COST ACCOUNTING

Assignment on
MATERIALS

INTRODUCTION:

The term “materials” denote the commodities or substances supplied to factories

for the sake of converting them into finished goods the term “stores” is often
interchangeably used to denote the materials. However it is used in a broader sense to
include sundry supplies, maintenance, stores, tools and jigs in addiction to raw materials
used in the production process. Sometimes materials are also denoted by the term
“inventory” which is used in the broadest sense. Inventory includes raw materials, semi-
finished goods and finished goods.
The Institute of Charted Accountants of India define inventory as “tangible property help
(i)For sale in the ordinary course of business or
(ii)In the production of sales or
(iii) For consumption in the production of goods or services for sales, including
maintenance supplies and consumables other than machinery spares”

DIRECT AND INDIRECT MATERIALS:

From the cost accounting point of view materials used in a manufacturing organization
may be classified into two types

• Direct Materials

• Indirect Materials

Materials are called Direct Material when the satisfy the following characteristics-

• They are capable of being identify with the finished product

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 • They vary directly with the volume of the finished product.

• They become part and parcel of finished goods

• They are measurable in terms of related production units

• They are significant in amout and determination of the cost of the same is of
practical use for control.

Following are the some of the specific examples of direct materials:

• Jute in manufacturing gunny bags

• Steel in manufacturing cars

• Fruits in manufacturing jams

• Timber in manufacturing furniture

• Turpentine oil in manufacturing paint

• Pollythene granules in manufacturing plastic products

Materials are said to be indirect when a direct relations cannot be establish

between materials used with the specific productions units. Indirect materials are
ancillary to production although some such materials are also used in repairs
department canteen department, office and administration department and selling
and distribution department as no specific production unit consumes them.
Whereas direct materials cost forms part of prime cost, indirect material cost is
treated as part of overheads. Some of the examples of indirect materials are
sewing thread used in dress-making, nails used in the furniture making, glue used
in book building polishing compound used in vessels manufacturing.

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TYPES OF MATERIALS:

The following are some of the important types of materials used in factory:

 RAW MATERIALS:
o These are the basic materials which undergo change during the
manufacturing process so as to become finished goods. Examples of raw
materials are coal, steel, lead, copper, rubber, cotton, wool, timber,
limestone, etc

 COMPONENT PARTS:
o These are the piece parts manufactured from raw so as to assemble them
to get a finished product. Usually of component parts are the finished
products of one industry which become the raw materials of another
industry. Some examples of components parts are collar in dress-making,
tires and tubes in cycle industries, battery cells in transistors.

 EQUIPMENTS AND SPARES:

o This type of stock is usually more important in extractive industries,
public utility undertakings and such other organizations. They include
machines installations, vehicles and other spare parts associated with such
equipments.

 TOOLS:
o These may relate to hand tools such as hammers, screw drivers, etc used
on machines or machine tools such as drills, milling cutters, portable
electric and pneumatic tools.

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 GAUGES:
o Gauges are the materials which are used to measure the dimension of
shapes of materials or components. Examples of gauges used are caliper,
screw gauge common balance, etc

 JIGS AND FIXTURES:

o These are equipments used for handling the materials when they are in the
process of manufacturing, fitting, assembly or other process .They are
mainly used in mass-production factories.

 WORK-IN –PROGRESS:
o Work-in-progress refers to party finished goods and which require further
processing so as to convert them into finished products.

 PRIMARY PACKING MATERIALS:

o Primary packing materials which are used for easy handling of finished
goods such as bottles, tins, polythene bags, etc constitute one of the
important types of material in some factories.

 SCRAPS AND RESIDUES:

o These are the waste, used or surplus materials arising out of the
manufacturing process. Examples of materials falling under this category
are iron filling and other scrap metals, rejected components, sawdust etc

 SUNDRY MATERIALS OR SUPPLIES:

o All other materials which do not fall under any of the above category are
classified as sundry materials are cleaning such as cotton waste, sand
paper, oil, grease, etc.

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PROCUREMENT OF MATERIALS:

The process of purchasing of raw materials involves the following stages.

1. Purchase Requisition
It is an indication to the purchase department to purchase certain material. It is
used either by store keeper or by production department. Following particulars
must appear in the purchase requisition.
i. Material to be purchased: It should be clearly specified. To make it
more specific, in addition to the description of the material required, code
number should also be specified.
ii. When it is required: Unless the material is required for regular
production purposes, purchase requisition should mention the last date by
which the material is required. Ideally the material should be purchased
whenever the market for the same is favourable.
iii. How much to be purchased: purchase requisition should state the
quantity of the material required. Before deciding the quantity of the
material to be purchased, the principle which should be kept in mind, is
that there should not be any overstocking or understocking of materials as
both these situation involves cost.

Overstocking may have following consequences:

o Blocking of working capital.
o Risk of deterioration of quality and obsolescence.
o More storage facilities.
o Additional insurance cost.
o More material handling and upkeeping.
o Risk of breakage or pilferage etc.
Understocking may have following consequences:
o Productions hold ups, resulting into disturbed delivery schedule.
o Frantic eleventh hour purchase which may result into unfavourable prices
and quality.

