Unit: 3 Accounting for Material

INDEX

3.1 Introduction 2

3.2 Accounting for Material Cost, Ordering, Receiving, and Issuing materials 2
3.2.1 Procedure for Purchasing and Receiving Material 3
3.2.2 Procedure for Issuing Material 3
3.2.3 Recording Receipts and Issue 4

3.3 Methods of valuation for Purchase and Issue 4

3.3.1 Valuation of Material Receipts 4
3.3.2 Valuation of Materials Issued 5
First-In-First-Out Method (FIFO) 5
Last-In-First-Out Method (LIFO) 6
Weighted Average Method 6

3.4 Concept of Economic Order Quantity (EOQ) 8

3.5 Inventory Levels 9

3.5.1 Re-order Stock Level 9
3.5.2 Re-order Quantity level 10
3.5.3 Maximum Stock Level 10
3.5.4 Minimum Stock Level 10
3.5.5 Average Stock Level 11
3.5.6 Danger Stock Level 11
3.5.7 Buffer Stock 11

3.6 Illustration 11

3.7 Inventory Management Policies 12

Conclusion 14

Glossary 15

Short Answers 15

Questions for discussion forum 15

Multiple Choice Questions 16

Case study 19

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Objectives
Accounting for material costs, ordering, receiving, and issuing material
Methods of valuing purchases and issues (FIFO, LIFO, and Weighted Average methods)
Economic Order Quantity
Inventory Levels

Learning outcomes
Distinguish between the various inventory management policies and their objectives.

3.1 Introduction
Any substance that is part of or made up of a finished product is referred to as a material.
The resources supplied to an enterprise for utilization in the production process, giving
service, or conversion into products are referred to as material. Although the term "stocks"
is usually used interchangeably with "materials," it has a broader definition that includes
goods such as incidental supplies, spare parts, manufactured parts, components, tools,
molds, and other things, as well as consumables like grease, lubricants, and so on. Finished
and partially finished products are frequently referred to as 'Stock.' Inventory is another
name for materials.
Raw materials, other stores, work-in-progress, finished goods, and scrap are all included in
the definition of Materials / Inventory. Material costs make up a major portion of a
product's total cost. As a result, material cost analysis and control are critical.

3.2 Accounting for Material Cost, Ordering, Receiving, and Issuing

materials

Material: Any substance that is part of or made up of a final product is referred to as a

material. The goods supplied to an enterprise for consumption in the production process,
rendering service, or transforming into products are referred to as material.

Material cost: The Institute of Cost and Management Accountants defines material cost as
"the cost of commodities supplied to an undertaking." The cost of cotton or cotton yarn for
a textile mill are examples of material costs.

The following items make up the material cost:

1. Purchase costs: The price paid to suppliers for products purchased is referred to as the
cost of purchase.

2. Ordering costs: The cost of placing an order and getting products into the store is referred
to as the ordering cost. Example: Transportation cost.

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3. Storage or holding costs: The costs of keeping stock in the business are referred to as
holding costs. Example: Warehouse rent.

4. Cost of stock out: Stock out cost is the cost incurs when a company runs out of stock for
production. Example: Revenue loss due to Sales loss.
3.2.1 Procedure for Purchasing and Receiving Material

1. Purchase Requisition: A Purchases Requisition is a formal request to the Purchase

Department to obtain materials of a specific description, grade, and volume within a
certain time frame. This request gives Purchase Department permission to create a
Purchase Order.
2. Selection of Suppliers: Once the purchasing department gets a properly authorized
purchase requisition, it must choose a supplier. The procurement department usually
keeps track of suppliers for each type of material and chooses one after requesting
tenders and quotations.
3. Purchase Order: A Purchase Order is a written proposal to a selected supplier to provide
goods of the required quality and quantity (as per the purchase requisition) at the
accepted prices, terms, and conditions. The purchaser agrees to accept delivery of the
materials specified in the Purchase Order if the requirements stated therein are met.
4. Receipt of Material: The material received is sent to the stores' department with a
delivery note. It will compare the quantity received with the quantity on the Purchase
Order and issue a Goods received note. This is an important document since it serves as
the foundation for accounting entries in the store ledger and stock records. It also serves
as the foundation for payments to be made to the supplier for materials provided by
him.
5. Inspection and Testing of Materials: The quantity of goods received should be verified to
confirm that they meet the purchase order parameters. One copy of the goods received
note is also sent to the Inspection Department, which approves the note for the Stores
Department to accept the materials after inspection is done.

