Material Costs | CMA Inter Syllabus

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Material Costs

Material cost is the cost of materials used to manufacture a product or provide a service. Material is the most important element of cost. In most manufacturing organisations, 50% to 70% of the total cost of a product is represented by the cost of the material. The percentages may differ from industry to industry. Especially for manufacturing sector, the material costs are of great significance. Inventory also constitutes a vital element in the working capital. So, it is conceptually equivalent to cash. Materials, as such, are the basic substances that are transformed into finished goods. Materials costs may be either direct or indirect.

• Direct Materials – There are three characteristics of direct materials:
  1. They are easily traced to the product.
  2. They represent a major material of the finished product.
  3. They can be identified directly with production of the product.

Paragraph 4.7.1 of CAS 6 defines direct material as materials the costs of which can be attributed to a cost object in an economically feasible way.

Examples may include cotton used for spinning cotton yarn, wood used in making furniture, or leather used in shoe-making.

• Indirect Materials –These include all other materials used in production (i.e., nails in furniture manufacturing) and are considered to be a factory overhead cost.

Paragraph 4.7.2 of CAS 6 defines indirect material as materials, the costs of which cannot be directly attributed to particular cost object.

Material Control

Since material cost comprises a significant portion of the total cost of the product, it requires control. Materials control may be defined as a system which ensures availability of the required quantity of material of proper quality at the proper time and at the same time avoidance of unnecessarily blocking up of capital in stores. The system of material control should be so comprehensive that it covers the whole procedure from the point when order is placed with the suppliers up to the stage until the materials are consumed in production. Some authors define material control as a management activity that administers how the inventory employed in the production process is procured, acquired, handled and utilized. It is a process that requires planning, organisation an auditing of all the elements employed in certain productive activity. Simply put, Materials control may be defined as the systematic control over the procurement, storage and usage of materials so as to maintain an even flow of materials and at the same time avoiding excessive investment in inventories.

Therefore, two important aspects:

1. To ensure the smooth flow of production without interruptions.
2. Prevention of excessive investments in materials stock.

In the below mentioned lines the objectives of material control are discussed.

Objectives of Material Control: The following steps have to be taken to see that there is no inefficiency as regards materials:

• Availability: The various materials and stores9 necessary for carrying on production smoothly should always be available. This means not only ensuring supplies of the main raw materials and the chief stores which are required but also of small and inexpensive but necessary materials. For example, in a cotton textile mill supplies of cotton and coal will always be looked after, but it is also necessary that the proper lubricating oil for machines is also always available. Stoppage of production due to any reason is very costly and the person in charge of supply of materials and stores must see to it that production is not interrupted for want of any item of materials and stores.
• Proper quality and price: While purchasing the materials and stores, care should be taken to see that the requisite quality of materials is purchased and that the price paid is reasonably low. It is no use purchasing goods of inferior quality or of very superior quality. For every product or job there is a particular quality of materials which is needed and that quality alone should be purchased. For printing text books, for example, neither art paper nor newsprint is to be used rather simple white printing paper of reasonable weightage will be needed. But a book containing art pictures and priced quite high must be printed on good quality art paper; newspapers have to use newsprint as otherwise the cost will be too high. Prices also must be unnecessarily high although in certain cases it may be the company’s policy to encourage certain supplies by paying them a price higher than prevailing in the market; but this can be only for a short period and in special cases.
• Minimum wastage: While various materials are being stored in the godowns, the loss of or damage to the various items must be kept as low as possible. The losses usually are pilferage or damage due to rust dust dirt or water. All these losses must be thoroughly kept under control.
• No overstocking: Investment in stocks of materials and stores must be kept as low as possible. This means that unnecessarily large stocks must not be maintained.
• Information about availability of stocks: Information must be continuously available regarding stock. This will ensure proper planning of work and also replenishment on time.
• Minimum loss during process: While the materials are being used in the factory the wastage must be kept at the minimum possible level. Some wastage is bound to be there, but efficiency demands that the wastage must not be allowed to go above the minimum level.

From the above mentioned objectives, the importance of material control can be stated as follows (represented pictorially)

In order to have a good material control system, an organisation should have the following issues at place. This is also referred as the requisites of material control system:

1. Coordination and cooperation between the various departments concerned viz purchase, receiving, inspection, storage, issues and accounts and cost departments.
2. Use of standard forms and documents in all the stages of control.
3. Classification, coordination, standardization and simplification of materials.
4. Planning of requirement of material.
5. Efficient purchase organisation.
6. Budgetary control of purchases.
7. Planned storage of materials, physical control as well as efficient book control through satisfactory storage control procedures, forms and documents.
8. Appropriate records to control issues and utilization of stores in production.
9. Efficient system of internal audit and internal checks.
10.  System of reporting to management regarding material purchase, storage and utilization.

There are three broad areas where material control can be implemented:

1. Purchase and receipt
2. Stores and
3. Issue of material

This is pictorially represented as follows:

Thus, the first aspect where material control can be effected is procurement of material (purchase) which is taken up in the following lines.

Procurement of Materials

The crucial function of procurement of material lies with the purchase department. Before proceeding with the function the manager in charge of purchase along with other top management personnel would have to be clear about a set of questions which are mentioned as below:

1. What to purchase? – Right Material with good quality
2. When to purchase? – Right Time
3. Where to purchase? – Right Source
4. How much to purchase? – Right Quantity
5. At what price to purchase? – Right Price

The function of purchase

As such, purchasing involves procurement of materials of requisite quantity and quality at economic price. It is of extreme importance particularly to a manufacturing concern because it has bearing on all vital factors of manufacture such as quantity, cost, efficiency, economy, prompt delivery, volume of production and so on.

The purchase function in an organisation can be categorized either as centralized purchasing system or decentralized purchasing system. Purchasing process in most of the organisation is a centralized function because the advantages of a centralized purchasing outweighs its disadvantages.

Merits of a Centralized and Demerits of Decentralized Purchase Organisation:

1. When materials are purchased favourable terms (Trade discount, economies of transport etc) can be obtained because the quantity will be large. In case of decentralized system these benefits cannot be realized.
2. Specialized purchasing officer can be appointed with the specific purpose of highly efficient purchases functions of the concern. In case of decentralized purchase system, the business entity cannot afford a specialized purchasing officer in every location.
3. Effective control can be exercised over the stock of materials because duplication of purchase of the same materials may easily be avoided in centralized purchase system, where as in decentralized purchase system, duplication of purchase of same material cannot be avoided.
4. Under centralized purchase system effective control can be exercised on the purchases of all the materials as the purchase function is channelized through one track which would make the system of receiving, checking and inspection efficient. Where as in decentralized purchase system it is very difficult to exercise controls.
5. Under centralized system of purchase materials, components and capital equipments can be suitably standardized so that the maximum purchasing benefits be availed of storage facilities can be improved and available production facilities can be greatly utilized to the maximum possible extent. Under decentralized purchase system standardization of materials, storage facilities etc is very difficult to achieve.
6. Under centralized system of purchase closer cooperation between the financial and purchasing departments can be achieved which may not be easy under decentralized purchase system.

Demerits of a Centralized and Merits of Decentralized Purchase Organisation:

1. It may take unnecessary long time to place a purchase order under centralized purchase system because to collect the relevant data from various departments / branches / locations may take more time. These delays can be avoided under decentralized purchase system.
2. In case of centralized purchasing system, branches at different places cannot take advantage of localized purchasing, whereas under decentralized purchase system localization savings can be realized.
3. Due to chances of misunderstanding / miscommunication between the branch and the centralized purchasing office may result in wrong purchase of material also. Whereas under decentralized purchase system, the chances of iscommunication / misunderstanding are very limited.
4. Centralized system will lead to high initial costs because a separate purchasing department for purchase of materials is to be set up. No such costs are required to be incurred in the decentralized system.
5. Replacement of a defective item may take long time resulting in strain on smooth production flow under centralized system of purchase. No such delay in decentralized system.

