Management

Accountancy
MM/EBM 2153

Material Cost

Warunika N. Hettiarachchi
Learning Outcomes

 Understand the principles of material control

 Be able to describe purchasing, reception and storage
procedures
 Calculations of material costing
Material Costing/Control
 Systematic control over the purchasing, storing and
issuing of materials that ensure continuous production
while minimizing over stocking is called as material
costing.

Proper controls on materials and their cost from purchasing

to their consumption
Materials
 Raw materials (Direct and Indirect )
 Specially designed components for final product
 Other utilities and packing materials

Direct materials: Materials that can be identified separately

as a part of the product
Indirect materials: Other consumable used in
manufacturing activity, but cannot be identified as an
essential part of the products
Ex. 02: Milk powder
Direct raw materials- ?
Indirect raw materials- ?
Ex.01: Garment factory
Direct raw materials- ?
Indirect raw materials- ?
Objectives of material control
Elements involved in material costing
 Purchasing
 Storing
 Issuing for consumption
 Verification of inventories
 Purchasing
The objectives of cost control can be achieved by
determining the right materials to purchase and the right time
of purchase.

 Centralized and Decentralized purchasing

Purchase process

1. Receipt of a purchase requisition note

2. Invitations for price quotations
3. Receipt of price quotations, selections and sending the
purchase order
4. Receipt of materials and checking the quality
5. Settlement of due/ rejection and replacement
Receipt of purchase requisition from
departments

 Source document: Purchase Requisition Note

 Prepare by production manager

 Ex: The purchase requisition prepared by the stores

requesting 10 000 liters of chemical B from the
purchasing department on 30.05.xx is given
Invitation for price quotation
 Send to approved suppliers.
 Sending letter to suppliers, news paper advertisements

Receipt of price quotation, selection and

sending the purchase order
 Prepare a document including prices, delivery conditions,
payments by purchasing manager
 Approval for the order is made by the tender board
Follow up of order
 Procurement department is on alert on the reception of
ordered items

Reception of materials and inspection

 Source document: Good Received Note
 Copy is send to Quality Control Department together with
sample of items
 Inform the supplier to replace the items if QCD rejects
 Debit Note is issued to the supplier for rejected items
Issue, transfer and return of materials

 Source document: Material Requisition Note

 Submitted to store keeper by each department
 Store keeper issuing materials only for an authorized
Material Requisition Note
 Relevant Bin Cards are updated with issues
 Responsibility of updating the store ledger and the pricing
decisions are with accounting branch
Material Transfer Note

 Prepare when materials or goods are transferred from one

department to another.

Ex: Production Department 2 have to transfer 100kg of

material C to Production Department 1
Material Return Note

 When retuning excess materials back to the stores

 Only a internal document
Records on Materials
 Records in order to control materials

1. Bin Cards (maintain by stores)

2. Stores Ledger (maintain by accounting department)

 Bin Card
 Receipts, issues and the balance of the quantity of items of a
material are recorded
 Maximum stock level, minimum stock level and reorder level
are mentioned
 Values of materials are not mentioned
 Keep at the place where items are stored
 Stores Ledger
 Record the monetary value
 Material storage and stock levels

• Should control stock to minimize stock damages,

diminishing quality, obsolescence, unnecessary capital
investment, shortages
• To have a better control of materials its required to decide;
 Maximum stock level
 Minimum stock level
 Reorder level
 Reorder quantity
 Reorder level
 Purchasing process start when stock reach to the reorder
level
 Lead time and the maximum consumption during the lead
time should consider in determining reorder level
 Lead time: Time duration between the date of order and date
of reception of materials
Reorder level= Maximum lead time x Maximum consumption
or

Reorder level= Minimum stock level + (Average consumption x

Average lead time)
Ex.01:Lahiru PLC produces coconut oil
1 100 coconuts are the average daily requirement
Minimum daily requirement of coconuts are 1000
and the maximum requirement of coconut are
1200
Lead time is 8 to 10 days
Minimum stock level is 2 100
Economic reorder quantity is 20 000 coconuts
Calculate reorder level
Reorder level= Maximum lead time x Maximum consumption
= 10 x 1 200
= 12 000 coconuts

or
Reorder level= Maximum stock level + (Average consumption x
Average lead time)
= 2 100 + (1 100 x 9)
= 12 000 coconuts
 Minimum stock level
 A buffer stock (can utilize in urgent situations)
 If stock level decreases beyond this level, its danger level

Minimum stock level = Reorder level - (Average consumption x

Average lead time)

