Chapter 8

Costing and Control

of Materials

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 COSTING AND CONTROL OF
MATERIALS

Control of Materials

Cost of Inventory and

Costing methods

Just-in Time
Inventory/Production

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 Materials
Materials are the basic input that are transformed
into finished goods in the production process.

Materials costs based on relationship with finished

goods, can be broken down into direct
and indirect costs.

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 Control of Materials
Accounting for materials in a manufacturing
company usually involves two activities.

(1) Purchase of Materials (2) Issue of Materials

(i) Purchase (i) Periodic Inventory
Requisition System
(ii) Purchase order (ii) Perpetual Inventory
(iii) Receiving Materials System

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 1. Purchase Requisition
Purchase is initiated through a purchase requisition.

Avon Company Ltd Number

Purchase Requisition
Department/Individual making request……………..
Order date …………. Delivery date requested……………..

Quantity Catalogue number Description Unit price Total

Approved b y………………………….. Total cost

Figure 1: Purchase Requisition

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 2. Purchase Order
After the requisition has been approved, the purchasing
department places order.
Avon Company Ltd Number
(full address)
Purchase Order
Supplier…………………. Order date…………………
Address…………………… Date delivery requested by………………
Delivery terms………………. Payment terms………………..
Quantity Catalogue number Description Unit price Total

Approved b y………………………….. Total cost

Figure 2: Purchase Order

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 3. Receiving of Materials

Quantities and condition on receipt of goods are noted by the

receiving department on a Receiving Report as shown in Figure 3.

Avon Company Ltd Number

Receiving Report
Supplier ……………….
Purchase order number……………
Date received……………..
Quantity Catalogue number Description Unit price Total

Approved signature…………

Figure 3: Receiving Report

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 Storing and Issuance
of Materials
The basic accounting records of any inventory system are the
documents required to authorise and record materials movements
in/out of the store, namely, stocks/stores/materials ledger cards,
bin cards and materials requisition note.

Stock/Stores/Materials Ledger Cards

They show quantities on order, expected delivery dates and
quantities reserved/required for work to be processed. They
show the account number; description/type of material;
location; unit measurement; minimum and maximum quantities
to carry; details about the materials received; issued and
balance.

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 Bin Card
Bin card shows quantities of each type of material
received, issued and on hand.
Avon Company Ltd
Bin Card
Description ………………. Bin card ………….
Stores ledger number………… Code number………….
Date received………………… Unit number ………..
Date Received Issue Balance Check
quantity
Reference Quantity Reference quantity

Figure 4: Bin Card

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Materials Requisition Note/Form
The issuance of materials is authorised by means of a materials
requisition form prepared by the production
manager/departmental supervisor.

Materials Requisition Form

Date requested …………….. Approved by …………….
Department requesting …………… Date issued ………….
Requisition number……………….. Issued to ……………
Quantity Description Job number Units cost Total

Figure 5: Materials Requisition Note

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 Periodic Inventory System
Periodical inventory system involves physical count
of materials on hand at periodical intervals to
arrive at the ending inventory.
Exhibit 1: Cost of Materials Issued
Materials inventory-opening
+ Purchases
= Materials available for use
– Materials inventory-closing (based on physical count)
= Cost of materials issued

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 Perpetual Inventory System

Perpetual inventory system shows both cost of

materials issued and ending materials
inventory directly.

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 Recording/Accounting for
Material Cost
When a perpetual inventory system is used to account for materials
inventory, a subsidiary ledger records
card is maintained.

Inventory Record Card

Item………. Description…………….
Received Issued Balance
Date Quantity Amount Date Quantity Amount Date Quantity Amount

Figure 6: Inventory Record Card

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 The use of perpetual inventory system also involves physical count of materials on
hand, at least once a year, in order to check for
possible loss or shrinkage due to theft or spoilage.
If the physical count does not match with the balance in the inventory record
cards, the book figures are adjusted upward/downward to reflected the actual
count.