3.2.2 Procedure for Issuing Material

Materials held in the stores are to be sent to production departments as and when required.
Only when a material requisition is made, the storekeeper should issue materials.

1. Material Requisition - A material requisition note is a document that gives the

storekeeper authority to issue materials. The storekeeper assigns a serial number to
each requisition and passes entries on the bin card. The requisitions are then forwarded
to the cost accounting department, where the value of the material issued is also filled
in, and credit is provided to the material issued in the stores' ledger, while the job
receiving the material is debited in the job ledger.
2. Bills of Materials - It is a document that lists all of the materials needed for a specific job,
order, or process, along with the quantity needed. The bill of materials is used to
requisition materials. A bill of material is created so that the production department can

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 estimate all of the supplies required for the job before it begins. This is useful for
estimating the material costs of the job to submit proposals or bids.
3. Return of Surplus Material - Excess materials are sometimes supplied to production
divisions. When such materials are returned to stores, the division that holds the extra
materials must produce a Material Return Note. In most cases, three copies are made.
The division that is returning the material keeps one copy. The storekeeper receives two
copies. One copy is kept by the storekeeper for entries in the Bin card, while the other is
forwarded to the cost accounting department for entries in the stores' ledger and
crediting the job where the material is in excess.
4. Transfer of Surplus Material - Excess materials should be transferred from one job to
another only when it is necessary. This is because a transfer record may not exist. Only
with the creation of a material transfer note will the transfer be permitted, since the
cost of the material transferred will be debited to the job receiving the material and
credited to the job transferring the material.

3.2.3 Recording Receipts and Issue

The two major documents used to record the receipt, issue, and balance of stocks held are
as follows:

● Bin Card: This card is used to manage stock flows in a certain bin or area. It keeps track
of the storekeeper's receipts and issues of materials, and also stock balances. In other
words, it contains quantitative details of materials received, issued, and returned to
stores. The entries are made in the bin card at the time of receipt, issue, or return.
● Stores Ledger Account: This is a subsidiary ledger kept by the cost accounting
department to monitor the quantity and value of goods movement. The posting is done
in this ledger after the transaction is executed.

3.3 Methods of valuation for Purchase and Issue

The precise valuation of the cost of material used in the product is essential for appropriate
cost determination. The material cost is made up of the invoice price plus freight,
transportation, duties, taxes, and storage cost, among many other things.
Materials are distributed to various departments, contracts, units, and jobs. Therefore, the
material consumed must be accurately allocated to the jobs. However, the material in stores
will be from various lots received at various costs at various times. This necessitates
determining the amount to be charged to departments or contracts that are issued with
materials from various lots.
3.3.1 Valuation of Material Receipts
Materials receipts valuation is the process of determining the cost of materials acquired.
Other costs incurred in bringing inventory to its current location and condition are also
included in its cost.
Material cost =

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Purchase price
+ duties and taxes paid on such purchase
+ penalties, fines, and charges paid related to such purchase
+ other expenses incurred (Transit insurance, commission, freight inward, etc.)
(-) Trade discount/ quantity discount received
(-) Subsidy/ grant/ incentives received
Illustration: Following is the information given for one lot of 1000 units of material
purchased.
- List price of Lot $100000
- Trade discount 10%
- CGST and SGST 12% (6% each)
- Freight and insurance $5000
- Toll tax paid $1200
- Cash discount 5%
- Commission and brokerage paid $2000
- Demurrage charges $1000
Calculate Total purchase cost or buying cost.
Answer:

List price 100000

(-) Trade discount @10% (10000)

= 90000

+ CGST @6% 5400

+ SGST @6% 5400

= 100800

+ Freight and insurance 5000

+ Toll tax 1200

+ Commission and brokerage 2000

+ Demurrage 1000

= Cost of purchase (1000 units) 110000

Cost per unit of material 110

✔ Cash discount is not deducted as it is treated as interest or finance charge.

