CHAPTER 4: MATERIAL COST

AND EMPLOYEE COST

Chapter objectives:
The objective is to provide an understanding of the accounting for material costs and
employee costs. In particular, the following are the learning objectives:
Learning Objective 1: General principles for accounting for material costs
Learning Objective 2: Cost formulas
Learning Objective 3: Inventory management
Learning Objective 4: Just-in-time production and inventory management
Learning Objective 5: Accounting for employee costs

Material costs and labour costs are important elements of the prime cost and overheads.
Therefore, every firm, particularly firms engaged in manufacturing activities, focuses on
the management and control of materials and employee time. Although material cost and
employee cost, as a proportion of the total cost, have been reduced in recent times due to
the increase in support services and automation, they still continue to be important cost
elements. Therefore, materials and employee time management continue to be important
functions in manufacturing organisations. However, in this book, our focus will be on
accounting for material cost and employee cost because materials management and
employee time management have emerged as separate disciplines, and it is difficult to
cover even the essential topics in one chapter.

LO1: ACCOUNTING FOR MATERIAL COST: GENERAL

PRINCIPLES
PURCHASE PRICE
The cost of a material is the total purchase price and all costs (e.g. customs duty, freight,
and transit insurance) incurred to bring the material to the stores. Any refund of tax (e.g.
GST credit) is deducted from the price paid to the supplier.
Trade discount and quantity discount

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Trade discount, which is the reduction given by a supplier to a retailer, and quantity
discount, which represents the discount on the purchase of a large quantity of material,
are deducted in arriving at the purchase price of the material.
Cash discount
Cash discount, which is the discount, which the purchaser earns if it pays earlier than the
allowable credit period, is an item of a purely financial nature. It is not deducted from the
purchase price to arrive at the purchase price of the material.
Container cost
Container cost, net of the amount refundable on return of the container, is included in the
material cost.
ISSUE PRICE
GENERAL PRINCIPLE
A general cost accounting principle is that the normal loss should be borne by units
produced, and abnormal loss or wastes should not be loaded into the product cost.
Abnormal loss is recognised in the costing profit and loss account, which is used for
internal reporting as a part of the management information system.
The normal loss inherent in the process is a technical estimate. Abnormal loss is the loss
over normal loss.
In the context of the material cost, storage and issuing losses may arise because of the
following reasons;
a) Some materials (e.g. transformer oil) do not permit exact measurement.
b) Units of purchase and unit of the issue may differ. For example, steel plates are
purchased by weight and issued by numbers.
c) Losses may occur due to evaporation, drying, shrinkage etc.
The issue price per unit of material might not be the same as the purchase price per unit
of that material, as the quantity is lower than the quantity purchased due to loss during
storing and handling of the same. The issue price per unit is the purchase price per unit
inflated to recover the normal loss from the units issued to production.
Example 4.1 (Normal loss)
Fact pattern

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1,000 units of material are purchased at $ 9 per unit. The normal loss is estimated at 10
per cent.
Required
Calculate the issue price per unit
Analyses
The issue price per unit should be:
($ 9 × 1,000) ÷ (0.90 × 1,000) = $ 10
Use of the issue price of $ 10 per unit results in the recovery of the total purchase price of
$ 9,000 on the issue of 900 units. 100 units are lost in the storing and issuing process.
Therefore, the number of god units that can be used is only 900.
Example 4.2 (Abnormal loss)
Fact pattern
1,000 units of material were purchased at $ 9 per unit. The normal loss was estimated at
10 per cent. The actual loss is 120 units.
Required
Calculate the issue price and the cost of the abnormal loss.
Analyses
The issue price per unit is:
($ 9 × 1,000) ÷ (0.90 × 1,000) = $ 10
Abnormal loss = (120 - 0.10× 1,000) × $ 10 = $ 200
Note that the units lost is more than the estimated normal loss. The units lost in excess of
the normal loss are also priced at the issue price to measure the value of the abnormal
loss.
The abnormal loss of $ 200 should be charged to the costing profit and loss account.
JOINT-PURCHASE COSTS
It is not unusual for firms to purchase materials with different specifications in a lot. The
invoice shows a single purchase price for the whole lot. The joint cost is allocated to
different materials based on their current market prices. If current market prices are not
available, the joint cost is allocated to different types of materials based on some
technical estimate.
Incidental expenses

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Incidental expenses incurred jointly should be allocated to different materials on an
equitable basis. For example, the transport and storage charges may be allocated to
different consignments based on the weight or volume of each consignment and the cost
of transit insurance based on the value of each consignment.

LO 2: COST FORMULAS
Costs of direct materials are charged directly to a particular job, batch, or process. Costs
of indirect materials are included in overheads. The objectives of accounting for material
costs are to assign those costs to different jobs, batches and processes on a realistic and
consistent basis; and to provide a satisfactory basis for the valuation of inventories. An
important issue in accounting for direct materials is selecting the appropriate cost formula
to price the issue of interchangeable materials.
Box 4.1: Interchangeable materials
Interchangeable materials are those which lose its separate identity once placed in the
bin. The standard speaker used in a particular type of audio system is an example of
interchangeable material. A firm purchases speakers periodically. Speakers received in
different batches, when placed in the bin, mingle with each other, and it becomes
almost impossible to identify a particular speaker with the batch in which it was
received, with reasonable effort. Suppose the prices of speakers received in different
batches are different. In that case, the firm has to make certain accounting assumptions
to determine the amount that will be charged to a particular batch of the audio system
towards the speaker’s cost. Cost formulas capture those assumptions.