Journal Entries: The purchase and issue of materials (direct as well indirect) are
journalised as follows:
(i) When materials are purchased:
Direct Materials Inventory A/c Dr
To Cash/Accounts Payable (credit purchases)
Indirect Material Inventory A/c Dr
To Cash/Accounts Payable A/c (credit purchase)
(ii) Issue of direct materials for production:
Work-in-process Inventory A/c Dr
To Materials Inventory A/c
(iii) Issue of indirect materials for production:
Factory Overhead Control A/c Dr
To Materials Inventory A/c
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 Adjustment for Discrepancies
Physical count of materials under the perpetual inventory system may not tally
with the inventory record cards (stores ledger). The discrepancy may result
from: (a) Unavoidable reasons (b) Avoidable reasons

(a) When book inventory is more than the physical inventory and the shortage is
normal:
Factory Overheads Control A/c Dr
To Stores Ledger Control A/c
(b) When the shortage in physical inventory is due to non-recording of inventory
shortage:
Work-in-process Control A/c Dr
To Stores Ledger Control A/c
In both the above situations, in the stores ledger, an entry for both quantity and value
is recorded in the Issue Column and a reduction is made in the Balance Column.

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(c) In case of inventory gain, that is, when the stores ledger balance is less
than the physical inventory (inventory overages), reverse adjusting entries
of (a) and (b) above are passed. In the stores ledger, an entry for quantity
and value both is recorded in the Received Column and addition is made in
the Balance Column.

(d) The above adjustments are made when the inventory shortage/overage is
normal and is expected in the normal course of business operations. If the
loss is abnormal/due to unusual circumstances such as fire, theft,
sabotage, the proper treatment is to transfer it to costing profit and loss
account:

Costing Profit and Loss A/c Dr

To Stores Ledger Control A/c
Abnormal loss is considered a non-manufacturing loss, and is taken as a
period charge against income of the current accounting period.
(e) If the discrepancies are slight, the balance of the stores ledger may be
accepted for inventory verification and accounting purposes. No
adjustment is required in such a situation.

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Inventory Control Techniques

(i) ABC (ii) Economic

Analysis Order Quantity

(iii) Reorder-
(iv) Safety Stock
Point

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 ABC Analysis
The first step in the inventory planning/control process is the
classification of different types of inventory to determine
the type and degree of control required for each.
The ABC system is a widely-used classification technique for the
purpose. On the basis of the cost involved, the various
items are classified into three categories:
(i) A, consisting of items with the largest investment.
(ii) C, with relatively small investments, but fairly large number
of items.
(iii) B, which stands mid-way between category A and C.
Category A needs the most rigorous control, C requires minimum
attention, and B deserves less attention than A but
more than C.
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Economic Order Quantity (EOQ)

The second key inventory problem relates to determination of the

size/quantity of inventory which would be acquired. This is
the order quantity problem.
Stated with reference to cost perspective, EOQ refers to the level
of inventory at which the total cost of inventory comprising
(i) order/setup cost, and (ii) carrying costs
is the minimum.
Carrying Costs are cost associated with the maintenance/holding
of inventory.
Ordering Costs are costs associated with acquisition of/placing
order for inventory.

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Example 1
A firm’s inventory planning period is one year. Its inventory requirement for this period is 1,600
units. Assume that its acquisition costs are Rs 50 per order. The carrying costs are expected to be
Re 1 per unit per year for an item.

The firm can procure inventories in various lots as follows: (i) 1,600 units, (ii) 800 units, (iii) 400
units, (iv) 200 units, and (v) 100 units. Which of these order quantities is the economic order
quantity?
Solution
Inventory Cost for Different Order Quantities
1. Size of order (units) 1,600 800 400 200 100
2. Number of orders 1 2 4 8 16
3. Cost per order Rs 50 Rs 50 Rs 50 Rs 50 Rs 50
4. Total ordering cost (2 × 3) 50 100 200 400 800
5. Carrying cost per unit 1 1 1 1 1
6. Average inventory (units) 800 400 200 100 50
7. Total carrying cost (5 × 6) 800 400 200 100 50
8. Total cost (4 + 7) 850 500 400 500 850

Working Notes
(i) Number of orders = Total inventory requirement/ Order size, (ii) Average inventory = Order size/2

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 Mathematical (Short-cut) Approach

The economic order quantity can, using a short-cut method, be

calculated by the following equation:
EOQ = 2 AB/C
√
Where A = Annual usage of inventory in units,
B = Buying cost per order,
C = Carrying cost per unit per year.

