Introduction to Cost

Accounting (ACC116)

CHAPTER 2
MATERIALS
 Definition
Materials are basic raw materials and parts that
have been purchased and are available for
conversion into finished goods.
 Classification of Materials
Raw materials must be available and must be acquired before production can begin
Have to be ordered, received, stored, issued and controlled continuously
Materials are classified as direct materials or indirect materials:

Direct Materials Indirect Materials

Materials which are directly involved in Materials which are not involved directly
producing the finished goods in producing the finished goods, but
needed to looks perfect, nice and ready
for sales
Example: Cake -> Flour Example: Cake -> hand gloves for making
cake, box, candles
 WHY WE NEED MATERIALS
CONTROL FOR OUR BUSINESS?

• Large sum of money invested in

acquiring materials.
• To ensure that material of the right
quality are purchased in the right
quantity, at the right time & at the
right price.

EFFECT INEFFICIENT
MATERIALS CONTROL
• Waste due to theft, obsolescence
• Production delays & others.
Material management
 Efficient purchasing
M  Control of material quality Saving in
A  Effective stores control material
T  Determining appropriate issue
E price
R  Timely report Reduction in
 Keeping records and systematic cost
I
accounting
A  Reducing loss of material
L  Applying cost management Increase in
techniques – JIT etc. profit
Materials Purchasing Procedure
Sources of demand: storekeeper, departmental heads

Request for material on purchase requisition

Selection of supplier by purchasing department

Despatch of purchase order to supplier

Receipt of goods and invoice by receiving department

Material checked and inspected and goods received notes (GRN) prepared

Material and GRN sent to store. Invoice, GRN and inspection report sent to
purchasing department

Materials checked against GRN by storekeeper

Invoice checked by purchasing department against purchase order, GRN and
inspection report
Invoice signed by buyer and sent to accounts department

Payments made by accounts department

 Material Control system
⚫ It is a system to determine the reorder level and the maximum or minimum
quantity to store.
⚫ Avoid overstocking and understocking
⚫ How much a storekeeper will request will depend on the following levels:-

i. Reorder Stock Level

ii. Minimum Stock Level
iii. Maximum Stock Level
iv. Average Stock Level
Objectives of Material Control system
 AVAILABILITY OF MATERIALS : There should be availability of all types of materials in the
factory so that the production may not held up for the want of materials.

 NO EXCESSIVE INVESTMENT IN MATERIALS : There should not be excessive investment in

materials. Overstocking must be avoided. Investment must not tied up funds that could be
better used in other activities.

 REASONABLE PRICE : while purchasing it is seen that it is purchased at low prices. But
quality should not be sacrificed at the cost of lower price. Choose suppliers that offer an
appropriate balance between quality, price and delivery
 MINIMUM WASTAGE : There should be minimum possible wastage of materials while these
are being stored in warehouse or used in factory. It should be allowed up to certain level
known as normal wastage.

 NO RISK OF SPOILAGE OR OBSOLESCENCE : In order to avoid spoilage or obsolescence ,

maximum quantity of each material is determined and proper method of issue of materials is
followed.
 READY INFORMATION ABOUT AVAILABILITY OF MATERIAL : The shopkeeper can supply
the information because he keeps an up to date record of every item of stocks under a
proper system of material control

 AVOID MISAPPROPRIATION OF MATERIAL : Material can easily be misappropriated by

employees. Therefore, this requires an internal check on materials which is a part of
material control.

 RIGHT AMOUNT OF PAYMENT TO SUPPLIERS : Invoices received from supplies should be

approved for payment only if items of materials ordered have been received and properly
checked to avoid excess payment to supplies.

 The control of material is very important because investment in materials are high: 
 To reduce costs
 To avoid wastage
Material Control system, con’t..
How to proper control the material?

◦ Authorization and approval from the top management.

◦ Capable suppliers -> high quality, reasonable price and
quick delivery.
◦ Proper inspection-check quality and specifications
◦ Proper storage.
◦ Proper documentation and accounting system.
◦ Proper stock management
Inventory Order Cycle

Order received Order received

Reorder level :the amount at which new stock is ordered. 300 items are ordered and it takes two weeks lead
time for ordered stock to arrive. There is always a buffer stock of 100 items held just in case deliveries
are held up or there is an unexpected large order.