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 o Payment for idle time to workers.
Before deciding the quantity to be purchased, consideration will have to be given to the
following factors also.
i. Quantity already ordered.
ii. Quantity reserved. There may be the case that a particular quantity, though in
hand, might have been reserved for a particular job which is not available for
other purposes. In such cases, this quantity is such, as if it is not in the stock.
iii. Funds availability- Amounts which are kept aside for drawing up purchase budget
should be considered.
The purchase requisition should be signed by Head of Department drawing the same. A
standard form of Purchase Requisition is shown below:

PURCHASE REQUISITION

To: Purchase Department From:

Department
No.
Date:

Please purchase the material stated below.

Sr. Quantity Quantity on

No. Description Code No. required hand Remarks

Signed by: Shopkeeper Approved by

For the use of Purchase Department only

Name of
Date P.O. No. supplier Delivery date Remarks

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 Signed: Purchase Manager
2. Selection of source of supply
For this purpose, the purchase department may call for the quotations from the
prospective suppliers of certain type of material. In practice, following types of
quotations may be called for:
i. Single tender: It is addressed to only one selected source when there is
only one source of supply available.
ii. Limited tender: It is addressed to only limited number of suppliers
known to be reliable sources on the basis of data maintained by the
purchase department.
iii. Open tender: It is open to all who can supply specific quality and
quantity of the required material. Tenders are called by giving
advertisements in the newspapers, journals etc.
iv. Global tender: Anybody from any part of the world can respond to these
tenders.
To discourage unreliable and unwanted sources from quoting, some tender deposit may
be insisted upon.
Comparative Statements:
After receiving the tenders as stated above, a comparison has to be made among various
available sources so that the best possible source can be selected. All the offers are
tabulated in a comparative statement. The authority which is authorized to accept the
order should be specified. The criteria for selecting the final source of supply, may
depend upon the terms of offer which can be compared in respect of price offered,
quality, other terms(like sales tax, octroi, freight etc.), terms of delivery, terms of
payment, guarantee offered by the supplier, goodwill of the supplier etc. Lowest
quotation may not be the best option.

3. Purchase order

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 The contractual obligation between the supplier and purchaser starts from
purchase order. It is drawn in favour of the supplier by the purchase department. It
may specify a number of facts.

o Material to be supplied.

o Quantity to be supplied.

o Price and other terms.

o Cash and trade discounts.

o Instructions in respect of delivery.

o Guarantee clause.

o Liquidity damages clause.

o Escalation clause.
o Inspection clause.
o Method of settlement of dispute.
o Details in respect of letters of credit, import license etc.
o Details in respect of interest payable in the event of late payment of dues.
Ideally, purchase order should be serially numbered. Normally, four or five copies of
purchase orders are drawn, to be distributed as below:
o One to Supplier
o One to User Department
o One to Store Department
o One to Accounts/Costing Department
o One with Purchase Department

A standard form of Purchase Order is as shown below:

PURCHASE ORDER

No.
Date:
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 Requisition No.
Date:

Please supply the following material on such terms and conditions

Code Rate Value Delivery

Description No. Quantity Rs. Rs Date Remarks

Delivery: Goods to be delivered at-

Extra as applicable
Excise Duty
Sales Tax
Packing charges
Insurance
Terms of payment

For___________(Purchasing Company)

Purchase Manager

4. Receipt and inspection

After material is received from the supplier, the quantity received actually is
compared with quantity ordered, variations if any, are taken up with the supplier
again. Excess material received may be dealt with in any of the following ways:
o Accept all the material received.
o Accept the material ordered and return the excess to the supplier.
Before accepting, material may be subjected to inspection. The extension may
vary from material to material.

5. Checking invoice and accounting for purchase

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 The suppliers invoice received for the supply of material is subjected to scrutiny
before the voucher is passed for the same for making the entry in the books of
accounts. For this purpose, the suppliers invoice may be compared alongwith the
following documents:
o Purchase order
o Goods received note
o Inspection report
If the quantity and/or rate as per purchase order and invoice match with each
other, the invoice of the suppliers is passed for making the entry in the books of
accounts. If the quantity and/or rate as per purchase order and invoice differ from
each other, the difference is adjusted by raising a debit or credit note in favour of
the supplier.

ORGANISATION OF PURCHASE DEPARTMENT:

The organisation of purchase department depends upon the size, the relative
importance of procurement, the availability of personal and the management policy. The
purchase function is common for all factories irrespective of the size. But in a large size
factory, it is under the control of a chief purchase manager who is assisted by assistant
purchase officers. In small factories all the purchase functions are performed by a single
individual.

1) Centralisation of purchases:

It refers to purchase of materials less than one purchase department. If the

firm has one plant, then it has to follow centralization of purchases. When firm
have many plants certain factors are to be considered before centralizing the
purchases. These factors are geographical location of plants, similarity of products
manufactured, type of materials, the quantity of materials, and the location of
suppliers. According to national association of purchasing management a firm
having several plants in the same country manufacturing similar products
requiring the same general types of materials should have centralized purchasing.

