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Chapter 6

Accounting For Materials


Ibrahim Sameer (MBA - Specialized in Finance,
B.Com Specialized in Accounting & Marketing)

www.ibrahimsameer.wordpress.com

Introduction
What is inventory control?
Inventory control includes the function of inventory

ordering and purchasing, receiving goods into


store, storing and issuing inventory and controlling
levels of inventory.

The Ordering, Receipt & Issue of


Raw 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; material transfer note &


material return note.

Storage of Materials
Objectives of storing materials:
Speedy issue & receipt of materials

Full identification of all materials at all times.


Correct location of all materials at all times.

Protection

of

materials

deterioration.
Efficient use of storage space.

from

damage

&

Bin Card
A bin card shows the level of inventory of an item
at a particular stores location. It is kept with the
actual inventory and is updated by the storekeeper
as inventories are received and issued.

Stores Ledger Account


Accounts department keep similar document like
bin card in the accounts department which include
inventory values.

Bin Card Vs. Stores Ledger


Account
Cost details are recorded in the stores ledger
account, so that the unit cost and total cost of
each issue and receipt is shown. The balance of
inventory after each inventory movement is also
valued. The value is recorded as these accounts
form part of the costing bookkeeping records.

Free Inventory
Managers need to know the free inventory balance
in order to obtain a full picture of the current
inventory position of an item. Free inventory
represents what is really available for future use
and is calculated as follows:

Free Inventory

Identification of Materials:
Inventory Codes (Material
Codes)
Materials held in stores are coded and classified.
Advantages of using code numbers to identify
materials are as follows:
Ambiguity is avoided
Time is saved
Computerized processing is made easier.

Inventory Count (Stocktake)


The inventory count (stocktake) involves counting
the physical inventory on hand at a certain date,
and then checking this against the balance shown
in the inventory records. The inventory count can
be carried out on a continuous or periodic basis.

Periodic Stocktaking
Periodic stocktaking is a process whereby all
inventory items are physically counted and valued
at a set point in time, usually at the end of an
accounting period.

Continuous Stocktaking
Continuous stocktaking is counting and valuing
selected items at different times on a rotating
basis.
This involves a specialist team counting and
checking a number of inventory items each day, so
that each item is checked at least once a year.
Valuable items or items with a high turnover could
be checked more frequently.

Advantages of Continuous
Stocktaking Compared to
Periodic Stocktaking
The annual stocktaking is unnecessary and the
disruption it causes is avoided.
Regular skilled stocktakers can be employed,
reducing likely errors.
More time is available, reducing errors and
allowing investigation.

Perpetual Inventory
Perpetual inventory refers to a inventory recording
system whereby the records (bin cards and stores
ledger account) are updated for each receipt and
issue of inventory as it occurs.
It means that there is a continuous record of the
balance of each item of inventory. OR
It records every receipt & issue of inventory as
they occur.

Obsolete, Deteriorating & Slow


Moving Inventories & Wastage
Obsolete inventories are those items which have
become out of date and are no longer required.
Obsolete items are written off and disposed off.
The typical measure of output wastage is the
number of quality rejects as a percentage of
total output.

Inventory Control Levels


Inventory costs include purchase costs, holding
cost, ordering costs and cost of running out
inventory.

Reasons for Holding Inventories


To ensure sufficient goods are available to meet
expected demand
To meet any future shortages.
To take advantages of bulk purchasing discount.
To allow production process to flow smoothly and
efficiently.

Holding Costs
If inventories are too high, holding cost will
incurred:
Cost of storage and stores operation.
Insurance cost
Risk of obsolescence.
Deterioration

Stockout Cost (Running out of


Inventory)
Loss of customers goodwill
Loss of future sales due to disgruntled customers

Labour frustration over stoppages.


Cost of production stoppages.

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.

Reorder Levels
When inventories

reach this level, an order

should be placed to replenish inventories.


Maximum lead time is the time between placing an
order with a supplier and inventory becoming
available for use.
Reorder Level = Maximum Usage x Maximum
Lead time

Minimum Levels
This is a warning level to draw management
attention

to

the

fact

that

inventories

are

approaching a dangerously low level and that


stockouts are possible.
Minimum Level = Reorder level (Average Usage
x Average Lead time)

Minimum Levels
This is a warning level to draw management
attention

to

the

fact

that

inventories

are

approaching a dangerously low level and that


stockouts are possible.
Minimum Level = Reorder level (Average Usage
x Average Lead time)

Maximum Levels
This is also as a warning level to signal to
management

that

inventories

are

reaching

potentially wasteful level.


Maximum Level = Reorder level + Reorder
Quantity - (Minimum Usage x Minimum Lead time)

Reorder Quantity
This is the quantity of inventory which is to be
ordered when reaches the reorder level. If it is set
so as to minimize the total costs associated with
holding and ordering inventory, then it is known as
the economic order quantity.

Average Inventory
The formula for the average inventory level
assumes that inventory levels fluctuates evenly
between the minimum (or safety) inventory level
and the highest possible inventory level.
Average Inventory = Safety inventory + Reorder
quantity

Lead Time
Lead time is sometimes referred as delivery
period, so lead time is the time between placing
an order for materials and the relevant materials
being received into inventory.

