — 2,13,200
February
10 4,000 21 84,000 6,000 --- 1,29,200
16 2,000 24.10 48,200 8,000 — 1,77,400
March
3 2,000 24.10 48,200 10,000 — 2,25,600
17 4,000 21 84,000 6,000 — 1,41,600
29 4,000 22.90 91,600 10,000 — 2,33,200
April
4 2,000 21.40 42,800 12,000 — 2,76,000
18 4,000 @ 93,400 8,000 — 1,82,600
23 2,000 20.40 40,800 10,000 — 2,23,400
May
12 1,000 24.10 24,100 9,000 — 1,99,300
24 3,000 20.00 60,000 12,000 — 2,59,300
June
10 1,000 24.10 24,100 11,000 — 2,35,200
30 2,000 20.20 40,400 13,000 — 2,75,600
Total 19,000 4,17,200 16,000 3,51,600
@ 1,000 22.10 22,100
1,000 23.10 23,100
2,000 24.10 48,200
4,000 — 93,400
 FIFO 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.

Weighted Average 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.
 LIFO 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.

Other methods of inventory valuation

•Base stock method

•Replacement Price method
•Standard Price method
•Actual cost method
Implications of Different Inventory
Valuation Methods
The implication of different inventory costing method
is:
 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.
Just-In-Time Inventory
1. The term JIT refers to a management tool that helps
produce only the needed quantities at the needed time.
2. Just in time inventory control system involves the
purchase of materials in such a way that delivery of
purchased material is assured just before their use or
demand.
3. The philosophy of JlT control system implies that the firm
should maintain a minimum (zero level) of inventory and
rely on suppliers to provide materials just in time to meet
the requirements.
Just-IN Time

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.

However, it is more than an approach to inventory

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