Elements

MATERIAL : It refers to raw materials used for

production.
LABOUR :The aggregate of all human physical and

mental effort used in creation of goods and services.

OVERHEADS : Resource consumed or lost in

completing a Process, that does not contribute directly to the end product. Also called burden cost.

Materials
The term Materials refers to substances and

commodities other than fixed assets introduced and consumed in the productive process of an organization.
It includes the following: Raw Materials Spare parts and components Consumable stores Packing materials Materials may be direct or indirect.

Materials Control
In almost all manufacturing concerns, materials constitute a

large proportion of total cost.

An efficient system of material control will lead to a significant

reduction in the cost of production.

Materials control means the regulation of the functions of an

organization relating to the procurement, storage and usage of materials in such a way so as maintain an even flow of production without excessive investment in material stock.

The materials control is divided in 3 stages: Purchase Control Storage Control Issue Control

Materials Control (Contd.)

Objectives of Materials Control

Availability of Materials Avoidance of wastage Avoidance of out-of-stock danger Economy in purchasing Effective utilization of materials

Methods/Ways/Techniques of Materials Control Centralized Vs. Decentralized Purchasing ABC Analysis Just-In-Time (JIT) System Fixation of Various Stock Levels Economic Order Quantity

Centralized Vs. Decentralized Purchasing

Centralized purchasing means that purchases are made by the

specialized department
its own purchases.

Decentralized purchasing means each branch or department makes Some advantages of Centralized purchasing: Since purchases are in bulk, they can be economical due to favorable terms such as higher trade, cash discount, lower transport costs, etc. Purchase department can employ qualified and experienced staff, having knowledge and skills, in order to avoid reckless and haphazard purchasing. Usually, centralized purchasing is preferred but in some cases, where

highly technical or precious materials are required, the purchases can be made by individual departments.

ABC Analysis
ABC Analysis is also known as Always Better Control. To have an effective and proper control on stores, all

the items of stores should be classified in 3 groups/categories on the basis of investment involved: Category A: Heavy Investment, very tight control, complete and accurate records, frequent review. Category B: Substantial Investment but not as much as Category A, less tightly controlled, good records, regular review. Category C: Not much of Investment required, simplest controls possible, minimal records, large inventories, periodic review and reorder.

Just-In-Time (JIT) System

It is a system in which purchases are contracted so that

receipt and usage of the material to the maximum extent possible coincide. This means raw materials are purchased Just-In-Time to proceed to production process. This system ensures maximum economy in material handling costs, ordering costs and stock holding costs. The chances of pilferage, leakage, spoilage, etc is reduced to the minimum.

Economic Order Quantity (EOQ)

EOQ is the size of the order which gives maximum

economy in purchasing any material. It involves 3 kinds of costs: Cost of Purchase Cost of Acquiring costs (Ordering Costs): Ordering costs will be greater if orders are placed more frequently and of lower quantities. Cost of Holding Inventory (Carrying Costs): The larger the volume of inventory, higher will be the inventory carrying costs and vice versa.

EOQ Model
10,000 Relevant Total Costs (Dollars) 8,000

Annual relevant total costs

6,000 5,434 4,000 Annual relevant carrying costs Annual relevant ordering costs

2,000

600 Order Quantity (Units)

988 1,200 EOQ

1,800

2,400

Assumptions of EOQ Model

The same quantity is ordered at each re-order point. Demand, ordering costs, carrying costs and purchase-

order lead time is known with certainty.

Purchasing costs per unit are unaffected by the

quantity ordered.

EOQ Model
EOQ =

2 AB C

Where, A = Annual Demand in units for a specified time period B = Relevant ordering/ Buying costs per purchase order C = Relevant carrying costs of one unit in stock

Example: Compute the Economic Order Quantity from the data given below: Annual usage of materials 6000 units Cost per unit Rs. 24 Buying Cost per order Rs. 60 Cost of carrying inventory 20%

EOQ Model Decision Model

What are the relevant total costs (RTC)? RTC = Annual relevant ordering costs + Annual

relevant carrying costs

A Q Q 2 AP Q QC 2

RTC =

or

Q can be any order quantity, not just the EOQ.

Fixation of Stock levels

In order to maintain a proper balance between under-

stocking and over-stocking, a storekeeper must fix various levels of stock:

Maximum Level Minimum Level/Safety Stock Level

Re-Order Level
Danger Level Average Stock Level

 Maximum Level: The level above which quantity of

inventory should not be allowed to be kept, else it would lead to over-stocking and blocking capital unnecessarily.
= Re-order level + Re-order Quantity (Minimum Consumption X Minimum Re-order Period)
Minimum Level/ Safety Stock Level: The level below which

quantity of inventory should not be allowed to fall in normal circumstances.

= Re-Order level (Normal Consumption X Normal Re-Order Period

Re-Order Level: The level at which purchase request is

initiated for replenishment of stock.

= Maximum Consumption X Maximum Re-order Period

 Danger Level: The level below which the actual stock

of material should not be allowed to fall in normal circumstances.

= Minimum Consumption X Minimum Re-Order Period

Average Stock level: It indicates the average stock held

by an enterprise during a year.

= Minimum Level + Maximum Level /2 OR = Minimum Level + (Re-Order Quantity)

Units

Maximum level 1500

Reorder level 1000

Minimum level
500
Danger level

Weeks

Question:
Two components X and Y are used as follows: Normal Usage: 600 units per week each Maximum Usage: 900 units per week each Minimum Usage: 300 units per week each Re-order Quantity: X 4,800 units and Y 7,200 units Re-Order period: X 4 to 6 weeks and Y 2 to 4 weeks Calculate for each component

(a) Re-Order level (b) Minimum level (c) Maximum Level (d) Danger Level (e) Average Stock Level

Inventory Systems
Periodic inventory System: It is a method of

recording inventory at the end of the accounting year after making a physical verification of the quantity in hand.
Perpetual Inventory System: It is a system of

recording inventory after each receipt and issue. Under this system, stock registers are regularly maintained and gives the balance of inventory at any time desired.

