Cost Accounting Techniques

Accounting for Material

Facilitator:
Dr Irfan Sahibzada
Contact Details:
Irfan.sahibzada@nbs.nust.edu.pk
Ph. Office: 051 90853154
Mob: 0342 5093739
Office: Room 311
 Accounting for Material
• The investment in inventory is very important for most
businesses, both in terms of monetary value and
relationships with customers (no inventory, no sale, loss
of customer goodwill).
• It is therefore vital that management establish and
maintain an effective inventory control system.
• This chapter will concentrate on the inventory control
system for materials, but similar problems and
considerations apply to all forms of inventory.
 Inventory Control
• Inventory control includes the functions of inventory
ordering and purchasing, receiving goods into store,
storing and issuing inventory and controlling levels of
inventory.
• Classifications of Inventories:
• Raw Materials
• Work in Progress
• Spare parts/Consumables
• Finished Goods
 Reasons for Inventory Control
• Holding costs of inventory may be expensive.
• Production will be disrupted if we run out of raw
materials.
• Unused inventory with a short shelf life may incur
unnecessary expenses.
• If manufactured goods are made out of low quality
materials, the end product will also be of low quality. It
may therefore be necessary to control the quality of
inventory in order to maintain a good reputation with
consumers.
Ordering, Receiving and Issuing of
Materials
• Every movement of material in a business should be
documented using the following as appropriate:
• Purchase requisition
• Purchase order
• Good received note (GRN)
• Materials requisition note
• Materials transfer note and
• Materials returned note.
• Many inventory control systems these days are
computerised. Computerised inventory control systems
vary greatly, but most will have the features outlined
above.
A Generic Process
 The Storage of Raw Materials
• Objectives of storing materials
• Speedy issue and receipt of materials
• Full identification of all materials at all times
• Correct location of all materials at all times
• Protection of materials from damage and deterioration
• Provision of secure stores to avoid pilferage, theft and fire
• Efficient use of storage space
• Maintenance of correct inventory levels
• Keeping correct and up to date records of receipts, issues
and inventory levels
 Recording Inventory Levels
• One of the objectives of storekeeping is to maintain
accurate records of current inventory levels.
• This involves the accurate recording of inventory
movements (issues from and receipts into stores).
• The most frequently encountered system for recording
inventory movements is the use of bin cards and
stores ledger accounts.
• Managers need to know the free inventory balance in
order to obtain a full picture of the current inventory
position of an item. Free inventory represents what is
really available for future use.
 Identification of Materials and the
Inventory Count (Stocktake)
• Materials held in stores are coded and classified. Advantages of
using code numbers were discussed earlier.
• The inventory count (stocktake) involves counting the physical
inventory on hand at a certain date, and then checking this against
the balance shown in the inventory records.
• The inventory count can be carried out on a continuous or periodic
basis.
• Periodic stocktaking is a process whereby all inventory items are
physically counted and valued at a set point in time, usually at the end
of an accounting period.
• Continuous stocktaking is counting selected items at different times
on a rotating basis. This involves a specialist team counting and
checking a number of inventory items each day, so that each item is
checked at least once a year. Valuable items or items with a high
turnover could be checked more frequently.
 Advantages of continuous
stocktaking vs periodic stocktaking
1. The annual stocktaking is unnecessary and the disruption it causes
is avoided.
2. Regular skilled stock takers can be employed, reducing likely
errors.
3. More time is available, reducing errors and allowing investigation.
4. Deficiencies and losses are revealed sooner than they would be if
stocktaking were limited to an annual check.
5. Production hold-ups are eliminated because the stores staff are at
no time so busy as to be unable to deal with material issues to
production departments.
6. Staff morale is improved and standards raised.
7. Control over inventory levels is improved, and there is less
likelihood of overstocking or running out of inventory.
 Other Relevant Terms
• Inventory discrepancies
• It refers to occasions when checks disclose discrepancies
between the physical amount of an item and the amount shown
in the inventory records. When this occurs, the cause of the
discrepancy should be investigated, and appropriate action taken
to ensure that it does not happen again.
• Perpetual Inventory Systems
• It refers to an inventory recording system whereby the records
(bin cards and stores ledger accounts) are updated for each
receipt and issue of inventory as it occurs.
• Obsolete Inventories
• They are those items which have become out of date and are no
longer required. Obsolete items are written off and disposed of.
 Objective of Inventory Control
• The overall objective of inventory control is to maintain
inventory levels so that the total of the following costs is
minimised:
• Holding costs
• Stockout costs
• Ordering costs
• Inventory Control Levels
• Inventory control levels can be calculated in order to
maintain inventories at the optimum level.
• The three critical control levels are reorder level, minimum
level and maximum level.
 Reorder, Minimum and Maximum
Level
• Reorder Level:
• When inventories reach this level, an order should be placed to
replenish inventories. The reorder level is determined by
consideration of the following formula:
• Reorder level = maximum usage x maximum lead time
• Minimum Level or Buffer Inventory:
• Reorder Level – (average usage x average lead time)
• Maximum Level:
• Reorder level + reorder quantity – (minimum usage x minimum
lead time)
 Example
• A large retailer with multiple outlets maintains a central
warehouse from which the outlets are supplied.
• The following information is available for Part Number SF525.
Average usage 350 per day
Minimum usage 180 per day
Maximum usage 420 per day
Lead time for replenishment 11 – 15 days
Reorder quantity 6,500 units

