F2-05 Accounting For Materials

Session 5
Accounting for Materials
FOCUS
This session covers the following content from the ACCA Study Guide.
B. Cost Accounting Techniques

1. Accounting for material, labour and overheads
a) Accounting for materials
i) Describe the different procedures and documents necessary for
ordering, receiving and issuing materials from inventory.
ii) Describe the control procedures used to monitor physical and "book"
inventory and to minimise discrepancies and losses.
iii) Interpret the entries and balances in the material inventory account.
iv) Identify, explain and calculate the costs of ordering and holding
inventory (including buffer inventory).
v) Calculate and interpret optimal reorder quantities.
vi) Calculate and interpret optimal reorder quantities when discounts apply.
vii) Produce calculations to minimise inventory costs when inventory is
gradually replenished.
viii) Describe and apply appropriate methods for establishing reorder
levels where demand in the lead time is constant.
ix) Calculate the value of closing inventory and material issues using
LIFO, FIFO and average methods.
Session 5 Guidance
Be aware of the procedures and documentation used in inventory systems (s.1, s.2).
Work through Illustration 5 and Example 1 for the mechanics of the valuation methods.
Note the specific accounts used to record inventory movements.
Note the reasons for holding inventory and the associated costs (s.3).
(continued on next page)

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VISUAL OVERVIEW
Objective: To describe the principles of managing inventories of materials and the
procedures for accounting for inventory movements, including describing the principles of
calculating reorder quantities and reorder levels.
PROCEDURES AND
DOCUMENTS
• Requisitioning
• Ordering
• Receiving
• Purchase Invoicing
• Issuing Materials
ACCOUNTING FOR
INVENTORY MOVEMENTS
• Stores Records
• Bin Cards
• Valuation Methods
• Account Entries
INVENTORY CONTROL
• Why Hold Inventory
• Associated Costs
• Buffer Inventory
• Inventory Problems
REORDER QUANTITY REORDER LEVEL INVENTORY CONTROL

SYSTEMS
• Cost Considerations • Lead Time
• EOQ Model • Optimal Reorder Level • "Two Bin"
• Gradual • Periodic Review
Replenishment • Just in Time ("JIT")
• Maximum Inventory • ABC Coding
• With Discounts • Perpetual Inventory
Methods
Session 5 Guidance
Understand and apply the economic order quantity model by working through Illustration 7 and
working through Example 3.
Learn how to apply the economic order quantity when holding cost does not vary with average
inventory (Example 5) and when discounts apply (Example 6).
© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 5-1

Session 5 • Accounting for Materials F2 Management Accounting
1 Procedures and Documents

For inventory, the procedures and documents required to maintain
balances start with requisitioning and end with purchase payment.
1.1 Requisitioning
 Storekeeper requests purchasing department to obtain reorder
quantity from appropriate supplier.
 Documentation is a purchase requisition, which is
authorised to raise a purchase order.
 Production department requests transfer of raw materials from
stores to the factory.
 Documentation is a materials requisition (s.2), where
items are despatched to production and inventory records
updated.
1.2 Ordering
 Purchasing officer (or buyer) requests supply of materials
listed. A copy is sent to goods inwards/warehouse.
 Documentation is a purchase order (PO), which specifies
quantity, price, delivery date and terms.
1.3 Receiving
 Goods are inspected and checked to the supplier's delivery
note and copy purchase order before being recorded.
 Documentation is a goods received note (GRN), which
creates a common format.
1.4 Purchase Invoicing

 When a supplier's invoice is received it is checked to a GRN
before being authorised for payment.
 Documentation is a purchase invoice.
Illustration 1 Purchase Requisition
PURCHASE REQUISITION Serial No. 17293

Date 8/12/2011
Quantity Description Code or reference
10 boxes 5 star office lever arch file 8792

70mm A4 Cloudy Grey (Pack of 10)
Date required: 15/12/2011 REQUISITIONED BY:
CHARGE ACCOUNT: Dept: Stationery Stores

Department: Stationery Stores
Job: N/A
Stock account: 5543 Signature: M�� P��l��
5-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

F2 Management Accounting Session 5 • Accounting for Materials
Illustration 2 Purchase Order
ATC (International Holdings) Ltd Order No 5483

16 Elmtree Road Date 8/12/2011
Teddington TW11 8ST PR No 12293
Tel (0208) xxx xxxx
PURCHASE ORDER
To: Lyreco.com/OLO
DESCRIPTION QUANTITY CODE PRICE
5 star office lever arch file 10 boxes 8792M $13.58 per box
70mm A4 Cloudy Grey
REQUIRED BY: 15/12/2011 DELIVER BY: 14/12/2011
Please supply the above goods.
BA Dowling
Purchasing Officer
Illustration 3 Goods Received Note
GOODS RECEIVED NOTE