 Calculate the minimum stock level for the Ex. 01

= 12 000 – (1 100 x 9)
= 2 100 coconuts
 Maximum stock level
 Stock level that should not get exceeded

Maximum stock level = Reorder level + Economic order quantity –

(Minimum lead time x Minimum consumption)

 Calculate maximum stock level for Ex. 01

= 12 000 + 20 000 – (8 x 1 000)
= 24 000 coconuts
Stock Turnover and Average Stock
Stock turnover ratio shows the number of times the stocks
have rotated over a particular period

Stock turnover ratio = Used materials during the period

Average stock for the period

Average stock is calculated by,

 Average of opening and closing stocks
Average of the maximum and minimum stock levels,
Adding half of the reorder quantity to the minimum stock
level
 If the actual use of coconut per day is 1 150, calculate the
stock turnover ratio for ex. 01
Average stock = 1200+1000
2
= 1100
Stock turnover ratio = 1 150
1 100
= 1.045
 Ex: Details related to a material used in Silver Plastic
Company is given below

Maximum Minimum
Consumption 300 100
Lead time (weeks) 5 4
Economic order quantity 900 units

Calculate;
1. Reorder level
2. Minimum stock level
3. Maximum stock level
4. Average stock level
1. Reorder level = Maximum lead time x Maximum consumption
= 5 x 300
= 1 500
2. Minimum stock level = Reorder level + (Avg consumption x
Avg lead time)
= 1 500 – (4.5 x 200)
= 600
3. Maximum stock level = Reorder level + Economic order
quantity – (Minimum lead time
x Minimum consumption)
= 1 500 + 900 – (100 x 4)
= 2 000
4. Average stock level = Maximum stock level + Minimum stock level
2
= 2 000 + 600
2
= 1 300
Re-order Quantity (ROQ)
 The quantity to be ordered when the stock level reaches to
the reorder level.
 Factors should be considered in deciding the reorder
quantity
 Pattern of material consumption
 Storage facilities
 Nature of materials (evaporation, perishable)
 Risk of price fluctuations
 Seasonal fluctuations in price and demand
 Discounts
 Holding cost and ordering cost
 Holding Cost and Ordering Cost
 Holding cost
Inventory carrying costs
Ex: Rent for stores, insurance, cost of capital investment in
stock, damages, evaporation and expirations, other storage
costs
 Ordering cost
Costs for acquire the inventory
Ex: cost of inviting for the price quotations, bank charges,
transportations and carriage cost
 Ordering cost
Annual number of orders can be found by dividing the
annual demand by the volume per order.
Number of orders = D
Q

Annual ordering cost

annual ordering cost is found by multiplying the number of
orders by cost per order.
Annual ordering cost = D
X Co
Q
 Annual Holding Cost

Annual holding cost is calculated for the average stock (half

of the stock).
Annual holding cost = Q
XH
2
Economic Order Quantity (EOQ)
 The total of both stock holding cost and ordering cost are
at the lowest
 Basic assumptions in EOQ model
1. The ordering quantity does not affect the unit cost of raw
materials
2. The ordered quantity is received at the end of the lead time
3. Unit holding cost and cost per order are constant
4. Production and sales can be forecasted accurately
  Formula

EOQ =

D = Annual Demand
Co = Cost per Order
Ch = Annual Holding Cost per unit/ (Cost per unit x Holding Cost %)
Ex: Details relating to orders made by a manufacturing
company are given below.
Monthly consumption – 250 units
Ordering cost – Rs. 60 per order
Cost of raw materials – Rs. 10
Holding cost – 10% of inventory value

Determine the EOQ.

Two approaches can be used:

1. solution using a table showing orders

2. solution using the equation of EOQ
Solution using the table

No of (A) (B) (C) (D) (E) (F)

orders Quantity Value of Average Holding Orderin Total cost
in an order Rs. stock cost Rs. g cost Rs.
order Rs. (A) X 10/- value Rs. (C) X 10% Rs. (D) + (E)
(B) / 2

3 1 000 10 000 5 000 500 180 680

Solution using the table

No of (A) (B) (C) (D) (E) (F)

orders Quantity Value of Average Holding Orderin Total cost
in an order Rs. stock cost Rs. g cost Rs.
order Rs. (A) X 10/- value Rs. (C) X 10% Rs. (D) + (E)
(B) / 2

3 1 000 10 000 5 000 500 180 680

4 750 7 500 3 750 375 240 615

5 600 6 000 3 000 300 300 600

6 500 5 000 2 500 250 360 610

7 429 4 290 2 145 215 420 635

using the equation of EOQ
Ex: Monthly sandal wood requirement of the business
of Rasika and Sujeewa is 2000 units. Unit cost is Rs.
200, any amount can be ordered and the bank charges
of Rs. 2000 must to be paid for an order. Rs. 2 needs
to be spent to store one unit of sandal wood for a
month in a refrigerator. Sujeewa argues that a 3
months requirement should to be ordered at once
while Rasika argues that 2 months requirement
should be ordered.