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3.3.2 Valuation of Materials Issued
1. First-In-First-Out Method (FIFO)
CIMA defines FIFO as “a method of pricing the issue of material using, the purchase price of
the oldest unit in the stock”. Under this method, materials are issued out of stock in the
order in which they were received into stock. The first material to arrive in stores is thought
to be the first material to be used.
Advantages of FIFO
● It is simple and straightforward to use.
● This method produces better outcomes when prices are declining.
● Market prices are shown by closing stocks. It is near to the valuation based on
replacement cost.
● Under standard accounting practice, this approach to inventory valuation is allowed.
Disadvantages of FIFO
● This method may result in accounting errors if prices fluctuate often.
● Production costs are understated in the event of rising pricing.
● Material expenses for the same job are likely to be charged at different rates.
● When various jobs are charged with different costs for the same material, the practice
makes cost comparison difficult.

2. Last-In-First-Out Method (LIFO)

This method uses the prices from the most recent order to price issues until it is consumed,
and so forth. In other words, the purchase price of the most recent unit in the stock is used
to price the issue of material. The newest purchase will be issued first under this procedure.
Advantages of LIFO
● The price of the materials given will be closer to or represent the existing market value.
● When prices decline, profits tend to grow due to lower material costs.
● Because material costs are charged at the most recent prices, product costs will tend to
be more accurate.
Disadvantages of LIFO
● If there are too many purchase receipts, the calculations become difficult.
● Companies that use a Just-in-time inventory system will be more susceptible to this
issue.
● In the preparation of financial statements, this approach of inventory valuation is not
allowed.
● It entails extra clerical work, and valuation may be affected.

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3. Weighted Average Method
It is a perpetual weighted average system in which the issue price is calculated after each
reception, taking into account both total quantities and total cost while computing the
weighted average price.
To determine the issue price, it considers the quantities that are utilized as weights. This
method divides the entire cost of material incurred by the unit or quantity of material
available for issue.
Issue Price = Total Cost of Materials in stock / Total Quantity of Materials in stock
Advantages of Weighted Average Method
● This approach tends to level out price fluctuations.
● The method is simpler than FIFO and LIFO since each batch does not need to be
identified independently.
● Because each issue is charged at the same price till a new batch of material is delivered,
it decreases the number of computations required.
Disadvantages of Weighted Average Method
● Every time a new batch is received, this technique adds the clerical effort involved in
calculating a new average cost.
● The computed issue price rarely corresponds to the actual purchasing price.

Illustration:
The following is the opening inventory balance and purchases made by the company
throughout the month of April 2022: Opening stock of material - 1000 units at Rs. 20 each
on Jan1. On April 15, 600 units of material were purchased at Rs. 25 per unit. On April 25,
900 units were bought for Rs.30 each.  In the month of April, the company utilized 1,500
units in production.
Calculate the value of closing stock as on April 30 if company follows:  a) FIFO, b) LIFO, c)
Weighted Average methods

Answer: FIFO Method

Particulars Quantity Cost per unit Total Cost

Opening Stock (1/04/2022) 1000 Rs.20 Rs.20000

+ Purchases (15/04/2022) 600 Rs.25 Rs.15000

+ Purchases (25/04/2022) 900 Rs.30 Rs.27000

= Total cost 2500 Rs.62000

(-) Cost of material consumed (1500 units) (1000) Rs.20 (Rs.20000)

(500) Rs.25 (Rs.12500)

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 = Closing Stock (30/04/2022) 100 Rs.25 Rs.2500
900 Rs.30 Rs.27000

Total Closing Stock Rs.29500

LIFO Method
Particulars Quantity Cost per unit Total Cost

Opening Stock (1/04/2022) 1000 Rs.20 Rs.20000

+ Purchases (15/04/2022) 600 Rs.25 Rs.15000

+ Purchases (25/04/2022) 900 Rs.30 Rs.27000

= Total cost 2500 Rs.62000

(-) Cost of material consumed (1500 units) (900) Rs.30 (Rs.27000)

(600) Rs.25 (Rs.15000)

= Closing Stock (30/04/2022) 1000 Rs.20 Rs.20000

Weighted Average Cost Method

Particulars Quantity Cost per unit Total Cost

Opening Stock (1/04/2022) 1000 Rs.20 Rs.20000

+ Purchases (15/04/2022) 600 Rs.25 Rs.15000

+ Purchases (25/04/2022) 900 Rs.30 Rs.27000

= Total cost 2500 Rs.62000

Weighted Average Cost (Total cost/Total units) 2500 Rs24.80 Rs.62000

(Rs.6200,0/2500units)