Received from: Lyreco GR number: 00356
Delivery note number: 2641 Date: 13/12/2011
DESCRIPTION QUANTITY ORDER NO
5 star office lever arch file 10 boxes 5483

70mm A4 Cloudy Grey
Inspector's report: Received by:
Good condition David South

1.5 Issuing Materials

 The materials requisition form details the materials that are
wanted for the production process.*
 It is used by the storekeeper as:
 an authorisation to issue stated materials (i.e. transfer to
the factory);
 a source document to record material usage.
*Materials requisition forms are a key source of materials data and

are used for updating raw materials inventory ("stores") records.
Illustration 4 Materials Requisition
Materials (or Stores) Requisition Number: 03147
Originated by Dept: Correspondence Courses Date: 14/12/2011
CHARGE TO: (Job or Department) Correspondence Courses
For Cost
Office use
Code Description Quantity Price Amount
8792M 5 star office lever arch file 1 box

70mm A4 Cloudy Grey
Authorised by: Issued by: J Stanmore
Date of issue: 14/12/2011
2 Accounting for Inventory Movements
2.1 Stores Record Cards/Inventory Cards

Prepared for each item of material. These show:
 the identification information and location in stores;
 the quantities on order/received/issued and a running balance
of quantity in inventory;
 the prices and values of all receipts and issues; and
 the control quantities (e.g. maximum or minimum reorder
levels and reorder quantity).

2.2 Bin Cards

Prepared for each bin or storage location, the data on these is
usually limited to:*
 the location code of bin; *The same inventory
material may appear
 the identification of material; and on more than one bin
 the receipts, issues and remaining balance of material held in card but not on more
that location. than one stores card.
2.3 Valuation Methods

2.3.1 Need For
 The cost of materials purchased normally will be derived from
suppliers' invoices.
 Where identical purchases have been made at differing prices
and it would be impractical to identify individual items, a
valuation method will be needed. For example:
 First in, first out (FIFO);
 Last in, first out (LIFO);
 Periodic (simple) average cost;
 Weighted average cost;
 Standard cost.
2.3.2 FIFO
 For raw materials, the units purchased first are deemed to be
the first issued to be used in production.*
*Similar to raw
 The unit cost for the first batch received (i.e. "first in") is the materials, for finished
issue price until the whole batch has been issued—then the goods, the units
unit cost of the next batch in becomes the issue price. manufactured first are
deemed to be the first
2.3.3 LIFO sold (e.g. cars finished
on a production line).
 For raw materials, the units purchased most recently (i.e. last)
are deemed to be the first issued to be used in production.*
 If a new batch is received before the previous batch is fully
issued, the new cost becomes the "last in" price until:
 the new batch is fully issued (when the previous last in
price will apply); or *It is possible for the
 a new delivery received (when the cost of the new batch
last units purchased
to be first used when
will apply). a "bin" system is used
and the items first
2.3.4 Weighted Average
removed from the top
 A weighted average price is calculated by weighting according were the last to be
to the number of units purchased at each price.* put in.
 The average price at any time is the total inventory value
divided by the number of units on hand.
*Weighted average price is used for homogeneous items which are

drawn from inventory without regard to when they were received.

Illustration 5 Periodic Average Method
Number Unit cost Total cost
$ $
Inventory at 30 November 100 8.50 850
05 December: Purchase 100 8.70 870
Goods for sale in December 500 4400
Less: Inventory at 31 December (400) 8.80 (3520)
Cost of goods sold 100 8.80 880
2.3.5 Periodic Average

 This method determines an average cost over a specified
period; the average cost is applied to units sold in the period
and to closing inventory, at the end of the period.
 The average is calculated on the cost of opening inventory
plus the costs of all subsequent purchases during the period.
2.3.6 Standard Cost

This is a predetermined estimate of the unit cost of purchasing
raw materials or manufacturing a product. It is widely used
for budgeting purposes and facilitates variance analysis (see
Session 16).
Example 1 Inventory Valuation Methods

The following data relate to the receipts and issues of an item in January. There was no
opening inventory.
5 January Receive 100 items @ $5.00 each
17 January Issue 40 items
Required:
Calculate the value of closing raw materials inventory using the following methods to
price issues:
(a) FIFO (b) LIFO (c) Weighted average

Example 1 Inventory Valuation Methods (continued)
Solution
(a) FIFO
Date Receipts Issues Balance