Maximum stock level : the largest amount of items to be stored on site (500).

Minimum stock level : the lowest amount of items to be stored on site (100).
 Reorder level
The level between the maximum & minimum stock levels. At this level a
request for new supplies will be made.

The level is fixed after considering:-

◦ The rate of consumption;
◦ The time required to obtain new supplies; and
◦ The minimum level.

Formula:

Maximum consumption x Maximum reorder period

Minimum Stock Level (Buffer Stock)
The lowest quantity to which the stocks should fall. Since this level is below
the reorder level, an order should already have been placed to reduce the
possibility of stock out (shortage).
It is fixed after considering:-
◦ The rate of consumption;
◦ The time required to obtain supplies; and
◦ Normal or average consumption for the production is fixed.

Formula:

Re-order Level – (Average Consumption x Average Re-order Period)

(Max. consumption +
Min. consumption) / 2
 Maximum Stock Level
The maximum quantity of material that should ever be held.
It is fixed after considering:-
◦ The rate of consumption;
◦ The time required to obtain supplies;
◦ The economic order quantity (EOQ);
◦ The risks of loss, deterioration and obsolescence; and
◦ Storage space.

Formula:

Re-order Level – (Min. Consumption x Min. Re-order Period) + EOQ

Average Stock Level
Shows the average stock held by a firm
Formula:

Max. Stock Level + Min. Stock Level

2
Example:
The following information is available on component X for the month of January:
Calculate the:
Maximum usage 200 kg
1. Reorder level
Minimum usage 100 kg 2. Maximum stock level
Reorder period 2 to 4 months 3. Minimum stock level
EOQ 400 kg 4. Average stock level

1. Reorder level 3. Minimum stock level

= 200 kg x 4 months = 800 kg – (200 kg + 100 kg/2) x ( 2 months + 4 months/2)
= 800 kg = 800 kg – (150 kg x 3 months)
= 350 kg

2. Maximum stock level 4. Average stock level

= 800 kg – (100 kg x 2 months) + 400 kg = 1,000 kg + 350 kg/2
= 800 kg – 200 kg + 400 kg = 675 kg
= 1,000 kg
Problems associated with Overstocking:
High costs of storage and maintenance
Large amount of space needed

Possible need for security measures

High insurance costs

Money is tied up in stock which could be used elsewhere

Risk of deterioration of quality and obsolescence resulting into the

material being unfit for use
 Problems associated with Under stocking:
Production hold-ups due to insufficient stock.

Firm may end up paying an idle labour force due to the production hold-ups.

Organisation can lose its important customer, as they fail to meet customer’s
order.

Cannot cope with unexpected changes in demand

 Economy Order Quantity
(EOQ)
EOQ is used to determine how much materials should be ordered.
EOQ is the order size that minimizes the total cost of stock :
 carrying costs – cost to keep stock
ordering costs – cost to obtain stock
Three methods/ways to obtain EOQ:
Formula/Equation Method (EOQ model)
Tabulation Method
Graphical Method
EOQ model is based on certain assumptions:
 Demand is constant
 Carrying and ordering costs are constant
 Unit price is constant
 Quick delivery
How EOQ Works

The Principles Behind EOQ: The Total Cost Curve

& 
orders quantity increase, orders quantity increase, EOQ : optimal order size that
carrying cost increase carrying cost increase, minimize total cost
ordering cost decrease (carrying and ordering stock)
 1. Formula/ Equation Method
The Economic Order Quantity (EOQ) can be derived by using formula below:

D = total Demand for material during a given period or annual quantity used
O = Costs of ordering and receiving an order /cost per order
C = the annual cost of carrying one unit of material
 EOQ is the optimal order size that minimizes carrying costs and
ordering costs, which make up total costs of stock.
Carrying/Holding costs are variable costs that include:
◦ Storage costs (rent, lighting, heating, air conditioning)
◦ Insurance
◦ Handling cost Total carrying cost) x C
◦ Rates (tax on property)
◦ Depreciation
◦ Obsolescence

Ordering costs are fixed costs that include:

◦ Transportation costs
◦ Receiving costs Total ordering cost) x O
◦ Production costs
◦ Set-up costs

Total Cost = Total carrying cost + ordering cost

Example
Find the EOQ where;
◦ The forecasted demand is 1000 units per month
◦ The ordering cost is RM350 per order

√( )
◦ The cost per unit is RM8 2(12 𝑥 1000)(350)
◦ Estimated storage cost are 15% per annum 𝐸𝑂𝑄=
0.15 𝑥 8

Answer:
D = 1000 units per month
O = RM350 per order
C = 15% x RM8
 Total carrying cost) x C

Total ordering cost) x O

Example;
Determine the total cost for the previous example;

Total cost = (Q/2 x C) + (D/Q x O)

= (2,646/2 x 1.2) + (12,000/2,646 x 350)
= 1587.60 + 1587.30
= RM 3,174.90
 2. Tabulation Method
Done by comparing the total cost incurred when placing various degree of order
size.
 TC = Co + Cs
EOQ will be the order size with the lowest annual stockholding cost.

Items Formula
No of order for stock in a year (times) D/Q
Average Stock (unit) Q/2
Total Ordering costs (annually) (RM) D/Q x O
Total Carrying/Holding/Storage costs (annually) Q/2 x C
(RM)
Total Cost (RM) (Q/2) x C + (D/Q) x O
D= Total annual Demand (D)
Q= Order Quantity (Q)
O= Cost per Order (O)
C= Carrying Cost per unit (C)
Example:
Tapa Trading is a successful business making and selling cakes to the
customers at Kuching, Sarawak. The demand for cakes is expected to
increase from year to year and the firm needs a proper material system to
buy its main ingredients including the flour.

Based on experience in 2015, the firm uses

2,500 kg flour in January until March 2015;
5,000 kg from April until September 2015 and
5,000 kg from October to December 2015.
The ordering cost incurred is RM2.50 for every order made.
The storage cost for the flour is RM4.00 per holding.

By using tabulation method, identify the EOQ with the number of order given are 250
times, 125 times, and 50 times. Currently, the purchase price for the flour is RM6.00
per kg.
Solution:
o Annual requirement, D= 2,500 kg + 5,000 kg + 5,000 kg = 12,500 kg per annum
o The ordering cost, O= RM2.50
o The storage cost, C= RM4.00 per holding

Order size, in kg (Q) 50 kg 100 kg 250 kg

(12500/250) (12500/125) (12500/50)

No. of order (times) 250 times 125 times 50 times

Average stock (kg) [Q/2] 25 kg 50 kg 125 kg

Ordering cost (RM) [D/Q x O] RM 625 RM 312.50 RM 125

Storage cost (RM) [Q/2 x C] RM 100 RM 200 RM 500

Total cost (RM) RM 725 RM 512.50 RM 625

[(Q/2) x C + (D/Q) x O]

EOQ
 3. Graphical Method
 This method depends on the tabulation method for the data to the plotted on
the graph

Steps to find EOQ using graphical method :

1. Identify order size (x axis)
2. Identify total ordering cost
3. Identify total storage cost
4. Plot the graph according the value.
5. EOQ will be the intersection between total ordering
cost and total storage cost.
EOQ Graphical Method
The point at which the ordering cost and
Annual cost carrying cost intersects each other, total cost is
(RM) minimum.

250
Total cost

200
Total storage cost

150 EOQ

100 Total ordering cost

50
Order
0 100 200 300 400 500 Quantity
(Unit)
EOQ using graphical method
Problem of Material Pricing
❖When store department issued material to production department, the
issues must be valued or priced because it will affects the cost of the
products produced by the production.

❖The basic problem in valuing material issues to production department is to

decide which price to be used.

❖Several factors which influence it:

 Rapidly changing prices of materials and components purchased.
 The stock of any given material is usually made up of several deliveries,
which may have been made at different prices.
 Impossibility of identifying items.
 Sensitivity of profit calculations to the pricing method adopted especially
where materials form a large part of total cost.
Objectives of valuing material issues
1) To charge a realistic figure for material consumed & value of stock on
hand.

