1. © www.paperhint.com Costing and Control of Materials

2. © www.paperhint.com Materials Materials are the basic input that are transformed into finished goods in the production process. Materials costs based on relationship with finished goods, can be broken down into direct and indirect costs.

3. © www.paperhint.com Control of Materials Accounting for materials in a manufacturing company usually involves two activities. (1) Purchase of Materials(2) Issue of Materials (i)Purchase Requisition (ii)Purchase order (iii)Receiving Materials (i)Periodic Inventory System (ii)Perpetual Inventory System

4. © www.paperhint.com 1. Purchase Requisition Purchase is initiated through a purchase requisition. Total costApproved b y………………………….. TotalUnit priceDescriptionCatalogue numberQuantity Department/Individual making request…………….. Order date …………. Delivery date requested…………….. NumberAvon Company Ltd Purchase Requisition Figure 1: Purchase Requisition

5. © www.paperhint.com After the requisition has been approved, the purchasing department places order. Order date………………… Date delivery requested by……………… Payment terms……………….. Total costApproved b y………………………….. TotalUnit priceDescriptionCatalogue numberQuantity Supplier…………………. Address…………………… Delivery terms………………. NumberAvon Company Ltd (full address) Purchase Order Figure 2: Purchase Order 2. Purchase Order

6. © www.paperhint.com Quantities and condition on receipt of goods are noted by the receiving department on a Receiving Report as shown in Figure 3. Approved signature………… TotalUnit priceDescriptionCatalogue numberQuantity Purchase order number…………… Date received…………….. Supplier ………………. Number Avon Company Ltd Receiving Report Figure 3: Receiving Report 3. Receiving of Materials

7. © www.paperhint.com Storing and Issuance of Materials The basic accounting records of any inventory system are the documents required to authorise and record materials movements in/out of the store, namely, stocks/stores/materials ledger cards, bin cards and materials requisition note. Stock/Stores/Materials Ledger Cards They show quantities on order, expected delivery dates and quantities reserved/required for work to be processed. They show the account number; description/type of material; location; unit measurement; minimum and maximum quantities to carry; details about the materials received; issued and balance.

8. © www.paperhint.com Bin Card Bin card shows quantities of each type of material received, issued and on hand. quantityQuantity Code number…………. Unit number ……….. Bin card …………. Reference CheckBalance quantity IssueReceivedDate Stores ledger number………… Date received………………… Description ………………. Avon Company Ltd Bin Card Figure 4: Bin Card

9. © www.paperhint.com Materials Requisition Note/Form TotalUnits costJob numberDescriptionQuantity Approved by ……………. Date issued …………. Issued to …………… Date requested …………….. Department requesting …………… Requisition number……………….. Materials Requisition Form Figure 5: Materials Requisition Note The issuance of materials is authorised by means of a materials requisition form prepared by the production manager/departmental supervisor.

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

11. © www.paperhint.com Perpetual Inventory System Perpetual inventory system shows both cost of materials issued and ending materials inventory directly.

12. © www.paperhint.com Recording/Accounting for Material Cost When a perpetual inventory system is used to account for materials inventory, a subsidiary ledger records card is maintained. Inventory Record Card Item………. Description……………. ReceivedIssuedBalance DateQuantityAmountDateQuantityAmountDateQuantityAmount Figure 6: Inventory Record Card

13. © www.paperhint.com The use of perpetual inventory system also involves physical count of materials on hand, at least once a year, in order to check for possible loss or shrinkage due to theft or spoilage. If the physical count does not match with the balance in the inventory record cards, the book figures are adjusted upward/downward to reflected the actual count. Journal Entries: The purchase and issue of materials (direct as well indirect) are journalised as follows: (i)When materials are purchased: Direct Materials Inventory A/c Dr To Cash/Accounts Payable (credit purchases) Indirect Material Inventory A/c Dr To Cash/Accounts Payable A/c (credit purchase) (ii)Issue of direct materials for production: Work-in-process Inventory A/c Dr To Materials Inventory A/c (iii)Issue of indirect materials for production: Factory Overhead Control A/c Dr To Materials Inventory A/c

14. © www.paperhint.com Adjustment for Discrepancies Adjustment for Discrepancies Physical count of materials under the perpetual inventory system may not tally with the inventory record cards (stores ledger). The discrepancy may result from: (a) Unavoidable reasons (b) Avoidable reasons (a)When book inventory is more than the physical inventory and the shortage is normal: Factory Overheads Control A/c Dr To Stores Ledger Control A/c (b)When the shortage in physical inventory is due to non-recording of inventory shortage: Work-in-process Control A/cDr To Stores Ledger Control A/c In both the above situations, in the stores ledger, an entry for both quantity and value is recorded in the Issue Column and a reduction is made in the Balance Column.

15. © www.paperhint.com (c) In case of inventory gain, that is, when the stores ledger balance is less than the physical inventory (inventory overages), reverse adjusting entries of (a) and (b) above are passed. In the stores ledger, an entry for quantity and value both is recorded in the Received Column and addition is made in the Balance Column. (d)The above adjustments are made when the inventory shortage/overage is normal and is expected in the normal course of business operations. If the loss is abnormal/due to unusual circumstances such as fire, theft, sabotage, the proper treatment is to transfer it to costing profit and loss account: Costing Profit and Loss A/cDr To Stores Ledger Control A/c Abnormal loss is considered a non-manufacturing loss, and is taken as a period charge against income of the current accounting period. (e)If the discrepancies are slight, the balance of the stores ledger may be accepted for inventory verification and accounting purposes. No adjustment is required in such a situation.