Quantity Value
5 Jan
16 Jan
17 Jan
20 Jan
23 Jan
30 Jan
(b) LIFO

Quantity Value
5 Jan
16 Jan
17 Jan
20 Jan
23 Jan
30 Jan
(c) Weighted average

Quantity Value
5 Jan
16 Jan
17 Jan
20 Jan
23 Jan
30 Jan

2.3.7 Comparison of Methods
Advantages Disadvantages
FIFO Provides an up- Out-of-date cost

to-date closing of issues (if prices
In periods of rising
inventory value are increasing or prices (which is the
(i.e. fair and inventory held is old). norm), FIFO shows
commercial). Tedious record higher inventory
values and higher
A realistic reflection keeping.
profits than LIFO.
of physical Identical jobs may
movement of have different costs.
materials (e.g. on a
"conveyor belt").
LIFO Provides an up-to- Out-of-date closing
date cost of issues inventory valuation
to production (i.e. (if purchased some
reflects current time ago).
economic values). Often unrealistic as
oldest materials,
etc should be issued
first.
Tedious record
keeping.
Weighted Provides a Tedious calculations
average compromise of weighted average
between inventory (on every receipt).
valuation and Issue price may be
pricing of material fictional (i.e. not an
issues. actual price).
Realistic for
identical items to
have the same
value.
Simplifies record
keeping.
*In financial accounts
the debit would be
2.4 Account Entries and Balances to purchases with a
corresponding credit
 The costs of raw material purchases are debited to the to cash or trade
materials (stores) account(s):* payables. However,
the cost accountant
Materials (stores) a/c is not interested in
whether the purchases
$ $ are paid for and so
credits a "financial
Materials purchases (goods Direct materials issues (to ledger a/c" which is a
x x
received) production process)
control a/c to maintain
Indirect materials
(transfer to production x the double entry.
overhead)

 A transfer is made when raw materials are issued to

production:*
Dr Work in progress (or production) a/c
Cr Materials a/c *Similar to what is
done for raw materials,
Production process (WIP) a/c entries are made from
labour and overhead
$ $ accounts to WIP to
reflect their input
Direct materials issues x into the production
process. (See
Direct labour x Transfer to Finished goods x Sessions 6 and 7).
Manufacturing overheads x
 A further transfer is made when goods are completed:

Dr Finished goods a/c
Cr WIP a/c
Finished goods a/c
$ $
Transfer to Cost of goods sold

Transfer from WIP x x
(in Income Statement)
 Finally, when goods are sold:

Dr Cost of goods sold a/c
Cr Finished goods a/c
 Balances in the materials, WIP and finished goods accounts
should all be closing inventory values.*
3 Inventory Control *Any shortfall between

physical inventory and
the inventory records
3.1 Reasons for Holding Inventory represents a cost
(e.g. of wastage or
 To satisfy customer demand "Transactions" motive theft) to be expensed
(finished goods) or avoid production immediately.
stoppages (raw materials).
 To provide a "buffer" if there are "Precautionary" motive
shortages in supplies, high demand
for inputs or a long "lead time" (i.e.
waiting on receipt of goods).
 To take advantage of quantity "Bulk" buying
discounts.
 To buy in ahead of a shortage or "Speculative" motive
price rise.
 For technical reasons (e.g. maturing
whisky or keeping oil in pipelines).

3.2 Associated Costs

Purchase price  after quantity discounts
+/- conversion  labour, overheads, etc
costs
Holding costs  cost of capital tied up (often largest

component)
 insurance
 obsolescence (deterioration/perishing),
pilferage (i.e. theft)
 warehousing (and other "space" costs)
 stores administration
Procurement/  transport (goods inwards)

ordering costs  clerical and administration
 batch set-up costs
Shortage costs*  production stoppages (caused by lack of

raw materials)
 "stock-out" costs for finished goods (lost
sales/goodwill)
*Assuming no
 emergency costs of remedial action
discounts and no
Systems costs  people/computers maintaining records shortages, the only
costs which vary with
the level of inventory
are variable holding
3.3 Buffer Inventory costs and the fixed
Buffer inventory is inventory held as a reserve principally against costs of placing an
order.
short-term shortages (of raw materials).
 Buffer inventory also may be held to provide a cushion against
excessive fluctuations in purchase prices of supplies. The
buffer may be used to avoid having to pay premium prices
during a shortage or "out of season".
 Where buffer inventory is held:*
 there will be an associated cost of holding it (depending on
the level);
 if the level does not change the cost of holding it will be
*In determining the
fixed for a period. optimal level of buffer
 One of the assumptions of the "economic order quantity inventory to be held,
(EOQ) model", which follows, is that there is no requirement management would
for such "safety" or buffer inventory. consider the costs of
holding less buffer
inventory (which could
Illustration 6 Buffer Inventory be none) against
the costs of running
A company holds a buffer inventory of 1,500 components of X used out of components
in the manufacture of a range of products. The purchase cost of (e.g. if consumption
each component is $20. The most significant element of variable is high in a period
cost associated with holding inventory is the cost of capital which is when supplies are late
estimated at 9% per annum. in being received).
The annual cost of holding one component in inventory is therefore Determination of this
$1.80. The annual cost of holding the 1,500 component buffer level, however, is
inventory is therefore $2,700. outside the scope of
the F2 syllabus.
3.4 Inventory Decisions

 How much to order at a time  economic order quantity
(EOQ).
 When to place an order  reorder level (ROL).