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Advantages of centralised purchasing:

a) The purchase manager can be solely held responsible for inefficient

purchasing.

b) It results in economy of purchase record.

c) Bulk purchasing results in reduced price of materials on account of trade

discount, cash discount facilities.

Disadvantages of centralized purchasing:

a) Emergency purchases cannot be made under this system

b) Delay in receiving, checking and approving the invoices as central purchasing

office has to receive all the reports and invoices from all the plants.

c) This system of purchases leads to communication difficulties between

centralized purchasing office and the plants.

2) Decentralised purchases:

Under this system a separate purchase department is established to make

purchase independently. It is applicable only for those manufacturing concern
which operates several plants in different localities manufacturing different
products and each plant requiring different types of materials. Each purchase
department will have a purchase authority who enjoys the freedom of making
purchases of materials required for his department.

Advantages of decentralized purchases:

a) Greater flexibility- If a centralized buyer is purchasing for a number of plants he

will find it difficult to react rapidly changes in the requirements of individual
plant. But under decentralization system, the buyer can buy the required quantity
and quality and at the time when material required.
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 b) Quick procurement of materials- the delay involved in centralized purchasing
system where in pooling all the purchase requisition and placing the order and the
supply of materials to each and every plant is avoided under this system.

3) Centralised - Decentralised system-

Firm which have more than one plant located in and around, adopt this system of
purchasing. Though such plants produced different products there are some materials
which are common to all plants. Under such circumstances it is desirable to partially
centralize and partially decentralize the purchase function. Under this system, it is
necessary to make clear that which type of material are to be bought by the centralized
buying officer and which type of material by departmental officer.

For the successful operation of this system of buying, the following requirements are
essential:

a) The centralized purchase manager has to establish policies, procedures, record

keeping method and exercise central control and restrict the authority and range of
buying by each decentralized purchase officer.

b) All decentralized purchases must be reported immediately to the central office.

c) Approval of the central office must be obtained by the decentralized buying

officer for special and excess quantity purchases.

d) The plan should be kept flexible so that specific buying authorities can be
reassigned as conditions change.

RECORDING THE MATERIAL COST:

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 The transactions that deal with material may be classified as buying it, receiving
it, storing it, putting it into operation, tracing it, and re-storing it as part-finished or
finished stock. Part-finished stock includes all parts of the product made in different parts
of the plant and transferred either to stock or to an assembling department.
Any product, on which the operating processes have begun but are not yet finished, is
termed work in process, except where part-finished stock is transferred from Work in
Process account to Part-Finished Stock account.
The forms, upon which information about material is ordinarily recorded, are:
(1) Purchase Requisition
(2) Purchase Order
(3) Material Received Sheet
(4) Stock Record—Raw Material
(5) Production or Factory Order
(6) Material Requisition or Bill of Material
(7) Inventory Test
(1) Purchase Requisition:
A "Purchase Requisition" is a request for the purchase of raw material or supplies, made
out preferably by the stores clerk, but sometimes by the superintendent, or the man in
charge of the department requiring the material or supplies. Every factory should
determine standard maximum and minimum amounts of raw stock and supplies to be
carried, below which it is not safe to go on account of the risk of delay in filling orders,
and above which it is inadvisable to go on account of the capital that would be tied up.

(2) Purchase Order:

The filing of catalogues and quotations is a matter of Bce organization, and only the
purchase order concerns the cost clerk. The form is made out in duplicate, or in as many
more copies as desired. The original copy goes to the selling firm, and the duplicate is
kept by the purchasing concern on the file of unfilled orders. The purchase order is given
a serial number, which should be entered by the selling firm on its invoice, as a means of
simplifying reference to the order if any question arises.

(3) Material Received Sheet:

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Where it is not advisable to use a copy of the purchase order as a material received
record, a distinct and separate form is used. The choice of forms for this purpose will
depend largely upon whether charges consisting of freight, drayage, etc., on raw material
received are to be added to the material cost. If this is not the case, a very simple form
will answer the purpose; but if such charges are included, the design will depend largely
on the class of product received and the distribution of the charges.

(4) Stock Record—Raw Material:

The "Stock Record" is one of the most important of the factory records. It bears the same
relation to stock that the cash book does to money, and should be kept with just as much
care as the cash book. Stock represents money, and is, indeed, only another form of it. In
the same way that the cash book shows the receipt and disbursement of money and the
balance on hand, the stock record shows the material received, material delivered, and
what should be in the storeroom.
(5) Production or Factory Order:
The importance of the production order depends on the functions it is designed to
perform. In practice it ranges from a mere informal notice to begin operations upon a
certain class of work up to a complete controlling and cost-finding agent of a special
order. Its primary purpose is to substitute written for verbal instructions, so as to avoid
mistakes. Besides this, it may be so designed as to describe the order, state the material,
patterns and dies needed, plan the work as to time and department, trace the work at any
stage, report the actual production and classify it as good or defective, collect the costs as
they are incurred, and also show their distribution. It is not recommended, however, that
the form be used for all these purposes, except under certain conditions in a special order
system.