SPECIFIC IDENTIFICATION METHOD

Materials purchased for a specific job or a batch or process can be traced to that job,
batch or process. Therefore, the actual costs of those materials are assigned to respective
jobs, batches or processes for which they are purchased. For example, a job order for the
production of a large compressor is charged with the actual cost of motors and castings
purchased specifically for the job. Similarly, the costs of decorative items purchased for
decorating an office building are assigned to that building and are added to the
construction cost of that building.
FIRST-IN-FIRST- OUT METHOD (FIFO)

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The FIFO method assumes that materials are issued in strictly chronological order. Under
this method, the price of the earliest delivery in stock is considered for pricing materials
issued to production. The assumption that material received first is issued first is only an
accounting assumption. The physical movement of the material may or may not be in that
order.
Example 4.3 (FIFO)
Fact pattern
From the following transactions extracted from the books of accounts of a manufacturing
concern as of December 31, 2023:
Date Transaction Quantity (in units) Rate per unit ($)
2023 December 1 Opening stock 300 9.70
3 Purchase 250 9.80
11 Issues 400
15 Purchase 300 10.05
20 Issues 210
25 Purchase 150 10.30
29 Issues 100
Required
Calculate the (a) value of raw materials consumed in that month; and (b) value of the
closing stock as of December 31, 2023, applying the FIFO formula for pricing issues.
Show results in a tabular form.
Analyses
Date Receipts Issues Balance
Dec. Qty. Rate Value Qty. Rate Value Qty. Rate Value
2023 (Units) ($) ($) (Units) ($) ($) (Units) ($) ($)
1 300 9.70 2,910
3 250 9.80 2,450 550 5,360
11 300 9.70 2910
100 9.80 980
400 3890 150 9.80 1,470
15 300 10.05 3,015 150 9.80 1,470
300 10.05 3,015
400 4,485
20 150 9.80 1,470 240 10.05 2,412

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 60 10.05 603
210 2,073
25 150 10.30 1,545 240 10.05 2,412
150 10.30 1,545
390 3,957
29 100 10.05 1,005 140 10.05 1,407
150 10.30 1,545
290 2,952

LAST-IN-FIRST- OUT METHOD (LIFO)

This method assumes that the latest receipt of the material in stock is issued first. The
assumption that material received last is issued first is only an accounting assumption.
The physical movement of the material may or may not be in that order.
Example 4.4 (LIFO)
Fact pattern
The fact pattern is the same as provided in example 4.3 above.
Required
Prepare the Stores Ledger Accounts applying the LIFO formula of pricing issues.
Analyses
Date Receipts Issues Balance
Dec. Qty. Rate Value Qty. Rate Value Qty. Rate Value
2023 (Units) ($) ($) (Units) ($) ($) (Units) ($) ($)
1 300 9.70 2,910
3 250 9.80 2,450 550 5,360
11 250 9.80 2,450
150 9.70 1,455
400 3,905 150 9.70 1,455
15 300 10.05 3,015 150 9.70 1,455
300 10.05 3,015
400 4,470
20 210 10.05 3015 150 9.70 1,455
90 10.05 904.50
240 2359.50
25 150 10.30 1,545 150 9.70 1,455

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 90 10.05 904.50
150 10.30 1.545
390 3,904.50
29 100 10.30 1,030 150 9.70 1,455
90 10.05 904.50
50 10.30 515
290 2,874.50

WEIGHTED-AVERAGE COST METHOD

In this method issue prices are calculated by dividing the value of the stock on the date of
issue by the quantities in hand. The weighted average rate is calculated every time a fresh
lot is received. In absence of a fresh receipt, the weighted average price remains the same
after each issue.
Illustration 4.5 (Weighted average cost)
Fact pattern
The fact pattern is the same as provided in example 4.3 above.
Required
Prepare the Stores Ledger Accounts applying the LIFO formula of pricing issues.
Required
Prepare the Stores Ledger Accounts by applying the weighted average cost formula of
pricing issues.
Analyses
Date Receipts Issues Balance
Dec. Qty. Rate Value Qty. Rate Value Qty. Rate Value
2023 (Units) ($) ($) (Units) ($) ($) (Units) ($) ($)
1 300 9.70 2,910
3 250 9.80 2,450 550 9.7455 5,360
11 400 9.7455 3,898.2 150 9.7455 1461.80
15 300 10.05 3,015 450 9.9484 4,476.80
20 210 9.9484 2089.16 240 9.9484 2,387.64
25 150 10.30 1,545 390 10.0837 3932.64
29 100 10.0837 1,008.37 290 10.0837 2,924.27

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OTHER METHODS
Base Stock Method
This method assumes that a fixed minimum stock is always carried at the original cost.
The issue price is calculated using one of the conventional methods (i.e. FIFO and LIFO).
For example, if we use the data given in Example 4.3 and assume a base stock of 100
units, 100 units in the closing stock will always be valued at $ 9.70 and will be ignored
while applying the FIFO or LIFO formula.
Simple average price
This is the average price of the lots in stock, irrespective of the quantities involved.
Periodic-simple average price
In this method, the issue price is calculated at the end of the period. The issue price is
calculated with reference to the purchases during the period. Therefore, the opening stock
does not enter into the calculation.
Periodic-weighted average price
In this method, the issue price is calculated at the end of the period. The issue price is
calculated with reference to the purchases during the period. Therefore, the opening stock
does not enter into the calculation.
Moving-simple average price
In this method, the issue price is calculated by dividing the total of the periodic simple
average prices of a given number of periods (including the period in which the material to
be priced is issued) by the number of periods. The moving average price uses a number
(say 3,5 or 7) of periodic simple average prices, the last of which is that of the period in
which the material is used.
Moving-weighted average price
In this method, the issue price is calculated by dividing the total of the periodic weighted
average prices of a given number of periods (including the period in which the material to
be priced is issued) by the number of periods.
Standard price
Under this method, each issue is priced at a pre-determined standard price. This method
is used when the firm has a full standard costing system. Careful consideration of all the