4 Reorder Quantity
4.1 Relevant Cost Considerations

The problem is trading off the costs of carrying large inventories
against the costs of placing more orders.
4.1.1 Annual Holding Cost

 Holding costs that vary with inventory levels are relevant.*
 For example, opportunity cost of capital invested in
inventory. This cost is normally expressed as a percentage
per dollar of average investment.
*Holding costs that do
 As order quantity , inventory holding  therefore total
not vary are irrelevant
annual holding cost (TCh) . (e.g. fixed annual
 If x is the reorder quantity and it is consumed at a constant insurance premium,
rate, then: storekeepers' salaries,
depreciation of
warehouse, etc).
Acquisition costs of
Quantity purchase/manufacture
are also irrelevant
(assuming no
discounts).
x
average = x/2
Time
 If holding a unit in inventory for one year costs $Ch then the
annual inventory holding cost (TCh) is Ch x .
2
4.1.2 Annual Order Cost
 There is an incremental cost to placing each order to buy more
inventory.
 For example, each order may have a fixed cost of placing it
due to the cost of sending a fax.
 As order quantity , number of orders . Therefore total
annual ordering costs (TCo) .
 If Co is the fixed cost of an order and D the demand per
CοD
annum in units, then the annual order cost (TCo) is .
x

4.1.3 Graphical Representation
Annual Cost $
Total Costs
Holding Costs
Reorder Cost
EOQ Order Quantity, Q
Example 2 Annual Total Cost
D = 40,000, Co = $2 and Ch = $1.

Required:
Find the annual ordering cost, annual holding cost and annual total cost when orders
of the following sizes are placed:
(a) 200
(b) 400
(c) 600
Solution
(a) Q = 200
Annual ordering cost =
Annual holding cost =
Total cost =
(b) Q = 400
Total cost =
(c) Q = 600
Total cost =
Summary
(i) Order (ii) Holding (iii) Total
(a)
(b)
(c)

4.2 Economic Order Quantity Model

4.2.1 Symbols Used
Co = Cost of placing order Ch = Cost of holding one unit

for a year
D = Annual demand Q = Order quantity
Illustration 7 Total Annual Costs
Annual demand for a particular inventory item (D) is steady at 120 units. The incremental cost of
ordering the inventory (Co) is $20 and the cost of holding a unit of inventory for a year (Ch) is $3.
Solution
Order Average Annual Numbers Annual Total
quantity inventory holding of orders reorder cost annual cost
Q Q/2 cost QCh/2 p.a. D/Q CoD/Q QCh/2 + CoD/Q
120 60 180 1 20 200
60 30 90 2 40 130
40 20 60 3 60 120
30 15 45 4 80 125
20 10 30 6 120 150
10 5 15 12 240 255
4.2.2 EOQ Formula

Ch D
Total annual cost = Q + Co is minimised when:
2 Q
2CoD
EOQ = The EOQ formula is
Ch provided in the exam
2 × $20 × 120 and the derivation
In the above illustration, EOQ= = 40
$3 of this formula is not
examinable.
4.2.3 Assumptions (Limitations of the Basic Model)
These assumptions can be also considered limitations of the
basic model.
Constant unit purchase price (i.e. no discounts).
Constant demand (or instantaneous resupply).
Constant lead time.
No shortage costs because "stock outs" will not arise
(so no safety stock requirement).
Reorder cost is independent of order size.
Holding cost per unit (Ch) is constant (i.e. no stepped costs
such as additional storekeepers).
X
Average inventory holding is (i.e. constant rate of
consumption). 2

Example 3 EOQ
D = 40,000, Co = $2 and Ch = $1.

