Notes

Of
Cost and Management Accounting
(For Spring 2020 Session)
Prepared By: Awais Farooq, ACA
Material procurement, process and documentation.

Flow of documents, (it varies depending upon the need, size, complexity and nature of
organization)

Document name Initiated by (department) Requested from

/ person (department) / person
Store Issue requisition Production Store
Purchase Demand Store Procurement
/Requisition
Purchase order Procurement Purchaser
Delivery note Supplier Gate/store
Gate Entry Gate Store
Inward Gate pass Store Store
Goods Receipt and inspection Store Store
note

Benefits of documentation:
1. Prevents error and fraud
2. Basis for financial accounting purchases
3. Provides record for cost accounts
4. Physical control over inventory
5. Avoid improper uses

Inventory Valuation
Inventory must be valued specifically for financial accounting purposes; the value so
calculated is used in closing stock, opening stock and cost of goods sold.

Before jumping upon the methods of valuation two concepts to make clear
1. periodic inventory system (at period end)
2. Perpetual inventory system ( continuous at every transaction)
The cost Inventory ledger Card

Inventory valuation general rule Lower of cost and NRV

Following are the methods
1. First-in, first-out method of valuation (FIFO)
2. Weighted average cost (AVCO) method
 Inventory Management
Cost Associated with inventory:
1. Purchase Price ( purchase from market)
2. Ordering Cost (Cost of delivery, Telephone calls, inspections cost etc)
3. Holding Cost (Tied up capital, insurance cost, warehouse cost, obsolescence,
damage, expiry etc)
4. Shortage Cost (loss of profit , goodwill , stoppage cost)
Relationship between holding cost and ordering cost is inverse.

Total Cost of inventory = Total Purchase price + Total Ordering cost + Total Holding cost +
Total Shortage cost

Total Purchase price = Purchase quantity * rate – discount (if any)

Total Ordering Cost = No of orders * ordering cost per order
Total Holding Cost = Average inventory * Holding cost per unit (average inventory = order
quantity/2)
Total Shortage Cost = Loss of sale/opportunity cost (will be discussed in detail in decision
making)

Following are the tools for inventory management

a) Economic Order Quantity (EOQ)
b) Re-order level
c) Safety tock / buffer stock
d) Maximum level
e) Minimum level

Economic order quantity (EOQ):

It is the order quantity where total cost of inventory is at minimum.
Assumption for EOQ
1. No bulk purchase discount so purchase price is irrelevant
2. Lead time is known and consumption is constant
3. Annual demand is constant and there is no shortage

Practice Question 1.

In reality assumption 1 does not holds.

If there is purchase discount then the total cost is minimized at the order quantity at which
discount is given or EOQ quantity.

Practice Question 2.

Reorder level:
Also the Assumption 2 is not valid as lead time is uncertain and so does the consumption
(demand) of the material during the lead time.

So we have to set a reorder level to avoid shortages.

There are two possible ways in which we can deal with reorder level.
1. Certain lead time and constant demand
Reorder level = Demand for material per day/week (lead time) * lead time in days/weeks
2. Uncertain demand in lead time
Reorder level = Maximum Demand for material per day/week (lead time) * Maximum
supply lead time in days/ weeks

Safety Stock:
If there are uncertainties in lead time and demand of material then there would be risk of
stock outs or shortages. In order to overcome a company maintains a stock in excess of its
average inventory which is known as buffer or safety stock.

When the company has safety stock then average inventory would be calculated as follows

Average inventory = order size /2 + safety stock

Maximum Inventory Level:

Minimum Inventory Level:

Using Probabilities to find out average consumption or average lead time.

Accounting for overheads
After we have understood the concept of cost associated with inventory i.e the cost from order to
the cost up to the delivery of inventory. The concept which we had understood basically relate to
trading type of business. What if we are manufacturing goods from raw material (inventory).

For this we have to understand the following questions:

How many types are cost which are associated in a manufacturing concern business?
How would the cost of a finished good would be calculated?

Type of cost associated in a manufacturing concern

1. Production/ Manufacturing cost (directly or indirectly relate to goods/inventory/production)
2. Non-production/ non -manufacturing cost (no connection with production)
Following table shows the cost types and which cost is to be added to inventory.

Depends upon the costing system:

There are two types of costing systems
1. Marginal Costing System (Period Cost) (Chapter 4)
2. Absorption Costing System (Product Cost)
Absorption costing measures cost of a product or a service as:
1. its direct costs (direct materials, direct labour and sometimes direct expenses and
variable production overheads); plus
2. a share of fixed production overhead costs
It is a system of costing in which a share of fixed overhead costs is added to direct costs and
variable production overheads, to obtain a full cost. This might be:
1. a full production cost, or
2. a full cost of sale

All variable costs are directly attributable to the inventory but in order to find out a fixed
overhead absorption rate following general formula can be used.
OAR=Fixed production overheads/Number of units
To find out Fixed production overheads under mentioned point should be taken into
consideration:
1. Identify which cost is fixed production and which is not.
2. Finding out a department wise or cost Centre wise fixed production overhead from
total overheads.
3. Estimate on a reasonable basis fixed overhead absorption rate.

Following are the steps in determining the cost per cost Centre:
1. Allocation (particular cost related to a particular department or cost Centre)
2. Apportionment (if cost is not allocate-able then cost is distributed on a reasonable
basis)
3. Absorption (charging cost to product)
Marginal costing and absorption
costing
Key Concepts