Below listed is a set of documents (along with a specimen of the respective document) which enables procurement function of the purchase department:

1. Bill of Material

Bill of Material is a complete schedule of parts and materials required for a particular order prepared by the drawing office and issued by it together with necessary blue prints of drawings. For standard products, printed copies of bill of material are kept with blank spaces for any special details of modification to be filled in for a particular job / order. The schedule details everything, even to bolts and nuts, sizes and weights. The documents solve a number of useful purposes, such as:

1. It provides a quantitative estimate of budget of material required for a given job, process or operation which might be used for control purposes.
2. It substitutes material requisitions and expedite issue of materials.
3. The store keeper can draw up a programme of material purchases and issue for a given period.
4. It provides the basis for charging material cost to the respective job / process.

The specimen form of Bill of Material is shown below:

Modern Ltd
Bill of Materials
No…………… Date…………..  Order No……………..  Job No……………….  Assembly drawing no…….
Component Parts			Materials			For use of purchase dept.
Symbol No.	Description	No. reqd.	Description	Code No.	Qty.  Reqd.	Date	Regn. No.	Order No.	Date of Delivery	Remarks
Purchase dept. copy	Date of order Delivery		Prepared by: Checked by:			Purchase order given by:

2. Material Requisition Note

Material Requisition is a document issued by a department in charge requesting the storekeeper to issue certain materials to a job or standing order number. It is an important document as it authorises issue of materials from stores and thereby should authenticated by appropriate authority. It forms the basis of crediting the marginal account in the stores ledger as the materials are taken out on the strength of such documents. The corresponding debit to work in progress account for job account for standing order number is also made on the basis of such documents. The document enables the accounts department to value the issue of the materials to find out the cost of materials issued. The storekeeper uses this department to check total item wise issues made by him during a certain period by adding up the details of issue from this document.

3. Purchase Requisition

Purchase Requisition is a request made to the Purchase Department to procure materials of given description and of the required quality and quantity within a specified period. It is a formal request and it authorises the purchase department to issue a purchase order to secure materials intended for periodic requirements of a given material or materials to provide guidance to the purchase department to estimate the future requirements in order to secure maximum purchase benefits in the form of higher discount and better credit terms. The extent and range of materials requirements provide a basis for preparation of purchase budget. The actual requirements of a given period can be summarised from the purchase requisition and compared with the purchase budget in order to determine the variances and reason thereof. This form is prepared by storekeeper for regular items and by the departmental head for special materials not stocked as regular items.

The purchase requisition is prepared in three copies. Original will be sent to purchase department, duplicate copy will be retained by the indenting (request initiating) department and the triplicate will be sent to approver for approving the purchase requisition.

Purchase Requisition provides the three basic things:

1. What type of material is to be purchased?
2. When to be purchased?
3. How much is to be purchased?

The specimen form of Purchase Requisition is as shown below:

Modern Ltd
Purchase Requisition or Indent
Purchase Req. Type: Special / Regular: Purchase Requisition Date: Purchase Req. No: Department:
S. No.			Material Code	Description of the Goods	Quantity Required	Material Required by date	Remarks

Requested by	Approved by
For use in Purchase Department
Quotations from
(1)	PO placed: Yes/No
(2)	PO no:
(3)

 

A number of factors should be considered before deciding from where the purchase should be made viz. inquiry and call for tenders or quotations, analysis of tenders called, selection of the appropriate source with appropriate fixation of price, quality, time of delivery, terms of payment, mode of delivery, etc.

4. Purchase Order

Purchase Order (PO) is a request made in writing to selected supplier to deliver goods of requisite quality, quantity, (as per the purchase requisition) at the prices, terms and conditions agreed upon. It is a commitment on the part of the purchaser to accept the delivery of goods contained in the Purchase Order if the terms included therein, are fulfilled. Purchase Order contains the following details:

(a) Purchase Order No; (b) PO Date; (c) Supplier Name and Address; (d) Material Code; (e) Material description; (f) Grade and Other particulars of the material; (g) Quantity to be supplied; (h) Price; (i) Place of delivery; (j) Taxes; (k) Terms of Payment (Credit period) etc.

Usually, a purchase order is made in five copies, one each for suppliers, Receiving / Stores Department, Originating Department, Accounts Department and filing. Thus, all the concerned departments with the materials are informed fully about all the details of every purchase and it becomes easier for everyone to follow up on any relevant matter.

The Specimen form of Purchase Order is as shown below:

Modern Ltd
Purchase Order
To  Supplier__________  Address: PO No: PO date:  Quotation Reference:  PR No. Please supply the following items in accordance with the instructions mentioned therein on the following terms and conditions.
S. No.			Material Code	Material Description	Quantity	Rate per unit	Delivery Date	Amount	Remarks
Packing and Freight Taxes Total Amount
Delivery: Goods to be delivered at  Delivery date:  Payment terms: Authorised Signatory

5. Goods Received cum Inspection Note

The stores department will receive the material after the gate entry. It will compare the quantities received with the PO Quantity. It is a valuable document as it forms the basis of accounting entry in the stores ledger and stock records. It is the document basis for quality control department to carry inspection of the material in warded.

It also forms the basis of payments to be made to the supplier in respect of the materials supplied by him. Supplier’s invoices are checked with goods received notes for actual receipt of the goods supplied by the supplier. One copy of such note is also sent to inspection department who after inspection of materials approves the notes for stores department to receive the materials. Outstanding goods received notes which are not linked with supplier’s bills enable the accounts department to estimate at the year end the liability for goods purchased for which supplier’s bills not received.

The specimen of the Goods Received cum Inspection Note as below:

Modern Ltd
Goods Received cum Inspection Note
Received from:  Received at:  GRN No:  GR Date: PO Ref. No:  Gate Entry No: Please supply the following items in accordance with the instructions mentioned therein on the following terms and conditions.
S. No.			Material Code	Material Description	Quantity Received	Quantity accpeted	Quantity rejected	Rate per unit	Delivery Date	Remarks
Prepare by  Inspected by  Received by Storekeeper

6. Material Transfer Note

Material Transfer Note is a document used for transferring the material from one department to other department or one site to other site or one job to other job. The need for Material Transfer Note arises under the following conditions:

1. Great urgency for such materials as normal procedure for requisitioning the materials may result in delay in completion of the job.
2. Where two jobs are being executed side by side or very near to each other and stores department is situated at a great distance, adoption of normal procedure for requisitioning the materials may mean unnecessary expenditure in handling and transportation, especially in cases of heavy materials (e.g., iron nails).
3. Frequent shifting of materials (for returning to stores and for re-issue) may result in wastage or breakage.
4. If the goods are of perishable nature (e.g., Vegetable or Fruits) and refrigeration may not keep them fresh for a long time.

Procedure to be followed to transfer the material

1. Transferring supervisor will prepare a Material Transfer Note giving all the details of the materials transferred and will send this note to the supervisor of the job to which materials being transferred.
2. Transferee supervisor will sign the note in token of receipt of the materials and send it back to the transferring supervisor.
3. This note will then be send to cost office where necessary entries will be passed and respective job accounts debited and credited.

Material Return Note

At times materials have to be returned to the suppliers after these are received in the factory. If the return takes place before the preparation of Goods Received Note, such materials will not be included and shown in the stores ledger. However, if the material is returned after the entry into the Goods Received Note, a document called “Material Return Note” will be prepared simultaneously to exclude the quantity and value of the returned material from the stores ledger.

Purchase Quantity

Important requirement for an efficient system of purchase control is to ensure that only the correct quantity of materials is purchased. The basic factors to be considered while fixing the ordering quantity are as follows:

1. There should be no overstocking.
2. Materials should always be available in sufficient quantity to meet the requirements of production and to avoid plant shut down.
3. Purchases should be made in economic lots.

Other factors to be considered are quantity already ordered, availability of funds, business cycle etc.

Purchase department in manufacturing concerns is usually faced with the problem of deciding the quantity of various items, which they should purchase basing on the above factors. If purchases of material are made in bulk, then inventory cost will be high. On the other hand, if the order size is small each time, then the ordering cost will be very high. In order to minimize ordering and carrying cost it is necessary to determine the order quantity which minimizes these two costs. Thus Economic Order Quantity (EOQ). 