Buffer Inventory
Buffer (safety) inventory is the inventory that is
kept in reserve to cope with fluctuations in demand
& with suppliers who cannot be relied upon to
deliver the right quality & quantity of materials at
the right time. The introduction of buffer
inventory would result in the increase of average
inventory levels. The introduction of buffer

inventory would not have an effect on holding


cost, ordering cost nor the EOQ.

Economic Order Quantity (EOQ)


The economic order quantity (EOQ) is the order
quantity which minimizes inventory costs. The
EOQ can be calculated using table, graph or
formula.
Eg: of holding stock include warehouse rent,
interest on inventory investment & inventory theft.

Economic Order Quantity (EOQ)

Economic Batch Quantity (EBQ)

How to Calculate Annual Cost

Other Systems of Stores Control


& Reordering
Order Cycling Method
Under the order cycling method, quantities on

hand of each stores item are reviewed periodically


(for 1,2 &3 months).

Other Systems of Stores Control


& Reordering
Two Bin System
The two bin system of stores control (or visual

method of control) is one whereby each stores


item is kept in two storage bin. When the first bin is
emptied, an order must be placed for re-supply;
the second bin will contain sufficient quantities to
last until the fresh delivery is received.

Other Systems of Stores Control


& Reordering
Classification of materials
This is sometimes called ABC method whereby

materials are classified A, B and C according to


their expense group A being the expensive, group
B the medium cost and group C the inexpensive
materials.

Other Systems of Stores Control


& Reordering
Pareto (80/20) Distribution
Pareto (80/20) distribution which is based on the

finding that in many stores, 80% of the value of


stores is accounted for by only 20% of the stores
items, and inventories of these more expensive
items should be controlled more closely.

Accounting for Materials


Any increase in material inventory will result in a
debit entry in the material control account whilst
any reductions in materials inventory will be
shown as a credit entry in the material

Inventory Valuation
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 (First in, First Out)


FIFO assumes that materials are issued out of
inventory in the order which they were delivered
into inventory; issues are priced at the cost of the
earliest delivery remaining in inventory. OR
The first materials issued will be priced at the cost
of the earliest goods still in inventory.

FIFO (First in, First Out)


Advantages of FIFO
It is a logical pricing method which probably

represents

what is physically

happening:

in

practice the oldest inventory is likely to be used


first.
It is easy to understand and explain to mangers.

FIFO (First in, First Out)


In a period of rising purchase prices, the closing
inventory valuation will be close to current
purchase price

FIFO (First in, First Out)


Disadvantages of FIFO
FIFO can be cumbersome to operate because of

the need to identify each batch of material


separately.
Managers may find it difficult to compare costs
and make decisions when they are charged with
varying prices for the same materials.

FIFO (First in, First Out)


In a period of high inflation, inventory issue prices
will lag behind current market value.

LIFO (Last in, First Out)


LIFO assumes that material 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.

LIFO (Last in, First Out)


Advantages of LIFO
Inventories are issued at a price which is close to

current market value. This is not the case with


FIFO when there is a high rate of inflation.
Managers are continually aware of recent costs
when making decisions, because the costs being
charged to their department or product will be
current costs.

LIFO (Last in, First Out)


Disadvantages of LIFO
The method can be cumbersome to operate

because it sometimes results in several batches


being only part used in the inventory records
before another batch is received.

LIFO (Last in, First Out)


LIFO is often the opposite to what is physically
happening and can therefore be difficult to
explain mangers
As with FIFO, decision making can be difficult
because of the variation in prices.

AVCO (Cumulative Weighted


Average Pricing)
The cumulative weighted average pricing method
(or AVCO) calculates a weighted average prices
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.

AVCO (Cumulative Weighted


Average Pricing)
A new weighted average price is calculated
whenever a new delivery of materials is received
into store. This is the key feature of cumulative
weighted average pricing.

AVCO (Cumulative Weighted


Average Pricing)
Advantages of AVCO
Fluctuation in prices are smoothed out, making it

easier to use the data for decision making.


It is easier to administer than FIFO & LIFO,
because there is no need to identify each batch
separately.

AVCO (Cumulative Weighted


Average Pricing)
Disadvantages of AVCO
The resulting issue price is rarely an actual price

that has been paid, and can run to several decimal


places.
Prices tend to lag a little behind current market
values when there is gradual inflation.

Periodic Weighted Average


This periodic weighted average pricing method
calculates an average price at the end of the
period, based on the total purchase in that period.
Periodic weighted average = cost of opening
inventory + total cost of receipts / Units of opening
inventory + total unit receipt.

Remember
FIFO uses the price of the oldest item in inventory.
When prices are rising this will be the items with
the lowest prices. Consequently costs are lower
(understated) & profits are higher (overstated).
FIFO uses the price of the oldest item in inventory.
When prices are falling this will be the items with
the lowest prices. Consequently costs are higher
(overstated) & profits are lower (understated).

Remember
If prices are rising then the LIFO method will
charge

the

more

recent,

higher

prices

to

production costs. Therefore production cost will


be lower using weighted average pricing rather
than LIFO.

Remember
If prices are rising production cost will be higher
using LIFO rather than FIFO.
Raw materials inventory values will be lower using
LIFO rather than weighted average method.

Questions & Answers

Thank You

Ibrahim Sameer
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