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Financial Accounting, Cost Accounting And Management Accounting

Financial accounting Financial accounting is mainly concerned with recording business transactions in the books of account for the purpose of presenting final accounts to management, shareholders and tax authorities, etc. The information supplied by financial accounting is summarized in the following three statements at the end of a period, generally one year. a) Profit and Loss Account showing the net profit or loss during the period; b) Balance Sheet showing the financial position of the

Firm at a point of time; c) Cash Flow Statement showing the inflows and outflows of cash arising from the business activities during the period covered by the statement. Cost Accounting Cost accounting is a relatively recent development. Modern cost accounting developed only during the nineteenth century. It is concerned with the ascertainment of past, present and expected future costs of products manufactured or services supplied. The information supplied by cost accounting acts as a management tool for decision-making, to optimize the utilization of scarce resources and ultimately add to

the profitability of business by controlling expenditure under various heads. Management Accounting The Chartered Institute of Management Accountants (CIMA), London has defined management accounting as “the presentation of accounting information in such a way as to assist management in the creation of policy and in the day-to-day operations of an undertaking.”

No material control system 5. No proper classification of costs 7. No labour cost control 6. No cost comparison 10. No analysis of losses 8. Historical in nature 3. Shows only overall performance 2.Limitations of Financial Accounting 1. Inadequate information for price fixation 9. No performance appraisal 4.Fails to supply useful data to management .

” An authoritative definition of cost accounting has been given by CIMA. “the techniques and processes of ascertaining costs. London as follows: “Cost accounting is the process of accounting for costs from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centres and cost units.Meaning of Costing and Cost Accounting The Chartered Institute of Management Accountants (CIMA). London has defined costing as.” . it embraces the preparation of statistical data. the application of cost control methods and ascertainment of profitability of activities carried out or planned. In its widest usage.

art and practice of cost control and the ascertainment of profitability. universities. shipping and road transport companies. . railways. Wholesale and retail businesses. banking and insurance companies. hotels.Cost Accountancy It is defined by CIMA. “the application of costing and cost accounting principles. London as. It includes the presentation of information derived therefrom for the purposes of managerial decision making. hospitals.” Applications of Cost Accounting Manufacturing and non-manufacturing. methods and techniques to the science. schools colleges. farming and cinema houses.

. Ascertainment of cost Cost control and cost reduction Guide to business policy Determination of selling price Cost Accounting And Financial Accounting – Comparison Basis Financial Accounting Cost Accounting 1. 2. 4. external users. i.1. internal users. The main purpose of cost accounting is to provide detailed cost information to management.. These accounts have to be prepared according to the legal requirements of Companies Act and Income Tax Act. 2.e. 3. Statutory requirements Maintenance of these accounts is voluntary except in certain industries where it has been made obligatory to keep cost records under the Companies Act. Purpose The main purpose of financial accounting is to prepare Profit and Loss Account and Balance Sheet for reporting to owners or shareholders and other outside agencies. . i.e.

Control aspect 5. Profit and Loss Account. i.Basis 3. etc. . periodically.e. 4. It provides for a detailed system of controls with the help of certain special techniques like standard costing and Inventory control etc. Periodicity of reporting Financial Accounting Cost Accounting Financial reports (Profit and Cost reporting is a Loss Account and Balance continuous process and may Sheet) are prepared be daily. Balance Sheet and Cash Flow Statement Cost accounting has varied forms of presenting cost information which are tailored to meet the needs of management and thus lacks a uniform format. usually on an annual basis It lays emphasis on the recording of financial transactions and does not attach any importance to the control aspect. weekly monthly. Format of Financial accounting has a presenting single uniform format of information presenting information..

Expense and Loss Expense is defined as “an expired cost resulting from a productive usage of an asset. London) Cost Vs. .” (CIMA.Meaning of Cost Cost is “the amount of expenditure (actual or notional) incurred or attributable to a given thing.

expense and loss .Cost Expired Cost Unexpired Cost Expense Loss Shown in Balance Sheet as an asset Shown in Profit and Loss Account on debit side Relation of cost.