2) To enable the store department to charge a consistent, reasonably simple

method of valuing stock to production dept.
INVENTORY RECORDING-PERPETUAL
INVENTORY SYSTEM
⚫ A system of records whereby the receipts and issues of stores are
continuously updated after each transaction and the balance shows up-to-
date position

⚫ Type of records maintained under this system are:

1) Bin cards
- Material received is recorded on bin card , attached to the bin / shelf
- also record when materials are issued from the store

2) store ledgers card

- kept more detailed record of each item of material by storekeeper

⚫ Nowadays, most of the business use computerized store recording system to

update their stock balance
 STOCKTAKING
Two types of stocktaking system are:
1. Continuous stock taking system
Physical verification of stock items is conducted on a continuous basis to
determine the actual physical balance

2. Periodic stock taking system

Stock items are verified on periodic basis, usually annually
Stock Valuation
to overcome the problem in pricing material issues

Methods of Stock Valuation

a. First In First Out (FIFO)
b. Last In First Out (LIFO)
c. Weighted Average Price

Company must decide the most suitable method to be used

Three methods of Stock Valuation

Weighted Average Method

First-In-First-Out (FIFO) Last-In-First-Out (LIFO)
(WAM)
• FIFO will issue the oldest batch of • LIFO will issue latest batch of • This method is use the average
stock for production stock first price.
• Calculated by dividing the total
• Material issued are priced at the • Material issued are charged out cost of materials by the total
price of the oldest batch in stock at the price of the most recent quantity of material in the
until all units of the batch have been batch received and continue to stock
issued (chronological order) be charged until a new batch is
received.
• the closing stock will be at the
latest price of market stock. • The closing stock using LIFO
will be based on old market
• Frequently used for material of: price of the stock;
• High value and demand.
• Rapid price changes.
• Ratio of the number of issues to
the number of receipt is not large
 a. First In First Out (FIFO)
ADVANTAGES DISADVANTAGES
• Ensures that materials are issued at •Material cost based on oldest material
actual cost. prices, lag behind current condition.

• Unrealised profit and loss does not arise •Difficult and expensive to be
since it is an actual cost system. Ie. Cost administered.
of issue is equal to cost of purchase.

•Stock value is presented fairly at current •Difficult to compare cost between jobs
market value. due to different materials issue price.

•Avoid obsolescence as materials that are •Effect on inflation may result in the price
received first are issued first. to be under or over stated.

•Realistic: most logical method since it

makes the same assumption as the
physical flow of materials, that is,
materials that are received first are
issued first.
 b.Last In First Out (LIFO)
ADVANTAGES DISADVANTAGES

•Actual cost system •Frequently result in many batches being

only partly charged to production when
new batch arrives.

•Product cost closely related to current •Closing stock will be valued at

prices levels (more realistic) oldest/out of date price.

•During inflation, profit is understated •Administratively complicated.

thus giving hedges against inflation.

•Result in profit ratio be more stable •Difficult to compare cost between jobs.
years after years (accounting information
will be more reliable).

•Induce obsolescence.
•Not realistic
i.e. Assumes physical issue principle to
be opposite of that actual flow.
 c. Weighted Average Method
ADVANTAGES DISADVANTAGES

•Less complicated as in FIFO & LIFO. •Does not represent actual buying price.

•Effect on product cost is between FIFO •Issue price may not reflect current
& LIFO. economic values.

•Easier to compare cost between jobs. •Any changes in the current

replacement cost of material concerned
will not be immediately reflected.

•Give more satisfactory result when

there is price fluctuation.

•No unrealized stock profit and loss it is

based on actual cost.
Stock Discrepancies
Occurs when stock checks disclose discrepancies between the physical
amount of an item in stock and the amount showed in the stock
records.

The causes of discrepancy should be investigated and appropriate

action taken to ensure that it does not happen again.
Cause of Discrepancies
1. Suppliers deliver a different quantity of goods than is shown on the
goods received note.
2. The quantity of stock issued to production is different from that shown
on the materials requisition note.
3. Excess stock is returned from production without documentation.
4. In this case, a material returned note should be raised.
5. Clerical errors may occur in the stock records.
6. Breakages in stores may go unrecorded.
7. Stock stolen by employees.
Thank You