Economic Order Quantity (EOQ)

The total costs of a material usually consist of Buying Cost + Total Ordering Cost + Total Carrying Cost.

Economic Order Quantity is ‘The size of the order for which both ordering and carrying cost are minimum’.

Ordering Cost: The costs which are associated with the ordering of material. It includes cost of staff posted for ordering of goods, expenses incurred on transportation, inspection expenses of incoming material etc.

Carrying Cost: The costs for holding the inventories. It includes the cost of capital invested in inventories. Cost of storage, insurance etc.

The assumptions underlying the Economic Order Quantity (EOQ): The calculation of economic order of material to be purchased is subject to the following assumptions:

1. Ordering cost per order and carrying cost per unit per annum are known and they are fixed.
2. Anticipated usage of material in units is known.
3. Cost per unit of the material is constant and is known as well.
4. The quantity of material ordered is received immediately i.e., lead time is zero.

The famous mathematician ‘WILSON’ derived the formula used for determining the size of order for each purchase at minimum ordering and carrying costs, which is as below:

Economic Order Quantity =√(2AO/C)

where, 

 A = Annual demand / consumption
 O = Ordering Cost per Order
 C = Carrying Cost per unit per annum

Inventory Management and Control

 Material Storage and Control

Once the material is received, it is the responsibility of the stores in charge, to ensure that material movements in and out of stores are done only against the authorised documents. Stores in charge is responsible for proper utilization of storage space and exercise better control over the material in the stores to ensure that the material is well protected against all losses as theft, pilferage, fire, misappropriation etc.

Duties of Store Keeper

The duties of store keeper are as follows:

1. To exercise general control over all activities in stores department.
2. To ensure safe storage of the materials.
3. To maintain proper records.
4. To initiate purchase requisitions for the replacement of stock of all regular materials, whenever the stock level of any item in the store reaches the minimum level.
5. To initiate the action for stoppage of further purchasing when the stock level approaches the maximum level.
6. To issue materials only in required quantities against authorised requisition documents.
7. To check and receive purchased materials forwarded by the receiving department and to arrange for storage in appropriate places.

Different classes of stores

Broadly speaking, there are three classes of stores:

Centralized Store

The usual practice in most of the concerns is to have a central store. Separate store to meet the requirements of each production department are not popular because of the heavy expenditure involved. In case of centralized stores materials are received by and issued from one store department. All materials are kept at one central store.

Advantages of centralized stores

1. Better control can be exercised over stores because all stores are housed in one department. The risk of obsolescence of stores can be minimized.
2. The economy of staff-experts, or clerical, floor space, records and stationery are available.
3. Better supervision is certainly possible.
4. Obsolescence of the store items can be kept under strict vigil and control.
5. Centralized material handling system can be put into operation thus further economizing on space, personnel and equipments.
6. Investment in stocks can be minimized.

Disadvantages of centralized stores

1. The transportation costs of the materials may increase because the movements of the stores may be for a greater distance since the storing is centralized.
2. If the user departments are far away from the stores there may be delay in receipt of the stores by those departments.
3. Breakdown of inter departmental transport system may hold up the entire process, and similarly labour problem in the centralized stores may bring the entire concern to standstill.
4. There is greater chance of losses through fire, burglary or some other unhappy incidents.
5. It may not be safe to have some hazardous elements bunched together in the centralized stores.

2. Decentralized stores

Under this type of stores, independent stores are situated in various departments. Handling of stores is undertaken by the store keeper in each department. The departments requiring stores can draw them from their respective stores situated in their departments. The disadvantages of centralized stores can be eliminated, if there are decentralized stores. But these types of stores are uncommon because of heavy expenditure involved.

Central stores with sub-stores / Imprest Stores

In large organisation, factories / workshops may be located at different places which are far from the central stores. So, in order to keep the transportation costs and handling charges to the minimum level, sub-stores should be situated near to the factory. For each item of materials, a quantity is determined and this should be kept in the stock at the beginning of any period. At the end of a period, the store keepers of each sub-store will requisition from the central stores the quantity of the materials consumed to bring the stock up to the predetermined quantity. In short, this type of stores operates in a similar way to a petty cash system, so this system of stores is also known as the imprest system of stores control.

Advantages

1. It ensures the prompt issue of stores.
2. It confines the advantages of centralized stores with sub-stores and at the same time it does not sacrifice the centralized control.
3. It reduces handling cost of materials.
4. It avoids the maintenance of elaborate inventory records.

Control of the Stores

Classification and Codification of Material

In case of large organisations, the number and types of materials used is considerable and unless each item is distinguished and stored separately it would be impossible to find them out when they are required for production or any other operation. It may happen that either one type of material is in excess or another type may be altogether non-existent. It is therefore, essential that a proper system of classification and codification is developed. 

Classified into different categories according to their nature or type, viz., mild steel, tool steel, brass, bronze, copper, glass, timber, etc., and then again within such broad classification into rounds, bars, strips, angles, etc. There are two steps in the classification and codification of materials – determination of the number of items, their nature, other characteristics and classification of items of comparable nature or type into suitable groups or classes.

Various classes of coding are in practice and the common types are stated below:

1. Alphabetical Scheme: Alphabets are only used for codification. Like Mild Steel Sheets are coded as MSS.
2. Numeric Scheme: In this scheme numericals are used instead of alphabets. For example, if steel is given main code of 300, mild steel may be coded as 310 and mild steel sheet may be coded as 311, mild steel bar may be coded as 3112.
3. Decimal Scheme: It is similar to the numeric scheme in which the groups are represented by number and digits after the decimal indicate sub-groups of items. For example, where the steel is coded as 3.00 mild steel may be coded as 3.10 and mild steel can be coded as 3.11 and mild sheet bar as 3.12 and so on.
4. Block Scheme: In this case block of number are allotted for classification of specific groups such as for material classification the block of number 1 to 999 may be reserved, for raw materials; 1000 to 1999 for stores and spares; 2000 to 2999 for finished goods.
5. Combination Scheme: Here the code structure takes in account both alphabetic and numeric schemes and strikes a balance between the two. Mild steel by coded as MS and the sheets, bars, strips, rounds of mild steel may be coded as MS01, MS02, MS04 and so on. This code is most commonly used because this system has got the advantage of both the alphabetic and numeric systems and is quite flexible in nature.

Advantages of Classification and Codification of materials

1. The procedure assists in the easy identification and location of the materials because of their classification.
2. It minimizes the recording of the nature / type of the materials with detailed description on every document relating to the transaction of materials.
3. Codification is a must in the case of mechanization of the stores accounting.
4. The method is simple to operate and definitely saves time and money in respect of both physical location / identification of materials as well as recording of the materials.
5. After the material classification and codification is done for all the materials, for each material code, minimum level, maximum level, re-order level and re-order quantity to be fixed. It is the storekeeper’s responsibility to ensure inventory of any material is maintained between the minimum level and maximum level.

Maximum Level

The maximum level indicates the maximum quantity of an item of material that can be held in stock at any time.

The stock in hand is regulated in such a manner that normally it does not exceed this level.

While fixing the level, the following factors are to be taken into consideration:

1. Maximum requirement of the store for production purpose, at any point of time.
2. Rate of consumption and lead time.
3. Nature and properties of the store: for instance, the maximum level is necessarily kept low for materials that are liable to quick deterioration or obsolescence during storage.
4. Storage facilities that can be conveniently spared for the item without determinant to the requirements of other items of stores.
5. Cost of storage and insurance.
6. Economy in prices: for seasonal supplies purchased in bulk during the season, the maximum level is generally high.
7. Financial considerations: Availability of funds and the price of the stores are to be kept in view. For costly items, the maximum level should be as low as possible. Another point to be considered is the future market trend. If prices are likely to rise, the concern may like to stock-piling for keeping large stock in reserve for long term future uses and in such a case, the level is pushed up.
8. Rules framed by the government for import or procurement. If due to these and other causes materials are difficult to obtain and supplies are irregular the maximum level should be high.
9. The maximum level is also dependent on the economic ordering quantity

Maximum Level = Re-Order Level + Re-Order Quantity – (Minimum Rate of Consumption × Minimum Re-Order Period)

 

Minimum Level

The minimum level indicates the lowest quantitative balance of an item of material which must be maintained at all times so that there is no stoppage of production due to the material being not available. In fixing the minimum level, the following factors are to be considered:

1. Nature of the item: For special material purchased against customer’s specific orders, no minimum level is necessary. This applies to other levels also.
2. The minimum time (normal re-order period) required replenishing supply. This is known as the lead time and are defined as the anticipated time lad between the dates of issuing orders and the receipts of materials. Longer the lead time, lower is minimum level, the re-order point remaining constant.
3. Rate of consumption (normal, minimum or maximum) of the material.