Required:
Calculate:
(a) the economic order quantity
(b) the number of orders to be placed each year
(c) the frequency of orders (assume 300 working days).
Solution
(a) EOQ =
(b) Number of orders =
(c) Frequency of orders =
4.2.4 Application to Manufacturer

Just as a consumer of products purchased wishes to minimise
his inventory costs, a supplier manufacturing goods in batches
may seek to produce them most economically (i.e. trading off
the cost of set-up for each batch against the inventory holding
cost). The EOQ formula can be used from the manufacturer’s
perspective by replacing the cost of placing an order with the
cost of setting up a batch.
Illustration 8 Application of EOQ
Annual demand for component X manufactured by ABC is 9,000 units. The

cost of adjusting the production line to manufacture batches of X is $90; this is
the set-up cost. The cost of holding X is $2 per unit per year.
2 × 90 × 9, 000
Using the EOQ formula the optimal batch size = = 900 units
2
9, 000
ABC will therefore have = 10 production runs a year.
900
4.3 Gradual Replenishment

One assumption behind the EOQ model is that inventory is
replenished in entirety once an order is placed. This may not
always been the case. Once an order is placed it may be fulfilled
gradually (e.g. where a component is being transferred in from
another division).
This means that, ignoring buffer inventory, the amount of
inventory held will always be lower than the order quantity. How
much lower depends on the rate of replenishment as compared
with the rate of demand.

4.3.1 Economic Batch Quantity (EBQ)

One assumption behind the economic order quantity model is
that inventory is replenished immediately once an order is placed.
This may not always been the case. Once an order is placed, the
supplier may have to produce a special batch. It may take a few
days (or even longer) to supply the total order.
 This means that the amount of inventory held will be lower
than if inventory were replenished instantly.
 The EBQ model adjusts the EOQ model to take account of
the reduced holding costs where inventory is replenished
gradually.
 The exam formula is:
2CoD
EBQ =
 D Just as ACCA’s EOQ
Ch 1 − 
 R exam formula applies
to orders and batches
where there is instant
Where: replenishment this
EBQ exam formula
D = annual demand (or usage) applies to orders
R = annual replenishment rate and batches where
there is gradual
Co = order cost (or set up costs per batch) replenishment.
Ch = holding cost per unit per year
Example 4 EBQ
Same data as for Example 3, except that having placed an order, inventory is replaced
gradually. The supplier can deliver at a rate equivalent to 120,000 units per year.
Required:
Calculate:
(a) the economic batch quantity
(b) the number of orders to be placed each year
(c) the frequency of orders (assume 300 working days).
Solution
(a) EBQ =
(b) Number of orders to be placed =
(c) Frequency of orders =

4.3.2 Application to Manufacturer

When a manufacturer produces items in batches the number
of items held will depend on the rate at which items can be
produced.
Illustration 9 Application of EBQ
As for Illustration 9. ABC has the capacity to manufacture 45,000

units of X each year. Using the EBQ formula:
2CoD 2 × 90 × 9, 000
D 9, 000
EBQ = Ch(1 − ) = 2 × (1 − ) = 1, 012, 500 = 1,006
R 45, 000
9, 000
ABC will now have , i.e. 9 production runs a year.
1, 006
4.4 Maximum Inventory Levels

The EOQ formula assumes that holding costs fall as inventory
levels fall. It therefore attempts to minimise total holding costs,
where total holding costs = Q/2 x Ch. Holding costs are based on
average inventory levels (Q/2).
 Some elements of cost do not fall as inventory levels fall (e.g.
rent). The amount of space required for holding inventory is
based on the maximum inventory level of Q, not the average
inventory level of Q/2.
 Because the EOQ assumes holding costs depend on average
holding of inventory rather than maximum level of inventory, it
is necessary to adjust Ch for those holding costs which depend
on maximum level of inventory. This is done by multiplying
the holding cost per unit by 2.
Potentially the most difficult aspect of inventory reorder quantities

is dealing with the complication of a holding cost which varies with
maximum inventory and not with average inventory. When you have
worked through section 5.4 and Example 5 you should appreciate
that the simple "trick" is to multiply such costs by 2 in order to apply
the formula in the normal way.

Example 5 EOQ With Maximum Inventory Levels
Annual demand = 500,000 units

Fixed cost of placing an order = $20
Sundry holding costs (including the cost of capital tied up) = $3 per unit per annum.
Inventory is held in a warehouse owned by another company. The rental cost for the space
required is $4.25 per square metre. Each unit of the product uses 2 square metres of space.
Required:
Determine the optimal order quantity. (Tip: Find a value of Ch which can be used in
the EOQ formula.)
Solution
Sundry holding costs =
Warehousing cost =
Therefore Ch to be put in the formula:
EOQ =
4.5 Reorder Quantity When Discounts Apply

Suppliers may offer quantity discounts if orders are greater than
a given size. These must be taken into account when calculating
the reorder quantities. The steps to follow in such situations are You should appreciate
as follows: that it is highly
1. Calculate EOQ as above, ignoring any possible discounts. unlikely that the "trial
and error" approach
2. If the reorder level calculated falls within a discount band which is called for
(qualifies for a discount) it will be necessary to recalculate when discounts apply
EOQ, adjusting the value of Ch to take into account the can be examined
discounted price (if Ch depends on the price paid for the items). computationally in
an MCQ. But you
3. Calculate total annual costs (purchase costs + holding costs + should understand
order costs) at the EOQ. the principle of the
4. Calculate total annual costs of ordering just enough items to approach and the
qualify for each discount band above the EOQ. The reason for effect that discounts
can have on order
this is that it may be worth exceeding the EOQ if the discount
quantities.
received compensates for the extra holding costs that would be
incurred as a result of ordering a larger quantity.
5. Select the order quantity which minimises total annual costs.