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factors (such as quantity to be purchased, prevailing prices and likely fluctuations, and
estimated incidental expenses) is essential in setting standard prices.
Replacement price
The replacement price is the current market price of the material. At the point of every
issue, the replacement price is determined and the same is applied in pricing the
particular issue.
Next-in-first-out (NIFO) method
In this method, issued are priced at the next price, i.e. price of the material which has
been ordered (latest order) but is yet to be received. This is an attempt to value issues at
an actual price which is closer to the current market price and should be the replacement
price.
CHOICE OF THE METHOD
International Financial Reporting Standard (IFRS) restricts the choice between the FIFO
and average cost pricing methods for the purpose of valuing inventories for the purpose
of financial reporting to outsiders, including investors. There is no such restriction for
internal reporting.
Most firms use the weighted average method to price materials issued because it
smoothens price fluctuations and it is easy to operate. However, a firm which has a
definite pattern of material movement uses FIFO or LIFO depending on which of the two
methods is appropriate.
Firms which has a full standard costing system use the standard price method for pricing
materials issued.
The replacement cost method is the most appropriate method for use in determining the
product cost for the purpose of pricing decisions. However, it is difficult to operate.
Therefore, it is not in common use.

LO3: INVENTORY MANAGEMENT

The objective of inventory management is to minimise the total cost of carrying
inventory and order materials while ensuring that ‘stock outs’ do not occur and the
surplus stocks are not accumulated and carried.

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CONTROL LEVELS
Firms establish control levels for standard materials, which are in regular use. Control
levels cannot be established where the rate of consumption is erratic, the market of the
material is uncertain, or the material is not in common use.
Safety stock
Safety stock is the stock of the material in excess of the expected usage during the lead
time. Firms establish safety stock levels. Safety stock provides the cushion against the
stock-out position
Lead time (Reorder period)
The lead time (also called, reorder period) is the time taken to obtain the desired quantity
of the material from the time the need for the same is ascertained.
REORDERING LEVEL
This is the level at which the storekeeper initiates purchase requisition.
Reordering level = Maximum re-order period × Maximum usage
Alternatively
Reordering level = Safety stock + Average re-order period × Average usage
MINIMUM LEVEL
This is the level at which the purchasing department initiates actions to expedite supply.
Minimum level = Re-ordering level – (Average re-order period × Average usage)
MAXIMUM LEVEL
This is the level at which the consumption pattern and the re-order period are reviewed.
Maximum level =
Re-ordering level + Re-ordering quantity – (Minimum re-order period × Minimum usage)
DANGER LEVEL
At this level, emergent purchase actions are initiated. It is fixed somewhere below the
minimum level.
Example 4.6 (Control levels)
Fact Pattern
The following information is available in respect of material M:
Re-order quantity 2,000 units
Re-order period 4 – 8 weeks

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Usage Maximum 500 units per week
Normal 400 units per week
Minimum 300 units per week
Required
Calculate (i) Re-order level (ii) Minimum stock level and (iii) Maximum stock level
Solution
Reordering level =
Maximum re-order period × Maximum usage = 8 × 500 = 4,000 units
Minimum level =
Re-ordering level – (Average re-order period × Average usage) =
4,000 – (6 × 400) = 1,600 units
Maximum level =
Re-ordering level + Re-ordering quantity – (Minimum re-order period × Minimum usage)
= 4,000 + 2,000 – (4 × 300) = 4,800 units
Example 4.7 (Control levels)
Fact pattern
The minimum stock level and average stock level of raw material M are 4,000 and 9,000
units respectively.
Required
Calculate the reorder quantity.
Solution
Average stock level = (Maximum level + Minimum level)/2
Thus, Maximum level = Average level × 2 – Minimum level
Therefore, Maximum level = 9,000 × 2 – 4,000 = 14,000 units
The maximum level is touched immediately on replenishment.
Therefore, Maximum level = Minimum level + Reordering quantity
Thus, Reordering quantity = Maximum level – Minimum level =
14,000 – 4,000 = 10,000 units
ECONOMIC ORDER QUANTITY (EOQ)
Reorder quantity is the quantity to be ordered in a single purchase order.
The following factors are considered to determine the reorder quantity:

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  Consumption pattern
 Reorder period
 Availability of resources
 Nature of the material, e.g. risk of deterioration or evaporation
 Risk of price fluctuations
 Risk of obsolescence
 Storage space available
 Seasonal considerations as to the price and availability of supplies
 Quantity discount
 Carrying cost and ordering cost
The most important single factor which influences the decision on reorder quantity is the
total carrying cost and ordering cost. Carrying costs and ordering costs move in opposite
directions. An increase in the reorder quantity increases the carrying costs and reduces
the ordering costs. EOQ model aims at minimising the total carrying cost and ordering
cost. The model assumes the following:
 Demand, and purchase order lead time are known with certainty.
 Cost per unit is unaffected by order size and, therefore, is irrelevant in
determining EOQ.
 The cost of stock-out is prohibitively high and, therefore, the stock is replenished
before stock-out occurs.
 Ordering cost per order is constant and does not vary with the size of the order.
 The carrying cost varies directly with the average inventory.
The above assumptions are simplistic and are the main weaknesses of the EOQ model.