. Cost Centre A cost centre is defined by CIMA.Loss – Loss is defined as “reduction in a firm‟s equity. London as “a location. person. London as a “unit of product or service in relations to which costs are ascertained. or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of control”. other than from withdrawals of capital for which no compensating value has been received”.” Cost Object Cost object may be defined as “anything for which a separate measurement of cost may be desired”. Cost Unit A cost unit is defined by CIMA.

1. 3. This method “applies where work is undertaken to customers special requirements. The cost of a batch or group of identical .Methods of Costing The methods or types of costing refer to the techniques and processes employed in the ascertainment of costs. Contract costing is most suited to construction of buildings dams. etc. This is a variation of job costing. Batch costing. Contract costing or terminal costing. Job order costing. a contract is a big job and a job is a small contract. This is also a variation of job costing.” 2. bridges and roads. shipbuilding.

This method is used in companies engaged in the production of readymade garments. 4. sugar mills. Process costing. Operation costing. etc. A more detailed application of process costing. component parts. A process may consist of a number of operations and operation costing . shoes. 5. soap manufacturing. etc. refineries. Textile mills. tyres and tubes. chemical works. This method is used in mass production industries manufacturing standardized products in continuous processes of manufacturing. toys.products is ascertained and therefore each batch of products is a cost unit. The finished product of one process is passed on to the next process as raw material.

steel productions. flour mills. output or unit costing. This method of cost ascertainment is used when production is uniform and consists of a single or two or three varieties of the same product. quarries. etc. Operating or service costing. brick kilns. It is used in undertakings which provide services instead of manufacturing products. hospitals. transport undertakings (road transport. 6.involves cost ascertainment for each operation instead of a process. hotels. . cinemas. 7. electricity companies. railways. This method is applied in mines. airlines. For example. shipping companies). Single. etc.

cars. Standard costing. The difference between standard and . 1. scooters. and actual performance is measured against the standard. standard cost is pre-determined as target of performance. locomotives. This method is used in industries where a number of components are separately manufactured and then assembled into a final product. Air-conditioners. Techniques of Costing These techniques may be used for special purpose of control and policy in any business irrespective of the method of costing being used there. In this technique. refrigerators.8. Multiple or composite costing.

3. Marginal costing.Actual costs are analyzed to know the reasons for the difference so that corrective actions may be taken. 2. Fixed cost is treated as period cost and no attempt is made to allocate or apportion this cost to individual cost centres or cost units. A budget is an expression of a firm‟s business plan in financial form and budgetary control is a technique applied to the control of total expenditure on materials. This technique is used to study the effect on profit of changes in volume or type of output. Budgetary control. Marginal costing regards only variable costs as the cost of the products. wages and overheads by comparing actual performance with planned performance. .

Different types of industries. Uniform costing. operation costing. These methods are job costing. It is a traditional method of costing whereby total costs (fixed and variable) are charged to products. single costing and multiple costing.4. It simply denotes a situation in which a number of firms adopt a uniform set of costing principles. different methods are employed for ascertaining cost. contract costing. batch costing. . Total absorption costing. 5. process costing. Cost Ascertainment and Cost Estimation Cost ascertainment Cost ascertainment is concerned with computation of actual costs incurred.

3. losses and inefficiencies occurring in the form of idle time. . They help in evaluating performance. 2. excessive scrap. Cost estimation Cost estimation is the process of predetermining costs of goods or services. Estimated costs are definitely the future costs and are based on the average of past actual costs adjusted for anticipated changes in future.Ascertainment of actual costs reveals unprofitable activities. Cost estimates are used in the preparations of budgets. etc. Cost estimates may have the following uses: 1. Cost estimates are used in making price quotations and bidding for contracts.

5. Indirect costs These are general costs and are incurred for the benefit of a number of cost units. . process or department. Cost estimates may serve as targets in controlling the costs. Classification into Direct and Indirect Costs Direct Costs These are those costs which are incurred for and conveniently identified with a particular cost unit. Cost of raw materials used and wages of a machine operator are common examples of direct costs. They are used in preparing projected financial statements. Classifications of Cost 1.4.

these do not increase or decrease when the volume of production changes. No. 2. are common examples of indirect costs. lighting. i. Depreciation of machinery. 20. managerial salaries..000 20.000 100 10 . insurance.000 1. rent. materials used in repairs.e.000 10.000 Total fixed cost Rs.processes or departments.000 20. etc. power. These costs remain constant in „total‟ amount over a specific range of activity for a specified period of time.000 20. 20.000 Fixed cost per unit Rs. of units produced 1 2 20 200 2.000 20. Classification into Fixed and Variable Costs i) Fixed costs..