Using the facts in Example 1, find out the EOQ by applying

the short-cut mathematical approach.
EOQ = 2 × 1,600 × 50 = 400 units.

√ 1

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 Reorder Point
The re-order point is that level of inventory when a fresh order
should be placed with suppliers. It is that inventory level which is
equal to the consumption during the lead time or procurement time.

Re-order level = (Daily usage × Lead time) + Safety stock.

Minimum level = Re-order level – (Normal usage × Average delivery
time).

Maximum level = Reorder level – (Minimum usage × Maximum delivery

time) + Re-order quantity.

Average stock level = Minimum level + (Re-order quantity)/2.

Danger level = (Average consumption per day × Lead time in days for
emergency purchases).

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 Safety Stock
The safety stock are the minimum additional inventory which serve
as a safety margin to meet an unanticipated
increase in usage.
The first step is to estimate the probability of being out of stock,
as well as the size of stock-out.
Stock-out costs are costs associated with the shortage
(stock-out) of inventory.
After the determination of the size and probability of stock-out,
the next step is the calculation of the stock-out cost.
Then, the carrying cost should be calculated.
Finally, the carrying costs and the expected stock-out costs at each safety
level should be added.
The optimum safety stock would be that level of inventory at which the total
of these two costs is the lowest.

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Figure 7 has been drawn to show clearly the interrelationship that exists among various concepts of inventory
discussed so far. It serves the useful purpose of presenting an integrated picture at one place.
In the Figure, inventory of 400 units is delivered on Day 0. The company has the policy of maintaining a safety
stock of 200 units. With the receipt of 400 units inventory on Day 0, the inventory level reaches 600 units (the
maximum level).

With the withdrawal of

Y Maximum raw material inventory
inventory level from the store at the rate
600 of 40 units per day, the
Us
560 Us (s ag balance of inventory
(s ag lo e
pe Ra stock declines to 360
lo e
480 pe Ra ) ge units after 6 days [600
) ge units – (40 units x 6
days)]. This level is the
400 reorder point. If delivery
320 Reorder Average inventory is on time, the next
point replenishment point is
(ROP) reached at Day 10. On the
240 10th day the company has
200 a maximum level of stock
160 Replenishment Lead time Safety stock of 600 units. If, however,
yr ot nev ni f o sti n U

point (4 days) usage during lead inventory is not received

Safety time delay in time, the company has
80
stock) a safety stock of five days
0 to fall back upon.
X
0
2 4 6 8 10 12 14 16
Days Stock outs

Figure: 7
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 Cost of Inventory
The cost of inventory may be said to be composed of two elements: (i)
Inventory quantities determined on the basis of either physical count or
perpetual inventory records and (ii) Unit cost.

In general, the basis of inventory valuation is the “lower of cost or market” or

more appropriately “the lower of actual cost or replacement cost.”

Although replacement costs can be estimated for interim periods, and

adjustments made later on to reflect the conditions at the close of the year,
the market value can be known with certainty only at the close of the
accounting period.

As regards the actual cost, there are several elements associated with it.
They are: (i) Invoice cost, (ii) Freight charges and costs of buying, receiving
and storing, and (iii) Discounts-trade/quantity as well as cash.

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 Methods of Inventory
The proper costing of inventory is important from the
point of view of the income determination
and asset measurement. The important
inventory costing methods are:

Weighted
FIFO Method Average Method

Inflated Cost
LIFO Method Method

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 FIFO Method
The FIFO method assumes that the inventory is consumed
in chronological order, that is, items received first are
deemed to have been issued/consumed first
and priced accordingly.