EOQ=
√ 2× Anual Re quiredunits×CostPerOrder
CostPerUnit×CarryingCost ( ExpressedAs % ofCostPerUnit )

EOQ=
√ 2× Anual Re quiredunits×CostPerOrder
AnnualcarryingCostPerUnit
Example 4.8 (EOQ and Control levels)
Fact pattern
(i) Cost of placing a purchase order: $ 20

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 (ii) Number of units to be purchased during the year: 5,000
(iii) The purchase price per unit including the transportation cost: $ 50
(iv) Annual cost of storage per unit: $ 5
(v) Lead time: Average: 10 days; Maximum: 15 days; Minimum: 6 days; For
emergency purchase: 4 days
(vi) Rate of consumption: Average: 15 units per day; Maximum: 20 units per day
Required
Calculate;
(a) Reordering level
(b) Maximum level
(c) Minimum level
(d) Danger level
Analyses

EOQ=
√ 2× Anual Re quiredunits×CostPerOrder
AnnualcarryingCostPerUnit

EOQ=
√ 2×5 , 000×20
5
=200 units

Reordering level = Maximum reorder period × Maximum usage = 15 × 20 = 300 units

Maximum level =
Reorder level + Reorder quantity – (Minimum usage × Minimum reorder period) =
300 + 200 – (6 × 10) = 440 units
Minimum level =
Reorder level – (Average usage × Average reorder period) = 300 – (10 × 15) = 150 units
Danger level = Average usage × emergency reorder period = 15 × 4 = 60 units
Note
Minimum usage = 2 × Average usage – Maximum usage = 2 × 15 – 20 = 10 units
Example 4.9 (EOQ)
Fact pattern
A wholesaler supplies 30 stuffed dolls each weekday (Monday – Friday) to various
shops. Dolls are purchased from the manufacturer in lots of 120 each at $ 1,200 per lot.

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For each order it places on the manufacturer of the dolls, the wholesaler incurs a handling
charge of $ 60 plus a freight charge of $ 250 per lot. It can place an order for multiple and
fractional lots. All orders are executed the next day. The incremental cost is $ 0.60 per
year to store a doll in inventory. The wholesaler finances inventory investment by paying
its holding company 2 per cent monthly for borrowed funds.
Required
(a) How many dolls should be ordered at a time to minimise the total annual inventory
cost? Assume that there are 250 weekdays in a year.
(b) How frequently should it order?
Analyses
Working Notes
(i) Annual requirements = 30 × 250 = 7,500 dolls
(ii) Cost per doll = $ 1,200/120 = $ 10
(iii) Annual carrying cost per doll = ($ 10 × 24% p.a) + $ 0.60 = $ 3
(iv) Ordering cost per order = $ 60 + $ 250 = $ 310

(a)
EOQ=
√ 2× Anual Re quiredunits×CostPerOrder
AnnualcarryingCostPerUnit

EOQ=
√ 2 ×7,500 × $ 310
$3
EOQ = 1,245 dolls
(b) Number of orders p.a. = 7,500/1,245 = 6.02 orders
Frequency of order = 12/6 = 2 months
ABC ANALYSIS (SELECTIVE CONTROL PLAN) – PARETO ANALYSIS
ABC analysis is the inventory management technique that applies the Pareto’s principle
to inventory management.
Applying that principle, we may state that:
The majority of inventory value is represented by relatively few items.
Box 4.2: Pareto’s law
The Pareto principle states that for many outcomes, roughly 80% of consequences
come from 20% of causes. This principle is also known as the 80/20 rule, the law of

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 the vital few, or the principle of factor sparsity. Joseph M. Juran, a management
consultant, developed the concept based on the works of Italian economist Vilfredo
Pareto, who showed that approximately 80% of the land in Italy was owned by 20% of
the population. Juran developed the concept in the context of quality control and
improvement.

ABC analysis categorisation of materials into A, B, and C categories based on their

importance. Usually, materials are classified as follows:
 A Category: A small number of items (say, 10% of the total number) account for
substantial usage (say, 70% of total cost)
 B Category: Items that are not categorised as A or C, 20% in number
representing 20% of the total cost
 C Category: A large number of small value items (say, 70% of the total number)
accounts for a very small usage (say, 10% of the total cost).
Categorisation of materials into the three categories enables the management to use
different control systems for each group of materials. Simple and less expensive controls
are applied to category ‘C’ category items, while rigorous controls are applied to ‘A’
category items.
Criticality of materials
ABC classification does not rank materials in terms of their criticality. Sometimes stock-
out costs may be very high for category ‘C’ items. For example, a delayed supply of very
high-value equipment (e.g. compressor) for want of some small value components (for
example, an item of special quality fastener) might result in a very high opportunity cost
of the funds locked up in an otherwise 100% complete equipment and might result in
payment of the penalty imposed by the customer. It might also hurt the relationships with
the customer. However, building a slightly higher ‘Safety stock level’, disciplined
recording of transactions, and proper monitoring of stock level would effectively avoid
the shortage position.
Procedure for classifying items into A, B, and C categories
The following procedure may be useful for classifying items under categories A, B and
C:

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  Rank all the items according to their annual usage value in descending order
putting the highest value item on the top.
 Show cumulative percentage of total consumption against each material.
 Similarly, show against each material, cumulative percentages of the total number
of items.
 Take a decision about the percentages of total usage value that should be covered
by the various categories.
The key criterion for classification
The ABC plan is drawn on the basis of the total cost of materials consumed or expected
to be consumed, which is calculated by multiplying the average number of units
consumed by the average price per unit. A material whose unit cost is highest among the
materials consumed may not be included in category ‘A’ if the average consumption, in
quantity, is very low. On the other hand, an item whose unit cost is not very high may be
included in category ‘A’, if consumption, in quantity, is high.
TWO BIN SYSTEM
The two-bin system of inventory control has many variations of the basic procedure.
Under this system, for each item, two bins are maintained. If materials are not kept in
bins, two separate piles are made for each material. One of the two bins contains enough
stock for usage during the period between receipt of a fresh supply of the material to the
date of placing the next order. The other bin contains quantity to cover normal usage
during the re-order period plus ‘safety stock’. A purchase requisition is issued
immediately when the second bin is tapped.
This system is simple, and in addition to being helpful in inventory control, facilitates
easy handling, physical counting, and control of the materials.

LO 4: JUST-IN-TIME (JIT)
Just-in-time is a management philosophy which aims at eliminating waste from every
aspect of manufacturing and its related activities.
Waste is defined by Fujio Cho of Toyota as:
“anything other than the minimum amount of equipment, materials, parts, space
and worker’s time, which are absolutely essential to add value to the product”

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Thus the waste is any resource used in excess of the minimum amount required to add
value to the product.
JIT PRODUCTION
The term JIT in the context of production refers to the approach of producing only what
is needed, when it is needed, in just the amount needed. In other words, JIT production
means producing required parts, at the required time, in the required amount, at each step
of the production process in the most economical manner.
The JIT philosophy aims at reducing waste. More specifically, JIT seeks to achieve the
following goals:
(a) Elimination of non-value-added activities
(b) Zero inventory
(c) Batch sizes of one
(d) Zero breakdown
(e) A 100% on-time delivery service
In practice, although firms using JIT may not achieve those goals fully, JIT creates an
environment of continuous improvement.
The following are the three key features of JIT production:
(a) The production line is run on a demand-pull basis so that activity at each workstation
is authorized by the demand of downstream workstations. Thus, parts move through the
production system based on end unit demand, focusing on maintaining a constant flow of
parts rather than batches of WIP.
(b) Set-up time and manufacturing lead time are minimized. Demand-led production may
require manufacturing small quantities of the product at a time and producing small
batches is economical only if set-up times are small.
(c) The production line is stopped if parts are absent or defective work is discovered. In
absence of buffer stock, emphasis is placed on doing the job right the first time. The
focus is on eliminating the root causes of defects, waste, or re-work. JIT goes hand in
hand with total quality.
(d) Production is organized in work cells. It reduces material handling costs.
JIT production is most appropriate where large volume products are made, or where it is
easy to switch machinery from making one product to another.

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Benefits
In a JIT environment,
(i) In the absence of large materials and work-in-process inventory, managers can control
inventory through visual inspection,
(ii) The cost of holding work-in-process constitutes, a lower percentage of the total cost
of production;
(iii) The need for an elaborate cost accounting system of stores requisition, material
transfer notes, rework accounting and so forth is avoided.
All the above provide a tremendous cost advantage to firms adopting JIT production.
Work Cells (Manufacturing Cells)
‘Work cells’ or ‘manufacturing cells’ refers to the system of organizing the
manufacturing process in a cluster. The main features of work cells are:
(a) Organizing related manufacturing processes in clusters
(b) Grouping of all the different types of equipment used to manufacture a given product.
(c) Grouping all activities from the raw material stage to the finished goods stage in the
same cell.
‘Work cell’ system reduces movement of materials and work-in-progress and provides
visual control. This reduces the cost of material handling and supervision and improves
production quality.
JIT PURCHASING
JIT purchasing demands working in close co-operation with vendors. Usually, firms work
with a few vendors and develop a kind of partnership with them. Firms using JIT
purchasing enter into long-term contracts with them to enable vendors to plan their
annual production. JIT purchasing aims at achieving a smooth flow of materials in
vendors’ factories. They pay a premium for on-time delivery of high-quality goods in the
exact quantity required. Thus, the responsibility for checking quality and quantity is
placed on vendors.
Proponents of JIT purchasing argue that firms following conventional purchasing policy
overestimate ordering costs and underestimate the holding cost of inventories. The
argument seems plausible if we include in the holding cost the cost of quality (e.g.,
inspection cost of incoming materials, cost of returning defective materials, scrap cost,

18
rework cost, cost of idle capacity arising due to defective materials), the cost of delayed
delivery (e.g., expediting cost, the contribution margin of lost sales, cost of idle capacity)
and the cost of early delivery (e.g., incremental carrying cost). All those costs should be
viewed as derived holding costs. Ordering cost comes down significantly for firms which
use the computer-aided integrated system for production and material planning.
Let us consider how these factors affect the EOQ model.