(6) Material Requisition or Bill of Material:

A "Material Requisition" is generally used where the material consumed on orders is
subject to constant changes. It is made out by the department requiring the stock, and
presented to the stock clerk, who may compare the requisition with the corresponding
production order before honoring it. The requisition should be dated and numbered,

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should show in detail the description and quantity of the material wanted, should be
signed by the party receiving the material, and approved by some one in authority.

(7) Inventory Test:

This form is intended only for testing the correctness of the book inventory, i. c, the stock
record, and may be used in connection with raw material, part-finished and finished
stock, and sometimes with goods in process of manufacture, depending upon the system
in use. Where inventories are not taken at frequent intervals, some means of testing the
correctness of the book inventory should be provided. The reliability of cost figures
depends to a great extent upon the correctness of the records showing the quantity of
stock received and delivered to the operating departments of the factory.

ORDER QUANTITY PROBLEM:

Economic Order Quantity (EOQ):

While purchasing raw materials or finish goods, the questions to be addressed are;
how much inventory should be bought in one lot under on each replenishment? Should
the quantity to be purchased be large or small? Or, should the requirement of material
during a given period of time be acquired in installment or in several small lots? Such
inventory problems are called order quantity problems.

The determination of the appropriate quantity to be purchased in each lot to replenish

stock as a solution to the order quantity problem necessitates resolution of conflicting
goals. Buying in large quantities implies a high average inventories level which will
assure

1) Smooth production / sale operations and

2) Lower ordering or set-up cost

But it will involve higher carrying cost. On the other hand, small orders would increase
as there is a likelihood of interruption in the ope3ration due to stock-outs. A firm should

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place neither too large nor too small orders. The optimum level of inventory is popularly
referred to as the Economic Order Quantity (EOQ). It is also known as the economic
lot size. The economic order quantity may be defined as that level of inventory order that
minimises the total cost associated with inventory management. EOQ refers to the level
of inventory at which the total cost of inventory comprising acquisition / ordering / set-up
costs and carrying cost is minimal.

Assumption:

The EOQ model, as the technique to determine the EOQ, illustrated by us, is based on
three restrictive assumptions:

1) The firm knows with certainty the annual usage (consumption) of a particular
item of inventory.

2) The rate at which the firm uses inventory is steady over time.

3) The orders placed to replenish inventory stocks are received at exactly that point
in time when inventories reach zero.

In addition, it may also be assumed that ordering and carrying costs are constant over the
range of possible inventory levels being considered.

Approaches:

The EOQ model can be illustrated by (i) The long analytical approach or trial and error
approach, and (ii) the short cut or simple mathematical approach.

Trial and Error (Analytical) Approach:

Given the total requirement of inventory during a given period of time depending
upon the inventory planning horizon, a firm has different alternative to purchase its
inventories. For instance it can buy entire requirement in a one single lot at the beginning
of inventory planning period. Alternatively, the inventories may be procured in small lots
periodically, say, weekly, monthly, quarterly, six-monthly and so on. If the purchases are
made in one lot, the average inventory holding would be relatively small when the
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acquisition of inventory is in small lots; the smaller the lot, the lower is average inventory
and vice-versa. According to this approach, the carrying and acquisition costs for
different sizes of order to purchase inventories are computed and the order size with the
lowest total cost of inventory is EOQ. The mechanics of computation of EOQ with the
analytical approach is illustrated in below mentioned example.

Example : A firms inventory planning period is one year. Its inventory requirement for
this period is 1600 units. Assume that its acquisition cost is Rs. 50 per order. The
carrying cost are expected to be Rs. 1 per unit per year for any item.

The firm can procure inventory inventories in various lots as follows: (1) 1600units
(2)800units (3) 400 units (4) 200 units (5) 100 units. Which of this quantity is EOQ?

Inventory cost for different order Quantities

1. Size of order (Units) 1600 800 400 200 100

2. No. of orders 1 2 4 8 16
3. Cost per order (Rs.) 50 50 50 50 50
4. Total order cost 2x3 (Rs.) 50 100 200 400 800
5. Carrying cost per unit (Rs.) 1 1 1 1 1
6. Average inventory (Units) 800 400 200 100 50
7. Total carrying cost 5x6 (Rs.) 800 400 200 100 50
8. Total cost 4x7 (Rs.) 850 500 400 500 850

From the above mentioned table, it can be seen that Total cost is lowest for the order size
of 400 units. This, therefore, is the EOQ.

Working note:

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 1) Number of orders = total inventory requirement/order size.

2) Average inventory = order size / 2.

TECHNIQUES OF INVENTORY CONTROL:

1. Fixation of Inventory Levels: -

Fixation of various inventory levels facilitates initiating of proper action in
respect of the movement of various materials in time so that the various materials
may be controlled in a proper way.

(1)Only the fixation of inventory levels does not facilitate the inventory control.
There has to be a constant watch on the actual stock level of various kinds of
materials so that proper action can be taken in time.