Y Y Rs. . Cost Total fixed cost line O X Volume of Production Rs. Cost O X Volume of Production Behaviour of fixed cost.

total variable cost also decreases. and vice versa.Relevent Range – Fixed cost remains fixed only in relation to a given range of output and for a given time span. Variable Costs Direct materials Direct wages Power Royalties Normal spoilage Commission of salesmen Small tools . ii) Variable costs. when volume of output increases. In other words. total variable cost also increases. when volume of output decreases. These costs tend to vary in direct proportion to the volume of output. Fixed Costs Rent and lease Managerial salaries Building insurance Salaries and wages of permanent staff Municipal taxes. the fixed cost will also increase. but the variable cost per unit remains fixed. If the output is to be increased beyond the range.

Y Y Rs. . Cost Rs. Cost Variable cost per unit O X Volume of Production O X Volume of Production Behaviour of variable cost.

iii) Semi-variable or semi-fixed costs (mixed costs). Semi-variable Costs Supervision Maintenance and repairs Compensation for accidents Telephone expenses Light and power Depreciation . A semi-variable cost often has a fixed element below which it will not fall at any level of output. These costs include both a fixed and a variable component.

Cost (Rs.) O Volume of Production Behaviour of semi-variable cost.) O Volume of Production O Volume of Production Cost (Rs. .) Cost (Rs.

Y Cost (Rs. variable and semi-variable costs.) A B A = Fixed cost line B = Semi-variable cost line C = Variable cost line X Volume of Production C O Comparative behaviour of fixed. .

3. research and development cost and salaries of low level managers . Discretionary Costs These are those costs which can be avoided by management decisions. Advertising. Classifications into Committed and Discretionary Cost Fixed costs are further classified into committed costs and discretionary (or programmed) costs. They are unavoidable. Depreciation of plant and equipment is committed because these facilities cannot be easily changed in the short run. Committed Costs These are those costs that are incurred in maintaining physical facilities and managerial set up.

direct labour and some of the factory overheads. Such costs are incurred for a time period and are charged to Profit and Loss Account of the period. . These consist of director materials. Administration and selling expenses are generally treated as period costs. Classification into Product Costs and Period Costs Product Costs These are those costs which are necessary for production. Period Costs these are those costs which are not necessary for production and are incurred even if there is no production.4.

For unsold goods Product Cost Recorded as an asset in the form of inventory in the Balance Sheet Product Cost Recorded as an expense in the Profit and Loss Account of the current period Accounting treatment of product and period costs .

All costs are controllable in the long run at some appropriate management level. Variable costs are generally controllable. Non-Controllable Costs These are those costs which cannot be influenced.5. . A cost which is uncontrollable at one level of management may be controllable at another level of management. Classification into Controllable and Noncontrollable Costs Controllable Costs These are the costs which may be directly regulated. Controllable costs cannot be distinguished from non-controllable costs without specifying the level and scope of management authority.

This cost is a part of cost of production.6. Classification into Normal and Abnormal Costs Normal cost may be defined as a cost which is normally incurred on expected lines at a given level of output. Abnormal cost is that which is not normally incurred at . Classification into Historical Costs and Predetermined costs Historical Costs These are those costs which are ascertained after these have been incurred. 7. nothing but actual costs. Pre-determined costs These are future costs which are ascertained in advance of production on the basis of a specification of all the factors affecting cost. These costs are extensively used for the purpose of planning and control. Historical costs are thus.

It is charged to costing Profit and Loss Account. management should consider only future costs and revenues that will differ under each alternative. One may have to decide about . SPECIAL COSTS FOR MANAGEMENT DECISIONMAKING Relevant Costs and Irrelevant Costs Relevant cost Not all costs are relevant for specific decisions. Irrelevant costs These are those costs that will not be affected by a decision. In decision making.a given level of output. Such cost is over and above the normal cost and is not treated as a part of the cost of production.