EOQ=
√ 2× Anual Re quiredunits×CostPerOrder
AnnualcarryingCostPerUnit

EOQ=
√ 2 × D ×CO
CH

Situation A Situation B
(Conventional perceptions) (JIT perceptions)
D: 100 units per annum 100 units per annum
CO: Rs. 100 Rs. 10
CH: Rs. 10 per annum Rs. 100 per annum
EOQ = 44.72 units, say 45 units EOQ= 4.47 units, say 4 units
Thus, under JIT perception, EOQ is much lower as compared to EOQ under conventional
perceptions.
Under the JIT environment, the EOQ model has lost its relevance because the focus is on
the synchronization of delivery and usage. A firm compares the reduction in costs of
quality, costs of delayed delivery, costs of early delivery and ordering costs, (e.g., cost of
negotiations, cost of placing purchased order, cost of processing documents for making
payments against each transaction) with the premium payable to suppliers to estimate the
net benefit from JIT purchasing. Firms using JIT purchasing have reported significant
savings in cost.
KANBAN
Kanban is a Japanese word meaning ‘display’ or ‘instruction card’. In a factory setting,
the card describes the part number, the number of parts that should accompany the card,
the source of supply, the delivery location, the reorder point on the shelf stack, and the

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lead time negotiated between the internal customer and producer or the plant and an
external subcontractor.
Firms use ‘Kanban’ or any similar communication system as a production control tool.
The downstream process (subsequent step in the production process) details of part for
the upstream process (previous step in the production process) according to the
information described in the detached Kanban card (move card). People in the production
process produce parts according to the information described on the Kanban card
(production card). If there is no Kanban card, there will be no production or transfer of
materials.
The Kanban card is always attached to the bin except when it is in transit to order
production or transportation of parts. Kanban system works efficiently, only if 100 per
cent quality parts are produced.
Kanban, when used in conjunction with JIT, reduces lead time, decreases inventory, and
improves productivity by linking different processes together.

LO 5: ACCOUNTING FOR EMPLOYEE COSTS

ELEMENTS OF EMPLOYEE COST
Employee cost is the total cost to the company (CTC) for compensating employees for
their services and also for retaining them. Therefore, employee cost includes both
monetary and non-monetary benefits.
Employee cost does not include the cost of recruiting and training employees.
Examples of monetary benefits are:
 basic salary and dearness pay/allowance;
 overtime pay;
 productivity and profit sharing bonus;
 house rent allowance;
 the fair value of employee stock options;
 special allowances such as night shift allowance and attendance allowance;
 contribution to post-retirement benefit schemes like pension, provident fund; and
 contribution to staff welfare schemes.

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Examples of non-monetary benefits are free accommodation, medical facilities,
subsidised canteen services, subsidised transport, and recreational and sports facilities.
ACCOUNTING FOR EMPLOYEE COSTS
Table 4.1 below summarises the accounting principles for accounting for employee costs:
Table 4.1: Accounting for employee costs
Particulars Accounting principles and methods
1. Normal idle time Normal idle time arises from allowed lunch breaks
and other breaks, normal waiting time for materials
etc.
The employee cost per hour applied for assigning
employee costs to cost objects (rate) is inflated to
include normal idle time. For example, if
employees are paid for eight hours and the normal
idle time is one hour, the hourly rate is calculated
by dividing the total employee costs by seven
hours.
2. Abnormal idle time Costs arising from the abnormal idle time (like idle
time due to machine breakdown, and disruptions in
the power supply) are charged to the Costing Profit
and loss Account.
3. Direct employees’ costs Direct employees’ costs are traced to cost
objectives like, jobs, batches, and processes.
4. Indirect employees’ costs Costs of indirect employees are included in
overheads.
5. Overtime premium The difference between overtime and normal rates
is called overtime premium.
(a) Premium related to overtime work attributable
to a particular job/batch is directly booked to that
job.
(b) Premium related to overtime work arising from
an increased workload is included in the
manufacturing overhead.
(c) Premium related to overtime work necessitated
to cover up a loss of production due to the fault of
another workstation is included in the
manufacturing overhead of that workstation.
(d) Premium related to overtime work necessitated
to cover up the loss of production due to abnormal
conditions is charged to the Costing Profit and Loss
Account.
6. Night-shift allowance Same as the accounting for the overtime premium.
7. Holiday and vacation pay (a) Usually, holiday and vacation pay is included in
the manufacturing overheads. Alternatively, direct
labour hour rate is inflated to cover holiday pay and

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 vacation pay.
(b) If a special vacation is allowed to a special
category of employees because of the very nature of
the job, holiday pay and vacation pay of such
category of the employees should be charged to the
special job.

EMPLOYEE TURNOVER
Employee turnover refers to the change in the labour force during a specified period. It is
a normal phenomenon in every firm. Every firm aims to reduce employee turnover and
retain talent. However, in certain industries ( like call centres) higher employee turnover
is considered beneficial to the firm, as the firm can recruit new employees with similar
skills at a cost lower than the cost of employees who are replaced by new employees.
LO: 4 EMPLOYEE TURNOVER RATE
Various methods are used to measure the labour turnover rate. The following are the
popular methods for measuring employee turnover rate:
NumberOfEmployeesRe placed×100
Re placementRate=
AverageNumberOfEmployeesOnRoll
NumberOfEmployeesSeparated×100
SeparationRate=
AverageNumberOfEmploeesOnRoll
AccessionDuringThePeriod ×100
AcessionRate=
AverageNumberOfEmplyeesOnRoll
( Separation+ Accession )×100
FluxRate=
AveragefEmployeesOnRoll
Some accountants use the following formula to calculate the flux rate:
( Separation+Re placements )×100
FluxRate=
AveragefEmployeesOnRoll
Accession = The number of employees at the end of the period – Number of employees
at the beginning + Number of employees left during the period
Example 4.10 (Employee turnover)
Fact pattern
The number of employees on the payroll:
At the beginning of the month: 900
At the end of the month: 1,100