• What is the reorder level?

• What is the maximum level of inventory?
• What is buffer inventory?
 Average Inventory
• The formula for the average inventory level assumes that inventory
levels fluctuate evenly between the minimum (or safety) inventory
level and the highest possible inventory level (the amount of
inventory immediately after an order is received, i.e. safety
inventory + reorder quantity).
• Therefore the formula will be:

• Example: A component has a safety inventory of 500, a reorder

quantity of 3,000 and a rate of demand which varies between 200
and 700 per week.
• The approximate average inventory would be?
 Reorder Quantity
• This is the quantity of inventory which is to be ordered
when inventory reaches the reorder level.
• If it is set so as to minimise the total costs associated
with holding and ordering inventory, then it is known as
the Economic Order Quantity.
 Economic Order Quantity
• Economic order theory assumes that the average inventory
held is equal to half of the reorder quantity.
• The economic order quantity (EOQ) is the order quantity
which minimises inventory costs.
• The EOQ can be calculated using a table, graph or formula.

• Where:
• = Cost of ordering a consignment from supplier
• = Demand during the time period
• = Cost of holding one unit of inventory for one time period
 Example
• Suppose a company purchases raw material at a cost of
$16 per unit. The annual demand for the raw material is
25,000 units. The holding cost per unit is $6.40 and the
cost of placing an order is $32.
• Notes
a) Average inventory = order quantity ÷ 2 (assuming no safety
inventory)
b) Number of orders = annual demand ÷ order quantity
c) Annual holding cost = average inventory x $6.40
d) Annual order cost = number of orders x $32

• Answer on the next slide.