Minimum Level = Re-Order Level – (Normal Rate of Consumption × Normal Re-Order Period)

 

Re-Order Level

When the stock in hand reaches the ordering or re-ordering level, store keeper has to initiate the action to replenish the material. This level is fixed somewhere between the maximum and minimum levels in such a manner that the difference of quantity of the material between the Re-Ordering Level and Minimum Level will be sufficient to meet the requirements of production up to the time the fresh supply of materials is received.

The basic factors which are taken into consideration in fixing a Re-Ordering Level for a store item include minimum quantity of item to be kept, rate of consumption and lead time which are applied for computing of this level.

Re-Ordering Level = Minimum Level + (Normal Rate of Consumption × Normal Re-Order Period) Or,  = Minimum Level + Consumption during Lead Time Or, = Maximum Rate of Consumption × Maximum Re-Order Period (Lead Time)

 

Danger Level

It is the level at which normal issue of raw materials are stopped and only emergency issues are only made. This is a level fixed usually below the minimum level. When the stock reaches this level very urgent action for purchases is indicated. This presupposed that the minimum level contains a cushion to cover such contingencies. The normal lead time cannot be afforded at this stage. It is necessary to resort to unorthodox hasty purchase procedure resulting in higher purchase cost.

The practice in some firms is to fix danger level below the Re-Ordering Level but above the minimum level. In such case, of action for purchase of an item was taken when the stock reached the re-ordering level, the danger level is of no significance except that a check with the purchases department may be made as soon as the danger level is reached to ensure that everything is all right and that delivery will be made on the scheduled date.

Danger Level = Normal Rate of Consumption × Maximum Re-Order Period for emergency purchases

 

Perpetual Inventory System

Perpetual inventory system may be defined as ‘a system of records maintained by the controlling department, which reflects the physical movements of stocks and their current balance’. Thus, it is a system of ascertaining balance after every receipt and issue of materials through stock records to facilitate regular checking and to avoid closing down the firm for stock taking. To ensure the accuracy of the perpetual inventory records (bin card and stores ledger), physical verification of stores is made by a programme of continuous stock taking.

The operation of the perpetual inventory system may be as follows:

1. The stock records are maintained and up to date posting of transactions are made there in so that current balance may be known at any time.
2. Different sections of the stores are taken up by rotation for physical checking. Every day some items are checked so that every item may be checked for a number of times during the year.
3. Stores received but awaiting quality inspection are not mixed up with the regular stores at the time of physical verification, because entries relating to such stores have not yet been made in the stock records.
4. The physical stock available in the store, after counting, weighing, measuring or listing as the case may be, is properly recorded in the bin cards / inventory tags and stock verification sheets.

Perpetual Inventory System and Continuous Stock Taking

Perpetual inventory system should not be confused with continuous stock taking. Continuous Stock Taking is an essential feature of perpetual inventory system. Perpetual inventory means the system of stock records and continuous stock taking, whereas continuous stock taking means only the physical verification of the stock records with actual stocks.

In continuous stock taking, physical verification is spread throughout the year. Everyday 10 to 15 items are taken it random by rotation and checked so that the surprise element in stock verification may be maintained and each item may be checked for a number of times each year. On the other hand, the surprise element is missing in case of periodical checking, because checking is usually done at the end of the year.

Advantages of Perpetual Inventory System

1. The system obviates the need for the physical checking of all items of stock and stores at the end of the year.
2. It avoids the dislocation of the routine activities of the organisation including production and despatch.
3. A reliable and detailed check on the stores is maintained.
4. Errors, irregularities and loss of stock through other methods are quickly detached and through necessary action recurrence of such things in future is minimized.
5. As the work is carried out systematically and without undue haste the figures are readily available.
6. Actual stock can be compared with the authorised maximum and minimum levels, thus keeping the stocks within the prescribed limits. The disadvantages of excess stocks are avoided and capitalized up in stores materials cannot exceed the budget.
7. The recorder level of various items of stores are readily available thus facilitating the work of procurement of stores.
8. For monthly or quarterly financial statements like Profit and Loss Account and Balance Sheet the stock figures are readily available and it is not necessary to have physical verification of the balances.

ABC Analysis

The “ABC Analysis” is an analytical method of stock control which aims at concentrating efforts on those items where attention is needed most. It is based on the concept that a small number of the items in inventory may typically represent the bulk money value of the total materials used in production process, while a relatively large number of items may present a small portion of the money value of stores used resulting in a small number of items be subjected to greater degree of continuous control.

Under this system, the materials stocked may be classified into a number of categories according to their importance, i.e., their value and frequency of replenishment during a period. The first category (also known as group ‘A’ items) may consist of only a small percentage of total items handled but combined value may be a large portion of the total stock value. The second category, naming it as group ‘B’ items, may be relatively less important. In the third category, consisting of group ‘C’ items, all the remaining items of stock may be included which are quite large in number but their value is not high.

This concept may be clear by the following example:

Category			No. of Items	% of the Total No. of Items	Value Amount (₹)	% of the Total Value Item	Average Value Amount (₹)
A			75	6	70,000	70	933.33
B			375	30	20,000	20	53.33
C			800	64	10,000	10	12.50
			1,250	100	1,00,000	100

Category ‘A’ items represent 70% of the total investment but as little as only 6% of the number of items. Maximum control must be exercised on these items. Category ‘B’ is of secondary importance and normal control procedures may be followed. Category ‘C’ comprising of 64% in quantity but only 10% in value, needs a simpler, less elaborate and economic system of control.

Advantages of ABC Analysis:

1. Closer and stricter control of those items which represent a major portion of total stock value is maintained.
2. Investment in inventory can be regulated and funds can be utilized in the best possible manner. ‘A’ class items are ordered as and when need arises, so that the working capital can be utilized in a best possible way.
3. With greater control over the inventories, savings in material cost will be realised.
4. It helps in maintaining enough safety stock for ‘C’ category of items.
5. Scientific and selective control helps in the maintenance of high stock turnover ratio.

VED Analysis

VED stands for Vital, Essential and Desirable – analysis is used primarily for control of spare parts. The spare parts can be classified in to three categories i.e., Vital, Essential and Desirable – keeping in view the criticality to production.

Vital – The spares, stock-out of which even for a short time will stop the production for quite some time, and where in the stock-out cost is very high are known as Vital spares. For a car assembly company, ‘Engine’ is a vital part, without the engine the assembly activity will not be started.

Essential – The spares or material absence of which cannot be tolerated for more than few hours or a day and the cost of lost production is high and which is essential for production to continue are known as Essential items. For a car assembly company ‘Tyres’ is an essential item, without fixing the tyres the assembly of car will not be completed.

Desirable– The Desirable spares are those parts which are needed, but their absence for even a week or more also will not lead to stoppage of production. For example, CD player, for a car assembly company.

Some spares though small in value, may be vital for production, requires constant attention. Such spares may not pay attention if the organisation adopts ABC analysis.

FSN Analysis

FSN analysis is the process of classifying the materials based on their movement from inventory for a specified period. All the items are classified in to F – Fast moving, S – Slow moving and N – Non moving items based on consumption and average stay in the inventory. Higher the stay of item in the inventory, the slower would be the movement of the material. This analysis helps the store keeper / purchase department to keep the fast moving items always available and take necessary steps to dispose off the non-moving inventory.