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During the month 10 employees left, 40 employees were discharged and 250 employees
were recruited. Of these, 25 employees are recruited in vacancies of those leaving, while
the rest were engaged in an expansion scheme.
Required
From the following data given by the Personnel Department, calculate the labour
turnover rate by applying:
(a) Separation method
(b) Replacement method
(c) Flux method
Analyses
NumberOfEmployeesSeparated×100
SeparationRate=
AverageNumberOfEmploeesOnRoll
Average employees = (900 + 1,100)/2 = 1,000
Number of employees separated = (10 + 40) = 50
Separation Rate = (50/1,000) × 100 = 5%
NumberOfEmployeesRe placed×100
Re placementRate=
AverageNumberOfEmployeesOnRoll
= (25/1,000) × 100 = 2.5%
( Separation+ Accession )×100
FluxRate=
AveragefEmployeesOnRoll
Accession = 1,100 – 900 + 50 = 250
Flux rate = (50 + 250)/ 1,000 = 30 %
Alternatively:
( Separation+Re placements )×100
FluxRate=
AveragefEmployeesOnRoll
= (75/1,000) × 100 = 7.5%
CAUSES OF EMPLOYEE TURNOVER
Causes of employee turnover may be grouped under the following categories:
 Personal causes
 Unavoidable cusses
 Avoidable causes

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Table 4.2 below presents examples of causes for employee turnover
A. PERSONAL CAUSES
1. Dissatisfaction with the industry, job, locality or environment
2. Domestic reasons
3. Change of job for the betterment
4. Retirement due to old age or ill health
5. Retirement due to old age or ill health
6. Death of a kin
B.UNAVOIDABLE CAUSES
1. Seasonal nature of business
2. Shortage of resources like material, power, funds etc.
3. Market recession
4. Plant relocation
5. Discharge on disciplinary grounds
C. AVOIDABLE CAUSES
1. Dissatisfaction with the compensation package, fringe benefits (e.g. housing
facilities), job, working conditions etc.
2. Lack of career planning
3. Dissatisfaction with management policies
4. Strained relationship with superiors and co-workers

REMEDIAL STEPS
Turnover can be managed by introducing:
(i) A system for the correct assessment of overall personality and family background at
the time of recruitment;
(ii) An effective system of job analysis and evaluation for proper placement of workers
(iii) A career plan for each employee
(iv) A system for human resource development including training and re-training
(v) A system of counselling on personal problems;
(vi) An effective system of conflict resolution
(vii) A system for benchmarking compensation packages with those offered by
comparable firms
(v) Transparency in implementing the personnel policy
COSTS OF EMPLOYEE TURNOVER
Cost of employee turnover may be grouped under two broad headings:
(a) Preventive costs; and
(b) Replacement costs

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Preventive costs
Preventive costs are incurred to manage employee turnover.
Examples:
 costs on personnel administration,
 costs of medical services,
 costs of welfare activities,
 cost of human resource development,
 cost of better retirement benefits (difference between the benefit being provided
by the firm and industry average), and
 better remuneration(difference between the remuneration being provided by the
firm and industry average).
Replacement costs
Replacement costs arise because of high labour turnover.
Examples:
 costs associated with inefficiency of new employees,
 expenses of recruitment, training and induction of new employees,
 loss of output due to delay in obtaining new employees,
 costs associated with abnormal breakage of machines and tools, costs associated
with abnormal scrap and spoilt work, and costs arising from accidents.
Increase in preventive costs reduces labour turnover resulting in reduction in the
replacement costs. Management aims to minimise the total labour turnover costs.
ASSIGNMENT
2.1 (EOQ)
The following information relating to a type of raw materials is available:
Annual demand 2,400 units
Unit price CU 2.40
Ordering cost per order CU 4.00
Storage cost 2% per annum
Interest rate 10% per annum
Lead time Half month

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Calculate economic order quantity and total annual inventory cost in respect of the
particular raw material.
(Adapted, ICWA, Inter)
[Answer: EOQ 258 units; Ordering cost CU 40; Carrying cost CU 37.15; Purchase cost
CU 5,760.00; Total annual inventory cost CU 5,837.15.]
2.2 (Control levels)
Calculate maximum level, minimum level and re-ordering level from the following data:
Re-ordering quantity: 1,200 units; Maximum consumption: 300 units per week
Re-ordering period: 4 to 6 weeks; Minimum consumption: 200 units per week
Normal consumption: 250 units per week.
(Adapted, B.Com (Hons.), CU)
[Answer: Maximum level 2,200 units; Minimum level 550 units; Re-ordering level 1,800
units)]
2.3 (Control levels)
In a company, weekly minimum and maximum consumption of Material A are 25 and 75
units respectively. The re-order quantity as fixed by the company is 300 units. The
material is received within 4 to 6 weeks from issue of supply order. Calculate minimum
level and maximum level of Material A.
(Adapted, CA, Inter)
[Answer: Minimum level 200 units; Maximum level 650 units.]
2.4 (EOQ)
A company uses 5,120 units of a component in a year. The purchase price per unit of the
component is CU 5 and the carrying cost including interest is estimated at 20% of the
average investment on annual basis. The cost of placing an order and process the delivery
is CU 10. Ascertain the economic order quantity and the number of orders, each of the
economic order quantity, to be placed for the component in a year.
Assuming the average daily consumption of the above components is 14 units and that
the normal lead time is 15 days, calculate the ordering level for the component, where
safety stock is considered to be equal to 25 days consumption.
(Adapted, B.Com (Hons.), CU)