(-) Cost of material consumed (1500 units) 1500 Rs.24.80 Rs.37200

= Closing Stock (30/04/2022) 1000 Rs.24.80 Rs.24800

3.4 Concept of Economic Order Quantity (EOQ)

The term "economic order quantity" refers to the order size that has the lowest ordering
and carrying costs. The order size that optimizes the total of ordering and holding expenses
associated with raw materials or finished stocks is known as the economic order quantity
(EOQ). In other words, it is the optimal quantity to procure from the supplier in order to

8
reduce the company's overall annual inventory cost. Economic order quantity is also known
as optimal order size and optimal order quantity.
Buying Cost + Total Ordering Cost + Total Carrying Cost usually makes up the total material
costs.
● Buying cost: Amount paid or payable to the supplier for the goods. The material received
should be valued at the purchase price, including duties and taxes, and other
procurement-related expenses, except trade discounts, rebates, and refundable taxes
and duties.
● Ordering cost: The ordering costs are the expenses incurred each time an inventory
order is placed with a supplier. It covers the cost of staff assigned to ordering products,
shipping costs, material inspection costs, and so on. The total cost of an order is usually
proportionate to the frequency of orders placed.
● Carrying cost: The costs of keeping inventory in a store or warehouse are known as
carrying costs. The costs of keeping inventories on hand. It takes into account the cost of
capital spending on inventories. It is also known as holding costs. The overall holding
cost is usually determined by the size of the inventory order. The higher the annual
holding cost, the larger the order size, and vice versa. Example: Warehouse rent,
insurance, etc.
The Economic Ordering Quantity is based on the following assumptions:
a) Carrying cost per unit per annum and ordering cost per order are known and constant.
b) The expected use of materials in units is determined.
c) The material cost per unit is fixed and well-known.
d) The quantity of material ordered is promptly delivered, implying no lead time.
The formula for determining EOQ was devised by the great mathematician 'WILSON':

Economic Ordering Quantity =

√ 2 AO
C
Here,
A= Annual demand
O= Ordering Cost
C = Carrying Cost
Illustration: Calculate the Economic Order Quantity using the information below. Also,
provide the expected number of orders per year.
Material consumption per year: 25,000 kg
The cost of placing an order is $10 per order.
Raw material cost per kilogram: $5
Storage costs average 10% of total inventory.

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Answer: EOQ =
A= Annual demand
√
2∗A∗O
C

O= Ordering Cost
C = Carrying Cost

EOQ = √(2∗25000∗10)/(5∗10)/100

EOQ = √ 1000000
EOQ = 1000 kg
Expected number of orders per year = Material consumed during the year/ EOQ
Expected number of orders per year = 25000/1000 = 25 Orders per year

3.5 Inventory Levels

It is an inventory management technique wherein quantitative levels of control are set for
inventory consumption, inventory purchase order or re-order, stock of inventory to be
maintained, etc.
3.5.1 Re-order Stock Level
The level at which a new purchase order for stock replenishment must be issued. This level
is set halfway between the maximum and minimum levels, such that the difference in
material quantity between the Re-ordering Level and the Minimum Level is capable to
accommodate production requirements until the new supply of material arrives.
The primary elements that are considered when determining a Re-ordering Level:
● Minimum quantity of the item to be stored.
● The utilization rate or usage rate.
● Lead time
Re-order Level = Maximum usage × Maximum lead time
Or
Re-order level = Minimum stock level + (Average usage * Average lead time)
3.5.2 Re-order Quantity level
When stocks reach the re-order stock level, the quantity of stocks ordered is referred to as
re-order quantity. The maximum stock level formula can be used to compute the re-order
quantity. The quantity is called Economic Order Quantity when it is properly chosen to
minimize overall stock cost.