Just-in-Time (JIT)

JIT is a production strategy that strives to improves a business return on investment by reducing in process inventory and associated carrying costs. Inventory is seen as incurring costs, or waste, instead of adding and storing value, contrary to traditional accounting. In short, the JIT inventory system focuses on “the right material, at the right time, at the right place, and in the exact amount” without the safety net of inventory.

Advantages

1. Increased emphasis on supplier relationship. A company without inventory does not want a supply system problem that creates a part shortage. This makes supplier relationships extremely important.
2. Supplies come in at regular intervals throughout the production day. Supply is synchronized with production demand and the optimal amount of inventory is on hand at any time. When parts move directly from the truck to the point of assembly, the need for storage facilities is reduced.
3. Reduces the working capital requirements, as very little inventory is maintained.
4. Minimizes storage space.
5. Reduces the chance of inventory obsolescence or damage.

Inventory Turnover Ratio

Inventory turnover signifies a ratio of the value of materials consumed during a given period to the average level of inventory held during that period. The ratio is worked out on the basis of the following formula:

 Inventory Turnover Ratio = Value of material consumed during the period/Value of average stock held during the period

The purpose of the above ratio is to ascertain the speed of movement of a particular item. A high ratio indicates that the item is moving fast with a minimum investment involved at any point of time. On the other hand, a low ratio indicates the slow moving item. Thus, inventory turnover ratio may indicate slow moving dormant and obsolete stock highlighting the need for appropriate managerial actions.

Inventory Accounting & Valuation

Valuation of Material Receipts

Principles of valuation of receipt of materials as per CAS – 6 are as follows

1. The material receipt should be valued at purchase price including duties and taxes, freight inwards, insurance and other expenditure directly attributable to procurement (net of trade discounts, rebates, taxes and duties refundable or to be credited by the taxing authorities) that can be quantified with reasonable accuracy at the time of acquisition.
2. Finance costs incurred in connection with the acquisition of materials shall not form part of material cost.
3. Self manufactured materials shall be valued including direct material cost, direct employee cost, direct expenses, factory overheads, share of administrative overheads relating to production but excluding share of other administrative overheads, finance cost and marketing overheads. In case of captive consumption, the valuation shall be in accordance with Cost Accounting Standard 4.
4. Spares which are specific to an item of equipment shall not be taken to inventory, but shall be capitalized with the cost of the specific equipment. Cost of capital spares and / or insurance spares, whether procured with the equipment or subsequently, shall be amortised over a period, not exceeding the useful life of the equipment,
5. Normal loss or spoilage of material prior to reaching the factory or at places where the services are provided shall be absorbed in the cost of balance materials net of amounts recoverable from suppliers, insurers, carriers or recoveries from disposal.
6. Losses due to shrinkage or evaporation and gain due to elongation or absorption of moisture etc., before the material is received shall be absorbed in material cost to the extent they are normal, with corresponding adjustment in the quantity.
7. The forex component of imported material cost shall be converted at the rate on the date of the transaction. Any subsequent change in the exchange rate till payment or otherwise shall not form part of the material cost.
8. Any demurrage or detention charges, or penalty levied by transport or other authorities shall not form part of the cost of materials.
9. Subsidy / Grant / Incentive and any such payment received / receivable with respect to any material shall be reduced from cost for ascertainment of the cost of the cost object to which such amounts are related.

Valuation of Material Issues

Principles of valuation of issue of materials as per CAS – 6 are as follows:

1. Issues shall be valued using appropriate assumptions on cost flow.
   E.g., First In First Out, Last In First Out, Weighted Average Rate.
   The method of valuation shall be followed on a consistent basis.
2. Where materials are accounted at standard cost, the price variances related to materials shall be treated as part of material cost.
3. Any abnormal cost shall be excluded from the material cost.
4. Wherever, material costs include transportation cost, determination of costs of transportation shall be governed by CAS 5 – Cost Accounting Standard on Determination of Average (Equalized) Cost of Transportation.
5. Material cost may include imputed costs not considered in financial accounts. Such costs which are not recognized in financial accounts may be determined by imputing a cost to the usage or by measuring the benefit from an alternate use of the resource.
6. Self manufactured components and sub-assemblies shall be valued including direct material cost, direct employee cost, direct expenses, factory overheads, share of administrative overheads relating to production but excluding share of other administrative overheads, finance cost and marketing overheads. In case of captive consumption, the valuation shall be in accordance with Cost Accounting Standard 4.
7. The material cost of normal scrap / defectives which are rejects shall be included in the material cost of goods manufactured.
8. The material cost of actual scrap / defectives, not exceeding the normal shall be adjusted in the material cost of good production. Material Cost of abnormal scrap / defectives should not be included in material cost but treated as loss after giving credit to the realisable value of such scrap / defectives.

Materials issued from stores should be priced at the price at which they are carried in inventory. Material may be purchased from different suppliers at different prices in different situations, where as consumption may happen the entire inventory at a time or at different lots etc. So, issue of materials should be valued after considering the following factors:

1. Nature of business and production process.
2. Management policy relating to the closing stock valuation.
3. Frequency of purchases and price fluctuations.

Several methods of pricing of material issues have been evolved; these may be classified into the following:

Cost Price Method

1. First in First Out
2. Last in First Out
3. Base Stock Method

Specific price method. 

1. Average Price Method
2. Simple Average Price Method
3. Weighted Average Price Method
4. Moving Simple Average Method
5. Moving Weighted Average Method

Market Price Methods

1. Replacement Method
2. Realisable Price Method

 Notional Price Methods

1. Standard Price Method
2. Inflated Price Method

Brief discussion of the above methods is as follow:

First in First Out Method (FIFO Method)

It is a method of pricing the issue of materials in the order in which they are purchased. In other words, the materials are issued in the order in which they arrive in the store. This method is considered suitable in times of falling price because the material cost charged to production will be high while the replacement cost of materials will be low. In case of rising prices this method is not suitable.

Advantages

1. It is simple and easy to operate.
2. In case of falling price, this method gives better results.
3. Closing stocks represents the market prices.

Disadvantages

1. If the prices fluctuate frequently, this method may lead to clerical errors.
2. In case of rising prices this method is not advisable.
3. The material costs charged to same job are likely to show different rates.

2. Last in First Out Method (LIFO Method)

Under this method the prices of last received batch (lot) are used for pricing the issues, until it is exhausted and so on. During the inflationary period or period of rising prices, the use of LIFO would help to ensure the cost of production determined approximately on the above basis is approximately the current one. Under LIFO stocks would be valued at old prices, but not represent the current prices.

Advantages

1. The cost of materials issued will be either nearer to and / or will reflect the current market price.
2. In case of falling prices profit tends to rise due to lower material cost.

Disadvantages

1. The computations become complicated if too many receipts are there.
2. Companies having JIT system will face this problem more.

3. Base Stock Method

A minimum quantity of stock under this method is always held at a fixed price as reserve in the stock, to meet a state of emergency, if arises. This minimum stock is known as Base Stock and is valued at a price at which the first lot of materials is received and remains unaffected by subsequent price fluctuations. The quantity in excess of the base stock may be valued either on the LIFO basis or FIFO basis. This method is not an independent method as it used FIFO or LIFO. Its advantages and disadvantages therefore will depend upon the use of the other method.

4. Specific Price Method

This method is useful, especially when the materials are purchased for a specific job or work order, and as such these materials are issued subsequently to that specific job or work order at the price at which they were purchased. The cost of materials issued for production purposes to specific jobs represent actual and correct costs. This method is specific for non-standard products. This method is difficult to operate, especially when purchases and issues are numerous.

Simple Average Price Method

Under this method materials issued are valued at average price, which is computed by dividing the total of the unit prices of each purchase by the total number of units.

Material Issue Price = Total of unit prices of each purchase/Total Number of Units

This method is useful, when the materials are received in uniform lots of similar quantity and prices do not fluctuate considerably.

6. Weighted Average Price Method

This method removes the limitation of Simple Average Price Method in that it also takes into account the quantities which are used as weights in order to find the issue price. This method uses total cost of material available for issue divided by the quantity available for issue. 