(2) The various levels fixed are not fixed on a permanent basis and are subject to
revision regularly.

The various levels which can be fixed are as below.

(1) Maximum Level :

It indicates the level above which the actual stock should not exceed. If it exceeds,
it may involve unnecessary blocking of funds in inventory. Following factors are
considered while fixing this level:
(i) Maximum usage
(ii) Lead time
(iii) Storage facilities available cost of storage and insurance etc.
(iv) Prices for the material
(v) Availability of funds

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 (vi) Nature of material e.g. If a certain type of material is subject to
Government regulations in respect of import of goods etc. maximum level
may be fixed at a higher level.
(vii) Economic Order Quantity.

(2) Minimum Level:

It indicates the level below which the actual stock should not reduce. If it reduces,
it may involve the risk of non-availability of material whenever it is required.
While fixing this level, following factors are considered
(j) Lead time
(ii) Rate of consumption.

(3) Re-order Level:

It indicates that level of material stock at which it is necessary to take the steps for
procurement of further lots of material. This is the level falling in between the two
extremes of maximum level and minimum level and is fixed in such a way that
the requirements of production are met properly till the new lot of material is
received.

(4) Danger level:

This is the level fixed below minimum level. If the stock reaches it is level, it
indicates the need to take urgent action in respect of getting the supply. At this
stage, the company may not be able to make the purchases in a systematic manner
but may have to make rush purchases which may involve higher purchases cost.

• Calculation of various levels:

The various levels can be decided by using the following mathematical
expressions.

1) Re Order level:
Maximum Lead Time * Maximum Usage.

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2) Maximum Level:
Reorder Level + Reorder Quantity - (Minimum Usage * Minimum Lead Time)

3) Minimum Level:
Reorder Level - (Normal Usage * Normal Lead Time.)
4) Average Level:
(Maximum Level + Minimum Level)/2

5) Danger Level:
Normal Usage * Leadtime for emergency purchases.

Example:

Two components X and Y are used as follows:

Normal Usage – 50 units per week each

Minimum usage – 20 units per week each

Maximum usage – 75 units per week each

Reorder quantity – X – 400 units, Y- 600 units

Reorder period – X – 4 to 6 weeks, Y- 2 to 4 weeks

Calculate for each component:
a. Reorder level
b. Minimum level
c. Maximum level
d. Average stock level

Solution:
1) Re Order level:
Maximum Lead Time * Maximum Usage.
X= 6 weeks * 75 units = 450 units
Y= 4 weeks * 75 units = 300 units

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 2) Minimum Level:
Reorder Level - (Normal Usage * Normal Lead Time.)
X= 450 units – (50 units * 5 weeks) = 200 units
Y= 300 units – (50 units * 3 weeks) = 150 units

3) Maximum Level:
Reorder Level + Reorder Quantity - (Minimum Usage * Minimum Lead Time)

X= 450 units + 400 units - (25 units * 4 weeks) = 750 units

Y= 300 units + 600 units – (25 units * 2 weeks) = 850 unit
4) Average Level:

(Maximum Level + Minimum Level)/2

X= (200 units + 750 units)/2 = 475 units

Y= (150 units + 850 units)/2 = 500 units

2. ABC analysis:

ABC Analysis is analysis of a range of items which have different levels of significance
and should be handled or controlled differently. It is a form of Pareto analysis in which
the items (such as activities, customers, documents, inventory items, sales territories) are
grouped into three categories (A, B, and C) in order of their estimated importance.

ABC analysis is a business term used to define an inventory categorization technique

often used in materials management. It is also known as Selective Inventory Control.

ABC analysis provides a mechanism for identifying items that will have a significant
impact on overall inventory cost, while also providing a mechanism for identifying
different categories of stock that will require different management and controls.

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 When carrying out an ABC analysis, inventory items are valued (item cost multiplied by
quantity issued/consumed in period) with the results then ranked. The results are then
grouped typically into three bands. These bands are called ABC codes.

ABC codes:-

1. "A class" inventory will typically contain items that account for 80% of total
value, or 20% of total items.
2. "B class" inventory will have around 15% of total value, or 30% of total items.
3. "C class" inventory will account for the remaining 5%, or 50% of total items.

ABC Analysis is similar to the Pareto principle in that the "A class" group will
typically account for a large proportion of the overall value but a small percentage of the
overall volume of inventory.

Another recommended breakdown of ABC classes:

1. "A" approximately 10% of items or 66.6% of value

2. "B" approximately 20% of items or 23.3% of value
3. "C" approximately 70% of items or 10.1% of value

Kanban:

Kanban is a Japanese term which means display on instruction card. In a manufacturing

or factory organisation, kanban contains many information such as reorder point, lead
time, delivery location, source of supply, part number, quantity of parts that should be
possessed etc. it is a system of markers which authorizes production and movement to the
process which requires the parts.

Business firms can use kanban or any other similer technique as a production control
tool. The employees in the production department manufacture parts as per the details
mentioned on the kanban which is used like production card. If in a factory, there is no
Kanban card, production may not be done and transfer of materials may not take place.