The book value of an asset currently being used is not relevant in making the decision to replace. These costs are not relevant for decision-making about the future. However. Sunk Costs A sunk cost is an expenditure made in the past that cannot be changed and over which management no longer has control.Making a journey by own car or by a public transport bus. What is relevant is how much cash could be realised in future by selling it. In this decision. whatever alternative is chosen. . cost of petrol and other operating costs of car will differ under the two alternatives and thus. are relevant for this decision. insurance cost of car is irrelevant because it will not change.

Differential (or Incremental) Costs Differential cost is the increase or decrease in total cost that results from an alternative course of action. In choosing from the two alternative methods of production. in sales volume. The alternative choice may arise because of change in method of production. etc. change in product mix. take or refuse decision. it is an irrelevant cost. if direct material cost is the same under the two alternatives. .Not all irrelevant costs are sunk costs but all sunk costs are irrelevant. But direct material cost is not a sunk cost because it will be incurred in future and is a future cost. make or buy decisions.

project A requires a capital investment of Rs. For example. 40. 50. It helps in decisions like make or buy. Imputed Costs These are hypothetical costs which are specially computed outside the accounting system for the purpose of decision-making. selection of sales mix. Marginal costing is also a very important analytical and decision making tool in the hands of management. pricing of products. Both the projects .000 and project B Rs. Interest on capital invested is a common type of imputed cost. etc.000. Marginal cost is the same thing as variable cost.Marginal Cost Marginal cost is the additional cost of producing one additional unit.

Obviously. these two projects are not equally profitable since project B requires less investment and thus. it is considering a proposal to invest this amount in debentures where the yield is 17% p. a company has deposited Rs. Opportunity Cost Opportunity cost is the sacrifice involved in accepting an alternative under consideration.000 p.a.a. It is a cost that measures the benefit that is lost or sacrificed. interest. it will have to forego bank interest or Rs. For example.are expected to yield Rs. it should be preferred. It the company decides to invest in debentures. Now. which is the opportunity cost.000 as additional profit. 10.. rental value of building owned by a firm is also an imputed cost. . 1 lakhs in bank at 10% p. Similarly.a. 10.

But it is the historical costs which generally provide a basis for computing future costs. Future Cost The only relevant costs for decision-making are predetermined or future costs. Out-of-pocket Cost (Explicit and Implicit Cost) Out-of-pocket cost. also known as explicit costs. .Replacement Cost Replacement cost is the current market cost of replacing an asset. Depreciation on plant and machinery is an implicit cost because it does not involve any immediate cash outlay. are those costs that involve cash outlays or require the utilization of current resources.

.Conversion Cost This term is used to denote the sum of direct labour and factory overhead costs in the production of a product. Direct Material Prime cost Direct Labour Conversion cost Factory Overhead It should be noted that labour cost is a part of prime cost as well as conversion cost.

ELEMENTS OF COST Total Cost Direct Cost Indirect Cost Direct Material Direct Labour Direct Expenses Indirect Material Indirect Labour Indirect Expenses .

London. Trade discounts.” Material cost includes cost of procurement. directly attributable to the acquisition. Materials may be direct or indirect. etc. Direct materials Direct material cost is that which can be conveniently identified with and allocated to cost units. are deducted in determining the cost of material. duty drawbacks. rebates. sales tax. etc.. taxes. insurance. material cost is “the cost of commodities supplied to an undertaking.. Direct Materials Clay in bricks Leather in shoes Steel in machines Cloth in garments Timber in furniture Indirect Materials Lubricating oil Sand paper Nuts and bolts Coals Small tools Gum .Material Cost According to CIMA. refund on account of modvat. freight inwards.

