Materials and Inventory Cost Control Alie

Materials and Inventory Cost Control:
Materials control is the system that ensures the provision of the required quantity and
quality at the required time with in the minimum of investment. It covers the following
functions:
1. Stock control
2. Scheduling of requirements
3. Purchasing
4. Receiving and inspecting
5. Storing and issuing
6. The materials purchased by a concern may be classified as stock items which are
taken into store and held until required, or as direct deliveries to the point of
consumption. The control of those materials which are stock items is known as stock
control.
7. Materials represent an important asset and is the largest single item of cost in
almost every business; accordingly the success or failure of a concern may depend
largely upon efficient material purchasing, storage, accounting, utilization and
control.
8. Where materials are not properly controlled, excess stock of some items are likely to
occur with a result unnecessary tying up of capital and loss through deterioration and
obsolescence. Shortages of other materials may arise at the time when they are
urgently needed and production will then be delayed.
9. The purchasing of materials is a highly specialized function. By ordering the right
quantity and quality of materials at the most favorable price, and by ensuring that it
arrives at the right time, the efficient buyer is able to make a valuable contribution
to the success of a business. The efficient material control costs out losses and
forms of waste that otherwise ten to pass unnoticed. Theft, misappropriation,
deterioration, breakage and additional storage costs can be reduced to a minimum
by proper controls, and much avoid idle time in the factory will be cut out if materials
are available to meet the demands of the production staff. Finally and most
important to the cost accountant, it is impossible to produce reliable costing
information if the records of materials issue are unsatisfactory, because a cost
statement cannot be more accurate than the information on which it is based.
10.Inventory Quantity Standards:

11. Ordering Level or Ordering Point or Re-order Level:
12. This is that level of materials at which a new order for supply of materials is to be
placed. In other words, at this level a purchase requisition is made out. Click here to
continue
13. Minimum Level or Minimum Limit:
14. The minimum level or minimum stock is that level of stock below which stock should
not be allowed to fall. Click her to continue.
15. Maximum Level or Maximum Limit:
16. The maximum stock limit is upper level of the inventory and the quantity that must
not be exceeded without specific authority from management. Click here to continue.
17. Danger Level:
18. Some enterprise also calculate danger level. When this level of stock is reached, then
emergency steps are taken by the management to acquire material supplies. Click
here to continue.
19. Economic Order Quantity EOQ:
20. Economic order quantity (EOQ) is that size of the order which gives maximum
economy in purchasing any material and ultimately contributes towards maintaining
the materials at the optimum level and at the minimum cost. Click here to read full
article.
21.
Requirements of a System of Materials

Control:
The important requirements or essentials of adequate satisfactory system of

materials control are as follows:
1. Proper Coordination
2. Competent Purchasing Agent
3. Use of Standard Forms
4. Control by Budgeting Materials and Equipment
5. Storage Location
6. Operation of Perpetual Inventory
7. Standards or Level to be Fixed
8. Storage Control and Issue
9. Internal Check
10. Development of Controlling Accounts and Subsidiary Records
11. Regular Reports
Proper Coordination:
Proper coordination of all departments involved, in material purchasing, receiving, testing,
approving, storage, issue and accounting is essential.
Competent Purchasing Agent:

Centralization of purchasing in a purchasing department under the direct and authority of a
competent trained purchasing agent is also considered essential.
Use of Standard Forms:
The use of standard forms for orders, requisition etc., upon which written and signed
instructions are given are essential for proper control of materials.
Control by Budgeting Materials and Equipment:

Use of materials, supplies and equipment budgets so that the economy in purchasing and
use of materials can be realized, is important factor for adequate control of materials.
Storage Location:
Storage of all materials and supplies should be in a designated location properly safe
guarded under supervision and proper planning should be there for storing and issuing of
materials.
Operation of Perpetual Inventory:

Operation of proper perpetual inventory system should be used so that it is possible to
determine at any time the amount and value of each kind of materials in stock. It also
enables the comparison of book inventory with the result of physical counting.
Standards or Level to be Fixed:

A minimum quantity of each item of materials, below which point the inventory is not
allowed to drop, and a maximum quantity, above which stock is not carried should be fixed.
In the same manner ordering level and economic order quantity may be determined.
Storage Control and Issue:

The proper operation of a system of stores control and issue is introduced so that there will
be delivery of materials upon requisitions to departments in the right amount at the time
they are needed.
Internal Check:
The operation of internal check should be introduced to ensure that transactions involving
materials and equipment are checked by reliable and independent officials.
Development of Controlling Accounts and Subsidiary Records:

Controlling accounts and subsidiary records reveal summary of detailed materials costs at
each stage of materials receipt and consumption from the storeroom to finished goods.
Regular Reports:
Regular reports and information should be provided for the management in connection with
the purchase of materials, issues from stock, inventory balances, obsolete stock, goods
returned to vendors, and spoiled of defective units.
Stock Control:
Definition and Explanation:
The materials purchased by a concern may be classified as stock items which are taken into
store and held until required or as direct deliveries to the point of consumption. The control
of those materials which are stock items is known as stock control.
The function of stock control is to obtain the maximum stock turnover consistent with the
maintenance of sufficient stocks to meet all requirements. Stock turnover is the ratio which
the cost of the materials used per annum bears to the average stock of raw materials.
Discussions with regard to the quantity of materials stocked are reached after may
consideration such as:
• The availability of capital for the provisions of stocks
• The storage space available
• The cost of storage
• Risk of loss due to fall in prices, deterioration, obsolescence, theft etc.
• Economic order quantities
• Delivery delays
For effective control of materials, it is important to decide upon different levels of materials.
These levels are maximum limit or level, minimum limit or level and re-order level or
ordering point or ordering level. Maximum, minimum and re-order levels are not static.
They must be varied to suit the changing circumstances. Thus, alteration will take place if
the usage of certain materials is increased or decreased. If the re-order period changes, or
if, in the light of a review of capital available, it is decided that the overall inventory must be
increased or decreased.
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• Need for Materials Control
Re-order Level or Ordering Point or

Ordering Level:
1. Definition and explanation of re-order point

2. Formula of re-order level or ordering point
3. Examples
Definition and explanation:

This is that level of materials at which a new order for supply of materials is to be placed. In
other words, at this level a purchase requisition is made out. This level is fixed somewhere
between maximum and minimum levels. Order points are based on usage during time
necessary to requisition order, and receive materials, plus an allowance for protection
against stock out.
The order point is reached when inventory on hand and quantities due in are equal to the
lead time usage quantity plus the safety stock quantity.
Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation of reorder level or point.
[ Ordering point or re-order level = Maximum daily or weekly or monthly usage ×
Lead time ]
The above formula is used when usage and lead time are known with certainty; therefore,
no safety stock is provided. When safety stock is provided then the following formula will be
applicable:
[ Ordering point or re-order level = Maximum daily or weekly or monthly usage ×
Lead time + Safety stock ]
Examples:
Example 1:
Minimum daily requirement 800 units
Time required to receive emergency supplies 4 days
Average daily requirement 700 units
Minimum daily requirement 600 units
Time required for refresh supplies One month (30 days)
Calculate ordering point or re-order level
Calculation:
Ordering point = Ordering point or re-order level = Maximum daily or weekly or monthly
usage × Lead time
= 800 × 30
= 24,000 units
Example 2:
Tow types of materials are used as follows:
Minimum usage 20 units per week each
Maximum usage 40 units per week each
Normal usage 60 units per week each
Re-order period or Lead time

Material A: 3 to 5 weeks
Material B 2 to 4 weeks
Calculate re order point for two types of materials

Calculation:
Ordering point or re-order level = Maximum daily or weekly or monthly usage × Maximum
re-order period
A: 60 × 5 = 300 units
B: 60 × 4 = 240 units
Minimum Limit or Minimum Level of Stock:

Learning Objective:
1. Definite and explain minimum limit or minimum level of stock.
2. How is minimum limit or minimum level calculated?

The minimum level or minimum stock is that level of stock below which stock should not
be allowed to fall. In case of any item falling below this level, there is danger of stopping of
production and, therefore, the management should give top priority to the acquisition of
new supplies.
Formula:
Minimum level or minimum limit can be calculated by the following formula:
[ Minimum limit or level = Re-order level or ordering point – Average or normal
usage × Normal re-order period ]
Or the formula can be written as:
[ Minimum limit or level = Re-order level or ordering point – Average usage for
Normal period ]
Example:
Normal usage 100 units per day
Maximum usage 130 units per day
Minimum usage 70 units per day
Re-order period 25 to 30 days
Calculate: minimum limit or level

To calculate minimum limit of materials we must calculate re-order point or re-
order level first.
Calculation:
Ordering point or re-order level = Maximum daily or weekly or monthly usage ×
Maximum re-order
= 130 × 30
= 3,900 units
Minimum limit or level = Re-order level or ordering point – Average or normal

usage × Normal re-order period
= 3900 – (100 × 27.5*)
1150 units
*(25 + 30 ) / 2
Maximum Level or Maximum Limit of

Stock:
Learning Objective:
1. Definite and explain maximum limit or maximum level of stock.
2. How is maximum limit or maximum level calculated?

The maximum stock limit is upper level of the inventory and the quantity that must not
be exceeded without specific authority from management. In other words, the maximum
stock level is that quantity of material above which the stock of any item should not
normally be allowed to go. This level is fixed after taking into account such factors as:
capital, rate of consumption of materials, storage space available, insurance cost, risk of
deterioration and obsolescence and economic order quantity.
Formula:
Maximum level or maximum limit can be calculated by the help of following formula:
[Maximum limit or level = Re-order level or ordering point – Minimum usage ×
Minimum re-order period + Economic order quantity]
Example:
100 units per
Normal usage
day
130 units per

Maximum usage
day
70 units per
Minimum usage
day

Economic order quantity 5,000 units
Calculate maximum limit or level.

In order to calculate maximum limit of stock we must calculate re-order point or
re-order level first.
Ordering point or re-order level = Maximum daily or weekly or monthly usage ×
Maximum re-order
= 130 × 30
= 39,000 units
Calculation:
Maximum limit or level = Re-order level or ordering point – Minimum quantity
used in re-order period usage + Economic order quantity
= 3900 – (70 × 25) + 5,000
= 7150 units
Danger Level of Materials or Inventory

Stock:
Some enterprise also calculate danger level. When this level of stock is reached, then
emergency steps are taken by the management to acquire material supplies.
When danger level is reached, the try is made to purchase materials from the nearest
possible source or place so that the workers and plant and machinery may not remain idle
due to shortage of materials supplies.
Formula:
Danger level can be calculated by the help of the following formula:
[ Danger level = Average daily requirement × Time required to get emergency
supply ]
Example:
Normal usage or average requirement 700 units per day
Maximum usage 800 units per day
Minimum usage 600 units per day
Time required to receive emergency supplies 4 Days

Calculate danger level.
Calculation:
Danger level = Average daily requirement × Time required to get emergency
supply
= 700 × 4
= 2,800 units
Economic Order Quantity (EOQ):

Learning Objective:
1. Definite and explain economic order quantity (EOQ).
2. How is economic order quantity (EOQ) calculated?
1. Definition of EOQ
2. Formula
3. Example:

Economic order quantity (EOQ) is that size of the order which gives maximum economy
in purchasing any material and ultimately contributes towards maintaining the materials at
the optimum level and at the minimum cost.
In other words, the economic order quantity (EOQ) is the amount of inventory to be
ordered at one time for purposes of minimizing annual inventory cost.
The quantity to order at a given time must be determined by balancing two factors: (1) the
cost of possessing or carrying materials and (2) the cost of acquiring or ordering materials.
Purchasing larger quantities may decrease the unit cost of acquisition, but this saving may
not be more than offset by the cost of carrying materials in stock for a longer period of
time.
The carrying cost of inventory may include:
• Interest on investment of working capital
• Property tax and insurance
• Storage cost, handling cost
• Deterioration and shrinkage of stocks
• Obsolescence of stocks.
Formula of Economic Order Quantity (EOQ):

The different formulas have been developed for the calculation of economic order quantity
(EOQ). The following formula is usually used for the calculation of EOQ.
• A = Demand for the year
• Cp = Cost to place a single order
• Ch = Cost to hold one unit inventory for a year
• *=×
Example:
Pam runs a mail-order business for gym equipment. Annual demand for the TricoFlexers is
16,000. The annual holding cost per unit is $2.50 and the cost to place an order is $50.
Calculate economic order quantity (EOQ)
Calculation:
Underlying Assumptions of Economic Order Quantity:

1. The ordering cost is constant.
2. The rate of demand is constant
3. The lead time is fixed
4. The purchase price of the item is constant i.e no discount is available
5. The replenishment is made instantaneously, the whole batch is delivered at once.