 Example Answer
Order quantity
(units)
  100 200 300 400 500 600 800 1000

Average inventory
(units)
(a) 50 100 150 200 250 300 400 500

Number of orders (b) 250 125 83 63 50 42 31 25

    $ $ $ $ $ $ $ $
Annual holding
cost
(c) 320 640 960 1,280 1,600 1,920 2,560 3,200
Annual order cost (d) 8,000 4,000 2,656 2,016 1,600 1,344 992 800
Total Relevant
cost
  8,320 4,640 3,616 3,296 3,200 3,264 3,552 4,000
Example Using the Formula
EOQ Graph
 Example: EOQ and Holding Costs
• A manufacturing company uses 25,000 components at
an even rate during a year.
• Each order placed with the supplier of the
components is for 2,000 components, which is the
EOQ.
• The company holds a buffer inventory of 500
components.
• The annual cost of holding one component in
inventory is $2.
• What is the total annual cost of holding inventory of the
component?
 Economic Batch Quantity (EBQ)
• The economic batch quantity (EBQ) is a modification of the
EOQ and is used when resupply is gradual instead of
instantaneous. Therefore, it is the order size of a production
batch that minimizes the total cost.
• Batch production is a technique which is commonly used
today for distributing the total production in a series of small
batches rather than mass production in one go.
• Sometimes the production of goods in batches is necessary
because, for example, certain equipment used in
manufacturing (e.g. dyes) may wear out and need
replacement before the production can run again.
 EBQ Formula
• Where:
• = Set up cost
• = Demand during the time period
• = Cost of holding one unit of inventory for one time period
• R = Rate of production
• The formula is similar to EOQ with one notable difference in
the denominator. The cost of holding in EBQ formula is
decreased by the amount of inventory that will be produced
and sold on the same day, therefore not contributing to the
annual cost of holding the inventory.
 Example: EBQ
• Sarah owns and operates a small factory that manufactures
plastic bottles which she sells to bottling companies.
• Additional information:
• Annual demand is 1 million bottles spread evenly over the year
• Setup cost is $5000 per batch
• Holding cost is $3 per annum for each bottle
• Maximum production capacity is 2 million bottles per annum
• Currently, bottles are manufactured in 10 batches
A. Find the optimum production quantity that Sarah should
produce to minimize her costs.
B. Calculate the current annual holding cost and setup cost.
C. Calculate the savings to Sarah if she adopts the EBQ.
 EOQ and Bulk Discounts
• EOQ generally minimizes the total inventory cost.
However, EOQ may not be optimal when discounts are
factored into the calculation.
• The optimal order quantity when discounts are involved
is either:
• EOQ; or
• Any one of the minimum order quantities above
EOQ that qualify for additional discount.
• The optimum quantity is determined by comparing the
total inventory cost of the different order quantities
listed above EOQ.
 Example: Bulk Discount
• The annual demand for an item of inventory is 45 units.
• The item costs $200 a unit to purchase, the holding cost
for 1 unit for 1 year is 15% of the unit cost and ordering
costs are $300 an order.
• The supplier offers a 3% discount for orders of 60 units or
more, and a discount of 5% for orders of 90 units or
more.
• Calculate the cost-minimising order size?
 Example: Bulk Discount
• JD purchases bikes from PMX in orders of 250 bikes, the current EOQ.
• PMX is now offering the following bulk discounts to its customers:
• 2% discount on orders above 200 units
• 4% discount on orders above 500 units
• 6% discount on orders above 1,000 units
• JD thinks if the EOQ is still the most economical or increasing the
order size would actually be more beneficial?
• Following information is relevant to forming the decision:
• Annual demand is 5000 units
• Ordering cost is $100 per order
• Annual holding cost is comprised of the following:
• 5% insurance premium for the average inventory held during the year
calculated using the net purchase price
• Warehousing cost of $6 per unit
• Purchase price is $200 per unit before discount
 Other Systems of Cost Control
1. Order cycling method
2. Two-bin system
3. Classification of materials
4. Pareto (80/20) distribution
 Accounting for Material Cost
Raw material, work-in-progress, finished goods
• Raw materials are purchased and then undergo further processing
or are incorporated into products.
• Raw materials can be basic materials such as chemicals, timber,
plastic etc.
• Or raw materials can be items which are manufactured by the
supplier, such as components/parts for use in production.
• Work in progress refers to partly made products. They have
progressed from the bought in stage (raw materials) but are not yet
complete.
Example: Material Control Account
• Bossy Co manufactures a single product and has the following
transactions for material during a particular period.
1. Raw materials of $500,000 were purchased on credit from a
supplier (Timid Co).
2. Raw materials costing $10,000 were returned to the same supplier
due to defects.
3. The total stores requisitions for direct material for the period were
$400,000.
4. Total issues for indirect materials during the period were $15,000.
5. $5,000 of unused direct material was returned to stores from
production.
• Required: Prepare the material control account for the period,
showing clearly how each transaction is treated.
 Inventory Valuation
• The correct pricing of issues and valuation of inventory are of
the utmost importance because they have a direct effect on
the calculation of profit.
• Several different methods can be used in practice for this
purpose.
• Valuing inventory in financial accounts: In practice probably
they are valued at cost but by the end of year, the figures are
adjusted with lower of cost or net realisable value.
• There are three methods used for the valuation of closing
inventory in management accounting that you need to be
aware of for the exam - FIFO, LIFO, and Weighted average.
 LIFO, FIFO and Weighted Average
• FIFO assumes that materials are issued out of inventory in the
order in which they were delivered into inventory: issues are
priced at the cost of the earliest delivery remaining in inventory.
• LIFO assumes that materials are issued out of inventory in the
reverse order to which they were delivered: the most recent
deliveries are issued before earlier ones, and issues are priced
accordingly.
• The cumulative weighted average pricing method calculates a
weighted average price for all units in inventory. Issues are
priced at this average cost, and the balance of inventory
remaining would have the same unit valuation. The average
price is determined by dividing the total cost by the total
number of units. A new weighted average price is calculated
whenever a new delivery of materials is received into store.
 Example: LIFO, FIFO, Average
• Lets consider the following data to calculate inventory value
by using all three methods.
  Quantity Unit Cost Total Cost Market Value per
$ $ unit on date of
transaction
$
Opening balance, 1st May 100 2.00 200  
Receipts, 3rd May 400 2.10 840 2.11
Issues, 4th May 200     2.11
Receipts, 9th May 300 2.12 636 2.15
Issues, 11th May 400     2.20
Receipts, 18th May 100 2.40 240 2.35
Issues, 20th May 100     2.35
Closing balance, 31st May 200     2.38
1916