Material Issue Price = Total Cost of Materials in Stock/Total Quantity of Materials in Stock

7. Moving Simple Average Price Method

Under this method the rate for material issue is determined by dividing the total of the periodic simple average prices of a given number of periods by the number of periods. For determining the moving simple average price, it is necessary to fix up first period to be taken for determining the average. Suppose a three monthly period is decided upon and moving average rate for the month of April is to be computed. Under such situation, we have to make a simple list of the simple average price from January to March, add them up, and divide the total by three. To compute the moving average for May, we have to omit simple average rate pertains to January and add the rate relating to the April and divide the total by three.

8. Moving Weighted Average Price Method

Under this method, the issue, rate is computed by dividing the total of the periodic weighted average price of a given number of periods by the number of periods.

9. Replacement Method

Replacement price is defined as the price at which it is possible to purchase an item, identical to that which is being replaced or revalued. Under this method, materials issued are valued at replacement cost of the items. Advantage of this method is issue cost reflects the current market price. But the difficulties involved under this method is determination of market price of material before each issue.

10. Realisable Price Method

Realisable price means a price at which the material to be issued can be sold in the market. This price may be more or less than the cost price, at which it was originally purchased.

11. Standard Price Method

Under this method, materials are priced at some predetermined rate of standard price irrespective of the actual purchase cost of the materials. Standard cost is usually fixed after taking into consideration the current price, anticipated market trends. This method facilities the control of material cost and task of judging the efficiency of purchase department, but it is very difficult to fix the standard price when the prices fluctuate frequently.

12. Inflated Price Method

In case of materials that suffers loss in weight due to natural or climatic factors e.g., evaporation etc the issue price of the materials is inflated to cover up the losses.

Valuation of Work in Progress

Unlike closing stock of finished goods, which is valued at cost or market price, whichever is lower, work in progress is always valued on the basis of cost. The problem arises whether overheads should be included in the cost of work in progress.

There are three ways of valuing work in progress:

1. At prime cost
   This is a conservative method of valuation. Overheads are not added to prime cost for valuing work in progress. As a result of the exclusion of overheads. The cost of the subsequent period is understated and the cost of production for the current period is inflated to that extent.
2. Prime Cost plus Variable Overheads
   Under Marginal Costing Method, work in progress is valued at prime cost plus variable overheads. Fixed overheads are excluded on the basis that these are period costs and should be recovered from revenue, i.e., sales only.
3. At Total Cost
   The valuation is done at full costs inclusive of both variable and fixed overheads. The logic behind this method is that work in progress should carry the proportionate cost of the overheads and cost of production of completed items should not be burdened. This method is most commonly used.

Physical Verification, Slow and Non-moving Stock and Treatment of Losses

Physical Verification

This system envisages physical stock verification at a fixed date/period during the year. Generally, under this system the activity takes place at the end of the accounting period or a date close to such date. Usually, the system is opened in the following manner:

1. A period of 5/7 days, depending on the magnitude of the work is chosen during which all the items under stock are verified physically and such period is known as ‘cut-off’ period. During this period there are no movements of stock items and neither ‘receipts’ nor are ‘issues permitted’.
2. The items are physically counted / measured depending on their nature and are noted down in records which are signed by the auditors if they are present in stock verification.
3. The bin cards balances are also checked and initiated. Generally, the physical balances and bin card balances of various items should be same unless shortages / excesses are there or the recording / balancing in the cards are incorrect.
4. After the physical verification is completed work sheets are countersigned by the godown supervisors and the stock verified.
5. Thereafter reconciliation statement is prepared item wise where the physical balances and bin card balances are different.
6. Then the balance as per bin cards and as per stores ledger is also compared and necessary adjustments are made to show the correct position of stock at the year end.
7. Finally, the shortages / excess statement is prepared by the concerned departments and are placed before the higher management for their approval for adjustments.

Slow and Non-moving Stock and Treatment of Losses

Slow moving stock refers to those inventory items in the godown which has a low turnover ratio and generally varies between 1 to 3. Non-moving stock are those inventory items which has a turnover ratio of less than 1. These items may be purchased to meet emergency purposes. There may be reasons for accumulation of stocks which may result in low turnover ratio such as:

1. Uncertainty of supply in near future.
2. There may be high cost for ordering.
3. Availability of stock at cheap price.
4. High cost of stock out.

As per Indian Accounting Standard 2 inventories shall be measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated cost of completion and the estimated costs necessary to make the sale.

The cost of inventories shall comprise all costs of purchase, cost of conversion and other costs incurred in bringing the inventories to their present location and condition.

Here, a distinction has to be made for slow and non-moving inventories which are lying in stock with reference to their purpose of holding. The inventories which are finished goods and are ready for sale but for some reason or the other the finished goods remained in the godown and were not sold. So, if there is any impairment in the value of those stocks then it will be valued as per the Accounting Standard. If the slow and non-moving stocks are not for sale and have been purchased with an objective of use in the production then the impairment in the value of those stocks shall be ignored for cost accounting purpose.

Scrap, Spoilage, Defectives and Wastage

 Abnormal and Normal Wastage of Materials

Wastage may be classified as normal and abnormal according to the circumstances. Normal wastages denote that part of the wastage which is generally bound to arise in a manufacturing processing on account of evaporation, shrinkage of basic raw materials or on account of typical manufacturing process being involved. Usually, such wastage remains within certain normal ratio or percentage of the input.

On the other abnormal wastage is that loss which does not arise in the ordinary course of manufacturing process but is the result of certain adverse circumstances such as power failure, major breakdown of machinery non availability of the basic raw materials, etc. It is generally not possible to estimate the extent of such wastage before as they are much more than the normal ratio / percentage of loss compared to the input of basic materials.

Since the normal wastage of the materials is an unavoidable and uncontrollable issue, it should be recovered through good production. The cost of such normal wastages will be recovered as production overhead and apportioned on the number of units produced. Necessary, allowance should however be made for any amount which the wastage should realize when it is disposed of. On the contrary, the cost of abnormal wastage should be separately collected and charged off to the costing profit and loss account so as to vitiate the production cost of good units produced. 

Waste

This is the residue such a smoke, dust, gases, slag, etc., which arises in course of manufacturing process and practically no measurable sale or utility value. In certain types of processes and operations, some material physically disappears on account of shrinkage, evaporation etc., with the result that the quantity of the output is less than the input. Such wastage is termed invisible waste where the residual instead of fetching any value, creates a problem for its dispose which entails further costs. Special arrangements have to be made for disposal and refuse, effluent, obnoxious gases etc.

Accounting treatment of waste: As waste has practically no value, its accounting is relatively simple. The effect of the waste is to reduce the quantity of output; in order to arrive at the unit cost of the process, operation or job, the total cost of the process, etc., is distributed over the reduced output, i.e., the units of good production only. The cost of abnormal waste, should, however, be excluded from the total cost and charged to the profit and loss account.

The actual waste is observed against standards and periodically reported to the management.

Scrap

This is also in the form of incidental material residue coming out of certain types of manufacturing processes but it is usually in small amounts and has low measurable utility or market value, recoverable without further processing. Numerous examples of scrap may be given; scrap may arise in the form of turnings, borings, trimmings, fillings, shavings etc., from metals on which machine operations are carried out; saw dust and trimmings in the timber industry; dead heads and bottom ends in foundries; and cuttings, pieces, and split in leather industries. Scrap should always be physically available unlike waste which may or may not be present in the form of a residue.