• Need for Materials Control
Successful materials management requires the development of a highly integrated and coordinated
system involving sales forecasting, purchasing, receiving, storage, production, shipping, and actual sales.
Both the theory of costing materials and inventories and the practical mechanics of cost calculations and
record keeping must be considered.
Costing materials present some important, often complex, and sometime highly controversial questions
concerning the costing of materials used in production and the cost of inventory remaining to be
consumed in a future period. In financial accounting, the subject is usually presented as a problem of
inventory valuation; in cost accounting, the primary problem is the determination of the cost of various
materials consumed in production and a proper charge to cost of goods sold.
The discussion of materials management in this chapter deals with:
1. Procedures for materials procurement and use.
2. Materials costing methods.
3. Cost of materials in inventory at the end of a period.
4. Costing procedures for scrap, spoiled goods, and defective work
5. Summary of materials management
Procedures for Materials Procurement and Use:

Although production processes and materials requirements vary, the cycle of procurement and use of
materials usually involves the following steps:
1. Engineering and planning determine the design of the product, the materials specifications, and
the requirements at each stage of operations. Engineering and planning not only determine the
maximum and minimum quantities to run and the bill of materials for given products and
quantities but also cooperate in developing standards where applicable.
2. The production budget provides the master plan from which details concerning materials
requirements are eventually developed.
3. The purchase requisition informs the purchasing agent concerning the quantity and type of
materials needed.
4. The purchase order contracts for appropriate quantities to be delivered at specified dates to
assure uninterrupted operations.
5. The receiving report certifies quantities received and may report results of inspection and
testing for quality.
6. The materials requisition notifies the storeroom or warehouse to deliver specified time or is the
authorization for the storeroom to issue material to departments.
7. The materials ledger cards record the receipt and the issuance of each class of materials and
provide a perpetual inventory record.
Accounting procedures for materials procurement and use involve forms and records necessary for
general ledger financial accounting as well as those necessary for costing a job, process or
department, and for maintaining perpetual inventories and other statistical summaries. The purchase
requisition, purchase order, receiving report, materials requisition, bill of materials, scrap report, returned
materials report, materials ledger cards, and summary of materials used are some of the forms used for
materials control under a cost system. The purchases journal, the cash payments journal, the general
journal, and the general ledger control accounts are also used.
The discussion here is not based on any particular type or size of industry. It is, rather a general
description of the accounting and controlling procedure involved in the procurement and use of
materials. To understand the detailed procedure of purchasing, receiving stocking, and using materials
(materials procurement and use) click on the following links:
• Purchases of productive material.
• Purchases of supplies, services, and repairs.
• Materials purchasing forms.
• Receiving materials.
• Invoice approval and data processing.
• Correcting invoices.
• Electronic data processing (EDP) for materials received and issued.
• Cost of acquiring materials.
• Storage and use of materials.
• Issuing and costing materials into production.
• Materials ledger card--perpetual inventory.
Materials Costing Methods:

The ultimate objective in cost accounting is to produce accurate and meaningful figures. These figures
can be used for purposes of control and analysis and eventually matched against revenue produced in
order to determine net operating income.
After the unit cost and total cost of incoming materials are entered in the received section of a materials
ledger cards, the next step is to cost these materials as they move either from storeroom to factory as
direct materials or indirect materials or from storeroom to marketing and administrative expense
accounts as supplies. The more common methods of costing materials issued and inventories are:
1. First-in-First-Out (FIFO) Costing Method
2. Average Costing Method
3. Last-in-First-Out (LIFO) Costing Method
4. Other Methods-Month end average cost, last purchase price or market price at date of issue, and
standard cost.
These methods relate to assumptions as to flow of costs. The physical flow of units may coincide with the
method of cost flow, though such a condition is not a necessary requirement. Although this decision deals
with materials inventory, the same costing methods are also applicable to work in process (WIP) and
finished goods inventories.
Cost of Materials in Inventory at the End of a Period:

When the cost basis is used in costing inventories for financial statements and income tax returns, the
sum total of the materials ledger cards must agree with the general ledger materials control account
which, in turn, is the materials inventory figure on the balance sheet. Unless a shift from the cost basis is
made in valuing the year end inventory, the method used for costing materials issued is the method used
for assigning dollars to inventory.
• Inventory valuation at cost or market whichever is lower
• American Institute of Certified Public Accountant (AICPA) cost or market rules
• Adjustments for departures from the costing method used
• Inventory pricing and interim financial reporting
• Transfer of materials cost to finished production
• Physical inventory
• Adjusting Materials Ledger Cards and Accounts to Conform to Inventory Accounts
Costing procedures for scrap, spoiled goods, and defective

work:
Generally, manufacturing operations cannot escape the occurrence of certain losses or output reduction
due to scrap, spoilage, or defective work management and the entire personnel of an organization should
cooperate to reduce such losses to a minimum. As long as they occur, however, they must be reported
and controlled.
• Scrap and waste
• Spoiled goods
• Defective work
Discussion Questions and Answers about Controlling and Costing Materials
Summary of Materials Management:

Materials managers are constantly confronted with these problems and requirements:
1. Inventories account for a large portion of the working capital requirements of most businesses.
This fact makes materials or inventory management a major problem requiring constant
attention by all three management levels (top, middle and low).
2. At present, the problem of materials management has become even more acute due to market
conditions and inflation.
3. Effective materials management and materials control is found in an organization in which
individuals have been vested with responsibility for, and authority over, the various details of
procuring, maintaining, and disposing off inventory. Such a person or persons must have the
ability to obtain, coordinate, and evaluate the necessary facts and to take actions when and
where needed.
Issuing and Costing Materials into

Production:
To control the quantity and cost of materials, supplies, and services requires a systematic and efficient
system of purchasing, recording, and storing. Equally necessary is a systematic and efficient procedure
for issuing materials and supplies.
Materials Requisitions:
The materials requisition, illustrated below, is a written order to the storekeeper to deliver materials or
supplies to the place designated or to give the materials to the person presenting a properly executed
requisition. It is drawn by someone who has the authority to requisition materials for use in the
department. The authorized employee may be a production control clerk, or department head, a
supervisor, a group leader, an expeditor, or a materials release analyst. In a computerized system, the
computer program will often prepare the requisition in the form of a tabulating card.
The materials requisition is the basic form used to withdraw materials from the storeroom. Its preparation
results in entries in the issued section of the materials ledger card and in postings to the job order cost
sheets, production reports or the various expense analysis sheets for individual departments. All
withdrawals result in debits to work in process or to control accounts for factory overhead, marketing
expenses, or administrative expenses, and in credits to materials.
Materials Requisitioned Journal:

With the posting to the materials ledger cards, the job order cost sheets, the production reports, and the
expense analysis sheets completed, it is still necessary to post the materials withdrawals to the proper
ledger control accounts. This task is greatly facilitated by the use of a materials requisitioned journal. This
journal is a form of materials summary.
At the end of the month, the total of the various columns are posted directly to the ledger accounts,
except for the sundries column from which items are posted individually.
Tabulating cards as materials requisitions:

Tabulating cards are convenient input or output devices for computer operations to produce the card, the
computer is instructed by the console operator to perform certain materials issuance transactions for jobs
or products. The card serves as authority for the storekeeper to issue the materials, internal computer
operations will update the material data bank and eventually produce output reports including totals that
will be entered in the general ledger accounts, unless those accounts are also part of the EDP system.
Indirect materials or supplies for factory or office use will also be stored in the inventory data bank of the
computer. When such materials are needed, a request will inform the computer as to type, quantity, and
requesting department. Supplies requisitioned for marketing and administrative departments would be
charged to their respective departments.
Bill of Materials:
The bill of materials, a kind of master requisition, is a printed or duplicated form that lists all the materials
and parts necessary for a typical job or production run. Time is saved and efficiency is promoted through
the use of a bill of materials. When a job or production run is started, all the materials listed on the bill of
materials are sent to the factory or are issued on a prearranged time schedule. As the bill of materials is a
rather cumbersome medium for posting purpose, however, data processing improves the procedure by
simultaneously. Preparing tabulating cards for materials requisitions. While the storekeeper issues the
materials as stated on the bill of materials, the tabulating cards can be processed in the materials ledger
section and in the cost department at almost the same time as the materials are used in the factory. A
computer program will provide the print outs of the bill of materials and process the information internally
to update the accounting records.
Purchase of Productive Materials:

Learning Objective:
1. Explain the procedure of purchasing productive materials
The actual purchase of all materials is usually made by the purchasing department headed
by a general purchasing agent. In some small and medium size companies, however,
department heads or supervisors have authority to purchase materials as the need arises.
In any case, systematic procedures should be in writing in order to fix responsibility and to
provide full information regarding the ultimate use of materials ordered and received. The
purchasing department should receive purchase requisitions for materials, supplies,
and equipment; keep informed concerning sources of supply, prices, and shipping and
delivery schedules; prepare and place purchase orders; and arranging for adequate and
systematic reports between the purchasing, the receiving, and the accounting departments.
An additional function of the purchasing department in many enterprises is to verify and
approve for payments all invoices received in response to purchase orders placed by the
department. This procedure has the advantage of centralizing the verification and approval
of invoices in the department that originates the purchases and that has complete
information concerning items and quantities ordered, prices, terms, shipping instructions,
and other conditions and details of the purchases. However, invoice verification and
approval by the purchasing department may violate sound procedures and principles of
internal control, particularly if the same individual prepares an order and later approves the
invoice. Consequently, invoice audit and approval in many instances have been made a
function of the accounting department, which receives a copy of the purchase order. The
purchase order carries all necessary information regarding prices, discount agreement, and
delivery stipulations, as well as the number of the account to which the order is to be
charged. Furthermore, the centralization of invoice approval in the accounting department
helps avoid delaying payments beyond the discount period.
Materials Purchasing Forms:

The principle forms required in purchasing are the purchase requisition form and the
purchase order form.
Purchase Requisition Form:

The purchase requisition originates with (1) stores or where house clerk who observes
that quantity on hand is at a set ordering minimum, (2) a materials ledger clerk who may
be responsible for notifying the purchasing agent when to buy , (3) a works manager who
foresees the need for special materials or unusual quantities, (4) a research or engineering
department employee who needs materials or supplies of a special nature, or (5) a
computer that has been programmed to produce replenishment advice for the purchasing
department. For standard materials, little information other than the stock number may be
needed, and the purchasing agent uses judgment concerning where to buy and the quantity
to order. For other purchases requests, it may be necessary to give meticulous descriptions,
blueprints, catalog numbers, weights, standards, brand names, exact quantities to order,
and suggested prices. Below is an example of the purchase requisition:
Example/Sample of purchase requisition form:

Purchase Requisition
No. 07615
Mo | Day | Yr
To Purchasing Department
Deliver to _________________ Date Required___________________
Dept No. ________________
Acct. No. _______________
Suggested Supplier________________________________________________________________
Qty Item No. Description Unit Price Amount
Budget Control
Allowance for period ____ Balance Available___ Ordered By____
Amt This Purchase___ Approved By___
Remaining Balance___
One copy remains with the originating employee, and the original is sent to the purchasing
department for execution of the request.
Purchase Order Form:

The purchase order, signed by the purchasing agent or other official, is a written
authorization to a vendor to supply specified quantities of described goods at agreed terms
and at a designated time and place. As a convenience, the vendors order forms may be
used; but in typical practice, the order forms are prepared by the purchasing company, and
the form is adapted to the particular needs of the purchaser. As a matter of record and for
accounting control, a purchase order should be issued for every purchase of materials,
supplies, or equipment. When a purchase commitment is made by mail, telephone, or a
sales representative, the purchase order serves as confirmation to the vendor and places
the required documents in the hands of those concerned in the purchasing company.
The purchases order gives the vendor a complete description of the goods and services
desired, the terms, the prices, and the shipping instruction. When necessary, the description
may refer to attached blueprints and specification pages. The original and an
acknowledgment copy are sent to the vendor. The acknowledgment copy is a necessary
form for contract procedure, because other copies are distributed. The vendor is asked to
sign and return the copy to the purchaser, indicating that the order was received and will be
delivered according to the specifications enumerated in the purchases order.
Receiving Materials:
The function of the receiving department is to: unload and unpack incoming materials; check quantities
received against the shippers packing list; identify goods received with descriptions on the purchase
order; prepare a receiving report; notify the purchasing department of descriptions discovered; arrange for
inspection when necessary; notify the traffic department and the purchasing department of any damage in
transit; and rout accepted materials to the appropriate factory location.
The receiving report shows the purchase order number, the account number to be charged, the name of
the vendor, details relating to transportation, and the quantity and type of the goods receive. The form
also provides a space for the inspection department to note either the complete approval of the shipment
or the quantity rejected and the reason for the rejection, in inspection does not take place immediately
after receipt of the materials, the receiving report is distributed as follows:
1. The receiving department keeps one copy and sends another copy to the purchasing department
as notice of the arrival of the materials
2. All other copies go to the inspection department, and are distributed when inspection is
completed. After inspection, one copy of the receiving report, with the inspection result noted
thereon, is sent to the accounting department, where it is matched with the purchase order and
the venders invoice and the paid. Other copies go to various departments such as materials and
production planning. One copy accompanies the materials, so that the storekeeper knows the
quantity and the kind of materials received.
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Invoice Approval and Data Processing:

By the time materials reach the receiving department, the company unusually will have
received the invoice from the vendor.
This invoice and a copy of the purchase order are filled in the accounting department. When
the receiving report with its inspection reports arrives, the receiving report and the invoice
are compared to see that materials received meet purchase order specifications as to items,
quantities, price extensions, discount and credit terms, shipping instruction, and other
possible conditions. I the invoice is found to be correct or has been adjusted because of
rejects as noted by the inspection department, the invoice clerk approves it, attaches it to
the purchase order and the receiving report, and sends these papers to another clerk for the
preparation of the voucher.
Invoice approval is an important step in materials control procedure, since it certifies that
the goods have been received as ordered and the payment can be made. The invoice
approval information is often built into a rubber stamp and each invoice is stamped.
The verification procedure is handed by responsible invoice clerks, thus assuring systematic
examination and handling of the paper work necessary for adequate control of materials
purchases. The preparation of the voucher is based on the information taken from the
invoice approval stamp.
The voucher data are entered first in the purchases journal and are posted to the
subsidiary records. They are then entered in the cash payments journal according to the
due date for payment. The original voucher and two copies are sent to the treasurer for
issuance of the check. The treasurer mails the check with the original voucher to the
vendor, files a voucher copy, and returns one voucher copy to the accounting department
for the vendors file. Purchase transactions entered in the purchases journal affect the
control accounts and the subsidiary records as shown in the chart below:
General Ledger Control
Transaction Subsidiary Records
Debit Credit
Materials purchased Entry in the received section