Example 6 Optimal Reorder Level Including Discounts
Annual demand = 800,000 units

Fixed cost of placing an order = $1,200
Holding costs = 10% of the price paid
Price (before discounts) = $100
The supplier is offering discounts based on order quantities. The discounts are as follows:
0–4,999 units 0%
5,000–24,999 units 2%
above 25,000 units 3%
Required:
Determine the optimal order quantity.
Solution
Step 1 Calculate EOQ as normal, ignoring discounts:
Step 2 If EOQ falls within a discount band, recalculate with adjusted value of Ch:
Step 3 Calculate total annual costs at EOQ and beginning of subsequent discount bands:
Purchase costs Holding costs Order costs Total costs

(D × discounted price) (Q/2 × Ch) (Co × D/Q)
At EOQ
At 25,000
Conclusion:

5 Reorder Level
Having found how much to order each time (EOQ), the next
problem to be addressed is when to place an order—that is, to
what level (reorder level or ROL) can inventory fall before an
order is placed?
5.1 Lead Time

Lead time is the time between placing an order and the actual *Where neither
delivery of goods. demand nor lead time
are constant, buffer
5.2 Optimal Reorder Level inventory (as explained
earlier) should be held
 If demand is constant and the lead time is zero, then: to avoid "stockouts".
ROL = Zero The reorder level
would then be at least
 If demand is constant and the lead time is a finite and
as much as the level
constant period*, then of buffer.
ROL = Demand in lead time
Stock Level
ROL
L Time
Example 7 ROL
Given daily demand for projector pens at 30, the supplier always delivers exactly four days
after the order is placed.
Required:
Calculate the ROL.
Solution
ROL =

6 Inventory Control Systems
6.1 Reorder Level or "Two Bin" System

 Determine optimum reorder levels and reorder quantities
(e.g. as above).
 When inventory falls to reorder level ("reserve" bin), place an
order for fixed quantity of inventory. (Reorder level system is
also called the "Q system"—Q for quantity).
 On receipt of order, top up "reserve" bin and put balance into
main bin.
 The reorder quantity which minimises total inventory costs is
the EOQ.
6.2 Periodic Review System

 The periodic review system determines a review period (e.g.
to fit in with production schedules) and maximum inventory
levels. (Also called "cyclical review" or "P system"—P for
period).
 At the end of each fixed time interval place an order to
replenish inventory to maximum.*
*The time interval which minimises the annual cost of acquiring and
holding inventory is called the "economic review period".
In a JIT purchasing
6.3 Just in Time ("JIT") system, material
JIT is a production planning technique that emphasises acquiring purchases are
materials and producing goods and services (both internally and contracted so that
externally) at the moment they are required. receipt and usage
coincide to the
 This "pull" system is driven by demand for finished products. maximum possible
 Each component on a production line is produced only when extent.
needed for the next processing stage.
6.3.1 Necessary Conditions
 Cooperation/flexibility of suppliers and internal  To change output at short notice.

workers. May need a core workforce and
part-time/freelancers to change working hours
from one period to the next.
 Guaranteed quality of raw materials.  Must be maintained in production.
 Geographical proximity.  To make immediate deliveries.
 Low inventory levels and short production runs.  Therefore need low set-up costs.

6.3.2 Advantages and Disadvantages

Advantages Disadvantages
Inventories kept to absolute minimum Risk of "just too late".
(inventory holding costs ). More frequent handling of smaller
Space saving. batches (reorder and set-up costs ).
Less obsolescence when product Higher cost of monitoring and control.
specifications change. Increased stress.
6.4 ABC Coding Systems

 ABC coding systems direct maximum inventory control
effort to the most important (e.g. highest value) items. For
example, this is useful for businesses with several thousand
products.*
*Alternative
 The total purchase cost of each inventory item needs to be classifications to the
estimated for a period: highest value may
 "A" items represent the top 10% in terms of annual be according to the
purchase cost (require greatest control through quantitative level of difficulty of
techniques); getting replacements
 "B" items represent the next 20% (require less
or importance to the
production process.
sophisticated control);
 "C" items represent the remaining 70% (may be controlled
subjectively).
6.5 Perpetual Inventory Methods

 Up-to-date inventory balances are always known. This
facilitates continuous inventory taking which has several
advantages:
Less time pressure (than full inventory counting);
Counting may be more accurate;
Discrepancies revealed sooner.
 A replenishment point frequently triggers an order. Therefore
the system relies on accuracy of inventory records (not on
physical measures as in the "two bin" system).
 Point of sale (POS) terminals may automatically update
inventory records for each sale.
 The system provides data showing fastest-moving lines,
therefore tactical decisions on prices can be made to move
slow-moving items.