Pricing of Issues of Material

There are a number of methods available for pricing of

issues of materials, the popular ones are:

First In First Out (FIFO)
Last In Last Out (LIFO) Weighted Average Method

Question:
Following transactions took place in respect of materials: August 4 Received 500 units @ Rs. 2 each August 18 Received 350 units @ Rs. 2.10 each August 19 Issued 600 units August 24 Receipts 600 units @ Rs. 2.20 each August 25 Issued 450 units August 26 Received 500 units @ Rs. 2.30 each August 28 Issued 510 units August 30 Issued 100 units Calculate the value of closing stock of materials according to: FIFO Method LIFO Method Weighted Average Method

Stores Ledger (FIFO Method)

Receipts Quantity Aug 4 500 Rate 2 Amt 1000 Quantity Issues Rate Amt Quantity 500 Balance Rate 2 Amt 1000

Aug 18

350

2.10

735

500 350

2 2.10

1000 735

Aug 19

500 100

2.00 2.10 -

1000 210 250 250 600 2.10 2.10 2.20 525 525 1320

Aug 24

600

2.20

1320

Aug 25

250 200

2.10 2.20 -

525 440 400 400 500 2.20 2.20 2.30 880 880 1150

Aug 26

500

2.30

1150

Aug 28

400
110

2.20
2.30

880
253 390 2.30 897

Aug 30

100

2.30

230

290

2.30

667

Stores Ledger (LIFO Method)

Date Quantity Aug 4 Aug 18 500 350 Receipts Rate 2 2.10 Amt 1000 735 Quantity Issues Rate Amt Quantity 500 500 350 Aug 19 350 250 Aug 24 600 2.20 1320 2.10 2.00 735 500 250 250 600 Aug 25 450 2.20 990 250 150 Aug 26 500 2.30 1150 250 150 500 2 2.00 2.20 2.00 2.20 2.00 2.20 2.30 500 500 1320 500 330 500 330 1150 Balance Rate 2 2 2.10 Amt 1000 1000 735

Aug 28

500
10

2.30
2.20 2.20

1150
22 220

250
140 250 40

2.00
2.20 2.00 2.20

500
308 500 88

Aug 30

100

Stores Ledger (Weighted Average Method)

Date Receipts Issues Balance

Quantit y
Aug 4 Aug 18 Aug 19 Aug 24 Aug 25 Aug 26 500 350 600 500

Rate
2 2.10 2.20 2.30

Amt
1000 735 1320 1150

Quantit y
600 450 -

Rate
2.04 2.15 -

Amt
1225 968 -

Quantit y
500 850 250 850 400 900

Rate
2 2.04 2.04 2.15 2.15 2.24

Amt
1000 1735 510 1830 862 2012

Aug 28
Aug 30

510
100

2.24
2.24

1141
224

390
290

2.24
2.24

870
646

Inventory Valuation Methods

(a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income. (b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income.

(c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.
(d) Specific Identification method : This method determines specific costs for each unit in stock. This method is suitable when the stock is not homogenous, less in quantity and high in value.

Which is the Best method for inventory valuation ???

Inventory valuation affects the profit and loss account as well as the balance Sheet FIFO more realistic inventory value but unrealistic profit LIFO - more realistic profit but outdated inventory value WAC - the average of the two Accounting Standard does not allow the use of LIFO. Under Income Tax law any method may be adopted but it should be followed consistently.

Material Losses
There is usually a difference between the input of

material in a process and the output. This difference represents loss of materials.
Material Losses may be in the following forms: Waste Scrap Spoilage Defectives

 Waste: It is the portion of basic raw materials lost in the

It may be visible (sawdust, ash, sand, dust) or invisible

process having no recoverable value. E.g. smoke, gas, dust, etc.

(evaporation, shrinkage). Waste can be normal (bound to rise) or abnormal (due to external factors but is not a part of cost).

Scrap: It is the portion of visible wastage of materials having

low money or use value. In normal practice, the sale value of scrap is deducted from the cost of materials or factory overheads (Recoverable). Spoilage: Those materials or components which are so damaged in the manufacturing process that they cannot be repaired or reconditioned (Irrecoverable).
spoiled are sold as scrap. Spoilage can be normal or abnormal.

Some spoilage can be sold as seconds while some that are badly

Defectives: They are generally semi-finished or finished

It may be due to normal or abnormal reasons.

products which are not according to standard specifications but can be rectified.

Labour
Labour means human efforts engaged in the process of

production. Labour may be direct or indirect.

Direct labour is the labour which can be identified with

the production process. Indirect labour means the labour which is not directly engaged in the production but engaged to assist direct labour. E.g. Supervisory staff, storekeepers, foreman, time-keepers, watchmen, etc.

Labour Control
Labour costs represent 20 to 25% of the total cost of the product. There is a need for an effective control over labour costs. There are mainly 5 departments in an organization for labour control: Personnel Department: Performs functions of recruitment, selection, training and induction of various grades of workers, also looks after fixation of wages, promotion and discharge of employees. Engineering Department: Prepares plans and specification for each job schedule for production in order to reduce labour turnover rate. Time Keeping Department: Maintains records of effective utilization of labour time. Pay Roll Department: Involves computation of gross wages, deductions to be made and disbursement of pay. Cost Accounting Department: Collects and analyses all costs related to labour. This department prepares wages abstract or analysis sheet to give a number of information that facilitates decision-making.