Materials Accounts Payable
for stock in the materials ledger card
Materials purchased Entry in the direct materials

for a particular job or Work in process Accounts Payable section of the production or
department the job order
Materials and supplies

Entry in the received section
purchased for factory Materials Accounts Payable
of the materials ledger card
overhead purposes
Materials Entry in the received section
of the materials ledger card
Supplies purchased Marketing
or in the proper columns of
for marketing and expenses control Accounts Payable
the marketing or
administrative office
Administrative administrative expenses
expenses control analysis sheets
Factory
Overhead
Marketing Entry in the proper account
Purchases of services
Accounts Payable columns of the expenses
or repairs expenses control
analysis sheet
Administrative
expenses control
Purchase of Entry on the equipment
Equipment Accounts Payable
equipment ledger card
Correcting Invoices:
When the purchases order, receiving report, and invoice are compared, various adjustments may be
needed as a result of the circumstances described below:
1. Some of the materials ordered are not received and are not entered on the invoice. In this case
no adjustment is necessary, and the invoice may be approved for immediate payment. On the
purchase order the invoice clerk will make a notation of the quantity received in place of the
quantity ordered. If the vendor is out of stock or otherwise unable to deliver specified
merchandise, and immediate ordering from other sources may be necessary.
2. Items ordered are not received but are entered on the invoice. In this situation the shortage is
noted on the invoice and is deducted from the total before payment is approved. A letter to the
vendor explaining the shortage is usually in order.
3. The seller ships a quantity larger than called for on the purchase order. The purchaser may keep
the entire shipment and add the excess to the invoice, if not already invoiced; or the excess may
be returned or held, pending instructions from the seller. Some companies issue a supplementary
purchase order that authorizes the invoice clerk to pay the over shipment.
4. Materials of a wrong size are quality, defective parts, and damaged items are received. If the
items are returned, a correction on the invoice should be made before payment is approved. It
may be advantageous to keep damaged or defective shipments if the seller makes adequate
price concessions, or the items may be held subject to the seller's instructions.
5. It may be expedient for a purchaser to pay transportation charges, even though delivered prices
are quoted and purchases are not made on this basis. The amount paid by the purchaser is
deducted on the invoice, and the paid freight bill is attached to the invoice as evidence of
payment.
6.Electronic Data Processing System (EDP
System) for Materials Received and
Issued:
7. The preceding description of invoice approval and payment was for a manual operation
performed by an accounts payable clerk or an invoice clerk.
8. In an electronic data processing system (EDP system), the computer--to a great extent--
replaces the clerk. Upon receipt of the invoice (the source document), the accounts payable clerk
enters the account distribution on the invoice. The data are then directly inputted from the invoice
to the computer data bank via a terminal device. The data are edited, audited, and merged with
the purchase order and the receiving order data, both of which have been stored in the computer
data bank. The common matching criterion on all documents in the purchase order number.
Quantities, monetary values, due dates, terms, and unit prices are matched. When in agreement,
the cost data are entered in the accounts payable computer file with a date for later payment.
9. The above procedure deals with the accounts payable phase of a purchase transaction. Of equal
importance is the need for posting the data in quantities and dollar values to the materials
inventory file in the electronic data processing system (EDP system). The information enters the
EDP system from either the invoice or the invoice approval form, which would have to include all
computer-necessary data. The internal computer program updates the materials inventory file.
The withdrawal of materials could also be programmed, so that manual posting to the materials
inventory file would be eliminated
Cost of Acquiring Materials | Materials

Acquisition Cost:
A guiding principle in accounting for the cost of materials is that all costs incurred in entering a unit of
materials into factory production should be included.
Acquisition costs, such as the vendor's invoice price and transportation charges, are visible costs of the
purchased goods. Less obvious costs of materials entering factory operations are costs of purchasing,
receiving, unpacking, inspecting, insuring, storing, and general and cost accounting.
Controversial concepts and certain practical limitations result in variations in implementing the principles
of costing materials even with respect to easily identified acquisition costs. Calculating a number of cost
additions and adjustments to each invoice involves clerical expenses which may be greater than benefits
derived from the increased accuracy. Therefore, materials are commonly carried at the invoice price and
paid the vendor, although all acquisition costs and price adjustments affect the materials cost. As a result,
acquisition costs are generally charged to factory overhead when it is not practical to follow a more
accurate costing procedure.
Purchase Discount: The handling of discounts on purchases is one major problem in accounting for
materials costs. Trade discounts and quantity discounts normally are not on the accounting records but
are treated as price reductions. Cash discounts should be treated as price adjustments but often are
accounted for as other income, although income is not produced by buying. A low purchase cost may well
widen the margin between sales price and cost, but it takes the sale to produce income. When the vendor
quotes term such as 2/10, n/30 on a $100 invoice, is the sale price $100 or $98? The purchaser has two
dates to make payments: on the tenth day, which allows time to receive, unpack, inspect, verify, voucher,
and pay for the goods; or twenty days later. For the additional twenty days an additional charge or penalty
of two percent is assessed. If regarded as interest, the extra charge is 36 percent per year[(360 days / 20
days) × 2%]. On these terms the seller is pricing on essentially a cash basis, and the purchaser has no
reasonable choice except to buy on cash basis.
Although the nature of a purchase discount is readily understood, for practical reasons the gross
materials unit cost of the invoice is commonly recorded in the materials account; the cash discount is
recorded as a credit account item. Otherwise it would be necessary to compute the discount on each
item, with unit costs having four or more decimal places.
Freight in: Freight or other transportation charges on incoming shipments are obviously costs of
materials, but differences occur in the allocation of these charges. A vendor's invoice for $600 may show
25 items weighing 1,700 ponds shipped in five crates, with the attached freight bill showing a payment of
$48. The delivered cost is $648. But how much of the freight belongs to each of the invoice items, and
what unit price should go on the materials ledger card? When the purchased units are not numerous and
are large in size and unit cost, computation of actual amounts of freight may be feasible; otherwise, some
logical, systematic, and expedient procedure is necessary.
If freight charges are debited to materials, the total amount should be added proportionately to each
materials card affected. This might be done by assuming that each dollar of materials cost carries an
equal portion of the freight. For example, freight of $48 on materials costing $600 would add $0.08
($48/$600) to each dollar on the invoice. The relative weight of each item on the invoice might be
determined and used as a basis for calculating the applicable freight. If an invoice item is estimated to
weigh 300 ponds, then $8.47 [(300 / 1,700) × $48] would be added for freight. This procedure is also
likely to result in unit costs having four or more decimal places on the materials ledger cards. To simplify
procedures, all freight costs on incoming materials and supplies may be charged to freight in. As
materials are issued for production, an applied rate for freight in might be added to the unit price on the
ledger cards. The same amount is included in the debit to work in process (WIP) or factory overhead
(indirect materials), and freight in is credited. Any balance in freight in at the end of a period is closed to
cost of goods sold or prorated to cost of goods sold and inventories.
Another often advocated method of accounting for incoming freight costs on materials is to estimate the
total for an accounting period and include this amount in computing the factory overhead rate. Freight in
then would become one of the accounts controlled by factory overhead. For materials or supplies used in
marketing and administrative departments, freight, transportation, or delivery costs should be charged to
the appropriate non-manufacturing account.
Applied acquisition costs: If it is decided that the materials cost should include incoming freight charges
and other acquisition costs, and applied rate might be added to each invoice and to each item instead of
charging these costs directly to factory overhead. A single rate for these costs can be used but amore
accurate method is to use separate rates for each class of costs, as shown below:
• Rate per purchase or rate per dollar purchased = [Estimated purchasing
department cost for budget period / Estimated number of purchases or estimated
amount of purchases]
• Rate per item = [Estimated receiving department cost for budget period / Estimated
number of items to be received during period]
• Rate per item, cubic foot, dollar stored, etc. = [Estimated materials department cost
for budget period / Estimated number of items, feet of space, dollar value, etc.]
• Rate per transaction = Estimated accounting department cost for budget period /
Estimated number of transaction
This procedure results in the following accounting treatment:
Materials xxx
Applied purchasing department expense xxx
Applied receiving department expenses xxx
Applied materials department expenses xxx
Applied accounting department expenses xxx
Actual expenses incurred by each of the departments for which applied rates are used will be debited to
the applied accounts. Differences between the expenses incurred by the departments during the period
and the expenses applied to the materials cost would represent over or under applied expenses and
would be closed to cost of goods sold or prorated to cost of goods sold and inventories.
Imputed interest: A company making an inventory purchase with a non interest bearing not or a note with
an interest rate that varies from prevailing interest rates should classify the effective interest imputed to
the note as interest expenses, rather than as a cost of the materials. For example, assume that a
$100,000, six months, non interest bearing note is used to purchase materials. If the company can borrow
at a short term credit rate of 80%, the inventory should be costed at $96,154 ($100,000 × 0.96154, the
present value of one dollar at 8% for six months). The differences of $3,846 should be debited to interest
expense.
Storage and Use of Materials:

Materials, together with copy of the receiving report, or forwarded to the storeroom from the receiving or
inspection department.
The storekeeper and assistants are responsible for safeguarding the materials, which means that
materials and supplies are placed in proper bins or other storage spaces, that they are kept safely until
required in production, and that all materials taken from the storeroom are properly requisitioned. It is
good policy to restrict admittance to the storeroom to employees of that department only and to have
these employees work behind locked doors, issuing materials through cage windows.
Since the cost of storing and handling materials may be a substantial amount, careful designs and
arrangement of storerooms can result in significant cost savings. Materials can be stored according to:
1. The materials account number.
2. The frequency of use of the item.
3. The factory area where the item is used.
4. The nature, size, and shape of the item.
In practice, no single base is likely to be suitable, but the size and shape of materials usually dictate the
basic storeroom arrangement variations can then be introduced, such as placing most frequently used
items nearest the point of issue and locating materials used primarily in one factory area nearest that
area.
Bin cards or stock cards are effective ready references that may be attached to storage bins, shelves,
racks, or other containers. Bin cards usually show quantities of each type of materials received, issued,
and on hand. They are not a part of the accounting records as such, but they show the quantities on hand
in the storeroom at all times and should agree with the quantities on the materials ledger cards in the
accounting department.
• Purchases of productive material
Materials Ledger Card--Perpetual

Inventory:
As purchased materials go through the systematic verification of quantities, prices, physical condition, and
other checks, the crux of the accounting procedure is to establish a perpetual inventory-maintaining for
each type of material a record showing quantities and prices of materials received, issued, and on hand.
Materials ledger cards or stock ledger sheets constitutes a subsidiary materials ledger controlled by the
materials are inventory accounts in the general ledger or in the factory ledger.
Materials ledger cards commonly show the account number, description or type of material, location,
unit measurement, and maximum and minimum quantities to carry. These cards are the materials ledger
with new cards prepared and old ones discarded as changes occur in the types of materials carried in
stock. The ledger card arrangement is basically the familiar debit, credit, and balance columns under the
description of received, issued, and balance. Following is an example of material ledger card:
Example | Sample of materials ledger card:
Piece or Part No.____________________ Reorder Point___________________
Description________________________ Reorder Quantity_________________
Maximum Quantity__________________
Received Issue Balance
Date Res. No Qty Amount Date Res. No Qty Amount Qty Unit cost Amount
The approved invoice with supporting documents, such as the purchase order and receiving report, goes
to the materials ledger clerk. These documents enable the clerk to make the necessary entries in the
received section of the materials ledger card. Each receipt increase the balance on hand and the new
balance is extended upon entry of the receipt.
Unsatisfactory goods or defective units should be detected by the inspection department before being
stored or even paid for. The receiving report should show materials actually accepted, and the ledger
entries are made after all adjustment. However, goods accepted in the storeroom may be found
unsatisfactory after part of a shipment has been used in the factory, and the balance may then be
returned to the vendor. Since these units were entered in the received and balance section of the
materials ledger card when they were placed in the storeroom, an adjustment must be made. The
recommended procedure is to enter the quantity and the value of the returned shipment in red in the
received section and to reduce the balance accordingly.
When the storekeeper issues materials, a copy of the requisition is sent to the materials ledger clerk, who
then makes an entry in the issued section of the materials ledger card showing the date, requesting
number, job, lot, or department number, quantity, and cost of the issued materials. The new balance is
computed and entered in the balance column. As already explained, these manual operations can be
performed in an electronic data process (EDP) system based on the computer program designed for
the materials transactions
First In First Out (FIFO) - Materials and

Inventory Costing Method:
Learning Objectives:
1. Define and explain FIFO method.
2. Give an example of FIFO method
3. What are advantages and disadvantages of fist in first out (FIFO) costing method?
1. Definition and Explanation of FIFO Method
2. Advantages of First in First out-FIFO-Costing Method
3. Example of FIFO Method
4. Disadvantages or Limitations of FIFO Costing Method