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3.5.3 Maximum Stock Level
The Maximum Level specifies the maximum amount of material that can be maintained in
stock at any given point of time. The stock in hand is controlled in such a way that it rarely
exceeds this level. If stocks rise over this level, far too much money will be invested in them.
Maximum stock level = Re-order level + Re-order quantity - (Minimum Usage * Minimum
lead time)
The following factors should be considered while determining the level:
● At any particular time, the store's maximum requirement for manufacturing purposes.
● Utilization rate and lead time.
● Storage and insurance costs.
● Pricing economy: The maximum level is usually high for seasonal products purchased in
bulk during the season.
● Materials that are prone to rapid deterioration or expiry during storage must be kept
low.
● Funds availability and retail prices must be taken into account.
● The future market trend is another factor to examine. If prices are expected to grow, the
company may want to stockpile for the future.
● Materials are scarce and supplies are unpredictable, the maximum level should be large.
3.5.4 Minimum Stock Level
The Minimum Level signifies the least quantitative balance of a material that must be
maintained at all times to prevent production from being halted, owing to a lack of material.
If stock out is to be avoided, it is the minimum level of stocks that should not drop below.
Minimum stock level = Re-order level − (Average usage * Average lead time)
Here,
Average usage = (Minimum usage + Maximum usage)/ 2
Average lead time = (Minimum lead time + Maximum lead time)/ 2
3.5.5 Average Stock Level
This is the level of inventory or material that is generally maintained on hand over a period
of time. This is also known as the Normal stock level.
Average stock level = (Minimum stock level + Maximum stock level)/ 2
(or)
= Minimum stock level + (Re-order quantity/ 2)
3.5.6 Danger Stock Level
It is the point at which normal raw material issues are discontinued and only emergency
supplies are made. This is a fixed level that is usually lower than the Minimum Level. When

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the inventory reaches this level, immediate buying is recommended. This assumes that the
minimum level includes a buffer to account for such occurrences. At this point, the regular
lead time is not feasible. It is required to use an unconventional quick purchase strategy,
which results in a greater purchase.
If the action was done to purchase the material when the stock reached the Re-Ordering
Level, the Danger Level becomes irrelevant.
Danger Stock = Average usage * Lead time for emergency purchase
3.5.7 Buffer Stock
A buffer stock is a quantity of stock stored for contingencies, to be used in the event of
a sudden order or an emergency.

3.6 Illustration
The company requires Material A and Material B for producing the finished good XYZ. Its
material consumption and re-order information is as follows:
Particulars A B

Normal Usage or average usage 500 450

Maximum Usage 750 600

Minimum Usage 250 300

Re-order quantity 2500 2400

Re-order period or lead time 2 to 4 weeks 2 to 4 weeks

Calculate: Re-order level, Maximum stock level, Minimum stock level and Average stock
level.
Answer:
● Re-order Level = Maximum usage × Maximum lead time
A = 750*4 = 3000
B = 600*4 = 2400
● Maximum stock level = Re-order level + Re-order quantity - (Minimum Usage *
Minimum lead time)
A = 3000 + 2500 – (250*2) = 5000
B = 2400 + 2400 – (300*2) = 4200
● Minimum stock level = Re-order level − (Average usage * Average lead time)
A = 3000 – (500*3) = 1500
B = 2400 – (450*3) = 1050
Average usage = (Minimum usage + Maximum usage)/ 2
A = (250+750)/2 =500
B = (300+600)/2 =450
Average lead time = (Minimum lead time + Maximum lead time)/ 2
A = (2+4)/2 = 3

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B = (2+4)/2 = 3
● Average stock level = (Minimum stock level + Maximum stock level)/ 2
A = (1500 + 5000)/ 2 = 3250
B = (1050 + 4200)/ 2 = 2625

3.7 Inventory Management Policies

1. Just-in-time Inventory Management

Just-in-Time inventory system prioritizes "the right material, at the right time, in the right
place, and the appropriate amount" without relying on inventories. JIT is a type of inventory
management that entails working closely with suppliers to ensure that raw materials arrive
on time, but not earlier. The idea is to keep as little inventory on hand as possible to meet
demand.
JIT inventory ensures that you have adequate inventory to manufacture only what you
require when you require it. The goal is to achieve high-volume manufacturing while
reducing inventory and eliminating waste.
Benefits of JIT
● Low inventory levels lessen the danger of inventory being unsold and becoming obsolete
in the storage.
● JIT increases productivity by lowering the time and effort needed for manufacturing.
● Minimal inventory levels in JIT keep the amount of working capital required to a
minimum.
● Because less space is utilized, inventory holding costs (such as warehousing rent) are
negligible.
● Quality is guaranteed in advance by suppliers. As a result, goods are sent directly to
production areas rather than being kept at receiving for inspection.