Material Cost Indirect materials These are those materials which cannot be conveniently identified with individual cost units.. pins.g. Direct Labour Machine operator Shoe-maker Carpenter Weaver Tailor Indirect Labour Supervisor Inspector Cleaner Clerk Peon Watchman ..g. etc. nuts and bolts. e. etc. lubricating oil and grease. soap. screws. Small and relatively inexpensive items which may become a part of the finished product. sand paper used in polishing. thread. e. Those items which do not physically become a part of the finished products. coal.

etc. contribution. Indirect Labour Indirect labour is not directly engaged in the production operations but only to assist or help in production operations. incentive bonus. gratuity.F.Labour Cost “The cost of remuneration (wages. salaries.) of the employees of an undertaking. idle time etc. wages for holidays. bonuses.” It includes all fringe benefits like P. overtime. ESI. commissions. Direct labour Direct labour cost consists of wages paid to workers directly engaged in converting raw materials into finished products. .

“t expenses are those expenses which can be identified with and allocated to cost centres or units. All costs other than material and labour are termed as expenses.Expenses – Which can be easily allocated to cost cuts.” Direct or Chargeable Expenses Hire of special plant for a particular job Travelling expenses in securing a particular contract Cost of patent rights Experimental costs Cost of special drawings. London. It is defined as “the cost of services provided to an undertaking and the notional cost of the use of owned assets. Direct Expenses According to CIMA.”(CIMA). designs and layouts Job processing charges Royalty paid in mining Depreciation or hire of a plant used on a contract at site .

other than indirect materials and indirect labour costs. direct labour cost and direct expenses. Indirect Expenses Rent and rates Depreciation Lighting and Power Advertising Insurance Repairs Direct material+Direct labour+Direct expenses = Prime Cost. are termed as indirect expenses. Prime Cost This is the aggregate of direct material cost. DM+DL+DE .Indirect expenses All indirect costs. Thus.

wages of factory sweeper. Overheads are divided into three groups as follows: 1. indirect labour cost and indirect expenses. wages of factory watchman. cotton waste..Overhead This is the aggregate of indirect material cost. oil. Thus Indirect material+Indirect labour+Indirect expenses=Overhead. Factory overhead. stationery in factory office. b) Indirect labour – Examples: Works manager‟s salary. . salary of inspector and supervisor. works overhead or manufacturing overhead. salary of factory office staff. Production overhead. brush. etc. etc. sweeping broom. grease. a) Indirect material – Examples: Coal.

c) Indirect expenses – Examples: Factory rent. factory lighting and power. This is the indirect expenditure incurred in general administrative function. postage. a) Indirect material – Examples: Stationery used in general administrative office. insurance of factory building. c) Indirect expenses – Examples: Rent of office building. etc. repair and maintenance of plant. depreciation of office furniture and . Office and administration overhead. legal expenses. salary of managing director. sweeping broom and brush. 2. b) Indirect labour – Examples: Salary of office staff. depreciation of plant. office lighting and power. telephone expenses. remuneration of directors of the company. internal transport expenses.

upkeep of delivery vans. Selling and distribution overhead.. salary of warehouse staff. oil.equipments. b) Indirect labour – Examples: Salary of sales manager. sundry office expenses. etc. etc. . insurance of goods in transit. a) Indirect material – Examples: Packing material. office air-conditioning. Selling overhead is the cost of promoting sales and retaining customers. Advertisements. salaries of salesmen etc. Carriage outwards. price list. stationery used in sales office. Distribution cost includes all expenditure incurred from the time the product is completed until it reaches its destination. for delivery vans. catalogues. warehousing. samples and free gifts. salary of sales office staff. grease etc. salary of drivers of delivery vans. cost of samples. 3.

Elements of cost may be grouped as follows. insurance of goods in transit. carriage outwards. Cost of Production = Works cost+Administration overhead. rent of warehouse. travelling expenses. Components of Total Cost . i) ii) iii) iv) Prime cost = Direct material+Direct labour+Direct expenses. etc. showroom expenses. bad debts. Works cost or Factory cost = Prime cost+Factory overhead.c) Indirect expenses – Examples: Advertising. Total cost or cost of Sales = Cost of production+Selling and distribution overhead .

Total Cost Material Cost Labour Cost Expenses Direct Material Indirect Material Direct labour Indirect labour Direct Expenses Indirect Expenses Prime Cost Overhead Production Overhead Admin. Overhead Selling and Distribution Overhead Elements of cost .