The first in first out (FIFO) method of costing is used to introduce the subject of
materials costing. The FIFO method of costing issued materials follows the principle that
materials used should carry the actual experienced cost of the specific units used. The
methods assumes that materials are issued from the oldest supply in stock and that the
cost of those units when placed in stock is the cost of those same units when issued.
However, FIFO costing may be used even though physical withdrawal is in a different order.
Advantages of First in First out (FIFO) Costing Method:

Advantages claimed for first in first (FIFO) out costing method are:
1. Materials used are drawn from the cost record in a logical and systematic manner.
2. Movement of materials in a continuous, orderly, single file manner represents a
condition necessary to and consistent with efficient materials control, particularly for
materials subject to deterioration, decay and quality are style changes.
FIFO method is recommended whenever:
1. The size and cost of units are large.
2. Materials are easily identified as belonging to a particular purchased lot.
3. Not more than two or three different receipts of the materials are on a materials card
at one time.
Example:
This example is based on the following transactions:
February
(1)Beginning balance: 800 units @ $6 per unit.
(4)Received 200 units @ $7 per unit.
(11)Issued 800 units.
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the
latest issued price.
Calculation for the above transactions would be as follows:

FIFO Costing Method
February:
01. Beginning balance 800 units @ $6 $4,800
04. Received 200 units @ $7 $1,400
10. Received 200 units @ $8 $1,600 $7,800
11. Issued 800 units @ $6 $4,800
200 units @ $7 $1,400

Balance
200 units @ $8 $1,600 $3,000
12. Received 400 units @ $8 $3,200 $6,200
20. Issued 200 units @ $7 $1,400
300 units @ $8 $2,400 $3,800
300 units @ $8 $2,400

Balance
25. Returned to 100 units @ $8 $800
storeroom
28. Received 600 units @ $9 $5,400 8,600
400 units @ $8 $3,200

Balance
600 units @ $9 $5,400 $8,600
Disadvantages or Limitations of FIFO Method

FIFO method is definitely awkward if frequent purchases are made at different prices and
if units from several purchases are on hand at the same time. Added costing difficulties
arise when returns to vendors or to the storeroom occur.
Average Costing Method--Materials and

Inventory Costing:
1. Define and explain average costing method.
2. Give an example of Average costing method.
3. What are advantages and disadvantages of average costing.
1. Definition and Explanation of Average Costing Method

2. Advantages of Average Costing Method
3. Example
Issuing materials at an average cost assumes that each batch taken from the storeroom is
composed of uniform quantities from each shipment in stock at the date of issue. Often it is
not feasible to mark or label each materials item with an invoice price in order to identify
the used units with its acquisition cost. It may be reasoned that units are issued more or
less at random as for as the specific units and the specific costs are concerned and that an
average cost of all units in stock at the time of issue is satisfactory measure of materials
cost. However, average costing may be used even though the physical withdrawal is an
identifiable order. If materials tend to be made up of numerous small items low in unit cost
and especially if prices are subject to frequent changes.
Advantages of Average Costing Method:

Average costing method has the following main advantages:
1. It is a realistic costing method useful to management in analyzing operating results
and appraising future production.
2. It minimizes the effect of unusually high or low materials prices, thereby making
possible more stable cost estimates for future work.
3. It is practical and less expensive perpetual inventory system.
The average costing method divides the total cost of all materials of a particular class by the
number of units on hand to find the average price. The cost of new invoices are added to
the total in the balance column; the units are added to the existing quantity; and the new
total cost is divided by the new quantity to arrive at the new average cost. Materials are
issued at the established average cost until a new purchase is recorded. Although a new
average cost may be computed when materials are returned to vendors and when excess
issues are returned to the storeroom, for practical purposes, it seems sufficient to reduce or
increase the total quantity and cost, allowing the unit price to remain unchanged. When a
new purchase is made and a new average is computed, the discrepancy created by the
returns will be absorbed.
Example:
February
(25)Returned 100 excess units from the factory to
the storeroom to be recorded at the latest issued
price.
Calculations for the above transactions would be as follows

Average Costing Method Calculation Illustrated
01. Beginning balance 800 units @ $6 $4,800
04. Received 200 units @ $7 $1,400

1000 units $6,200 $6.20
Balance
10. Received 200 units @ $8 $1,600
12,00 units $7,800 $6.5

Balance
11. Issued 800 units @ $6.50 $5,200
400 units $2,600 $6.5

Balance
12. Received 400 units @ $8 $3,200
800 units $5,800 $7.25

Balance
20. Issued 500 units @ $7.25 $3,625
300 units $2,175 $7.25

Balance
Returned to storeroom 100 units $725
400 units $2,900 $7.25

Balance
28. Received 600 units @ $9 $5,400
1000
Balance
Last In First Out (LIFO) - Materials and

Inventory Costing Method:
1. Define and explain last in first out (LIFO) method.
2. Give an example of LIFO costing method
3. What are advantages and disadvantages of LIFO method?
1. Definition and explanation of LIFO method

2. Example of LIFO costing method
3. Advantages of Last in First Out method
4. Disadvantages of Last in First Out Method

The last in first out (LIFO) method of costing materials issued is based on the premise
that materials units issued should carry the cost of the most recent purchase, although the
physical flow may actually be different. The method assumes that the most recent cost (the
approximate cost to replace the consumed units) is most significant in matching cost with
revenue in the income determination procedure.
Under LIFO procedures, the objective is to charge the cost of current purchases to work in
process or other operating expenses and to leave the oldest costs in the inventory. Several
alternatives can be used to apply the LIFO method. Each procedure results in different
costs for materials issued and the ending inventory, and consequently in a different profit. It
is mandatory, therefore, to follow the chosen procedure consistently.
LIFO Costing Method Example:

This example is based on the following transactions:
February
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the
latest issued price.
Calculations for the above transactions would be as follows
LIFO COSTING METHOD

February:
1. Beginning balance 800 units @ $6.00 $4,800
4. Received 200 units @ $7.00 $1,400
10.Received 200 units @ $8.00 $1,600 $7,800
11. Issued 200 units @ $8.00 $1,600
200 units @ $7.00 $1,400
400 units @ $6.00 $2,400 $5,400
400 units @ $6.00 $2,400

Balance
Received 400 units @ $8.00 $3,200 $5,600
20. Issued 400 units @ $8.00 $3,200
100 units @ $6.00 $600 $3,800
300 units @ $6.00 $1,800

Balance
25. Returned to storeroom 100 units @ $6.00 $600
28. Received 600 units @ $9.00 $5,400 $7,800

400 units @ $6.00
Balance $2,400
600 units @ $9.00 $5,400 $7,800
The basic difference between the various applications of this costing method is the time
interval between inventory computations. In this example of LIFO costing a new inventory
balance is computed after each receipt and each issue of materials, with the ending
inventory consisting of 1,000 units valued at $7,800. If, however, a physical rather than a
perpetual costing procedure is used, whereby the issues are determined at the end of the
period by ignoring day to day issues and by subtracting total ending inventory from the total
of the opening balance plus the receipts, the ending inventory would consist of:
800 units @ $6 on hand in the beginning inventory $4,800
200 units @ $7 from the oldest purchase, Feb. 4 $1,400
-------
1,000 units, LIFO inventory at the end of February. $6,200
=====
Both procedures are appropriate applications of the LIFO method, even though the cost of
materials used and the ending inventory figures differ. Such a difference does not occur in
FIFO costing method.
Regardless of the cost flow assumptions, this later procedure is particularly appropriate in
process costing where individual materials requisitions are seldom used and the materials
move into process in bulk lots, as in floor mills spinning mills, oil refineries, and sugar
refineries. The procedure also functions smoothly for a company that charges materials to
work in process from month end consumption sheets which provide the cost department
with quantities used.
Advantages of Last In First Out (LIFO) Method:

The advantages of the last in first out method are:
Materials consumed are priced in a systematic and realistic manner. It is argued that
current acquisition costs are incurred for the purpose of meeting current production and
sales requirements; therefore, the most recent costs should be charged against current
production and sales.
Unrealized inventory gains and losses are minimized, and reported operating profits are
stabilized in industries subject to sharp materials price fluctuations.
Inflationary prices of recent purchases are charged to operations in periods of rising prices,
Thus reducing profits, resulting in a tax saving, and therewith providing a cash advantage
through deferral of income tax payments. The tax deferral creates additional working capital
as long as the economy continues to experience an annual inflation rate increase.
Disadvantages of the LIFO Costing Method:

The disadvantages or limitations of the last in first out costing method are:
1. The election of last in first out for income tax purposes is binding for all subsequent
years unless a change is authorized or required by the Internal Revenue Service
(IRS)
2. This is a "cost only" method with no right down to the lower of cost or market
allowed for income tax purposes. Furthermore, the IRS requires that when last in
first out is adapted an adjustment must be made to restore any previous right downs
from actual cost. Should the market decline below LIFO cost in subsequent years,
the business would be at a tax disadvantage. When prices drop the only option may
be to charge off the older (higher) cost by liquidating the inventory, however,
liquidation for income tax purposes must take place at the end of the year. According
to IRS regulations, liquidation during the fiscal year is not acceptable if the inventory
returns to its original level at the end of the year. Interim external financial reporting
principles impose a similar requirement when inventory is expected to be replaced by
the end of the annual period.
3. LIFO must be used in financial statements if it is elected for income tax purposes.
However, for financial reporting purposes, the lower of LIFO cost or market can be
used without violating IRS LIFO conformity rules.
4. Record keeping requirements under this method, as well as FIFO, are substantially
greater than those under alternative costing and pricing methods.
5. Inventories may be depleted due to unavailability of materials to the point of
consuming inventories costed at older or perhaps the oldest prices. This situation will
create a miss matching of current revenue and cost, sometimes companies using this
costing method counteract this problem by establishing an allowance for replacement
of the LIFO inventory account. Cost of goods sold is charged with current cost. The
allowance account is credited for the access of the current replacement cost over the
LIFO carrying cost for the inventory temporarily liquidated. When this inventory is
replenished, the temporary allowance (credit) is removed and the goods acquired are
placed in inventory at their old last in first out cost.
6. In standard number 411 "accounting for acquisition costs of materials, " the cost
accounting standards board "CASB" precludes the use of LIFO except when applied
currently on a specific identification basis. As a result, the use of this method, when
an annual LIFO adjustment is made, is ruled out for government contracts to which
CASB regulations apply.
The decision to adopt the last in first out method has had increased appeal in the last few
years, due to an accelerated rate of inflation; however its adoption should not be automatic.
Long range effects as well as short term benefits must be considered.
Cost or Market Whichever is Lower--

Inventory Valuation:
American costing tradition follows the practice of pricing year-end inventories at cost or
market, whichever is lower (lower of cost or market). This departure from any
experienced cost basis is generally defined on the grounds of conservatism. A more logical
justification for cost or market inventory valuation is that a full stock is necessary to
expedite production and sales. If physical deterioration, obsolescence, and price declines
occur, or if stock when finally utilized cannot be expected to realize its stated cost plus a
normal profit margin, the reduction in inventory value is an additional cost of the goods
produced and sold during the period when the decline in value occurred.
American Institute of Certified Public

Accountants (AICPA) Cost or Market Rules--
The American Institute of Certified Public Accountants (AICPA) moved away from
the traditional cost or market, whichever is lower principle of valuing inventories.
After defining inventory and that the major objective of accounting for inventories is the
proper determination of income through the process of matching appropriate costs against
revenue, the AICPA states:
The primary basis of accounting for inventories, is cost, which has been defined
generally as the price paid or consideration given to acquire an asset. As applied
to inventories, cost means in principle the sum of the applicable expenditures and
charges directly or indirectly incurred in bringing an article to its existing
condition and location.
The American Institute of Certified Public Accountants (AICPA) takes the position that cost
may properly be determined by any of the common methods. The position of the AICPA is
clearly stated in the following sentence: "In keeping with the principle that accounting is
primarily on cost, there is a presumption that inventories should be stated at cost." Having
advocated the basic cost principle, the AICPA then reverts at least part way to the
traditional cost or market value rule. The AICPA in effect says it is mandatory that cost be
abundant in valuing inventory when usefulness of goods is no longer as great as its cost.
This, then, becomes a principle of cost or residual useful cost, whichever is lower, as
described below:
A departure from the cost basis of pricing the inventory is required when the
utility of the goods is no longer as great as its cost. Where there is evidence that
the utility of goods, in their disposal in the ordinary course of business will be less
than cost, whether due to physical deterioration, obsolescence, changes in price
levels, or other causes, the difference should be recognized as a loss of the current
period. This is generally accomplished by stating such goods at a lower level
commonly designated as market.
The last sentence returns to the traditional meanings of cost or market, whichever is lower
by saying that the residual useful cost is "market," which in turn is defined as "replacement
cost." In the AICPA's cost or market approach to inventory valuation, it is clear that the
institute does not hold that a replacement cost should be used for inventory value merely
because it is lower than the acquisition cost figure. The real test is the usefulness of the
inventory (whether it will sell at its cost). The AICPA is more precise in stating which figure
should be used in case the inventory cost cannot be recovered:
As used in the phrase lower of cost or market, the term market means current
replacement cost (by purchase or by reproduction, as the case may be) except
that:
1. Market should not exceed the net realizable value (i.e., estimated selling
price in the ordinary course of business less reasonably predictable costs of
completion and disposal); and
2. Market should not be less than net realizable value reduced by an allowance
for an approximately normal profit margin.
The position of American Institute of Certified Public Accountants (AICPA) in regard to
inventory valuation may be interpreted as follows:
1. In principle, inventories are to be priced at cost.
2. Where cost cannot be recovered upon sale in the ordinary course of business, a
lower lower figure is to be used.
3. This lower figure is normally market replacement cost, except that the amount
should not exceed the expected sales price less a deduction for costs yet to be
incurred in making the sales. On the other hand, this lower market figure should not
be less than the expected amount to be realized in the sale of the goods, reduced by
a normal profit margin.
Example:
Assume that a certain commodity sells for $1; the marketing expense is 20 cents; the
normal profit is 25 cents. The lower of cost or market as limited by the forgoing receipt is
developed in each case.
Market
Floor (Estimated Ceiling
sales price less (Estimated
costs of sales price less Market
completion and costs of (Limited by
replacement disposal and completion floor and
Lower of cost
Case Cost cost normal profit) and disposal) ceiling values) or market
A $.65 $.70 $.55 $.80 $.70 $.65

B $.65 $.60 $.55 $.80 $.60 $.60
C $.65 $.50 $.55 $.80 $.55 $.55
D $.50 $.45 $.55 $.80 $.55 $.50
E $.75 $.85 $.55 $.80 $.80 $.75
F $.90 $1.00 $.55 $.80 $.80 $.80
A: Market is not limited by floor or ceiling; cost is less than market.