2. ABC Analysis
ABC analysis is a strategy for inventory management that assesses the value of stock items
based on their importance to the organization. ABC ranks products based on demand, cost,
and risk and inventory managers classify items according to those criteria. This assists
business leaders in determining which items or services are most important to their
company's financial success. They can utilize the data to concentrate their effort and time
on Class A products rather than B and C products. Inventory managers, for example, will
utilize ABC analysis to examine purchase orders for the highest-value products first, because
they earn the most money.

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"Class A" products are the most significant stock-keeping units in terms of either total sales
or profits, while "Class B" products are the next most important and "Clasroducts are the
least significant. Fast-moving, Slow-moving, and Non-moving Inventory
Benefits of ABC Analysis:
● Optimization of Inventory - The analysis determines which products are in high demand.
An organization can then use its valuable warehouse space to effectively stock such
items while keeping Class B and C stock levels low.
● Optimizing resource allocation - ABC analysis is a method of regularly evaluating
resource allocation to ensure that Class A items are in accordance with consumer
demand. Reclassify the item when demand drops to make better use of staff, time, and
space.
● Reduced Inventory Carrying Expenses: By holding the appropriate proportion of stock-
based on A, B, or C classes, companies can minimize inventory carrying costs associated
with retaining excess inventory.

3. Vital, Essential, and Desirable (VED) Analysis

VED stands for Vital, Essential, and Desirable analysis. VED analysis is a technique for
inventory management that classifies inventory according to its functional value. Stock is
divided into three categories based on its value and requirement for an organization's
production.

Inventory is included in the "Vital" category since it is required for manufacturing or any
other activity in an organization. A scarcity of products in this category can seriously impede
or interrupt operations. As a result, such supplies are constantly checked, evaluated, and
replenished. As a result, such inventory should be ordered ahead of time.

Inventory is under the essential category are also critical for any business because it can
create a production halt or impede other operations. However, the loss caused by their
unavailability could be momentary, or the stock item or part could be repaired.

The desirable category of inventory is the least critical of the three, and its limited
availability might cause small production or processing halts. Furthermore, such deficits may
be easily replenished in a short period of time.

Benefits of VED Analysis

● VED leads to optimally managed inventories.

● Helps in understanding and categorizing inventories in accordance with their
importance.
● Helps in optimizing resource allocation by investing more in items under vital and
essential categories.

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3.5 Conclusion
A material is any substance that is a component of or makes up a finished product. Material
refers to the goods provided to an enterprise for use in the manufacturing process,
providing services, or transforming into products. The definition of Materials includes raw
materials, other stores, work-in-progress, finished goods, and scrap.
The material cost includes, among other things, the invoice price plus freight,
transportation, tariffs, taxes, and storage costs. Buying Cost + Total Ordering Cost + Total
Carrying Cost usually make up a material's total costs.
Materials in the stores should be sent to the production departments as needed. A material
requisition note is a document that specifies the items that must be issued.
There are two major documents used to record the receipt, issue, and balance of stocks
held: Bin card and Stock ledger.
Valuation of material issues can be done using FIFO, LIFO, and Weighted average methods.
The order size that optimizes the total of ordering and holding expenses associated with raw
materials or finished stocks is known as the economic order quantity. The Economic
Ordering Quantity is based on the following assumptions:
● Carrying cost per unit per annum and ordering cost per order are known and constant.
● The expected use of materials in units is determined.
● The material cost per unit is fixed and well-known.
● The quantity of material ordered is promptly delivered, implying no lead time.
Economic Ordering Quantity =
√ 2 AO
C
Inventory level is an inventory management technique wherein quantitative levels of
control are set.
The Just-in-Time inventory system prioritizes "the right material, at the right time, in the
right place, and the appropriate amount" without relying on inventories.
ABC analysis is a strategy for inventory management that assesses the value of stock items
based on their importance to the organization.
VED analysis is a technique for inventory management that classifies inventory according to
its functional value.

3.6 Glossary
● Material: Any substance that is part of or made up of a final product is referred to as a
material.
● Purchase costs: The price paid to suppliers for products purchased is referred to as the
cost of purchase.
● Ordering costs: The cost of placing an order and getting products into the store is
referred to as the ordering cost.
● Holding costs: The costs of keeping stock in the business are referred to as holding costs.
● Stockout cost: Stockout cost is the cost incurred when a company runs out of stock for
production.