Summary
 Control procedures are needed over the requisitioning and ordering of materials and the
payment of purchase invoices.
 Stores record cards are held to record and control quantities of materials held (may be
computerised).
 Different methods of valuing material issues and inventory result in different reported
costs of production/goods sold and hence profit.
 There are many reasons for holding inventory, including the precautionary motive
(resulting in "buffer stock"). There are many associated costs.
 EOQ calculates the optimum order quantity to minimise total holding and order costs.
As order quantities are increased, holding costs increase. But there will be fewer orders,
thereby saving order costs.
 In EOQ exam formula: Co = fixed cost per order, Ch = holding cost of holding one unit of
inventory for one period (usually a year) and D = amount of material used or quantity of
goods demanded in one period.
 Where there is gradual replenishment, the EBQ formula is used where R is the annual
replenishment rate.
 A reorder level (ROL) may be set to "trigger" the timing of placing orders. If lead time is
constant and demand in lead time is certain, ROL will be demand in lead time.

Session 5
Session 5 Quiz
Estimated time: 10 minutes
1. Distinguish between a purchase requisition and a materials requisition. (1)
2. True or false? An item of material may appear on more than one bin card but not on more
than one stores record card. (2.2)
3. State the precautionary motive for holding inventory. (3.1)
4. Give FOUR examples of holding costs. (3.2)
5. Define "buffer inventory". (3.3)
6. State the costs that are traded off when determining the EOQ. (4.1.1, 4.1.2)
7. State precisely the cost that is represented by Ch in the EOQ formula. (4.2)
8. Define "lead time". (5.1)
Study Question Bank

Estimated time: 35 minutes
Priority Estimated Time Completed
Q12 Hamco 15 minutes
Q15 MCQs 20 minutes

Additional
Q11 Material H
Q13 Alter
Q14 Inventory control policy

EXAMPLE SOLUTIONS
Solution 1—Inventory Valuation Methods
(a) FIFO
Quantity Value
5 Jan 100 × $5.00 = 500 100 $500
16 Jan 50 x $5.50 = $275 150 $775
17 Jan 40 @ $5.00 = $200 110 $575
20 Jan 60 @ $5.00 = $300 40 $220

10 @ $5.50 = $55
23 Jan 50 @ $6.00 = $300 90 $520
30 Jan 40 @ $5.50 = $220 20 $120

30 @ $6.00 = $180
(b) LIFO

Quantity Value
5 Jan 100 @ $5.00 = $500 100 $500
16 Jan 50 @ $5.50 = $275 150 $775
17 Jan 40 @ $5.50 = $220 110 $555
20 Jan 10 @ $5.50 = $55

60 @ $5.00 = $300 40 $200
23 Jan 50 @ $6.00 = $300 90 $500
30 Jan 50 @ $6.00 = $300

20 @ $5.00 = $100 20 $100
(c) Weighted average

Quantity Value
5 Jan 100 @ $5.00 = $500 100 @ $5.00 = $500
16 Jan 50 @ $5.50 = $275 150 @ $5.17 = $775
17 Jan 40 @ $5.17 = $207 110 @ $5.17 = $568
20 Jan 70 @ $5.17 = $362 40 @ $5.17 = $206
23 Jan 50 @ $6.00 = $300 90 @ $5.62 = $506
30 Jan 70 @ $5.62 = $394 20 @ $5.62 = $112

Solution 2—Annual Total Cost
(a) Q = 200
Annual ordering cost = CoD $2 × 40, 000
= = $400
Q 200
Annual holding cost = ChQ $1 × 200
= = $100
2 2
Total cost = $400 + 100 = $500
(b) Q = 400
Annual ordering cost = $2 × 40, 000
= $200
400
Annual holding cost = $1 × 400
= $200
2
Total cost = $200 + 200 = $400
(c) Q = 600
Annual ordering cost = $2 × 40, 000
= $133.33
600
Annual holding cost = $1 × 600
= $300
2
Total cost = $133.33 + 300 = $433.33
Summary
(i) Order (ii) Holding (iii) Total
(a) $400 $100 $500
(b) $200 $200 $400
(c) $133 $300 $433

Solution 3—EOQ
(a) EOQ =
 2CoD 
 
 Ch 
2 × $2 × 40, 000
$1
160, 000 = 400
(b) Number of orders = 40,000 items are required p.a.