B: Market is not limited by floor or ceiling; market is less than cost.
C: Market is limited to floor; market is less than cost.
D: Market is limited to floor; cost is less than market.
E: Market is limited to ceiling; cost is less than market.
F: Market is limited to ceiling; market is less than cost.
The lower of cost or market may be applied to each inventory item, to major inventory
groupings, or the inventory as a whole. Application of this procedure to the individual
inventory items will result in the lowest inventory value. However, application to inventory
groups or to the inventory as a whole may provide a sufficiently conservative valuation with
less effort. The application method selected by a company must be followed consistently
from year to year. Work in process and finished goods inventories are also subject to the
lower of cost or market principle.
Adjustments for Departures from the Costing

Method Used--Inventory Valuation:
The problem of year end inventory valuation is primarily a question of the materials cost consumed in
products manufactured and sold to customers and the cost assignable to goods in inventory ready to
move into production and available for sales the next fiscal period. This question is important, because
the materials ledger card would have to be adjusted for any change in units prices if there is a departure
from the commonly used costing method. Since the new unit price could not be made available to the
materials ledger clerk for some time after the year end inventory was taken and priced, the detailed task
of changing hundreds and even thousands of costs would be cumbersome and time consuming.
Therefore, instead of adjusting the ledger cards, companies may create an inventory valuation account,
as illustrated by the following journal entry:
Cost of goods sold or factory overhead
xxx Dr
control
Materials--Allowance for inventory decline to
xxx Cr
market
Inventory adjustment--Lower of cost or market
In the subsequent fiscal period, materials--allowance for inventory decline to market is closed out to cost
of goods sold to the extent necessary to bring the materials consumed that are still carried at a higher
cost to the desirable lower cost level.
Use of the valuation account retains the cost of the inventory and at the same time reduces the materials
inventory for statement purposes to the desired cost or market, whichever is lower valuation without
disturbing the materials ledger cards. The preceding entry should result in the following balance sheet
presentation:
Material, at cost $100,000
Less allowance for inventory decline to market 5,000
--------
Materials, at cost or market, whichever is lower $95,000
The net charge to cost of goods sold may be shown in the cost of goods sold statement or deducted from
the ending inventory at cost, thus increasing the cost of materials used. Whenever the lower of cost or
market procedure is applied to each inventory item and the adjustment of materials ledger cards to a
lower market figure is not burdensome and the data are available early in the next year, the adjustment
should be accomplished by dating the entry with the last day of the fiscal period just ended and entering
in the balance section the units on hand at the unit price determined for inventory purposes. In such a
case, the credit portion of the adjusting entry would be to the materials account.
Inventory Pricing and Interim Financial

Reporting--Inventory Valuation:
Companies should generally use the same inventory pricing methods and make provisions
for write downs to make market at interim dates on the same basis as used at annual dates
when preparing published financial statements. However, the following exceptions are
appropriate at interim reporting dates:
1. Some companies use estimated gross profit rates to determine the

cost of goods sold during interim periods or use other methods
different from those used at annual inventory dates. These
companies should disclose the method used at the interim date and
any significant adjustments that result from reconciliations with the
annual physical inventory.
2. Companies that use the LIFO method may encounter a liquidation of
base period inventories at an interim date that is expected to be
replaced by the end of the annual period. In such cases the
inventory at the interim reporting date should not give effect to the
LIFO liquidation, and cost of sales for the interim reporting period
should include the expected cost of replacement of the liquidated
LIFO base.
Thus, if the liquidation of base period inventories is considered temporary and

expected to be replaced prior to year, the company should charge cost of goods sold
at current prices. The difference between the carrying value of the inventory and its
current replacement cost is a current liability for replacement of temporarily depleted
LIFO base inventory. When the liquidated inventory is replaced, inventory is debited
for the original LIFO value and the liability is removed from the books.
3. Inventory losses from market declines should not be deferred
beyond the interim period in which the decline occurs. Recoveries of
such losses on the same inventory in later interim periods of the
same fiscal year through market price recoveries should be
recognized as gains in the later interim period such gains should not
exceed previously recognized losses. Some market declines at
interim dates, however, can reasonably be expected to be restored
in the fiscal year. Such temporary market declines need not be
recognized at the interim date since no loss is expected to be
incurred in the fiscal year.
Transfer of Materials Cost to Finished

Production--Inventory Valuation:
The ultimate, intended destination of direct materials is finished products or finished goods delivered to
customers. The cost of materials used on each job or in each department is transferred from the materials
requisition to the job order cost sheet or to the cost of production report. When the job or process is
completed, the effect of materials used, as well as labor distributed and factory overhead applied, is
expressed this entry:
Finished Goods xxx Dr
Work in process xxx Cr
In production devoted to filling specific orders, cost sheets should provide sufficient information relative to
the cost of goods sold. If a considerable portion of production is to be used for stock, a finished goods
ledger is advantageous in maintaining adequate and proper control over the inventory. The finished
goods ledger, controlled by the finished goods account in the general ledger, is similar in form and use to
materials ledger card.
Some production may consist of components manufactured for use in subsequent manufacturing
operations. If the unit move directly into these operations, the transfer is simply from one departmental
work in process account to the next. However, if the components must be held in inventory, their cost
should be debited to materials and credit to work in process.
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Physical Inventory - Inventory Valuation:

Even with a perpetual inventory system, periodic physical counts are necessary to discover
and eliminate description between the actual count and the balances on materials ledger
card.
These descriptions may be due to:
Errors on transferring invoice data to the cards; mistakes in costing requisitions; unrecorded
invoices are requisitions; or spoilage, breakage, and theft. In some enterprises, plant
operations are suspended periodically during a seasonal low period or near the end of the
fiscal ear while a physical inventory is taken. In others, an inventory crew or members of
the internal edit department make a count of one or more stock classes every day
throughout the year, presumably on a well planned schedule, so that every materials item
will be inventoried at least once during the year.
Adjusting Materials Ledger Cards and

Accounts to Conform to Inventory Accounts -
When the inventory count differs from the balance on the materials ledger card, the ledger
card is adjusted to conform to the actual count.
if the ledger card balance shows more materials units than the inventory card, and entry is
made in the issued section; and the balance section is reduced to equal the verified
account. In case the materials ledger card balance is less than the physical count, the
quantity differences may be entered in the received section or may be entered in red in the
issued section with the balance section being increased to agree with the actual count.
In addition to the correction on the materials ledger card, the materials account must be
adjusted for the increase or decrease. If the inventory count is less than that shown on the
materials ledger card, the following journal entry should be recorded:
Dr
Factory Overhead control xxxx
Materials xxxx Cr
Inventory adjustment to physical control

• Purchases of productive material.
Cost Accounting Procedure for Scrap and

Waste:
In many manufacturing processes, waste and scrap result from:
1. The processing of materials.
2. Defective and broken parts.
3. Absolute stock.
4. Revisions or abandonment of experimental projects.
5. Worn out or absolute machinery.
This scrap should be collected and placed in storage for sale to scrap dealers. At the time of
sale, the following entry may be made:
Cash (or accounts receivable) xxxx Dr.
Scrape sales (or factory overhead control) xxxx Cr.
The amount realized from the sale of scrap and waste can be treated in two ways with
respect to the income statement:
1. The amount accumulated in scrap sales may be closed directly to income summary
and shown on the income statement under other income.
2. The amount may be credited to factory overhead control, thus reducing the total
factory overhead expense and thereby the cost of goods manufactured.
When scrap is collected from a job or department, the amount realized form the sale of
scrap is often treated as a reduction in the materials cost charged to the individual job or
product. In this case, the entry to record the sale would be:
Work in process xxxx Cr.
When the quantity and value of scrap materials is relatively high, it should be stored in
designated place under the supervision of a storekeeper. A scrap report ( as shown below)
is generally prepared in duplicate to authorize transfer and receipt of the scrap.
Example of Weekly Scrap Report
Department: Fabricating Weakly Scrap
Report
For Week Ending: November 10, 20---
Part No. Description Units used Scrapped % Scrap Cost Reason
115b Braces 7,200 108 1.50 $7.00
115e Fines 9,400 305 3.23 $30.50
115s Guides 15,600 520 3.33 $41.40 Defective
115k Supports 8,500 42 0.50 $25.30 Parts
Total for week............................................... $104.20
Scrap cost-Year to date................................ $4,533.75
Predetermined Scrap Allowance for Year $5,000.00
The original is forwarded to the materials ledger clerk, and a copy remains on file in the
department in which the scrape originated. The material ledger clerk can follow tow
procedures:
1. Open a materials ledger card, filling in the quantity only. The dollar value
would not be needed. When the scrap is sold, the entries and treatment of the
income item might be handled as discussed previously.
2. Record not only the quantity but also the dollar value of the scrap delivered
to the storekeeper. The value would be based on scrap prices quoted on the
market on the time of entry. The entry would be:
Scrap Materials xxxx Dr.
Scrape Sales (or work in process or overhead control) xxxx Cr.
When the scrap is sold the entry would be:

Scrap Materials xxxx Cr.
Any difference between the price at the time the inventory is recorded and the price realized
at the time of sale would be a plus or minus adjustment in the scrap sales account, the
work in process account, or the factory over head control account, consistent with the
account credited in the first entry.
To reduce accounting for scrap a minimum, often no entry is made until the scrap is actually
sold. At that time, cash or accounts receivable is debited while scrap sales is credited. This
method is expedient and is justified when a more accurate accounting becomes expensive
and burdensome, the scrap value is relatively small, or the price is uncertain.
Proceeds from the sale of scrap in reality a reduction in production cost. As long as the
amounts are relatively small, the accounting treatment is not a major consideration. What is
important is a effective scrap control system based on periodic reporting to responsible
supervisory personnel. Timely scrap reports for each producing department call attention to
unexpected items and unusual amounts and should induce prompt corrective actions.
Cost Accounting Procedure for Spoiled

Goods:
Cost accounting should provide product costs and cost control information. In the case of
spoilage, the first requirement is to know the nature and cause of the spoiled units.
The second requirement, the accounting problem is to record the cost of spoiled units and to
accumulate spoilage costs and report them to responsible personnel for corrective actions.
Attaining the degree of materials and machine precision and the perfection of labor
performance necessary to eliminate spoiled units entirely would involve costs far in excess
of a normal or tolerable level of spoilage. If spoilage is normal and happens at any time and
at any stage of the productive process, its cost should be treated as factory overhead,
included in the predetermined factory overhead rate, and prorated overall production of a
period. If, on the other hand, normal spoilage is caused by exacting specifications, difficult
processing, or other unusual and unexpected factors, the spoilage cost should be charged to
that order. In either cause, the cost of abnormal spoilage should be charged to factory
overhead.
Example:
Spoiled materials charged to total production: The Nevada Products company has a
monthly capacity to manufacture 125,000 three inch coil springs for use in mechanical
brakes. Production is scheduled in response to orders received. Spoilage is caused by a
variety of unpredictable factors and averages $0.05 per spring. During November, 100,000
springs were produced with a materials cost of $40 per unit, a labor cost of $50 per unit,
and factory overhead charged to production at a rate of 150% of the direct labor cost. This
rate is based an estimate that includes $0.05 per spring for spoilage. The entry to record
work put into production during the month is:
Work in process Materials 40,000 Dr.
Work in process Labor 50,000 Dr.
Work in process Factory overhead 75,000 Dr.
Materials 40,000 Cr.
Payroll 50,000 Cr.
Applied Factory overhead 75,000 Cr.
On the last working day of the month, the entry days production of 4000 units are spoiled
due to improper heat treatment; however, theses units can be sold for $50 each in the
second hand market. To record this normal loss on spoiled goods and the possible resale
value, the entry that charges all production during the period with proportionate share of
the spoilage is:
Spoiled Goods 2,000 Dr.
Factory Overhead Control 4,600 Dr.
Work in process Materials