Accounting treatment of scrap is as follows:

1. Sales credited to revenue
   In this method, the scrap is not cost and its value does not, therefore, appear separately in the cost accounts. Only a quantitative record of the scrap returned to storeroom from the shops is maintained and the sale value realised from time to time is credited to the profit and loss account as miscellaneous revenue.
2. Credit to overhead
   In this method and in the following method the scrap is assigned a cost. The cost is usually the sale value of the scrap less selling and distribution costs. If the scrap has no ready market but has only utility or use value, and is taken as a credit to manufacturing overhead. The effect of this credit is to reduce the overhead recovery rate. When predetermined overhead rates are in use, it is more expedient to credit an estimated allowance for the scrap instead of the amount of actual scrap.
3. Credit to jobs
   The scrap is assigned a cost and is traced to the job which yielded the scrap. This affords a reasonable amount of credit to the jobs and widely different.
4. Transfer to other jobs
   Scrap arising in one job may be issued for utilization in another job. Such transfers of scrap from one job to another should be affected through Material Transfer Notes. Alternatively, scrap may be returned to store room and subsequently issued to another job for utilisation. The latter method is more appropriate when some further processing is required on the scrap before it can be utilized for other jobs.

Control of Scrap
Scrap is also an unavoidable residue material arising in the process of manufacture. The basic difference between scrap and waste is that while waste may not have any value, scrap must necessarily have a value, though a comparatively small one. Scrap may be sold or re-used in some process. In some industries, arising of scraps of various types in significant quantities is a regular feature and, in such cases, it would be worthwhile having a proper administrative set-up for control of scrap. A scrap survey committee may be constituted which would be responsible for such matters as:

1. Classifying the various types of scrap;
2. Assessing the quantum of each, and
3. Deciding upon the manner of their use or disposal.

Control of scrap should start from the designing stage of the products. At the designing stage, the type, shape and form of materials which all result in the minimum of waste or the least quantity of scrap in manufacturing process are decided. The quantity of scrap resulting from a process also depends upon the manufacturing equipment used and the efficiency of the operative who performs the work. In order to minimize scrap, production should be planned so that the best possible equipment is used and properly trained personnel are employed on the job.

Spoilage

When production does not come up to the standard specifications or quality it has to be rejected outright. The components or materials are so damaged in the manufacturing process that they cannot be brought back to the normal specifications by repairs or reconditioning. Some spoiled work may be sold as seconds but in most cases, the entire production is sold for small value in the form of scrap or treated as waste if it has no market value.Spoilage involves not only loss of materials but also of labour and manufacturing overhead incurred up to the stage when the spoilage incurred.

Accounting and Control of Spoilage

Spoilage arises when the production output is damaged in such a manner and to such an extent that it cannot be used for the original purpose for which it was designed but is to be disposed off in some suitable manner without further processing. The distinction between scrap and spoiled work is that while normal scrap arises mostly as a result of the processing of materials, spoilage occurs due to some defect in operations or materials which may or may not be inherent in the manufacturing process or operation. Further, scrap has always a relatively low but some definite value, but the value of spoilage may range from low, if it is a waste, to comparatively high values if the spoilage is to be sold as seconds.

Spoilage involves not only the loss of material but also labour and manufacturing overheads.

Treatment of Packing Cost

Packing materials is of two types – primary and secondary. Primary containers are essential to put the goods in a saleable condition like ink in a bottle, jam in a jar, etc. Secondary containers are required for delivery / transportation like crates etc., they are returnable and reusable.

The cost of primary containers should be charged off as a production overhead and included in production cost. On the other hand, the cost of secondary containers should charge as a selling and distribution overhead. The cost of reusable container should be charged when they could not be used any more due to damage, wear and tear, etc. In some cases, the primary packing materials may be made decorative with a view to promote sales, and in such a case a part of the primary packing materials should be apportioned as a selling cost.

Carriage and Cartage Expenses

Carriage and cartage expenses are incurred in the course of movement of materials or goods. Materials may mean direct materials or indirect materials. The treatment of the carriage and cartage expenses differ with the kind of materials / goods transported. The carriage and cartage expenses relating to raw materials are treated as a part of direct materials cost and those relating to distribution of materials or finished goods are treated as distribution overhead. In case where the carriage and cartage are abnormal due to any reason the same is charged off to costing profit and loss account.

Treatment of Tools Cost

Tools may be classified as

1. Large tools and
2. Small tools

Large tools are normally capitalized and depreciation charged to factory overheads. For small tools the following treatment may apply:

1. Capitalization Method: In line with large tools.
2. Revaluation Method: At the end of the year revaluation for unused life of the tools is made and the difference between original cost and revalued cost is charged as factory overheads.
3. Write off Method: Whenever, such small tools are issued the department is debited with the cost. Alternatively, cost of tools issued during a period is accumulated and distributed to various departments on some suitable basis, e.g., hours worked.

Treatment of Discount Allowed by Suppliers for Bulk Purchases

Discounts allowed on purchased are of two types, viz., cash discount, and quantity discount and trade discount. Cash discount is usually allowed for prompt payment and the quantity and trade discount for heavy purchases. The amount of the latter discount is already credited in the invoice and the net landed cost of the material exclusive of the discount is considered as the material cost.

Treatment of Variance detected at Stock Trading

If the variances are due to normal causes, i.e., due to normal dry age, shrinkage, evaporation, etc., these are valued at the ruling ledger rates of the items of material concerned and the amount is taken as an item of stores overhead and recovered from production as a percentage of direct material cost consumed. If the variances are due to abnormal causes, viz., theft, fraud, misappropriation etc., these are valued by writing off to costing profit and loss account.

Illustration 1

Calculate the Economic Order Quantity from the following information. Also, state the number of orders to be placed in a year.

Consumption of materials per annum	10,000 kg
Order placing cost per order	₹ 50
Cost per kg. of raw materials	₹ 2
Storage costs	8% on average inventory

Solution:

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 Illustration 2

The average annual consumption of a material is 18,250 units at a price of ₹36.50 per unit. The storage cost is 20% on an average inventory and the cost of placing an order is ₹50. How much quantity is to be purchased at a time?

Solution:

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 Illustration 3

Two components, A and B are used as follows:

Normal usage	300 units week each
Maximum usage	450 units week each
Minimum usage	150 units week each
Re-order quantity	A: 2,400 units; B: 3,600 units
Re-order period	A 4 to 6 weeks, B 2 to 4 weeks

Calculate for each component

(a) Re-ordering level; (b) Minimum level; (c) Maximum level; (d) Average stock level.

Solution:

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 Illustration 4

 Compute the inventory turnover ratio from the following:

Opening Stock	₹ 10,000
Closing Stock	₹ 16,000
Material Consumed	₹ 78,000

Solution

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 Illustration 5

Prepare a statement showing the pricing of issues, on the basis of

(a) Simple Average and

(b) Weighted Average methods from the following information pertaining to Material-D 2016 March

1 Purchased 100 units @ ₹10 each

2 Purchased 200 units @ ₹10.2 each.

5 Issued 250 units to Job X vide M.R.No.12

7 Purchased 200 units @ ₹10.50 each

10 Purchased 300 units @ ₹10.80 each

13 Issued 200 units to Job Y vide M.R.No.15

18 Issued 200 units to Job Z vide M.R.No.17

20 Purchased 100 units @ ₹11 each

25 Issued 150 units to Job K vide M.R.No.25

Solution:

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 Illustration 6

The stock of material held on 1-4-2022 was 400 units @ 50 per unit. The following receipts and issues were recorded. You are required to prepare the Stores Ledger Account, showing how the values of issues would be calculated under Base Stock Method, both through FIFO AND LIFO base being 100 units.

2-4-2022 Purchased 100 units @ ₹55 per unit

6-4-2022 Issued 400 units

10-4-2022 Purchased 600 units @ ₹55 per unit

13-4-2022 Issued 400 units

20-4-2022 Purchased 500 units @ ₹65 per unit.

25-4-2022 Issued 600 units

10-5-2022 Purchased 800 units @ ₹70 per unit

12-5-2022 Issued 500 units

13-5-2022 Issued 200 units

15-5-2022 Purchased 500 units @ ₹75 per unit

12-6-2022 Issued 400 units

15-6-2022 Purchased 300 units @ ₹ 80 per unit

Solution:

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 Illustration 7

Prepare a Stores Ledger Account from the following information adopting FIFO method of pricing of issues of materials.