Weighted Average Method

According to the Weighted Average Method, the weighted
average price of purchases and inventory is taken as the
basis for determining the cost of the inventory.

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Table 1 Inventory Valuation (FIFO Method)
Date Receipts Issues Inventory
Quantity Cost Value Quantity Cost Value Quantity Cost Value

(1) (2) (3) (4) (5) (6) (7) (8) (9)

January
1 10,000 Rs 2.10 Rs 21,000
9 1,000 Rs 2.21 Rs 2,210 11,000 — 23,210
12 2,000 Rs 2.10 Rs 4,200 9,000 — 19,010
27 1,000 2.31 2,310 10,000 — 21,320
February
10 4,000 2.10 8,400 6,000 --- 12,920
16 2,000 2.41 4,820 8,000 — 17,740
March
3 2,000 2.41 4,820 10,000 — 22,560
17 4,000 2.10 8,400 6,000 — 14,160
29 4,000 2.29 9,160 10,000 — 23,320
April
4 2,000 2.14 4,280 12,000 — 27,600
18 4,000 @ 9,340 8,000 — 18,260
23 2,000 2.04 4,080 10,000 — 22,340
May
12 1,000 2.40 2,400 9,000 — 19,940
24 3,000 2.00 6,000 12,000 — 25,940
June
10 1,000 2.40 2,400 11,000 — 23,540
30 2,000 2.02 4,040 13,000 — 27,580
Total 19,000 2.19 41,700 16,000 35,140

@ 1,000 2.21 2,210

1,000 2.31 2,310
2,000 2.41 4,820
4,000 — 9,340
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Table 2 Inventory Valuation (Average Cost Method)
Date Receipt Issue Inventory
Quantity Cost* Value Quantity Cost** Value Quantity Cost** Value

(1) (2) (3) (4) (5) (6) (7) (8) (9)

January
1 10,000 Rs 2.10 Rs 21,000
9 1,000 Rs 2.21 Rs 2,210 11,000 2.11 23,210
12 2,000 Rs 2.11 Rs 4,220 9,000 2.11 18,990
27 1,000 2.31 2,310 10,000 2.13 21,300
February
10 4,000 2.13 8,520 6,000 2.13 12,780
16 2,000 2.41 4,820 8,000 2.20 17,600
March
3 2,000 2.40 4,800 10,000 2.24 22,400
17 4,000 2.24 8,960 6,000 2.24 13,440
29 4,000 2.29 9,160 10,000 2.26 22,600
April
4 2,000 2.14 4,280 12,000 2.24 26,880
18 4,000 2.24 8,960 8,000 2.24 17,920
23 2,000 2.04 4,080 10,000 2.20 22,000
May
12 1,000 2.20 2,200 9,000 2.20 19,800
24 3,000 2.00 6,000 12,000 2.15 25,800
June
10 1,000 2.15 2,150 11,000 2.15 23,650
30 2,000 2.02 4,040 13,000 2.13 27,690
Total 19,000 41,700 16,000 35,010

* Actual
** Average
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 LIFO Method
The LIFO method is based on the assumption that the cost of
inventory is computed on the basis of the inverse sequence
of receipts.

Inflated Cost Method

The Inflated Cost Method takes into account normal material
losses caused due to transportation, material handling
and storage losses.