1,600 Cr.
Work in process Labor 2,000 Cr.
Work in process Factory overhead 3,000 Cr.
The materials, labor, and factory overhead in the spoiled units reduced by the recovery or
sales value of these units ($1,600 materials+ $2000 labor + $3,000 factory overhead –
$2000 cost recovery = $4,600 spoilage loss) is relocated or transferred from work in
process to factory overhead control. Each of the 96,000 good units produced during the
month has a charged in cost of $0.05 for spoilage (96,000 × $0.05 = $4,800); the actual
spoilage during the period is $4,600.
The good units produced during the week are on the order where spoilage did occur carry a
cost of $0.40 for materials, $0.5 for labor, and $0.75 for overhead because spoilage is
charged to all production--not to the lot or order which happens to be in process at the time
of spoilage. In other words, the $165,000 monthly production cost less the $6,600 credit
resulting from spoiled units levels $158,400 to be divide by the 996,000 good units
manufactured during the month at a cost of $1.65 per good unit. The entry transferring the
good units to finished goods is:
Finished Goods 158,400 Dr.
Work in process Materials
38,400 Cr.
Work in process Labor 48,000 Cr.
Work in process Factory overhead 72,000 Cr.
During the month, the amounts charged to factory overhead control represent the
depreciation, insurance, taxes, indirect materials and indirect labor actually experienced,
along with the $4,600 spoilage cost. All production during the month is charged with
overhead of $0.75 per unit. Over head analysis reveals a $200 favorable variance ($4,600
actual minus $4,800 applied) attributable to the spoilage units. Any difference between the
price when the inventory was recorded and the price realized at the time of sale would be a
plus or minus adjustment to factory overhead control (loss on spoiled goods).
For effective cost control normal spoilage rates and amounts should be established for each
department and for each type of class of materials. Weakly or monthly spoilage reports
similar to the scrap report illustrated on scrap and waste page.
Spoiled materials charged to a particular job: The Nevada Products Company has
contract to manufacture 10,000 heavy duty coil springs for the Tri-state Supply Company.
This order requires a steel wire that is harder and slightly heavier than stock normally used,
but the production process, as well as labor time and overhead factors, is identical with the
standard product. Materials cost for each of these springs is $0.60 this special order
requires exacting specifications, and normal spoilage is to be charged to the order. The
$0.050 per unit spoilage factor is now eliminated from the overhead rate, and 140% of
direct labor cost, and $0.70 per unit, is the rate used on this job. The order is put into
production the first day of December, and sampling during the first hour of production
indicates that eleven units of production are required to secure ten good springs. Entries to
record costs placed into production for 11,000 units are:
Work in process Materials 6,600 Dr.
Work in process Labor 5,500 Dr.
Work in process Factory overhead 7,700 Dr.
Materials 6,600 Cr.

Payroll 5,500 Cr.
Applied Factory overhead 7,700 Cr.
One thousand units did not meet specifications and are spoiled but can be sold as seconds
for $0.45 per unit. The entry to record the spoilage is:
Spoiled Goods 450 Dr.
Work in process Materials 150 Cr.

Work in process Labor 125 Cr.
Work in process Factory overhead 175 Cr.
$450 / $1,800 cost of 1,000 units

= 25%
($6,600 Materials / $19,800 Total job cost) × $450 Sales recovery
($5,500 Labor / $19,800 Total job cost) × $450 Sales recovery
($7,700 Overhead / $19,800 Total job cost) × $450 Sales recovery
The entry transferring the completed order to Finished Goods would be:
Finished Goods $19,350 Dr.
Work in process Materials $6,450 Cr.

Work in process Labor $5,375 Cr.
Work in process Factory overhead $7,525 Cr.
The net result of this treatment is to charge the spoilage loss of $1,350 ($1,800 less $450
cost recovery) to 10,000 good units that are delivered at the original contract price. The
unit cost of completed springs is $1,935 ($19,350 / 10000 units).
Any difference between the price when the inventory was recorded and the price realized at
the time of sale should be an adjustment to work in process, finished goods, or cost of
goods sold, depending on the completion status of the particular job order. as an expedient,
the difference might be closed to factory overhead control.
Cost Accounting Procedure for Defective
Work:
In the manufacturing processes, imperfections may arise because of faults in materials, labor, or
machines.
If the unit can be reprocessed on one or more stages and made into a standard saleable product, it is
often profitable to rework the defective units. Although spoiled work cannot usually be made into a first
class finished unit without uneconomical expenditures, defective work can be corrected to meet specified
standards by adding materials, labor, and factory overhead. Two methods of accounting for the added
cost to upgrade the defective work are appropriate, depending upon circumstances:
If defective work is experienced in regular manufacturing, the additional cost to correct defective units
(based on previous experience) is included in the predetermined factory over head and in the resulting
factory overhead rate. Actual rework cost is charged to factory overhead control.
For example, assume that a company has an order for 500 units of a product that has direct production
costs of $5 for materials and $3 for labor, with factory overhead charged to production at 200% of labor
cost, 50 units are found to be defective and are to be reworked at a total cost of $30 for materials, $60 for
labor, and overhead at 200% of direct labor cost. The journal entries are:
Dr. Cr.
Work in process Materials 2,500
Work in process Labor 1,500
Work in process Factory overhead 3,000
Materials 2,500
Labor 1,500
Applied Factory overhead 3,000
Factory overhead control 210

Materials 30
Labor 60
Applied Factory overhead 120
Finished Goods 7,000

The unit cost of the completed unit is $14 ($7,000 / 500 units)
Suppose, however, that the same company received a special order for 500 units with the agreement
stating that any defective work is charge able to the contract. During production, 50 units are improperly
assembled. The total cost to correct these defective units is $30 for materials, $60 for labor, and 200% of
the direct labor cost for factory overhead. The entries in this case are:
Dr. Cr.
Materials 2,500
Labor 1,500
Applied Factory overhead 3,000
Work in process Materials 30
Work in process Labor 60
Work in process Factory overhead 120
Materials 30
Labor 60
Applied Factory overhead 120
Finished Goods 7,210

The unit cost in this case is$14.42 instead of $14
Whenever the defective work cost is charged directly to the job, a slight overcharge of factory overhead
results because of the inclusion of rework cost in the factory overhead rate. One remedy to correct this
discrepancy would be either to create a new independent overhead rate or to separate costs for the
special job.
direct material
Definition
All items such as raw materials, standard and specialized parts, and sub-assemblies
required to assemble or manufacture a complete product. Direct material costs are
assignable to a specific product, cost center, or work-order.
direct material cost
Definition
Part of raw material cost that can be specifically and consistently associated with or
assigned to the manufacture of a product, a particular work order, or provision of a
service.
indirect material
Definition
Consumables (such as cleaning chemicals, disposable tools, protective devices) not

used as raw materials, but which make the production of a good or service possible,
more efficient, or safer. Indirect material costs are not readily identifiable with a
specific product or job. They are termed indirect costs and are charged to overhead
accounts.
Material - Supplies that may be incorporated into, or attached to, an end product, or
that may be consumed or expended in the manufacturing process. This term includes
(but is not limited to) raw and processed material, components, parts, assemblies, sub-
assemblies, fuels, lubricants, coolants, cleaning agents, and small tools and accessories
that may be consumed directly or indirectly. Compare with materiel.
Market Value of Inventories [ARB No. 43, Chapter 4, Para. 9]
Market = Current replacement cost
Upper limit of Market

= Net Realizable Value (NRV)
Lower limit of Market
= Net Realizable Value (NRV) - Normal Profit Margin
Net Realizable Value (NRV)

= Estimated Selling Price - Cost of Completion and Disposal
Market = Current Replacement Cost
If Current Replacement Cost > Net Realizable Value (NRV),

then NRV is Market.
If Current Replacement Cost < (NRV - Normal Profit Margin),

then (NRV - Normal Profit Margin) is Market.
Example 1 (Company A)
Company has the following items as inventory as of December 31, 2010. What is the value of inventory by
applying Lower of Cost of Market?
Current Replacement Estimated Selling Completion & Disposal

Item Units Cost
Cost Price Cost
1 500 $65 $68 $80 $3
2 300 $80 $72 $102 $8
3 400 $90 $105 $112 $10
4 700 $38 $42 $40 $4
5 900 $20 $21 $30 $2
6 600 $55 $45 $67 $2
For all inventory items, Normal Profit Margin is 30% of cost.
Determine the Market
Points
Market = Current Replacement Cost
If Current Replacement Cost > Net Realizable Value (NRV),
then NRV is Market.
If Current Replacement Cost < (NRV - Normal Profit Margin),
then (NRV - Normal Profit Margin) is Market.
Rank the following three values, then the one in the middle is Market.
NRV
Current Replacement Cost
NRV - Normal Profit Margin
Net Realizable Value (NRV)

= Estimated Selling Price - Cost of Completion and Disposal
In this example, normal profit margin = 30% of cost.
Middle value among (A), (B)

(A) (B) (C)
and (C)
Current Replacement Normal - Normal Profit
Item NRV Market
Cost Margin
1 $68 $77 $57.5 $68
2 $72 $94 $70 $72
3 $105 $102 $75 $102
4 $42 $36 $24.6 $36
5 $21 $28 $22 $22
6 $45 $65 $48.5 $48.5
Compare the Cost and Market

Lower of Cost or
Item Cost Market Units LCM Inventory
Market (LCM)
1 $65 $68 $65 500 $32,500
2 $80 $72 $72 300 $21,600
3 $90 $102 $90 400 $36,000
4 $38 $36 $36 700 $25,200
5 $20 $22 $20 900 $18,000
6 $55 $48.5 $48.5 600 $29,100
Total $162,400
Inventory valuation at Cost, Market and LCM
Item Units Inventory at Cost Inventory at Market Inventory at LCM
1 500 $32,500 < $34,000 $32,500

2 300 $24,000 > $21,600 $21,600
3 400 $36,000 < $40,800 $36,000
4 700 $26,600 > $25,200 $25,200
5 900 $18,000 < $19,800 $18,000
6 600 $33,000 > $29,100 $29,100
Total $170,100 < $170,500 $162,400
LCM applied to each inventory item

--> Inventory at LCM = $162,400
LCM applied to all inventories as one pool

--> Total inventory at cost < Total inventory at market
Example 2 (Company B)
Company has the following items as inventory as of December 31, 2010. What is the value of inventory by
applying Lower of Cost of Market?
Current Replacement Estimated Selling Completion & Disposal

Item Units Cost
Cost Price Cost
1 800 $220 $250 $280 $15
2 600 $190 $175 $240 $11
3 350 $310 $370 $390 $23
4 500 $180 $185 $185 $8
5 750 $205 $210 $320 $14
6 900 $150 $110 $170 $7
For all inventory items, Normal Profit Margin is 30% of cost.
Determine the Market
Middle value among (A), (B)

(A) (B) (C)
and (C)
Current Replacement Normal - Normal Profit
Item NRV Market
Cost Margin
1 $250 $265 $199 $250
2 $175 $229 $172 $175
3 $370 $367 $274 $367
4 $185 $177 $123 $177
5 $210 $306 $244.5 $244.5
6 $110 $163 $118 $118
Compare the Cost and Market
Lower of Cost or
Item Cost Market Units LCM Inventory
Market (LCM)
1 $220 $250 $220 800 $176,000
2 $190 $175 $175 600 $105,000
3 $310 $367 $310 350 $108,500
4 180 $177 $177 500 $88,500
5 $205 $244.5 $205 750 $153,700
6 $150 $118 $118 900 $106,200
Total $737,950
Inventory valuation at Cost, Market and LCM
Item Units Inventory at Cost Inventory at Market Inventory at LCM

1 800 $176,000 < $200,000 $176,000
2 600 $114,000 > $105,000 $105,000
3 350 $108,500 < $128,450 $108,500
4 500 $90,000 > $88,500 $88,500
5 750 $153,750 < $183,375 $153,700
6 900 $135,000 > $106,200 $106,200
Total $777,250 < $811,525 $737,950
LCM applied to each inventory item

LCM applied to all inventories as one pool

--> Total inventory at cost < Total inventory at market
Perpetual Inventory System
Perpetual inventory system updates inventory accounts after each purchase or sale.
Inventory subsidiary ledger is updated after each transaction.

Inventory quantities are updated continuously.
Periodic Inventory System
Periodic inventory system records inventory purchase or sale in "Purchases" account.
"Purchases" account is updated continuously, however, "Inventory" account is updated on a periodic basis, at the
end of each accounting period (e.g., monthly, quarterly)
Inventory subsidiary ledger is not updated after each purchase or sale of inventory.
Inventory quantities are not updated continuously.
Inventory quantities are updated on a periodic basis.
On May 1, 2010: Purchased 1,000 units of merchandise at $30 per unit.
Under Perpetual inventory system
5/1/2010 Debit Credit
Merchandise Inventory 30,000
Accounts payable 30,000
Under Periodic inventory system
Purchases 30,000
Under periodic inventory system, all purchases during the accounting period are recorded in the "Purchases"
account.
On May 6, 2010: Sold 200 units of merchandise at $50 per unit on credit.
Accounts Receivable 10,000
Sales 10,000
Cost of goods sold 6,000
Merchandise inventory 6,000
Under perpetual inventory system, changes in merchandise inventory account are recorded after each transaction.