Advise Rasika and Sujeewa by critically solving the

problem.
 Answer:
EOQ = √2 x 24 000 x 2 000
24
= 2000
ABC Analysis
 By observing the quantity of materials and the value of
them,
 High percentage of items: having lower values
 Low percentage of items: having higher values

 Categorizing materials into three types is called as ABC analysis

 Important for cost control

 Objective is to give more attention to the items with high values

 A : These items small in quantity, but has a high value out
of the total inventory value
eg: 10% of items having a 75% value out of the total inventory

 B : Items fall in between A and C categories.

eg: 20% of items having a 15% value out of the total inventory

 C : These items are large in number, but has a low

value out of the total inventory value
eg: 70% of items having a 10% value out of the total inventory
Inventory item Quantity as a % of total Value as a % of total
inventory inventory value
A 10 75
B 20 15
C 70 10
Stock Verification/ Inventory Valuation

 Physical verification of inventory

 Can be periodical or continuous basis
 Carried out by technically experienced people
Valuing of Material Issues
 Helpful for determine the cost of materials use for
production
 Provide a basis for valuation of remaining inventory

 Cost based valuation method

- First In First Out (FIFO)
- Last In First Out (LIFO)
 Average based valuation method
- Simple Average
- Weighted Average
First In First Out (FIFO)
 Items are issued in the order they had been received to
the store.
 The inventory remaining at the end of the year is
valued based on the prices of the materials purchased
near to the end of the year.
 Ex: Following stock records are extracted from a company
for the month of May.

Date Description Quantity Price Rs.

(liters)
02.05.xx Opening stock 300 10
05.05 Purchase 400 11
09.05 Issue 400
14.05 Purchase 300 12
16.05 Issue 200
25.05 Purchase 200 14
26.05 Issue 200
 Analysis of closing stock
200 Liters x Rs. 12 = Rs. 2 400
200 Liters x Rs. 14 = Rs. 2 800
400 Rs. 5 200
 Amount of issues and closing stock
Opening stock = Rs 3 000
Add: Receipts = Rs 10 800 (4400+3600+2800)
Less: Issues = Rs (8 600) (4100+2200+2300)
Closing stock = Rs 5 200
Advantages and Disadvantages of FIFO
Last In First Out (LIFO)
 Materials purchase last is issued first
 The inventory remaining at the end of the year is
valued based on the prices of the materials purchased
at older prices.
 Good for inflationary situations
 Analysis of closing stock
300 Liters x Rs. 10 = Rs. 3 000
100 Liters x Rs. 12 = Rs. 1 200
400 Rs. 4 200
 Amount of issues and closing stock
Opening stock = Rs 3 000
Add: Receipts = Rs 10 800 (4400+3600+2800)
Less: Issues = Rs (9 600) (4400+2400+2800)
Closing stock = Rs 4 200
Advantages and Disadvantages of LIFO
Simple Average Method
 Issue of materials are valued using the average value of
the prices of outstanding inventories.
 Quantity available under each batch of inventories are not
considered, only their prices are considered.
 Relevant price of an item which has been issued
completely is not considered for the average price

In the above example;

 Value of issues:
09/05 (10+11) x 400 units = Rs. 4 200
2
16/05 (11+12) x 200 units = Rs. 2 300
2
26/05 (11+12+14) x 200 units = Rs. 2 467
3
 Amount of issues and closing stock
Opening stock = Rs 3 000
Add: Receipts = Rs 10 800 (4400+3600+2800)
Less: Issues = Rs (8 960) (4200+2300+2467)
Closing stock = Rs 4 833
Advantages and Disadvantages
Weighted Average method

 The weighted average cost is obtained by dividing

the total value (at cost) of materials in stock at the
time of issue by the total quantity of materials in
stock.
 Amount of issues and closing stock
Opening stock = Rs 3 000
Add: Receipts = Rs 10 800 (4400+3600+2800)
Less: Issues = Rs (8 924) (4228+2258+2438)
Closing stock = Rs 4 876
Advantages and Disadvantages
Thank You