ACOF014

Introduction to Costing
Semester 2 2008/ 2009

TOPIC 3: COSTING FOR MATERIALS

Learning Objectives:
After studying this topic students should be able to:

• Know the objectives of material pricing

• Understand the problems of material pricing
• Describe the characteristics of the main issue pricing systems; First in First Out (FIFO), Last in First
Out (LIFO), Average Price and Standard Price
• Know how to calculate issue prices and stock values using the pricing systems
• Describe and calculate control procedures for materials

1. Problems of Material Pricing

 Change in prices of bought in materials and components
 Different prices for several deliveries of stocks for materials
 Difficult to identify items with their delivery consignment
 Sensitivity of profit calculations to pricing method adopted

2. Techniques to determine cost of materials

Why?
 Cost of material issue is charged to jobs or OH accounts…
 Accounting dept. records the transactions….
∼ Reduce raw material inventory (reduce values in stores ledger accounts)
∼ Record amount in the relevant job/OH account

2. Pricing the issues of raw materials

 What should be the price of raw materials that have been used in production?
 Are all materials likely to be purchased at the same price?
 Problem: what cost to assign to each material issue?

3 stores pricing methods:

 FIFO - First in first out (FIFO): uses the price of the units in the first batch received until
all units have been issued, after which the price of next oldest is used

Characteristics:
 Actual cost system – no unrealized profits or losses
 Good representation of storekeeping – issue old items first
 Stock valuation based on current market value
 Product costs do not reflect current condition
 Acceptable by the IRB
 Administratively clumsy
 Difficult to compare costs between jobs

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  LIFO - Last in first out (LIFO): the latest batch of materials bought will be used first. Materials are
issued at price closer to current price level

Characteristics:
 Actual cost system – no unrealized profits or losses
 Many batches are only partly charged to production
 Product costs based on current prices
 Stocks do not reflect current condition - valued at oldest prices
 Not acceptable by the IRB
 Provides hedge against inflation – understate profits
 Administratively clumsy
 Difficult to compare costs between jobs

 WACO:
Average Price: the materials issued will be priced using average price i.e.
Total cost of materials in stock
Total quantity of materials in stock
Characteristics:
 Not an actual buying price
 Less complicated to administer than LIFO and FIFO
 Effects on products costs and stock valuation – somewhere between LIFO and FIFO
 Cost comparison between jobs are easier
 Reduce price fluctuation effect
 No unrealized profits or losses

3. Why do we need to price material issues?

∼ To allocate material costs to jobs for external reporting for stock valuation & π measurement
∼ To determine relevant costs for decision-making and product pricing
** Take note…. method chosen to meet external reporting needs may not be suitable for internal decision-
making….
Why?
→ External reporting uses historical costs whilst internal reporting is more interested in future
costs
→ Effects of inflation also needs to be considered

FIFO during inflation:

__________ materials are issued first…..at ____________ price

   ________ cost of sales  __________ π

 Closing stock value __________ because purchased ___________ at a _________ price

  _______ cost of sales  ____________ π

LIFO during inflation:

__________ materials are issued first…..at ____________ price

   ________ cost of sales  __________ π

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  Closing stock value __________ because purchased ___________ at a _________ price
  _______ cost of sales  ____________ π

4. For decision-making & internal reporting….

….. replacement cost would be most appropriate…Why?

 as we use materials, we need to replace them; and with inflation, prices will be higher at
replacement point

∴ stock valued at replacement cost  π will be adjusted too

* Any problem with using replacement cost in practice?

....how will you obtain info about replacement costs?

…will it be a problem obtaining that info on a regular basis?

 ∴ fall back on approximation of the replacement cost…

How?

 FIFO 
 LIFO 
depends on stock turnover rate; faster stock t/over, _________
∴ historical cost is __________ to replacement cost

 if fast, we use….
 if slow, we use

Other cost to consider?

 Standard cost = target cost on future cost of raw materials, set at beginning of year
→ need to review regularly
 problem: better for repetitive operations. If operations not repetitive, better make a cost vs
benefit analysis

EXAMPLE 1:
PV Manufacturing Sdn. Bhd, a company manufactures electronics parts for Sparkle Precision Sdn Bhd,
have the following stock purchase and issues for the month of June as follows:-

Stock movement for material “AB”

Purchase
1/6 100 pcs @RM1 per pcs
4/6 120 pcs @1.50 per pcs
12/6 200 pcs @2.20 per pcs
27/6 150 pcs @2.50 per pcs
Issues
10/6 70 pcs
17/6 90 pcs

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 25/6 180 pcs
30/6 200 pcs

Record the above transaction in a stores ledger account by using the FIFO, LIFO and WA method for
pricing the issues of materials “AB”.

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5. Inventory Control
 System used in a firm to control the firm’s investment in stock
 Includes: recording and monitoring of stock levels; forecasting future demands etc
 Objective: minimise the costs associated with stock (carrying costs, ordering costs, stock
out costs)
∼ Carrying costs – storage charges, material handling costs, insurance and security,
deterioration and obsolescence
∼ Ordering costs – clerical and administrative works, transportation costs
∼ Stock-out costs – Loss current, future sales; production stoppages

a. Inventory Control Terminology

i) Lead or procurement time: The period between ordering (externally or internally) and
replenishment i.e. when the goods are available for use

ii) Economic Order Quantity (EOQ): Calculated reorder quantity which minimizes the
balance of cost between carrying costs and ordering costs

iii) Buffer stock: A stock allowance to cover errors in forecasting the lead time or the
demand during the lead time

iv) Maximum level: A stock level calculated as the maximum desirable which is used as
an indicator to management to show when stocks have risen too high

v) Reorder level: Level of stock at which a further replenishment order should be

placed. Dependent on the lead time and the rate of demand during the lead time

vi) Reorder quantity: The quantity of the replenishment order, but not necessary EOQ

b. Calculating Control Levels

 Economic Order Quantity
o To be able to calculate a basic EOQ, certain assumptions are necessary:
a) A known constant carrying costs
b) A known constant ordering costs
c) Rates of demand are known
d) A known constant price per unit
e) Replenishment is made instantaneously

EOQ formula =
2.Co.D
Cc
Where, Co = Ordering cost per order
D = Demand per annum
Cc = Carrying cost per item per annum

 Reorder level: Maximum usage X maximum lead time

 Minimum level: Reorder level – average usage in average lead time

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  Maximum level: Reorder level + EOQ – minimum anticipated usage in minimum
lead time

EXAMPLE 2:
Find the EOQ where the forecasted demand is 1000 units per month, the ordering cost is RM350
per order, the units cost RM8 each and it is estimated that carrying costs are 15% per annum.

EXAMPLE 3:
Average usage 100 units per day
Minimum usage 60 units per day
Maximum usage 130 units per day
Lead time 20-26 days
EOQ (previously calculated) 4000 units

Calculate: Reorder level, minimum level and maximum level