40, 000
 = 100
400
(c) Frequency of orders = 100 orders to be placed during 300 working days
300
 =3
100
Orders should be placed every 3 days
40, 000
Alternatively, usage rate = = 133.33 per day
300
Items are ordered in batches of 400
400
Therefore = 3 days' worth of inventory
133.33
Solution 4—EBQ
(a) EBQ =
2CoD
D
Ch(1 − )
R
2 × $2 × 40, 000
 40, 000 
$1 ×  1 −
 120 , 000 
240, 000 = 490
(b) Number of orders to be placed = 40,000 items are required per annum.
40, 000
 = 82
490
(c) Frequency of orders = 82 orders to be placed during 300 working days

300
 = 3.7 days
82
Orders should be placed, on average, every 3.7 days.

Solution 5—EOQ With Maximum Inventory Levels
Sundry holding costs = $3
Warehousing cost = each unit's worth of space which is used has a cost
of $4.25 × 2 = $8.50.
However, rental costs depend on the maximum
inventory level, not on the average inventory level.
The EOQ formula assumes that holding costs depend
on average inventory levels and therefore $8.50
must be doubled to $17 to be used in the formula.
Therefore Ch to be put in the formula: $3 + 17 = $20
EOQ = 2 × 20 × 500, 000

= 1,000 units
20
Solution 6—Optimal Reorder Level Including Discounts
Step 1 Calculate EOQ as normal, ignoring discounts:
Ch = $100 x 10% = $10 per unit

$2 × 1, 200 × 800, 000
EOQ = = 13,856 units
$10
Step 2 If EOQ falls within a discount band, recalculate with adjusted value of Ch:
Ch = $100 × 98% × 10% = $9.80

$2 × 1, 200 × 800, 000
EOQ = = 13,997 units
$9.80
Step 3 Calculate total annual costs at EOQ and beginning of subsequent discount bands:
Purchase costs Holding costs Order costs Total costs

(D × discounted price) (Q/2 × Ch) (Co × D/Q)
At EOQ $78,400,000 $68,585 $68,580 $78,537,165
(13,997) (800,000 × $98) (6,998.50 × $9.80) ($1,200 × 57.15)
At 25,000 $77,600,000 $121,250 $38,400 $77,759,650
(800,000 × $97) (12,500 × $9.70) ($1,200 × 32)
Conclusion:
Optimal order quantity = 25,000 units
Solution 7—ROL
ROL = 4 × 30 = 120 units

F2-05 Accounting For Materials

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Session 5

Accounting for Materials

B. Cost Accounting Techniques

(continued on next page)

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REORDER QUANTITY REORDER LEVEL INVENTORY CONTROL

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 5-1

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1 Procedures and Documents

1.4 Purchase Invoicing

Illustration 1 Purchase Requisition

PURCHASE REQUISITION Serial No. 17293

Quantity Description Code or reference

10 boxes 5 star office lever arch file 8792

Date required: 15/12/2011 REQUISITIONED BY:

CHARGE ACCOUNT: Dept: Stationery Stores

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Illustration 2 Purchase Order

ATC (International Holdings) Ltd Order No 5483

DESCRIPTION QUANTITY CODE PRICE

REQUIRED BY: 15/12/2011 DELIVER BY: 14/12/2011

Please supply the above goods.

Illustration 3 Goods Received Note

GOODS RECEIVED NOTE

DESCRIPTION QUANTITY ORDER NO

5 star office lever arch file 10 boxes 5483

Inspector's report: Received by:

Good condition David South

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1.5 Issuing Materials

*Materials requisition forms are a key source of materials data and

Illustration 4 Materials Requisition

Materials (or Stores) Requisition Number: 03147

Originated by Dept: Correspondence Courses Date: 14/12/2011

CHARGE TO: (Job or Department) Correspondence Courses

Code Description Quantity Price Amount

8792M 5 star office lever arch file 1 box

Authorised by: Issued by: J Stanmore

Date of issue: 14/12/2011

2 Accounting for Inventory Movements

2.1 Stores Record Cards/Inventory Cards

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2.2 Bin Cards

2.3 Valuation Methods

*Weighted average price is used for homogeneous items which are

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Illustration 5 Periodic Average Method

Number Unit cost Total cost

2.3.5 Periodic Average

2.3.6 Standard Cost

Example 1 Inventory Valuation Methods

5 January Receive 100 items @ $5.00 each

16 January Receive 50 items @ $5.50 each

17 January Issue 40 items

20 January Issue 70 items

23 January Receive 50 items @ $6.00 each

30 January Issue 70 items

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