Step in Installation The installation of a costing system requires the following steps: 1. 2. . the nature of the product and methods of production will determine the type of costing system to be applied. The existing organisation should be disturbed to the minimum as may be advisable after full consideration. Preliminary investigations should be made elating to the technical aspects of the business. The organisation structure of the business should be studied to ascertain the scope of authority of each executive.Cost Sheet (Cost Statement) It is statement which is prepared periodically to provide detailed cost of a cost centre or cost unit. For instance.

The existing methods of remunerating labour should examined for the purpose of introducing any incentive plans. The methods of purchase. 8. Forms and accounting records should be so designed so as to involve minimum clerical labour and expenditure. The system should be effective in cost control and cost reduction. 5. Costing system should be simple and easy to operate. The size and layout of the factory should be studied.3. . Unnecessary details should be avoided. The installation and operation of the system should be economical. 9. storage and issue of materials should be examined and modified as per requirements. 6. 7. 4.

Guides in fixing selling prices 5.10. Practical Difficulties 1. Reveals profitable and unprofitable activities 2. Resistance from the accounting staff 3. Helps in inventory control . Helps in decision making 4. Helps in cost control 3. Non-cooperation of working and supervisory staff 4. Lack of support of top management 2. Advantages of Cost Accounting 1. The system should be introduced gradually. Shortage of trained staff.

I. has made cost audit compulsory in certain specified companies to be notified by the Central Government from time to time. is not compulsory in all companies.” Financial audit is compulsory in the case of all joint stock companies.6. Avoid unnecessary details. Cost audit. on the other hand. 1956. Cost Audit Cost audit is the specific application of auditing principles and procedures in the field of cost accounting. It has been defined by C. . 7. 233-B of the companies Act. Prompt and accurate reports.M.A London as “the verification of cost accounts and a check on the adherence to the cost accounting plan. Sec.

. tyres and tubes in a car. .MATERIAL COST The term „material‟ refers to all commodities that are consumed in the process of manufacture. set. etc..g. picture tube in a television. Direct materials include not only the raw materials entering at the start of the production but all of the following: i) Component part used in a product. any container sold with the final product.. e.g. i. fertilizer used in growing plants. e.e. cans for tinned food and drink. e. iii) Any primary packing material. ii) Any material used in production but wholly consumed in the production process.g..

storage and usage of materials in such a way so as to maintain an even flow of production.” . components. The term „inventory‟ is used to cover the stocks of raw materials. soap. Material Control (Inventory Control) Material or inventory control may be defined as “systematic control and regulation of purchase. at the same time avoiding excessive investment in inventories. Efficient material control cuts out losses and wastes of materials that otherwise pass unnoticed. work-in-progress and finished goods. grease and oil. sandpaper etc. Examples are coal.Indirect materials are those which cannot be conveniently identified with individual cost units.

Stock levels – Minimum. ABC technique. No under-stocking 2. Proper quality 5.Objectives of Material or Inventory Control 1. . Economy in purchasing 4. Information about materials Techniques of Inventory Control Various techniques commonly used for inventory control are listed below: 1. maximum and re-order levels. No over-stocking 3. Minimum wastage 6. 2.

5. Proper storage of materials. Perpetual inventory system.3. 9. 7. Economic order quantity (EOQ) Proper purchase procedure. 8. Inventory turnover ratio to review slow and non-moving materials. . 4. Preparation of material budgets (Used in Budgetary Control). 6. Fixation of material cost standards (Used in standard Costing).

ABC Technique (Selective Control) ABC technique is a value based system of material control. ABC technique is sometime called always Better Control method. „A‟ Items – These are high value items which may consist of only a small percentage of the total items handled. „B‟ Items – These are medium value materials which should be under the normal control procedures. „C‟ Items – These are low value materials which may represent a very large number of items.
Category A B C Total % of total value 70 25 5 100 % of total quantity 10 30 60 100 Type of control Strict control Moderate control Loose control

The information in the above table has been presented in the following diagram:
100 95 70 „A‟ 50





40 50


% of total quantity ABC categories of stock (cumulative percentages).

Stock Levels (i) Maximum level, (ii) minimum level, (iii) re-order level, (iv) re-order quantity.
Modern inventory management makes use of operations research and statistical techniques in fixing stock levels. However, given below is the description of various levels along with formulae that are commonly used in their computations. Factors Some of the factors which influence stock levels are: 1. Anticipated rate of consumption. 2. Amount of capital available. 3. Availability of storage space.

