PRICING AND COSTING

Chapter 2: Accounting for Materials Date: February 6, 2023

ACCOUNTING FOR MATERIALS:

A. Requirements are essential to an effective internal control system for materials as

follows:
1. To maintain a minimum inventory or investment (cash outlay) in materials and supplies.
2. Materials of the desired quantity and quality should be available when needed for
efficient and uninterrupted operations.
3. Materials should be purchased only when need arises, in economical quantities at most
favorable price and approved by authorized officers.
4. Materials should be checked and received by authorized personnel if they are in good
condition.
5. Payment of materials purchased should be properly checked and approved.
6. Issuance of materials should be properly authorized and accounted for.
7. Materials should be handled and under the responsibility of authorized personnel in
charge.

THERE ARE TWO BASIC ASPECTS OF MATERIAL CONTROL:

1. Physical Control
2. Control of the Investment (cash outlay) in materials.

● Physical Control of Materials

1. Effective Internal Control of Materials:

a) A system of authorization and approval.

- Authority and responsibility should be established and/or delegated. Specific personnel

are delegated the powers of approval and checks are instituted to determine that
transactions are approved by authorized personnel.
- In other words, control measures such as authorization and approval reduce the
likelihood of improper transactions.

b) Segregation of duties and responsibilities.

- Are the functions of materials requisition, purchasing, custody and recording

segregated? Said functions should be segregated to minimize opportunities for
pilferage, (a theft of small quantities of goods or of low-value goods) misappropriation
and misuse of materials inventory.
- In other words, long-term risk management and internal controls for a business.

3 under of segregation of duties and responsibilities:

1. Requisition/Purchasing
- Are materials requisitioned accurately prepared by materials stock clerk or materials
stockman. Are purchase orders approved by authorized officers?
- In other words, the first step of the company purchasing process.

2. Custody
- Only authorized personnel should have access to the materials stock room area.
Personnel in charge are directly accountable and responsible to the safekeeping of all
materials inventory. All issuance of materials for use in production should be properly
documented, checked and approved.
- In other words, it includes the settlement, safekeeping, and reporting of customers'
marketable securities and cash.

3. Recording
- All transactions such as requisition, purchasing, receiving, warehousing and releasing
are properly recorded. The stock card or general ledger/subsidiary being maintained by
the store room personnel and the accounting department.
- In other words, tracking/recording the business finances using the data.

_________________________________________________________________________

1
 c) Surprise audit should be made regularly
- Materials inventory should be examined and checked regularly by auditor’s. Actual
physical balance of materials should be compared with stock cards and ledger/s.
- In other words, to check that the accounting and other records are prepared and
kept up to date.

● Controlling the Investment (Cash Outlay) in Material

1. The Economic Order Quantity “EOQ” model.

- Also known as square root rule (SRR), economic lot size (ELS) and economic batch
size (EBS); that refers to the units of materials that should be purchased to minimize
total relevant inventory costs. The total inventory costs include the sum of ordering costs
and carrying costs.

Formula:
2 𝑥 𝐴𝐷 𝑥 𝑂𝐶
EOQ (Economic Order Quantity) = 𝐶𝐶𝑃𝑈
AD = Annual Demand
OC = Ordering Cost
CCPU = Carrying cost per unit of inventory

Example:

Given:
Annual demand or requirement = 24,000 units
Ordering cost = ₱750.00
Carrying cost per unit = ₱ 4.00

2 𝑥 𝐴𝐷 𝑥 𝑂𝐶
EOQ = 𝐶𝐶𝑃𝑈
2 𝑥 24,000 𝑥 ₱750.00
= ₱4.00
36,000,000.00
= ₱4.00
9,000,000.00
=
EOQ = 3,000 units

● Ordering Costs

- Cost of placing and receiving an order.

Formula:
Cost Per Order = Total Ordering Costs
Number of orders

Total Ordering Costs = (Cost Per Order x Number of Orders)

Number of Orders = Annual demand

Order size ( or EOQ)

Illustration:

Diane Garment Manufacturing Company expects to use 10,000 meters of cotton

cloth per month in 2016. In 2015, the total ordering costs amounted to ₱20,000.00 for a total of
40 orders. It is expected that prices in 2016 would be 10% higher than that of 2015. Compute
the expected ordering costs in 2016 if the company orders in a batch of 12,000 meters or
24,000 meters.

Solutions:

Annual demand = 10,000 meters x 12 months

= 120,000 meters
Expected cost per order in 2016 = ₱20,000 x 110% = ₱550.00
40 orders

____________________________________________________________________________

2
Solutions:

● Carrying Cost

- Are those costs incurred in maintaining or storing inventories.

Formula:
Carrying Cost per Unit = Total carrying costs
Average Inventory

Total Carrying Costs = Carrying Cost per unit x Average Inventory

Average Inventory = EOQ ( or Order size)

2
Carrying Cost per Unit = Unit cost x Carrying cost ratio

Carrying cost ratio = Carrying cost per unit

Unit Cost

Illustration:
In 2018, Asmirah Manufacturing Company incurred a total of ₱400,000.00 for
materials inventory carrying costs with an average materials inventory of 200,000 units. What
would be the total carrying costs in 2019 if the order size is 500,000 units or 900,000 units,
assuming the company does not maintain safety stock quantity.

