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Material Cost

Material Cost

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Published by Deepak Ehn
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Published by: Deepak Ehn on Mar 07, 2011
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ACCOUNTING
B 27
Study Note - 9
Material Cost
This Study Note includes
Introduction
Movement of Material
Material Cost
Perpetual Inventory & Physical Stock taking
Material Control and Inventory Control
Economic Ordering Quantity
Inventory levels
Inventory Turnover Ratios
ABC Analysis
Modern Techniques of Inventory Control
9.0 Introduction
In the previous study note we have seen that material costs form probably the highest proportionof the total costs. Among all the three elements material cost is the most significant element.The percentages may differ from industry to industry, but for the manufacturing sector materialcosts are of greatest significance. In service organisation also material cost may be significant.Consider an accounting or a legal firm, where use of computer stationery could be in very highvolumes, thus must be controlled properly. Analysis and control of material cost thereforebecome important in the quest of measuring and improving profitability. Even a small savingin the costs either by negotiating better rates or by reducing wastage could dramatically improveprofit margins. The term material is a very broad term and could include:a)Direct material such as raw material which is converted into finished product. A productmay be made out of single raw material item or multiple material items may be processedor blended together. It will also include the basic packing material without which aproduct cannot be stored or sold. E.g. fruit juice has to be offered either in a glass orplastic bottle or a sachet or tetra pack. Such packing material will be included as directmaterial as it can be easily identified with each liter of juice produced.b)Indirect material such as oil, grease, cleaning material, screws and nuts, secondarypacking. This material does not form part of the final product. Technically even itemslike office supplies and stationery may be included as indirect material.The categorization of material into direct and indirect may be difficult at times. For example,an item of material may be called as indirect material even if it forms part of (i.e. it is physicallypresent in) the final product. Consider polishing material used to polish wooden furniture.Although polished furniture does contain the polish, the cost of it is too insignificant to beidentified with the cost unit. Same is the case with nails used in footwear manufacturing or
 
Material Cost
ACCOUNTING
B 28glue used in book binding. What may be a direct material item for one industry may be anindirect item for another industry. We know normally oil and grease are considered as indirectmaterial in a manufacturing industry, but for an automobile service station it becomes a directcost.At times the material is classified as direct even if it is physically not present in the final product.Consider a beer manufacturing process where yeast or enzyme is added in the process. It actsmerely as a catalyst and is not present in the final product, but cost of it is significant. Hence it’sincluded as direct material cost.The classification of material cost into direct and indirect is important as the control mechanismsfor both are different. Whereas efforts to control direct material costs will be directed to minimizethe cost per unit, the indirect material costs may be controlled through other control measure.In different industries also material costs may be controlled in different ways e.g. in a chemicalor pharmaceutical company the production is based on a fixed formula of mixing material, thecosts are controlled through reduction in wastage and material rate negotiations.Of late, there is an increased importance given to not only the control over physical being of amaterial item but also on the entire logistics of material movement. From the stage of planningtill final usage of material, there are costs attached to each activity which need to be controlled.Inventory controls measures like EOQ, ABC analysis, Pareto analysis also help keeping materialcosts to minimum levels.
9.1 Movement of material
The flow of material routine may involve following:a)Planning for materialb)Procurement of materialc)Storage of material till its required for production andd)Issue of material at various stages of productione)Receive damaged material and dispose it of
9.1.1 Planning for material
There is a continuous planning required to be done for making sure that material of the rightquality, right quantity at right price are made available at right time for production activity.Companies may have planning cells to look after this activity. At times, the purchase departmentmay be involved in the planning activity with production and industrial engineering. Computeraided packages like Material Requirement Planning (MRP) are used to do errorless plan formaterial. Codification of material items is the pre-requisite right from planning stage for easyidentification of an item. A typical plan for material will indicate item-wise requirement of quantities for the planning period which may be a year. Companies also use rolling plan tomake adjustments for any changes therein. In projects execution companies, planning formaterial may be difficult as the requirement may depend upon the project getting awarded tothe organisation.
 
ACCOUNTING
B 29
9.1.2 Procurement of material
Based on the planning done, the purchase department may start buying material either on thebasis of quantities that are to be procured as per stocking policy or on the basis of specificrequisitions from stores department. There could be a requisition made directly by productiondepartment as well for a specific item required for a job or contract or a process. Depending onthe size of organisation and nature of business, the purchase activity could either be centralizedor decentralized. The purchase requisition acts as an authority for the purchase department tobuy the required material.At times, the procurement could be done based on rate contracts and quantities may be suppliedas and when needed. Adjustments may be made if rates fluctuate beyond a certain limit. Fornon-specific items of material, the crucial decisions to be made are:a)How much quantity should be bought at a time?b)When should the stocks be replenished?c)What should be the source of supply? Should there be single or multiple sources?d)How many quotations should be called for?The aim should be to order in just the right quantities so that the situation of over-stocking orunder-stocking is avoided.Overstocking may result into
·
Locking up of working capital and higher interest costs
·
Locking up of storage space
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Benefits of drop in prices of material may not be available
·
Increased risk of obsolescence or deterioration
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More material handling and upkeepUnder stocking, on the other hand, could lead to:
·
Production holdups causing disturbances in delivery schedules
·
Unfavourable price and credit terms for last minute distress buying
·
Payment for idle time to workers due to production holdupsFor specific items purchase actions are initiated based on purchase requisition or indent, whichis a request by the generating department to purchase department to procure items as indented.These indents could be made on the basis of Bill of Material prepared by the engineeringdepartment.The bill of Material (BOM) lists all material items required for making a complete product unitinclusive of all components or sub-assemblies. It is easy for the purchase department to act onsuch advance intimation about future requirements. Internal control can be established as thematerial can be issued for production only as per the BOM. Thus a stores person will not issueless or more material. The specimens of BOM and purchase requisition are illustrated below.The formats may differ from company to company.

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