Sales 10,000
Under periodic inventory system, the following journal entry is recorded at the end of accounting period.
Purchases 24,000
Quantity of merchandise inventory

= 1,000 units purchased - 200 units sold = 800 units left
Cost of merchandise inventory

= 800 units x $30 per unit cost = $24,000
Purchases 6,000
Cost of goods sold

= Total purchases - Ending balance of merchandise inventory
= 1,000 units x $30 per unit cost - 800 units x$30 per unit cost
= $30,000 - $24,000 = $6,000
Ending Inventory and Cost of goods sold (Company A)
Ending inventory
= Beginning inventory + Purchases during the period - Cost of goods sold
= $0 + $30,000 - $6,000 = $24,000
Cost of goods sold

= Beginning inventory + Purchases during the period - Ending inventory
= $0 + $30,000 - $24,000 = $6,000
Example 2 (Company B)
On June 5, 2010: Purchased 600 units of merchandise at $35 per unit.
Purchases 21,000
Under periodic inventory system, all purchases during the accounting period are recorded in the "Purchases"
account.
On June 16, 2010: Sold 400 units of merchandise at $55 per unit on credit.
Accounts Receivable
22,000
Sales 22,000
Merchandise inventory 14,000
Under perpetual inventory system, changes in merchandise inventory account are recorded after each transaction.

Sales 22,000
Under periodic inventory system, the following journal entry is recorded at the end of accounting period.
Purchases 7,000
Quantity of merchandise inventory

= 600 units purchased - 400 units sold = 200 units left
Cost of merchandise inventory

= 200 units x $35 per unit cost = $7,000
Purchases 14,000
Cost of goods sold

= Total purchases - Ending balance of merchandise inventory
= 600 units x $35 per unit cost - 200 units x$35 per unit cost
= $21,000 - $7,000 = $14,000
Ending Inventory and Cost of goods sold (Company B)
Ending inventory
= Beginning inventory + Purchases during the period - Cost of goods sold
= $0 + $21,000 - $14,000 = $7,000
Cost of goods sold

= Beginning inventory + Purchases during the period - Ending inventory
= $0 + $21,000 - $7,000 = $14,000
Inventory Valuation Methods
Inventory valuation example 1 in pdf file

FIFO example 1 in pdf file
LIFO example 1 in pdf file
Dollar Value LIFO
First-in First-out (FIFO)
Under FIFO, it is assumed that items purchased first are sold first.
Last-in First-out (LIFO)
Under LIFO, it is assumed that items purchased last are sold first.
Perpetual Inventory System
Perpetual inventory system updates inventory accounts after each purchase or sale.
Inventory subsidiary ledger is updated after each transaction.

Inventory quantities are updated continuously.
Periodic Inventory System
Periodic inventory system records inventory purchase or sale in "Purchases" account.
"Purchases" account is updated continuously, however, "Inventory" account is updated on a periodic basis, at the
end of each accounting period (e.g., monthly, quarterly)
Inventory subsidiary ledger is not updated after each purchase or sale of inventory.
Inventory quantities are not updated continuously.
Inventory quantities are updated on a periodic basis.
Inventory transactions in May 2010.

Units Purchased
Date Transactions Unit Cost Inventory Units
(Sold)
May 1 Beginning Inventory 700 $10 700

May 3 Purchase 100 $12 800
May 8 Sale (500) ?? 300
May 19 Purchase 200 $15 1,100
May 25 Sale (400) ?? 700
May 27 Sale (100) ?? 600
May 31 Ending Inventory ??
Ending Inventory = Beginning Inventory + Units Purchased - Units Sold

= 700 + 900 - 1,000 = 600 units
Example 1-1 (Perpetual Recording, FIFO Valuation)
FIFO valuation under perpetual inventory system

Date Transactions Units Sold Unit Cost Inventory Units
May 8 Sale (*1) (500) ?? 300
May 19 Purchase 200 $15 1,100
May 25 Sale (*2) (400) ?? 700
May 27 Sale (*3) (100) ?? 600
(*1) 500 units sold

= 700 units from beginning inventory of at $10 unit cost.
Cost of goods sold = 500x$10 = $5,000
(*2) 400 units sold

= 200 units from beginning inventory at $10 unit cost
+ 100 units from May 3 purchases at $12 unit cost
Cost of goods sold = 200x$10 + 100x$12 + 100x$14

= $2,000 + $1,200 + $1,400 = $4,600
(*3) 100 units sold
= 100 units from May 15 purchases at $14 unit cost
Total cost of goods sold

= 500x$10 + 200x$10 + 100x$12 + 100x$14 + 100x$14
= $5,000 + $2,000 + $1,200 + $1,400 + $1,400
= $5,000 + $4,600 + $1,400 = $11,000
Cost of ending inventory

= Beginning inventory + Cost of purchases - Cost of goods sold
= $7,000 + (100x$12 + 600x$14 + 200x$15) - $11,000
= $7,000 + $12,600 - $11,000 = $8,600
[Checking]
Quantity of ending inventory
= Beginning inventory + Units purchased - Units sold
= 700 + 900 - 1,000 = 600 units

= 400 x $14 (May 15 purchase) + 200 x $15 (May 19 purchase)
= $5,600 + $3,000 = $8,600
Example 1-2 (Perpetual Recording, LIFO Valuation)
LIFO valuation under perpetual inventory system

May 8 Sale (*1) (500) ?? 300
May 19 Purchase 200 $15 1,100
May 25 Sale (*2) (400) ?? 700
May 27 Sale (*3) (100) ?? 600
(*1) 500 units sold
Cost of goods sold = 100x$12 + 400x$10

= $1,200 + $4,000 = $5,200
(*2) 400 units sold

Cost of goods sold = 200x$15 + 200x$14
= $3,000 + $2,800 = $5,800
(*3) 100 units sold


= 100x$12 + 400x$10 + 200x$15 + 200x$14 + 100x$14
= $1,200 + $4,000 + $3,000 + $2,800 + $1,400
= $5,200 + $5,800 + $1,400 = $12,400

= $7,000 + (100x$12 + 600x$14 + 200x$15) - $12,400
= $7,000 + $12,600 - $12,400 = $7,200
[Checking]
= 700 + 900 - 1,000 = 600 units

= 300x$10 (beginning inventory) + 300x$14 (May 15 purchase)
= $3,000 + $4,200 = $7,200
Note: 400 units from beginning inventory were sold on May 8.

200 units from May 15 purchase were sold on May 25.

Example 1-3 (Periodic Recording, FIFO Valuation)
FIFO valuation under periodic inventory system

May 8 Sale (*1) (500) ?? 300
May 19 Purchase 200 $15 1,100
May 25 Sale (*2) (400) ?? 700
May 27 Sale (*3) (100) ?? 600
Under periodic inventory system, cost of inventories is calculated at the end of each accounting period (on May 31 in
this example).
[May 31, 2010]

= 700 + 900 - 1,000 = 600 units
Using FIFO, units purchased first are assumed to be sold first.
1,000 units sold

= 700 units from beginning inventory of at $10 unit cost
Cost of goods sold = 700x$10 + 100x$12 + 200x$14

= $7,000 + $1,200 + $2,800 = $11,000
600 units of inventory left


= 400x$14 + 200x$15 = $5,600 + $3,000 = $8,600
Example 1-4 (Periodic Recording, LIFO Valuation)
LIFO valuation under periodic inventory system

May 8 Sale (*1) (500) ?? 300
May 19 Purchase 200 $15 1,100
May 25 Sale (*2) (400) ?? 700
May 27 Sale (*3) (100) ?? 600
this example).
[May 31, 2010]

= 700 + 900 - 1,000 = 600 units
Using LIFO, units purchased last are assumed to be sold first.
1,000 units sold

+ 100 units from beginning inventory at $10 unit cost
Cost of goods sold = 200x$15 + 600x$14 + 100x$12 + 100x$10

= $3,000 + $8,400 + $1,200 + $1,000 = $13,600
600 units of inventory left

= 600x$10 = $6,000
Example 1-5 (Perpetual Recording, Moving Average Valuation)
Moving Average valuation under perpetual inventory system

Moving
Average
Unit
Cost
May 1 Beginning Inventory 700 $10 700 $10
$10.25
(*1)
May 8 Sale (500) ?? 300 $10.50
$12.75
(*2)
$13.16
May 19 Purchase 200 $15 1,100
(*3)
May 25 Sale (400) ?? 700 700
May 27 Sale (100) ?? 600 600
(*1) Average cost of 800 units
= (700x$10 + 100x$12) / (700 + 100)
= ($7,000 + $1,200) / 800 = $8,200 / 800 = $10.25
Cost of goods sold on May 8 = 500x$10.25 = $5,125
(*2) Average cost of 900 units

= (300x$10.25 + 600x$14) / (300 + 600)
= ($3,075 + $8,400) / 900 = $11,475 / 900 = $12.75
(*3) Average cost of 1,100 units

= (900x$12.75 + 200x$15) / (900 + 200)
= ($11,475 + $3,000) / 1,100 = $14,475 / 1,100 = $13.16


= 500x$10.25 + 400x$13.16 + 100x$13.16
= $5,125 + $5,264 + $1,316 = $11,705

= $7,000 + (100x$12 + 600x$14 + 200x$15) - $11,705
= $7,000 + $12,600 - $11,705 = $7,895
[Checking]
= 700 + 900 - 1,000 = 600 units
= 600 x $13.16 (Moving Average cost per unit as of May 31)
= $7,896
$7,896 - $7,895 = $1 (rounding error)
Example 1-6 (Periodic Recording, Weighted Average Valuation)
Weighted Average valuation under periodic inventory system

May 8 Sale (*1) (500) ?? 300
May 19 Purchase 200 $15 1,100
May 25 Sale (*2) (400) ?? 700
May 27 Sale (*3) (100) ?? 600
this example).
[May 31, 2010]

= 700 + 900 - 1,000 = 600 units
Weighted average cost per unit

= (700x$10 + 100x$12 + 600x$14 + 200x$15) / (700+100+600+200)
= ($7,000 + $1,200 + $8,400 + $3,000) / 1,600
= $19,600 / 1,600 = $12.25
Cost of goods sold

= (500 + 400 + 100) x $12.25
= 1,000 x $12.25 = $12,250

= 600 x $12.25 = $7,350
[Checking]

= Beginning inventory + Purchases - Cost of Goods Sold
= $7,000 + (100x$12 + 600x$14 + 200x$15) - $12,250
= $7,000 + $12,600 - $12,250 = $7,350
Periodic inventory system

An inventory system in which the balance in the inventory account is adjusted for
the units sold only at the end of the period.
Perpetual inventory system
An inventory system in which the balance in the inventory account is adjusted for
the units sold each time a sale is made.
INVENTORY TURNOVER
The number of times a company sold out and replaced its average stock of goods in a
year. The formula is:
(Cost of goods sold) / (Average inventory (beginning inventory + ending)/2 )
Inventory
Goods bought or manufactured for resale but as yet unsold, comprising raw materials,
work-in-progress and finished goods.
Inventory
The cost of the goods that a company has available for resale
inventory shrinkage
A term describing the loss of products from inventory
due to shoplifting by customers, employee theft, damaged and
spoiled products that are thrown away, and errors in recording the purchase
and sale of products. A business should make a physical count and
inspection of its inventory to determine this loss.
Finished goods inventory

Goods that have been completed by the manufacturing
process, or purchased in a complete form, but which have not yet been sold to
customers.
Raw materials inventory

The total cost of all component parts currently in stock that
have not yet been used in work-in-process or finished goods production.
Work-in-process inventory
inventory that has been partially converted through the
production process, but for which additional work must be completed before it can
be recorded as finished goods inventory.
Inventory
Goods that a firm stores in anticipation of its later sale or use as an input.
Inventory
The cost of unsold goods that are held for sale in the ordinary course of business or
that will be used or consumed in the production of goods to be sold.
Finished goods inventory
Completed inventory items ready for shipment to
customers.
Inventory
Those items included categorized as either raw materials, work-inprocess,
or finished goods, and involved in either the creation of products or service
supplies for customers.
Any stock that a firm keeps to meet its future requirement of production and sales is called “INVENTORY”. The basic
reason for holding inventory is to keep up to the production activities unhampered. It is neither physically possible nor
economically justifiable to wait for the stock to arrive at the time when they are actually required. Therefore, keeping
of inventory is a must for the efficient working of a business unit.
Raw materials represent goods kept by a manufacturing firm prior to their being utilized in the production process.
Supplies generally include tools and consumables which are consumed in the production of goods and services.
Goods in process represent the semi-finished goods; they include those materials that have been committed to
production process but have not yet been converted into finished goods.
Finished goods are completed goods awaiting sale in a manufacturing concern; they are the final output of the
production process.
The nature of inventory depends upon the type of activity carried on. In the case of a manufacturing unit, inventory
will generally include all types of inventories mentioned above, while in the case of a trading concern, it will comprise
only finished goods or stock-in-trade owned by it for sale to customers in the normal course of business. Inventory
needs proper control as it is one of the largest assets of a business.
Types of Inventory by Function
INPUT PROCESS OUTPUT
Raw Materials Work In Process Finished Goods
Consumables required for Semi Finished Production in various Finished Goods at Distribution
processing. Eg : Fuel, Stationary, stages, lying with various Centers through out Supply Chain
Bolts & Nuts etc. required in departments like Production, WIP
manufacturing Stores, QC, Final Assembly, Paint
Shop, Packing, Outbound Store etc.
Maintenance Items/Consumables Production Waste and Scrap Finished Goods in transit
Packing Materials Rejections and Defectives Finished Goods with Stockiest and
Dealers
Local purchased Items required for Spare Parts Stocks & Bought Out
production items
Defectives, Rejects and Sales