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Kanban is highly useful if used with JIT. The JIT pull system means that components are
not made until requested by the next process. This is normally done by monitoring parts
consumption at each stage and using a system of Kanban. Kanban, therefore, will reduce
inventory, decrease lead or supply time and finally will increase productivity through
integrating different processes.

3. Just-in-time:

Just-in-time (JIT) is a purchasing and inventory control method in which

materials are obtained just in time for production to provide finished goods just in time
for sale. A just-in-time manufacturing system requires making goods or service only
when the customer, internal or external, requires it. JIT requires better coordination with
suppliers so that materials arrive immediately prior to their use. JIT reduces or eliminates
inventory and the costs associated with carrying the inventory. JIT emphasizes that
workers immediately correct the system making defective units because they have no
inventory. With no inventory to draw from for delivery to customers, just-in-time relies
on high quality materials and production. It is required that the companies that use just-
in-time manufacturing must eliminate all the sources of failure in the system. Production
people must be better trained so that they can carry out their works without errors.
Suppliers must be able to produce and deliver defect free materials or components just
when they are required, and equipment must be maintained so that machine failures are
eliminated.

JIT applies to raw materials inventory as well as to work-in-process inventory.

The goals are that both raw materials and work in process inventory are held to absolute
minimums. In JIT system, production of an item does not commence until the
organisation receives an order. When an order is received for a finished product,
production people give orders for raw materials. As soon as production completes to fill
the order, production ends. Companies using just in time inventory generally have a
backlog of orders or stable demand for their products to assure continued production.

The fundamental objective of JIT is to produce and deliver what is needed, when it
is needed, at all stages of production process, just in time to be fabricated sub-assembled,
assembled, and dispatched to the customer. The benefits are low inventory, high
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manufacturing cycle rates, high output per employee, minimum floor space requirements,
minimum indirect labour, and perfect in-process control. And associated requirement of a
successful JIT operation is pursuit of perfect quality in order to reduce, to an absolute
minimum, delays caused by defective product units.

ACCOUNTING FOR MATERIAL LOSSES:

Some materials losses are bound to occur during manufacturing operations because of the
nature of the raw materials or other factors which reduce the expected production. These
losses may be, scrap, spoilage, wastage.

Scrap:

Scrap is residue from manufacturing operations that has measurable but relatively minor
recovery value. Scrap is saleable material from the primary manufacturing operations.

Scrap results from

1) The processing of materials,

2) Defective and broken parts,

3) Obsolete stock, revisions or abandonment of experimental projects and scrapping

of worn out or obsolete machinery.

In some cases scrap can be sold and should therefore be collected and placed in storage
so that it can be sold to scrap dealers. Scrap should be accounted for in some manner not
only from the point of view of efficiency, but because scrap is often a tempting source of
theft.

Scrap report:

It is advisable to prepare a daily, weekly, scrap report to account for scrap and to compare
it with predetermined norms or standards which, in turns, can reveal unexpected items
and usual amounts.

Spoilage:

Spoilage can be defined as the materials which in process of manufacture are badly
damage or have developed some imperfection which cannot economically be corrected,
and thus the goods ought to be sold as seconds. Spoiled units fail to rich the required

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standard of quality specification. The cost of spoiled goods may be treated by either of
the following methods.

1) The loss due to spoilage may be charged to be specific product or job on which
the spoilage occurred. If it is clearly traceable to the work done on that order.

2) The normal spoilage loss may be charged to factory overhead and thus spread
over the cost of all jobs/products.

3) The cost of abnormal spoilage is transferred to the costing profit and loss account.
Abnormal loss is unexpected and should have been avoided by management. It is
considered controllable by management.

Spoilage Report:

A spoilage report should be prepared detailing the spoiled units and cost of spoiled units.
To control spoilage, allowance for a normal spoilage should be determined in advance
and actual spoilage should be compared with the standard (allowed) spoilage. A spoilage
report may enable managements to provide overall control over the spoilage costs. If all
or many departments are involved, spoilage costs are then treated as factory overhead.
Sometimes spoilage can be controlled by the individual machine operators. This requires
daily or weekly spoilage reports which can reveal the spoiled work occurred, for its
occurrence and the cost of correcting the defects.

Wastage:

The terms “Spoilage” and “Wastage” are sometimes used synonymously. However,
wastage generally refers to the portion of raw material which is lost in storing, handling
and in manufacturing processes. It does not possess any recovery or realizable value.
Wastage for the purpose of accounting treatment is classified in two categories.

1) Normal waste

2) Abnormal waste

1) Normal waste is expected (unavoidable) and uncontrollable. It is treated as a part

of the cost of the product, that is, the cost of normal waste unit is borne by good
remaining units.

2) Abnormal waste is unexpected (avoidable) and controllable. It is valued like

good output. Its cost is transferred to the costing profit and loss account. In case
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 of normal waste cost per unit of finished output is relatively inflated. But in
abnormal waste, cost per unit remains the same for abnormal units as well as
good finished units.