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● Economic order quantity: It refers to the order size that has the lowest ordering and
carrying costs.
● Purchase Requisition Note: It is a document issued by the stores department to the
purchasing department authorizing the department to order new stocks.
● Goods Received Note: A goods received note is a document written to acknowledge that
items delivered by a supplier are accepted.
● Material Requisition Note: It is a document produced by a production or user
department to request materials from the stores department.
● Materials Return Note: It is a document issued when excess materials are being returned
to the store.
● Materials Transfer Note: This note is issued when materials are transferred from one job
or cost center to another without being returned to the store first.
● Order point: When the predefined minimum level of inventory on hand is reached, the
order point is reached, and the item should be ordered.
● Lead time: The lead time is the time between placing an order and receiving stock. It's
also known as the re-order period, delivery period, and so on.
● Usage: Usage, usually known as consumption, refers to the amount of stock utilized over
a given time period.

3.7 Short Answers

1) State the difference between the FIFO and LIFO methods of inventory issue. Which
method is suitable when stock is highly perishable?
2) Explain the weighted average method by giving an example.
3) What do you mean by bin card and how it is different from a stock ledger?
4) In a year, the company uses 3000 units of material. The material's purchase price is
Rs.10 per unit, excluding freight of Rs.3, duties and taxes of Rs.2, insurance of Rs.2, and a
trade discount of Rs.1. The carrying cost is estimated at 20% of the purchase price. It
costs Rs. 12 to place an order and process the delivery. Calculate EOQ.

3.8 Questions for discussion forum

1) A hospital's budget is heavily reliant on drugs and related supplies. Furthermore,
keeping the proper quantity of the right drugs is a difficult challenge for management.
While a shortage of crucial medicine can cause crises and even deaths, an
overabundance of non-essential medicines can cause money and space to be blocked, or
both. State the technique that can be used in hospitals to manage medical inventory
efficiently?
2) Economic Order Quantity (EOQ) can help you gain insight into your inventory condition
and, as a result, find ways to maximize revenues and lower costs. Explain.

3.9 Multiple Choice Questions

1) The cost of commodities supplied to an organization is known as
a) Stock out cost
b) Material cost

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 c) Ordering cost
d) Carrying cost
Explanation: The Institute of Cost and Management Accountants defines material cost as
"the cost of commodities supplied to an undertaking."
2) The definition of material does not include:
a) Finished goods sold in the normal course of business
b) Raw material
c) Work-in-progress
d) Assets sold in the normal course of business
Explanation: Raw materials, other stores, work-in-progress, finished goods, and scrap are all
included in the definition of Material.
3) The cost incurs when a company runs out of stock for production is
a) Sunk cost
b) Stock out cost
c) Shutdown cost
d) Storage cost
Explanation: Stock out cost is the cost incurs when a company runs out of stock for
production

4) _________ is a formal request to the Purchase Department to obtain materials.

a) Material Requisition note
b) Material transfer note
c) Goods Received note
d) Purchase Requisition note
Explanation: A Purchases Requisition is a formal request to the Purchase Department to
obtain materials of a specific description, grade, and volume within a certain time frame.
5) The document written to acknowledge that items delivered by a supplier are accepted.
a) Material Requisition note
b) Material Returned note
c) Goods Received note
d) Purchase Requisition note
Explanation: A goods received note is a document written to acknowledge that items
delivered by a supplier are accepted.
6) The time between placing and receiving an order and also known as the re-order period.
a) Lead time
b) Reception time
c) Purchase time
d) Requisition time
Explanation: - The lead time is the time between placing an order and receiving stock. It's
also known as the re-order period, delivery period, and so on.
7) While calculating Material cost, ________ is not taken into account.
a) Trade discount