Maximum Re-order Re-order Minimum x Minimum = level level + quantity .consumption re-order period . (c) evaporation. Storage/Warehousing costs. 6. (b) deterioration. Procurement costs. Reliability of suppliers. 5.4. etc. and (d) fall in market prices. 7. Minimum order quantities imposed by suppliers. 8. Risk of loss due to (a) obsolescence. Maximum Level This is that level above which stocks should not normally be allowed to rise.

Re-order = level Maximum x Maximum consumption re-order period . Maximum Re-order = level level Normal Normal x consumption re-order period Re-order Level or Ordering Level This is that level of material at which purchase requisition is initiated for fresh supplies.Minimum Level It is that level below which stock should not normally be allowed to fall.

Danger = level Maximum x Maximum re-order period consumption Under emergency conditions Average Stock Level This is computed as follows: Average stock level = ½ (Minimum level + Maximum level) Alternatively. Average stock level = Minimum level + ½ (Re-order quantity) Lead time is the time interval between the time when an item reaches re-order level and a fresh order is placed. . In order to meet such a situation a danger level is fixed.Danger Level Sometimes purchased materials are not received in time and stock level goes below the minimum level. to the time or actual receipt of materials. Danger level is a level at which normal issue are stopped and materials are issued for important jobs only.

While setting economic order quantity. It mainly includes the cost of stationery. etc. This is the cost of placing an order with the supplier. Cost of carrying stock. Economic order quantity is that size of the order which gives maximum economy in purchasing any material. It is the quantity which is most economical to order. salaries of those engaged in placing order. salaries of those engaged in receiving and inspection. This is the cost of holding the stock in storage. 2. Ordering cost. It includes the following: .Re-order Quantity (Economic Order Quantity or EOQ) Re-order quantity is the quantity for which order is placed when stock reaches re-order level. two types of costs should be taken into account: 1.

Y 800 Economic order quantity Cost (Rs.) 600 400 200 O 250 500 750 Units per order Economic Order Quantity .

b) The incidence of insurance cost. Mathematical formulae of EOQ EOQ = Where √ 2. . (salaries.B. C. stationery.).S EOQ = Economic Order Quantity A = Annual consumption in units B = Buying or ordering cost per order C = Cost per unit S = Storage or carrying cost as a percentage of average inventory.A. rent. d) Deterioration and wastage of materials. etc. c) Interest on capital locked up in store.a) Cost of operating the stores.

This method is particularly used when prices vary according to the quantity to be purchased.000 units Cost of ordering – Rs.Tabular Method Economic order quantity can also be determined with the help of a table prepared for this purpose. 15 per units Cost of material – Rs.25 per units Carrying cost – 20% of average inventory Solution – The following table may be prepared to determine the economic order quantity: . Determine EOQ from the following information using tabular method: Annual consumption – 12. 1.

000 3.714 1.000 4.667 1. 15 30 45 60 75 90 Carrying cost Rs. 1.071 105 120 135 150 165 180 195 210 214 188 167 150 136 125 115 107 319 308 302 300 301 305 310 317 15 800 1.400 2.750 3.000 2.142 1.000 7.000 225 100 325 .154 1.500 1.364 1.875 1. 1. of orders per year 1 2 3 4 5 6 Units per order 12.000 2.000 3. 15.500 5.333 1.250 1.500 1.000 6.000 Value per order Rs.000 923 857 2.500 750 500 375 300 250 Total cost Rs.200 1.091 1.515 750 545 435 375 340 7 8 9 10 11 12 13 14 1.No.500 Ordering cost Rs.

The greater the stock turnover. Cost of materials consumed during the period Stock Turnover Ratio = Average stock of materials during the period A high stock turnover ratio indicates fast moving materials and a low ratio indicates slow moving materials. Days of the period Stock Turnover in terms of days = Stock turnover rate If the length of the stock turnover period is short. .INVENTORY TURNOVER Inventory or stock turnover ratio tells us how many times in a year stock is used up and replaced. the material is considered to be fast moving. the more efficient is the stock policy.