COST PRICE METHODS:

1. FIRST-IN, FIRST-OUT (FIFO):

The FIFO method follows the principle that materials received first are issued first.
After the first lot or bunch of materials purchased is exhausted, the next lot is taken up for
supply. It does not suggest however, that the same lot will be issued from stores.
Sometimes, all materials are tagged with their arrival late and issued in date order
especially with stocks that deteriorate. The inventory is priced at the latest costs.

ADVANTAGES:

A good system of inventory management requires that oldest units should be sold or
used first and inventory should consist of the latest purchases. This is found in the FIFO
method of costing. Under the FIFO method, management has little or no control over the
selection of units in order to influence recorded profits. Valuation of inventory and cost
of goods manufactured are consistent and realistic. Besides, the FIFO method is easy to
understand and operate.

DISADVANTAGES:

The objective of matching current cost with current revenues is not achieved under
the FIFO method. If the prices of materials are rising rapidly, the current production cost
may be understated. If the sale price is fixed, the then sales revenue may not produce
enough income to cover the purchase of raw materials. The valuation of inventory in
terms of current cost depends on frequency of price changes and the stock turnover. In
case stock turnover rapidly, the inventory valuations will reflect current prices. There are
other limitations under the FIFO method. FIFO costing is improper if many lots are
purchased during the period at different prices. This method overstates profit especially
with high inflation. It does not consider the cost of replacing used materials, a situation
created by high inflation.
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 The FIFO method is suitable where (i) the size of cost materials units are large, (ii)
materials are easily identified as belonging to a particular purchased lot, and (iii) not
more than two or three different receipts of the materials are on hand at one time.

2. LAST-IN, FIRST OUT (LIFO):

The LIFO method of costing and inventory valuation is based on the principle that
materials entering production are the most recently purchased. The method assumes that
the most recent cost, generally the replacement cost is the most significant in matching
cost with revenue in the income determination. The cost of the last lot of materials
received is used to price materials issued until the lot is exhausted, then the next lot
pricing is used, and so on through successive lots. The inventory is priced at the oldest
costs.

Advantages:

1. It provides a better matching of current costs with current revenues.

2. It results in real income in times of rising prices, by marinating net income at a
lower level than other costing method.
3. In industries subject to sharp materials price fluctuations, the method minimizes
unrealized inventory gains and losses and tends to stabilize reported operating
profits. Income is reported only when it is available for distribution as dividends
or for other purposes.
4. Probably the most important argument in favour of LIFO is its role in tax saving.
It is generally considered a cheap form of tax avoidance by business firms. By
valuing inventory at beginning-of-period prices and calculating cost of sales at the
current prices, the firm creates secret reserves which are not taxed. As long as
prices and inventory levels do not decline, this benefit remains and in this case the
tax saving is permanent. However, if the tax rates go up in the meantime, the so-
called tax saving will be eliminated by higher tax rates.
5. LIFO produces an income statement which shows correct profit or losses and
financial position. It correlates current cost and sales, and income statements
show the result of operation, excluding profits or losses due to changing price
levels.

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Disadvantages:

The following are the limitations of the LIFO method of costing:

1. Inventory valuations do not reflect the current prices and therefore are useless in
the context of current conditions.
2. The argument that LIFO should be used for matching current costs with current
revenue is not sound. The most recent purchase costs are matched against the
revenues of the current period. However, unless both purchases and sales occur
regularly in even quantities, the revenues will not be matched with the current
costs at the time of sale. When purchases are irregular and unrelated to the timing
of sales, the matching is illogical and unsystematic, particularly if prices and costs
are changing rapidly.
3. The profit of a firm can be manipulated with the LIFO method in operation. By
timing purchases, a company can cause higher or lower costs to flow into the
income statement, thus increasing or decreasing reported net income at will.
4. Another limitation which also results from LIFO’s lowering of the earnings figure
is the effect it will have on existing bonus and profit sharing plans. Employees and
managers who are interested in the growth of these plans may have difficulty in
understanding a drop in the benefits which were created wholly or partially by an
accounting change.
During a period of rising costs, LIFO produces the desirable effect of reducing
taxable income and tax liability; thereby conserving cash. On the other hand, it also
affects he profit reported in the financial statements.

Example:

Prepare a stores ledger account from the following transactions under the LIFO method.

Jan.
1 Received 1,000 units @ Re.1.00 per unit
10 Received 260 units @ Rs.1.05 per unit
20 Issued 700 units
Feb.
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 4 Received 400 units @ Rs. 1.15 per unit
21 Received 300 units @ Rs. 1.25 per unit
March
16 Issued 620 units
April
12 Issued 240 units
May
10 Received 500 units @ Rs. 1.10 per unit
25 Issued 380 units

Solution: Stores Ledger Account (LIFO)