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[Answer: EOQ 320 units; Number of orders to be placed 16; and Re-order level 560
units]
Hint: Re-order level = 350 + (14 × 15) = 560 units.
2.5 (FIFO and LIFO methods)
The stock of material A as at 1.4.2008 is 500 units at CU 1 per unit. The following
purchases and issues of this item were made subsequently:
Purchases Issues
Date Units Rate (CU) Date Units
April 6 100 1.10 April 9 500
April 20 700 1.20 April 22 500
April 27 400 1.30 April 30 500
May 13 1,000 1.40 May 15 500
May 20 500 1.50 May 22 500
June 17 400 1.60 June 18 500
June 28 600 1.70 June 28 500
Prepare a statement, showing how the value of the above issues should be arrived at
under the LIFO and FIFO methods.
(Adapted, ICWA, Inter)
[Answer: Closing stock 700 units; Value LIFO CU 950.00, FIFO CU 1,180]
2.6 (Weighted average method)
(a) Copper is one of the important raw materials stored by ABC Cable Company. There
have been wide and sudden fluctuations in copper prices from time to time. From the
following transactions for the month of May 2008, prepare the Stores Ledger account for
copper for this company, adopting a suitable method of pricing for the issues. Issue rates
may be rounded off of nearest rupee for convenience.
May 1 Opening balance 3,000 kg @ CU 15 per kg
May 3 Purchased 5,000 kg @ CU 16.00 per kg (RR No. 101)
May 4 Issued (MR No. 101) 1,200 kg
May 10 Surplus from production returned to stores (SC No. 301) 200 kg
May 15 Stock verified (SV Notes No. 401) and quantity, 7,050 kg was found
May 20 Issued (MR No. 102) 4,000 kg

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May 25 Purchased (RR No. 102) 4,950 kg @ CU. 13 per kg
May 30 Issued (MR No. 203) 3,000 kg
(b) Explain the method of pricing following in part (a) above and indicate why this
method is preferred to other methods.
(Adapted, ICWA, Iner)
[Answer: Weighted-average method is used; closing stock 5000 kg CU. 68,150]
2.7 (Weighted average method)
From the following details of stores receipts and issues of material “EXE” in a
manufacturing unit, prepare the Store Ledger using weighted-average method of valuing
the issues:
Nov. 1 Opening stock 2,000 units @ CU 5.00 each
Nov. 3 Issued 1,500 units to production
Nov. 4 Received 450 units @ CU 6.00 each
Nov. 8 Issued 1,600 units to production
Nov. 9 Returned to stores 100 units (from the issues of Nov. 3)
Nov. 16 Received 2,400 units @ CU 6.50 each
Nov. 19 Returned to supplier 200 units out of the quality received on No. 4
Nov. 20 Received 1,000 units @ CU 7.00 each
Nov. 24 Issued to production 2,100 units
Nov. 27 Received 1,200 units @ CU 7.50
Nov. 29 Issued to production 2,800 units
(Use rates up to two decimal places)
(Adapted, ICWA, Inter)
[Answer: Closing stock 3,000 units CU 19,558.00.]
2.8 (Labour cost)
The following information gives details of the gross pay calculated for a production
worker.
Basic pay for normal hours worked: 40 hours at CU 10 per hour CU400
Overtime: 5 hours at double the rate CU100
Group bonus payment: CU 40
Gross wages for the week: CU540

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Although paid for 40 hours in normal time, the worker was in fact unable to work for 6
hours because of machine breakdowns.
Analyze the total of CU 540 into direct and indirect costs.
[Answer: Direct costs CU 430; Indirect costs CU 110.]
2.9 (Accounting for overtime)
A firm’s basic rate is CU 10 per hour and overtime rates are 150 per cent of the basic rate
for evenings and 200 per cent of the basic rate for weekend. Hours worked on three
different jobs are given below:
Job A Job B Job C
Clock hours Clock hours Clock hours
Normal time 500 200 150
Evening work 100 50 80
Week-need 20 30 10
Required:
Calculate the labour cost chargeable to each in the following circumstances:
(a) Where overtime is worked to cope with increase in product.
(b) Where overtime is worked at the customer's request to bring forward the delivery
time.
[Answer: (a) A CU 6,200; B CU 2,800; C CU 2,400 (b) A CU 6,900; B CU 3,350;
C CU 2,900]
2.10 (Labour turnover)
From the following data provided to you find out the Labour Turnover Rate by applying:
(a) Flux method; (b) Replacement method; (c) Separation method
Number of workers on the payroll:
At the beginning of the month 500
At the end of the month 600
During the month, 5 workers left, 20 persons were discharged and 75 workers were
recruited. Of these 10 workers were recruited in the vacancies of those leaving, while the
rest were engaged for an expansion scheme.
(Adapted, ICWA, Inter)
[Answer: Flux method 6.36%; Replacement method 1.82%; Separation method 4.54%.]

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