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Table 3 Inventory Valuation (LIFO Method)
Quantity Cost Value
PART A
Straight LIFO:
Inventory (January 1) 10,000 Rs 2.10 — Rs 21,000
Receipts 19,000 — — 41,700
Total 29,000 — — 62,700
Inventory (June 30) 13,000
Inventory (January 1) 10,000 — 2.10 21,000
Receipts (January 9) 1,000 — 2.21 2,210
(January 27) 1,000 — 2.31 2,310
(February 16) 1,000 — 2.41 2,410
13,000 _______ 27,930
Cost of inventory issued 16,000 34,770

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(Contd.)
PART B
Additions at average cost:
Inventory (January 1) 10,000 2,10 21,000
Receipts 19,000 2,19 41,700
Total 29,000 62,700
Inventory (June 30) 13,000
Inventory (January 1) 10,000 — 2.10 21,000
Added Inventory 3,000 — 2,19 6,585
13,000 — 27,585
Cost of inventory issued 16,000 35,115

PART C
Additional at FIFO cost:
Inventory (January 1) — 10,000 2.10 21,000
Receipts — 19,000 — 41,700
Total — 29,000 — 62,700
Inventory (June 30) — 13,000
Inventory (January 1) 10,000 — 2.10 21,000
Receipts (June 30) 2,000 — 2.02 4,040
Receipts (May 24) 1,000 — 2.00 2,000
13,000 — — — 27,040
Cost of inventory issued 16,000 35,660

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Table 4 Inventory Valuation (LIFO Method—6 Years)
Quantity Rate Value
Opening inventory at cost—first year‘ 10,000 Rs 2.10 Rs 21,000
Closing inventory:
First year—opening inventory 10,000 2.10 21,000
First year’s additions 3,000 2.31 6,930
Total 13,000 — 27,930
Second year—first year’s opening 10,000 2.10 21,000
First year’s additions 3,000 2.31 6,930
Second year’s additions 2,000 2.20 4,400
Total 15,000 — 32,330
Third year—first year’s opening 10,000 2.10 21,000
First year’s additions 2,000 2.31 4,620
Total 12,000 — 25,620
Fourth year—first year’s opening 10,000 2.10 21,000
First year’s additions 2,000 2.31 4,620
Fourth year’s additions 1,000 2.50 2,500
Total 13,000 — 28,120
Fifth year—remainder of first year’s opening 9,000 2.10 18,900
Sixth year—remainder of first year’s opening 9,000 2.10 18,900
Sixth year’s additions 1,000 2.60 2,600
Total 10,000 — 21,500

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 Implications of Different Inventory
Valuation Methods
The implication of different inventory costing method
is:
 When prices are stable, all inventory valuation methods
give the same figure of cost,
 When prices are rising, the LIFO produces the highest
cost flow and the lowest inventory,
 When prices are falling, the LIFO method produces the
lowest cost and the highest inventory. The impact of FIFO
is exactly opposite,
 The LIFO and the FIFO methods are extremes and the
weighted average method falls in between.
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Table 5: Impact of Inventory Valuation on Cost Flows/Profits
LIFO with additions at
FIFO Average LIFO Average FIFO
cost
Beginning Rs 21,000 Rs 21,000 Rs 21,000 Rs 21,000 Rs 21,000
inventory
Add: Receipts 41,700 41,700 41,700 41,700 41,700
Total 62,700 62,700 62,700 62,700 62,700
Deduct: Ending 27,560 27,690 27,930 27,585 27,040
inventory
Materials put into 35,140 35,010 34,770 35,115 35,660
process
It is clear from the table that each method produces a different figure for the
transfer of raw materials to work-in-process. Ultimately, when the goods are
sold, the varying methods of inventory valuation will have their impact on cost
of goods sold and, thus, on profits.

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 Just-IN Time
JIT, as an innovative manufacturing system, refers to
acquiring materials and manufacturing goods only as
needed to fill customer orders. Also called lean production
system, it is a demand-pull manufacturing system because
each component in a production line is produced as soon as
and only when needed by the next step in the production
line.

However, it is more than an approach to inventory

management. It is a philosophy of eliminating non-value-
added activities.

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 Financial Benefits

The benefits of JIT are in addition to lower carrying cost of

inventory, improved quality, reduced rework, faster
delivery and so on.

The measures of performance that managers use to evaluate

and control JIT are personal observations, financial,
and non-financial measures.

The effects of JIT on costing system are reduced overheads

and direct tracing of some indirect costs.

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