Receipt Issue Stocks

Date Qty Rate Amt Qty Rate Amt Qty Rate Amt
1 2 3 4 5 6 7 8 9 10
January
1 1,000 1.00 1,000 -- -- -- 1,000 1.00 1,000
10 260 1.05 273 -- -- -- 1,260 1,273
20 -- -- -- 260 1.05 273 560 560
440 1.00 440
February
4 400 1.15 460 -- -- -- 960 1,020
21 300 1.25 375 -- -- -- 1,260 1,395
March
16 -- -- -- 300 1.25 375 640 652
320 1.15 368
April
12 -- -- -- 80 1.15 92 400 400
160 1.00 160
May
10 500 1.10 550 -- -- -- 900 950
25 -- -- -- 380 1.10 418 520 532

The Closing stock consists of

120 units at Rs 1.10 = 132
400units at Re 1.oo = 400
----------------
Rs.532

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 ----------------

3. Highest–In–First–Out (HIFO):

An inventory distribution method in which the inventory with the highest cost of
purchase is the first to be used or taken out of stock .This is a variation to LIFO method
and gives similar results as in the case of LIFO during the period of continuous rising
prices. The purpose of this method is to charge with the highest rate of materials to the
current cost of production.

HIFO is considered by some to be an example of financial engineering and usually

results in lower taxes than FIFO making it a preferable choice. A corporation that uses
HIFO must use it consistently. The HIFO method may accelerate reportable capital losses
because the lot with the highest cost basis is sold first. Similarly HIFO can defer realized
capital gains.
The impact of this method over cost of production is that cost is overstated.
On profit, its impact is understatement of profit.
On valuation of closing stock its impact is understatement of the value of stock and
hidden reserve is created in the valuation of stock.

An example of how it works:

Let's say ABC TV has 100 LCD TVs in stock that it bought for a 1,000 a piece and
has just bought 100 new ones for 600 a piece. Under HIFO the first 100 TVs, ABC TV
sells will be valued at the COGS of 1,000 whether ABC sells from the first batch or the
second. The remainder is put on its balance sheet as their cheapest merchandise's
purchase price (600).
But if ABC sales were actually like this...100 units sold total consisting of 20 old tvs , 80
new tvs. ABC Tv's real life cost of goods sold obviously would not be a 1,000 a piece (as
LIFO it must be) since 80% of its sales were of inventory that cost 600 .ABC’s net
income as a result looks much much smaller than it actually is and he pays less taxes as a
result. That's good for business but can be deceptive to shareholders especially those who

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don't do their due diligence. This can lead to negative future earning shocks if managed
improperly.

AVERAGE PRICE METHOD:

1. Simple Average:

This method is based on the principle that materials issued should be priced on an
average price and not on exact cost price. The simple average is an average of prices
without having regard to the quantities involved. It should be used when prices do not
fluctuate very much and the stock value is small. The average under this method is
calculated by dividing the total of rates of materials in the storeroom by the number of
rates of prices. This method is easy to operate.

2. Weighted Average:

Under this method, issue of materials is priced at the average cost price of the
materials in hand, a new average being computed whenever materials are received. In this
method, total quantities and total costs are considered while computing the average price
and not the total of rates divided by total number of rates as in simple average. The
weighted average is calculated each time a purchase is made. The quantity bought is
added to the stock in hand, and the revised balance is then divided into the new cash
value of the stock. The effect of early price is thus eliminated. This method avoids
fluctuations in price and reduces the number of calculations to be made, as each issue is
charged at the same price until a fresh purchase necessitates the computation of a new
average. It gives an acceptable figure for stock values.

ADVANTAGES:

1. The method is logical and consistent as it absorbs cost while determining the average
for pricing material issues.

2. The changes in the prices of materials do not much affect the materials issues and
stock.

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3. The method follows the concept of total stock and total valuation.

4. Both cost of materials issued and in stock tend to reflect actual costs.

DISADVANTAGES:

However, the weighted average method also has the following disadvantages

1. Simplicity and convenience are lost when there is too much change in the prices of
materials.

2. An average price is not based on actual price incurred, and therefore is not realistic. It
follows only arithmetical convenience.

E. g: Prepare a store ledger account following the weighted average method.

Receipts Issue Stocks

Qty Rate Amt Qty Rate Amt Qty Rate Amt
Date
2002
Jan.1 500 20 10,000 - - - 500 20 10,000
Jan.10 300 24 7,200 - - - 800 21.50 17,200
Jan.15 - - - 700 21.5 15,050 100 2,150
0
Jan.20 400 28 11,200 - - - 500 26.70 13,350
Jan.25 - - - 300 26.5 8,010 200 5,340
0
Jan.27 500 22 11,000 - - - 700 23.34 16,340
Jan.31 - - - 20 23.3 4,668 500 11,672
0 4

3. Periodic Simple Average

In cost accounting, where job costs may be prepared infrequently, any monthly, or
bimonthly, it may be necessary to price materials issued by taking the average price
ruling during that period. If it is calculated monthly, the average of the unit prices of all
the receipts during the month is adopted as the rate for pricing issues during the month.

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Only a simple calculation has to be done at the end of the accounting period. The opening
stock is not considered for computing periodic simple average because it has not been
purchased during the current period and would have been included in the previous year's
calculations. However, purchases made during the current year and closing stock are
taken rate account while computing this average. Basically, this method fellow the
principle of simple average price, but a period is set for which the average is calculated.

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