Returns
Repaired Stock and Parts
Sales Promotion & Sample Stocks
Reasons why organizations maintain Raw Material Inventory

Most of the organizations have raw material inventory warehouses attached to the production facilities where raw
materials, consumables and packing materials are stored and issue for production on JIT basis. The reasons for
holding inventories can vary from case to case basis.
1. Meet variation in Production Demand

Production plan changes in response to the sales, estimates, orders and stocking patterns. Accordingly the
demand for raw material supply for production varies with the product plan in terms of specific SKU as well
as batch quantities.
Holding inventories at a nearby warehouse helps issue the required quantity and item to production just in
time.
2. Cater to Cyclical and Seasonal Demand
Market demand and supplies are seasonal depending upon various factors like seasons; festivals etc and
past sales data help companies to anticipate a huge surge of demand in the market well in advance.
Accordingly they stock up raw materials and hold inventories to be able to increase production and rush
supplies to the market to meet the increased demand.
3. Economies of Scale in Procurement
Buying raw materials in larger lot and holding inventory is found to be cheaper for the company than buying
frequent small lots. In such cases one buys in bulk and holds inventories at the plant warehouse.
4. Take advantage of Price Increase and Quantity Discounts
If there is a price increase expected few months down the line due to changes in demand and supply in the
national or international market, impact of taxes and budgets etc, the company’s tend to buy raw materials in
advance and hold stocks as a hedge against increased costs.
Companies resort to buying in bulk and holding raw material inventories to take advantage of the quantity
discounts offered by the supplier. In such cases the savings on account of the discount enjoyed would be
substantially higher that of inventory carrying cost.
5. Reduce Transit Cost and Transit Times
In case of raw materials being imported from a foreign country or from a far away vendor within the country,
one can save a lot in terms of transportation cost buy buying in bulk and transporting as a container load or
a full truck load. Part shipments can be costlier.
In terms of transit time too, transit time for full container shipment or a full truck load is direct and faster
unlike part shipment load where the freight forwarder waits for other loads to fill the container which can take
several weeks.
There could be a lot of factors resulting in shipping delays and transportation too, which can hamper the
supply chain forcing companies to hold safety stock of raw material inventories.
6. Long Lead and High demand items need to be held in Inventory
Often raw material supplies from vendors have long lead running into several months. Coupled with this if
the particular item is in high demand and short supply one can expect disruption of supplies. In such cases it
is safer to hold inventories and have control.
Why and when do Organizations hold Finished Goods Inventories ?

1. Markets and Supply Chain Design
Organizations carry out detailed analysis of the markets both at national as well as international / global
levels and work out the Supply Chain strategy with the help of SCM strategists as to the ideal location for
setting up production facilities, the network of and number of warehouses required to reach products to the
markets within and outside the country as well as the mode or transportation, inventory holding plan, transit
times and order management lead times etc, keeping in mind the most important parameter being, to
achieve Customer Satisfaction and Demand Fulfillment.
2. Production Strategy necessitates Inventory holding
The blue print of the entire Production strategy is dependant upon the marketing strategy. Accordingly
organizations produce based on marketing orders. The production is planned based on Build to stock or
Build to Order strategies.
While Build to Order strategy is manufactured against specific orders and does not warrant holding of stocks
other than in transit stocking, Build to Stock production gets inventoried at various central and forward
locations to be able to cater to the market demands.
3. Market penetration
Marketing departments of companies frequently run branding and sales promotion campaigns to increase
brand awareness and demand generation. Aggressive market penetration strategy depends upon ready
availability of inventory of all products at nearest warehousing location so that product can be made
available at short notice - in terms of number of hours lead time, at all sales locations through out the state
and city.
Any non-availability of stock at the point of sale counter will lead to dip in market demand and sales. Hence
holding inventories becomes a necessity.
4. Market Size, location and supply design
Supply chain design takes into account the location of market, market size, demand pattern and the transit
lead time required to reach stocks to the market and determine optimum inventory holding locations and
network to be able to hold inventories at national, regional and local levels and achieve two major objectives.
The first objective would be to ensure correct product stock is available to service the market. Secondly
stocks are held in places where it is required and avoid unwanted stock build up.
5. Transportation and Physical Barriers
Market location and the physical terrain of the market coupled with the local trucking and transportation
network often demand inventory holding at nearest locations. Hilly regions for example may require longer
lead-time to service. All kinds of vehicles may not be available and one may have to hire dedicated
containerized vehicles of huge capacities. In such cases the will have to have an inventory holding plan for
such markets.
Far away market locations means longer lead times and transportation delays. Inventory holding policy will
take into account these factors to work out the plan.
6. Local tax and other Govt. Rules
In many countries where GST is not implemented, regional state tax rules apply and vary from state to state.
Accordingly while one state may offer a tax rebate for a particular set of product category, another state may
charge higher local taxes and lower inter state taxes. In such cases the demand for product from the
neighboring state may increase than from the local state. Accordingly inventory holding would have to be
planned to cater to the market fluctuation.
While in case of exports from the country of origin into another market situated in another country, one
needs to take into account the rules regarding import and customs duties to decide optimum inventories to
be held en route or at destination.
7. Production lead times
FG inventory holding becomes necessary in cases where the lead-time for production is long. Sudden
market demand or opportunities in such cases require FG inventories to be built up and supplies to be
effected.
8. Speculative gain
Companies always keep a watch on the economy, annual state budget, financial environment and
international environment and are able to foresee and estimate situations, which can have an impact on their
business and sales.
In cases where they are able to estimate a increase in industry prices, taxes or other levies which will result
in an overall price increase, they tend to buy and hold huge stocks of raw materials at current prices. They
also hold up finished stock in warehouses in anticipation of a impending sale price increase. All such moves
cause companies to hold inventories at various stages.
9. Avoid Certain Costs
Finally organizations hold FG inventories to satisfy customer demand, to reduce sales management and
ordering costs, stock out costs and reduce transportation costs and lead times.
Inventory Costs
Inventory procurement, storage and management is associated with huge costs associated with each these
functions.
Inventory costs are basically categorized into three headings:
1. Ordering Cost
2. Carrying Cost
3. Shortage or stock out Cost & Cost of Replenishment
a. Cost of Loss, pilferage, shrinkage and obsolescence etc.

b. Cost of Logistics
c. Sales Discounts, Volume discounts and other related costs.
1. Ordering Cost
Cost of procurement and inbound logistics costs form a part of Ordering Cost. Ordering Cost is dependant
and varies based on two factors - The cost of ordering excess and the Cost of ordering too less.
Both these factors move in opposite directions to each other. Ordering excess quantity will result in carrying
cost of inventory. Where as ordering less will result in increase of replenishment cost and ordering costs.
These two above costs together are called Total Stocking Cost. If you plot the order quantity vs the TSC,
you will see the graph declining gradually until a certain point after which with every increase in quantity the
TSC will proportionately show an increase.
This functional analysis and cost implications form the basis of determining the Inventory Procurement
decision by answering the two basic fundamental questions - How Much to Order and When to Order.
How much to order is determined by arriving at the Economic Order Quantity or EOQ.
2. Carrying Cost
Inventory storage and maintenance involves various types of costs namely:
• Inventory Storage Cost
• Cost of Capital
Inventory carrying involves Inventory storage and management either using in house facilities or external
warehouses owned and managed by third party vendors. In both cases, inventory management and process
involves extensive use of Building, Material Handling Equipments, IT Software applications and Hardware
Equipments coupled managed by Operations and Management Staff resources.
a. Inventory Storage Cost
Inventory storage costs typically include Cost of Building Rental and facility maintenance and
related costs. Cost of Material Handling Equipments, IT Hardware and applications, including cost
of purchase, depreciation or rental or lease as the case may be. Further costs include operational
costs, consumables, communication costs and utilities, besides the cost of human resources
employed in operations as well as management.
b. Cost of Capital
Includes the costs of investments, interest on working capital, taxes on inventory paid, insurance
costs and other costs associate with legal liabilities.
The inventory storage costs as well as cost of capital is dependant upon and varies with the
decision of the management to manage inventory in house or through outsourced vendors and
third party service providers.
Current times, the trend is increasingly in favor of outsourcing the inventory management to third party service
provides. For one thing the organizations find that managing inventory operations requires certain core
competencies, which may not be inline with their business competencies. They would rather outsource to a supplier
who has the required competency than build them in house.
Secondly in case of large-scale warehouse operations, the scale of investments may be too huge in terms of cost of
building and material handling equipments etc. Besides the project may span over a longer period of several years,
thus blocking capital of the company, which can be utilized into more important areas such as R & D, Expansion etc.
than by staying invested into the project.
Inventory Planning - Basic ConceptsInventory Planning - Basic Concepts

inventory Planning –
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1. EOQ: Economic Order Quantity method determines the optimal order quantity that will minimize the total
inventory cost. EOQ is a basic model and further models developed based on this model include production
Quantity Model and Quantity Discount Model.
2. Continuous Order Model: works on fixed order quantity basis where a trigger for fixed quantity
replenishment is released whenever the inventory level reaches predetermined safety level and triggers re
ordering.
3. Periodic System Model: This model works on the basis of placing order after a fixed period of time.
EOQ Model
Example: Biotech.Co produces chemicals to sell to wholesalers. One of the raw material it buys is sodium nitrate
which is purchased at the rate of $22.50 per ton. Biotech’s forecasts show a estimated requirement of 5,75,000 tons
of sodium nitrate for the coming year. The annual total carrying cost for this material is 40% of acquisition cost and
the ordering cost is $595. What is the Most Economical Order Quantity ?
D = Annual Demand
C = Carrying Cost
S = Ordering Cost
D = 5,75,000 tons
C =0.40(22.50) = $9.00/Ton/Year
S = $595/Order
= 27,573.135 tons per Order.

This model pre supposes certain assumptions as under:
 No safety Stocks available in inventory.
 No Shortages allowed in order delivery.
 Demand is at uniform rate and does not fluctuate
 Lead Time for order delivery is constant
 One order = One delivery no shortages allowed.
 This model does not take into account other costs of inventory such as stock out cost, acquisition cost etc to
calculate EOQ.
In this model, the demand increases for production the inventory gets depleted. When the inventory drops to a critical
point the re order process gets triggered. New order is always place for fixed quantities. On receipt of the delivery
against the order the inventory level goes up.
Using this model, further data extrapolation is possible to determine other factors like how many orders are to be
placed in a year and what is the time lapse between orders etc.
EOQ For Production Lot:

This model is also used to determine the order size and the production lot for an item to be produced at one stage of
production and stored as work in progress inventory to be supplied to the next state of production or to the customer.
of
Inventory Control
•Ensures lab efficiency and
cost effectiveness
•Prevents costly, disruptive,
and/or wasteful steps in
patient care
•Builds critical relationships
between laboratories,
hospitals, suppliers and the
Uninterrupted availability of
reagents and supplies:
Inventory Control
Challenges
•In many countries purchasing

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Materials and Inventory Cost Control:

10.Inventory Quantity Standards:

Requirements of a System of Materials

The important requirements or essentials of adequate satisfactory system of

Competent Purchasing Agent:

Control by Budgeting Materials and Equipment:

Operation of Perpetual Inventory:

Standards or Level to be Fixed:

Storage Control and Issue:

Development of Controlling Accounts and Subsidiary Records:

Re-order Level or Ordering Point or

1. Definition and explanation of re-order point

Definition and explanation:

Formula of Re-order Level or Ordering Point:

Time required to receive emergency supplies 4 days

Average daily requirement 700 units

Minimum daily requirement 600 units

Time required for refresh supplies One month (30 days)

Calculate ordering point or re-order level

Normal usage 60 units per week each

Re-order period or Lead time

Calculate re order point for two types of materials

Minimum Limit or Minimum Level of Stock:

Definition and Explanation:

Maximum usage 130 units per day

Minimum usage 70 units per day

Re-order period 25 to 30 days

Calculate: minimum limit or level

Minimum limit or level = Re-order level or ordering point – Average or normal

Maximum Level or Maximum Limit of

Definition and Explanation:

130 units per

Re-order period 25 to 30 days

Calculate maximum limit or level.

Danger Level of Materials or Inventory

Maximum usage 800 units per day

Minimum usage 600 units per day

Re-order period 25 to 30 days

Time required to receive emergency supplies 4 Days

Economic Order Quantity (EOQ):

Definition and Explanation:

Formula of Economic Order Quantity (EOQ):

Underlying Assumptions of Economic Order Quantity:

You may also be interested in other relevant articles:

Procedures for Materials Procurement and Use:

Materials Costing Methods:

Cost of Materials in Inventory at the End of a Period:

Costing procedures for scrap, spoiled goods, and defective

Summary of Materials Management:

Issuing and Costing Materials into

Materials Requisitioned Journal:

Tabulating cards as materials requisitions:

Purchase of Productive Materials:

Materials Purchasing Forms:

Purchase Requisition Form:

Example/Sample of purchase requisition form:

Deliver to _________________ Date Required___________________

Dept No. ________________

Acct. No. _______________

Qty Item No. Description Unit Price Amount

Allowance for period ____ Balance Available___ Ordered By____

Amt This Purchase___ Approved By___

Purchase Order Form:

Deliver to _ Date Required___

Allowance for period __ Balance Available_ Ordered By____

Amt This Purchase_ Approved By_