____________________________________________________________________________

3
 2. Reorder Point (ROP)

- Sometimes called ad Lead Time Quantity (LTQ), refers to the inventory level where a
purchase order should be placed. Once an Economic Order Quantity (EOQ) has been
determined, management should decide when to place an order whether at reorder point
or at revised reorder point.

Formula:

Reorder Point = Average daily usage x Average lead time

Revised render point = Lead time quantity x Safety stock
Lead time quantity = Average daily usage x Average lead time
Safety Stock Quantity = Safety Stock (in usage) + Safety Stock (in time)
Safety Stock (in usage) = (Maximum daily usage - Average daily usage)
Safety Stock (in time) = (Maximum lead time - Average lead time) x
Average daily usage

➢ Lead Time
- Refers to the period between the placement of the order and the receipt of the
materials ordered.

➢ Lead Time Quantity

- Refers to the average daily usage during the lead time period.

➢ Average Usage
- Refers to the average daily usage of inventory during the period (annual usage /
working days in a year).

➢ Safety Stock
- Refers to additional inventory as a cushion against possible stock outs,
unforeseen such as surge in demand or a longer-than-usual lead time. Safety
stock is also known as buffer stock.

iIllustration:

Quezon Manufacturing Company has the following production data:

Annual Requirement = 80,000 units

Number of working days = 320 days
Average lead time = 10 days
Max. lead time = 16 days
Max. daily usage = 300 units
Economic Order Quantity = 5,000.00

____________________________________________________________________________

4
 3. Minimum- Maximum Method

- The minimum-maximum method sets the limits in inventory balances. Here the minimum
inventory level serves as the reorder point. It includes the average quantity to be used
from the time an order is placed up to the time the materials are received (i.e lead time).
The safety stock quantity is also included to minimize the occurrence to stock out. The
maximum inventory level is the sum safety stock quantity and the order size.

Illustration:

4. The two-bin system

- Materials are stored in bins or specific stocking areas. Two (2) bins are used, one bin
contains the quantities to be used from the date the materials are received up to the time
an order is to be placed and the other bin contains the quantities to be used during the
waiting time (or lead time) plus the safety stock. Once the first bin is consumed an order
from two (2) bins is automatically placed. Or simply two bins equally full of stocks are
used, when one bin becomes empty an order for stock (1bin) is placed. This should
arrive before the second bin is emptied.

5. ABC Classification

- The ABC model or selective control model classifies inventories into three classes. A, B
and C. Class A includes the high value items, Class B, the average value items and
Class C the low value items. Relevant principles and practices with regard to these
inventory classes are summarized as follows:

● The ABC Classification model is related to Pareto’s law or the 80-20 rule. That is, 80%of
the inventory value is grouped in class A, high-value inventory classification and the
remaining 20% are grouped in class B and class C classifications or it may also be 80%
of the inventory value are grouped in class B and C and the remaining 20& in class A.
____________________________________________________________________________

5
 ● Innovative Inventory and Production Management

- Traditional Inventory Model or sometimes called the just-in case system maintained
large amounts of the three types of inventories to act as buffers so that operations can
proceed smoothly just in case there are unanticipated interruptions.

- Just-in-time management (JIT) management is a managerial strategy applied in

manufacturing which involves having the right materials of right quality and quantity in
the right place and the right time. It has the objective of eliminating idle resources
throughout the company. It is the anti-thesis of just-in-case management which calls for
stocks to be held (buffer stocks) in case something goes wrong.

● Methods of Costing Materials

1. First-in, First-out Method (FIFO)

2. Weighted Average Method

a) Simple Weighted Average
b) Moving Average

3. Specific Identification Method

MEANING:

1. First-in, First-out Method (FIFO)

- Under this method, cost follows the usual physical flow of the materials. The cost of
materials purchased first is the first cost to be issued into production. The first (or
earliest) cost recorded for a particular type of materials in its stock card or subsidiary
ledger is the first cost taken out.

2. Weighted Average Method

a) Simple Weighted Average Method

- Used for periodic inventory systems. This method is based on the assumption that units
issued in a particular accounting period (usually 1 month) should be charged at an
average cost; such average being computed by the total amount of purchases divided by
the total number of units acquired. The inventory at the end is computed by multiplying
the weighted average cost per unit by the units on hand.

b) Moving Average Method

- Is used for perpetual inventory systems. Under a moving average method, a new
average is computed after each purchase of materials by dividing the total cost of the
materials available by the number of units then on hand. Issuance is recorded at this
latest average cost until a new purchase changes the average cost.

3. Specific Identification Method

- Under this method, it requires a detailed physical count of each item used or sold and
each item remaining in the inventory is identified. This method can be best applied to
companies with few inventories.

____________________________________________________________________________