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 b) Quantity discount
c) Cash discount
d) Duties and taxes
Explanation: Cash discount is not deducted as it is treated as interest or finance charge.
8) The formula for determining EOQ was devised by the great mathematician:
a) Michael Porter
b) Wilson
c) Neilson
d) Luca
Explanation: The formula for determining EOQ was devised by the great mathematician
'WILSON'
9) The purchase price of the newest batch in stock is used to price the issue of material?
a) LIFO method
b) FIFO method
c) Weighted average method
d) Perpetual weighted average
Explanation: Under LIFO, the purchase price of the most recent unit in the stock is used to
price the issue of material.
10) When prices decline, profits tend to grow due to lower material costs under:
a) FIFO
b) Weighted Average
c) LIFO
d) Perpetual Weighted Average
Explanation: When prices decline, profits tend to grow due to lower material costs under
LIFO method of inventory issue.
11) Each issue is charged at the same price till a new batch of material is delivered.
a) Weighted Average method
b) LIFO
c) FIFO
d) Perpetual Weighted Average
Explanation: Because each issue is charged at the same price till a new batch of material is
delivered under Weighted Average, it decreases the number of computations required.
12) Under which method production costs are understated in the event of rising pricing.
a) Weighted average method
b) LIFO
c) FIFO
d) LIFO and FIFO
Explanation: Under FIFO, production costs are understated in the event of rising pricing.
13) The Economic Ordering Quantity is not based on the following assumption:
a) Carrying cost per unit per annum and ordering cost per order are known and
fluctuating.

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 b) The expected use of materials in units is determined.
c) The material cost per unit is fixed and well-known.
d) The quantity of material ordered is promptly delivered, implying no lead time.
Explanation: Carrying cost per unit per annum and ordering cost per order are assumed
known and constant for calculating EOQ.
14) If the annual demand is 20000 units and the ordering cost and holding cost are Rs. 20
per order and Rs. 0.5 per unit, calculate EOQ.
a) 4000
b) 1689
c) 1265
d) 2499
Explanation: Economic Ordering Quantity (EOQ) =
units
√
2 AO
C
=√(2∗20000∗20)/ (0.5) = 1264.91

15) ________ is the point at which normal raw material issues are discontinued and only
emergency supplies are made.
a) Re-order level
b) Danger Stock level
c) Average Stock level
d) Minimum Stock level
Explanation: Danger stock level is the point at which normal raw material issues are
discontinued and only emergency supplies are made.
16) Calculate the Re-order level if the Minimum stock level is 1600 units, the Maximum
stock level is 2400 units, the Average usage is 400 units and the average lead time is 3
weeks.
a) 2700
b) 1200
c) 4800
d) 2000
Explanation: Re-order level = Minimum stock level + (Average usage * Average lead time)
[2400+(400*3)] = 2700 units
17) Quantity of stock stored for contingencies, to be used in the event of a sudden order or
an emergency situation.
a) Re-order quantity
b) Danger level stock
c) Buffer stock
d) Minimum stock
Explanation: A buffer stock is a quantity of stock stored for contingencies, to be used in the
event of a sudden order or an emergency situation.

18) Inventory system prioritizes the right material, at the right time, in the right place, and in
the appropriate amount is:

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 a) ABC analysis
b) VED analysis
c) JIT Inventory management
d) Ratio analysis
Explanation: Just-in-Time inventory system prioritizes "the right material, at the right time,
in the right place, and the appropriate amount" without relying on inventories.
19) A scarcity of products in this category can seriously impede or interrupt operations.
a) Desirable
b) Vital
c) Essential
d) Category B
Explanation: Inventory is included in the "Vital" category since it is required for
manufacturing or any other activity in an organization. A scarcity of products in this category
can seriously impede or interrupt operations.
20) _______ ranks products based on demand, cost, and risk, and inventory managers
classify items according to those criteria.
a) ABC analysis
b) VED analysis
c) JIT Inventory management
d) Ratio analysis
Explanation: ABC ranks products based on demand, cost, and risk, and inventory managers
classify items according to those criteria.

3.10 Case study

“Must Have” is a clothing brand selling a variety of styles all over the world. The brand has a
distinct concept that is rather distinctive to them. They are primarily interested in setting up
or sustaining fashion trends, and they can forecast what their clients would want to wear
months in advance. They usually design their complete collection for the rest of the season
and have it manufactured overseas. Their design staff, product developers, and
management are all located within a 20-minute drive of many of their production plants.
MUST HAVE primarily "follows the trend."  Two things dominate their strategic focus: speed
and pricing.
The manager, therefore, requires a strategy to manage inventories in an ideal way so that it
lowers the high cost of inventory in the clothing business. Stocking apparel is costly and
risky because more inventory is needed to meet the variety of styles, sizes, and colors needs
of customers.
Which Inventory management strategy would you suggest and why?

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