2016 March

1.Opening Balance 500 tonnes @ ₹200

3. Issue 70 tonnes

4. Issue 100 tonnes

5. Issue 80 tonnes

13. Received from suppliers 200 tonnes @ ₹190

14. Returned from Department A 15 tonnes.

16. Issued 180 tonnes

 20. Received from supplier 240 tonnes @ ₹195

 24. Issue 300 tonnes.

 25. Received from supplier 320 tonnes @ ₹200

 26. Issue 115 tonnes

 27. Returned from Department B 35 tonnes

 28. Received from supplier 100 tonnes @ ₹200

Solution:

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 Illustration 8

From this information provided as under, you are required to prepare a statement showing how issues would be priced if LIFO method is followed.
2016 Feb:

1.Opening Balance 100 units at  ₹10 each.

2. Received 200 units at  ₹10.50 each.

3. Received 300 units at  ₹10.60 each.

4. Issued 400 units to Job A vide M.R.No.015.

6. Issued 120 to Job B vide M.R.No.020.

7. Received 400 units at  ₹11 each.

8. Issued 200 units to Job B vide M.R.No.031

12. Received 300 units at  ₹11.40 each.

13. Received 200 units at ₹11.50 each.

 17. Issued 400 units to Job D vide M. R. No. 040.

Solution:

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 Illustration 9

Prepare Stores Ledger Account showing pricing of material issues on Replacement Price basis from the following particulars.

Opening balance 400 units at ₹4 each

10-3-2016 Received 100 units at ₹4.10 each

15-3-2016 Issued 300 units to Job XY vide M.R.No.14

17-3-2016 Received 200 units at ₹4.30 each

20-3-2016 Issued 250 units to Job AB vide M.R.No.20

25-3-2016 Received 400 units @ ₹4.50 each

26-3-2016 Issued 200 units to Job JK vide M.R.No.27

27-3-2016 Received 100 units @ ₹4.60 each.

30-3-2016 Issued 300 units to Job PQ vide M.R.No.32.

Replacement Price on various dates :

15-3-2016 - ₹4.20
20-3-2016 - ₹4.40
26-3-2016 - ₹4.60 &
30-3-2016 - ₹4.80

Solution:

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Illustration 10

Stocks are issued at a standard price and the following transactions occurred for a specific material:

1st January	Opening Stock	10	tonnes at ₹240 per ton
4th January	Purchased	5	tonnes at ₹260 per ton
5th January	Issued	3	tons
12th January	Issued	4	tons
13th January	Purchased	3	tons at ₹250 per ton
19th January	Issued	4	tons
26th January	Issued	3	tons
30th January	Purchased	4	tons at ₹280 per ton
31st January	Issued	3	tons.

The debit balance of price variation on 1st January was ₹20. Show the stock account for the material for the month of January, indicating how you would deal with the difference in material price variance, when preparing the Profit and Loss Account for the month.

Solution:

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 Illustration 11

Receipts and issues of an item of stores are made as follows: There was no balance before 9th January.

	Receipts		Issues
	Quantity	Price (₹)	Quantity
January 9th	10	17.0
19th	25	10.0
20th			10
29th			20
30th	15	8.0
February 13th	20	12.0
27th	10	16.9
28th			40
March 30th	20	20.0
31st			20

(i) What is the simple average of February receipts ?

ii) What are the moving monthly simple average price for January -February and February-March?

(iii) If a weighted average is used for pricing issues how does the value of the balance in stock change during January?

(iv) If a weighted average price is calculated at the end of each month and is then used for pricing the issued of that month, what will be the value of the month-end balance?

Solution:

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 Illustration 12

Two components, A and B are used as follows:

Normal usage	50 per week each
Maximum usage	75 per week each
Minimum usage	25 per week each
Re-order quantity	A: 300; B: 500
Re-order period	A: 4 to 6 weeks
	B: 2 to 4 weeks

Calculate for each component

(a) Re-ordering level

(b) Minimum level

(c) Maximum level

(d) Average stock level.

Solution:

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 Illustration 13

Anil Ltd. buys its annual requirement of 36,000 units in six installments. Each unit costs ₹ 1 and the ordering cost is ₹ 25. The inventory carrying cost is estimated at 20% of unit value. Compute the total annual cost of the existing inventory policy. Determine how much money can be saved by using EOQ? 

Solution:

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  Illustration 14

The annual demand for an item is 3,200 units. The unit cost is ₹ 6 and inventory carrying charges is 25% p.a. If the cost of one procurement is ₹ 150, determine:

1. EOQ
2. No. of orders per year
3. Time between two consecutive order

Solution:

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 Illustration 15

A Company manufactures a special product which requires a component ‘Alpha’. The following particulars are collected for the year 2021:

(i)	Annual demand of Alpha	8,000 units
(ii)	Cost of placing an order	₹ 200 per order
(iii)	Cost per unit of Alpha	₹ 400
(iv)	Carrying cost p.a	20%

The company has been offered a quantity discount of 4 % on the purchase of ‘Alpha’ provided the order size is 4,000 components at a time.

Required:

(i) Compute the economic order quantity

(ii) State whether the quantity discount offer can be accepted.

Solution:

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 Illustration 16

From the following particulars with respect to a particular item of materials of a manufacturing company, calculate the best quantity to order:

Ordering quantities (tonne)	Price per ton Amount (₹)
Less than 250	6.00
250 but less than 800	5.90
800 but less than 2,000	5.80
2,000 but less than 4,000	5.70
4,000 and above	5.60

The annual demand for the material is 4,000 tonnes. Stock holding costs are 20% of material cost p.a. The delivery cost per order is ₹6.00 

Solution:

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 Illustration 17

The particulars relating to 1,200 kgs. of a certain raw material purchased by a company during June, were as follows:-

Lot prices quoted by supplier and accepted by the Company for placing the purchase order :

Lot upto 1,000 kgs. @ ₹22 per kg.

Between 1,000 - 1,500 kgs, @ ₹20 per kg.

Between 1500 -2000 kgs. @ ₹18 per kg.

Trade discount – 20%.

Additional charge for containers @ ₹10 per drum of 25 kgs.

Credit allowed on return of containers, @ ₹8 per drum.

GST at 12% on raw material and 5% on drums.

Total fright paid by the purchaser ₹240/-

Insurance at 2.5% (on net invoice value) paid by the purchaser.

Stores overhead applied at 5% on total purchase cost of material.

The entire quantity was received and issued to production.

The containers are returned in due course. Draw up a suitable statement to show :-

(a) Total cost of material purchased and

(b) Unit cost of material issued to production.

Solution:

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 Illustration 18:

From the following data for the year ended 31st December, 2021, calculate the inventory turnover ratio of the two items and put forward your comments on them.

	Material A (₹)	Material B (₹)
Opening stock 1.1.2021	10,000	9,000
Purchase during the year 2021	52,000	27,000
Closing stock 31.12.2021	6,000	11,000

Solution:

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 Illustration 19

From the details given below, calculate:

(i) Re-ordering level

(ii) Maximum level

(iii) Minimum level

(iv) Danger level.

Re-ordering quantity is to be calculated on the basis of the following information:

The cost of placing a purchase order is ₹ 20

The number of units to be purchased during the year is 5,000

The purchase price per unit inclusive of transportation cost is ₹ 50

Annual cost of storage per unit is ₹ 5.

Details of lead time: Average- 10 days, Maximum- 15 days, Minimum-5 days.

For emergency purchases- 4 days.

Rate of consumption: Average: 15 units per day,

Maximum: 20 units per day.

Solution:

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Illustration 20

M/s Tubes Ltd. are the manufacturers of picture tubes for T.V. The following are the details of their operation during the year 2015:

Average monthly market demand	2,000 Tubes
Ordering Cost	₹ 100 per order
Inventory carrying cost	20% per annum
Cost of tubes	₹ 500 per tube
Normal usage	100 tubes per week
Minimum usage	50 tubes per week
Maximum usage	200 tubes per week
Lead time to supply	6 – 8 weeks

Compute from the above:

(i) Economic order quantity. If the supplier is willing to supply quarterly 1,500 units at a discount of 5% is it worth accepting? 

(ii) Re-order level

(iii) Minimum level of stock

(iv) Maximum level of stock

Solution:

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Exercise