16. © www.paperhint.com Inventory Control Techniques (i) ABC Analysis (ii) Economic Order Quantity (iii) Reorder- Point (iv) Safety Stock

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

18. © www.paperhint.com Economic Order Quantity (EOQ) The second key inventory problem relates to determination of the size/quantity of inventory which would be acquired. This is the order quantity problem. Stated with reference to cost perspective, EOQ refers to the level of inventory at which the total cost of inventory comprising (i) order/setup cost, and (ii) carrying costs is the minimum. Carrying Costs are cost associated with the maintenance/holding of inventory. Ordering Costs are costs associated with acquisition of/placing order for inventory.

19. © www.paperhint.com Solution Inventory Cost for Different Order Quantities 1.Size of order (units) 2.Number of orders 3.Cost per order 4.Total ordering cost (2 × 3) 5.Carrying cost per unit 6.Average inventory (units) 7.Total carrying cost (5 × 6) 8.Total cost (4 + 7) 1,600 1 Rs 50 50 1 800 850 800 2 Rs 50 100 1 400 500 400 4 Rs 50 200 1 200 400 200 8 Rs 50 400 1 100 500 100 16 Rs 50 800 1 50 850 Example 1 A firm’s inventory planning period is one year. Its inventory requirement for this period is 1,600 units. Assume that its acquisition costs are Rs 50 per order. The carrying costs are expected to be Re 1 per unit per year for an item. The firm can procure inventories in various lots as follows: (i) 1,600 units, (ii) 800 units, (iii) 400 units, (iv) 200 units, and (v) 100 units. Which of these order quantities is the economic order quantity? Working Notes (i) Number of orders = Total inventory requirement/ Order size, (ii) Average inventory = Order size/2

20. © www.paperhint.com Mathematical (Short-cut) Approach The economic order quantity can, using a short-cut method, be calculated by the following equation: EOQ = 2 AB/C Where A = Annual usage of inventory in units, B = Buying cost per order, C = Carrying cost per unit per year. √ Using the facts in Example 1, find out the EOQ by applying the short- cut mathematical approach. EOQ = 2 × 1,600 × 50 = 400 units. 1 √

21. © www.paperhint.com Reorder Point The re-order point is that level of inventory when a fresh order should be placed with suppliers. It is that inventory level which is equal to the consumption during the lead time or procurement time. Re-order level = (Daily usage × Lead time) + Safety stock. Minimum level = Re-order level – (Normal usage × Average delivery time). Maximum level = Reorder level – (Minimum usage × Maximum delivery time) + Re-order quantity. Average stock level = Minimum level + (Re-order quantity)/2. Danger level = (Average consumption per day × Lead time in days for emergency purchases).

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

23. © www.paperhint.com Units of inventory Stock outs X Y Figure: 7 Average inventory Lead time (4 days) Safety stock) 0 Safety stock usage during lead time delay Reorder point (ROP) Replenishment point Maximum inventory level Usage Rage (slope) 2468101214 16 320 240 200 160 80 0 600 560 480 400 Days Usage Rage (slope) With the withdrawal of raw material inventory from the store at the rate of 40 units per day, the balance of inventory stock declines to 360 units after 6 days [600 units – (40 units x 6 days)]. This level is the reorder point. If delivery is on time, the next replenishment point is reached at Day 10. On the 10th day the company has a maximum level of stock of 600 units. If, however, inventory is not received in time, the company has a safety stock of five days to fall back upon. Figure 7 has been drawn to show clearly the interrelationship that exists among various concepts of inventory discussed so far. It serves the useful purpose of presenting an integrated picture at one place. In the Figure, inventory of 400 units is delivered on Day 0. The company has the policy of maintaining a safety stock of 200 units. With the receipt of 400 units inventory on Day 0, the inventory level reaches 600 units (the maximum level).

24. © www.paperhint.com Cost of Inventory The cost of inventory may be said to be composed of two elements: (i) Inventory quantities determined on the basis of either physical count or perpetual inventory records and (ii) Unit cost. In general, the basis of inventory valuation is the “lower of cost or market” or more appropriately “the lower of actual cost or replacement cost.” Although replacement costs can be estimated for interim periods, and adjustments made later on to reflect the conditions at the close of the year, the market value can be known with certainty only at the close of the accounting period. As regards the actual cost, there are several elements associated with it. They are: (i) Invoice cost, (ii) Freight charges and costs of buying, receiving and storing, and (iii) Discounts-trade/quantity as well as cash.

25. © www.paperhint.com Methods of Inventory The proper costing of inventory is important from the point of view of the income determination and asset measurement. The important inventory costing methods are: FIFO Method Weighted Average Method LIFO Method Inflated Cost Method

26. © www.paperhint.com The FIFO method assumes that the inventory is consumed in chronological order, that is, items received first are deemed to have been issued/consumed first and priced accordingly. FIFO Method According to the Weighted Average Method, the weighted average price of purchases and inventory is taken as the basis for determining the cost of the inventory. Weighted Average Method

27. © www.paperhint.com Table 1 Inventory Valuation (FIFO Method) DateReceiptsIssuesInventory QuantityCostValueQuantityCostValueQuantityCostValue (1)(2)(3)(4)(5)(6)(7)(8)(9) January 1 9 12 27 February 10 16 March 3 17 29 April 4 18 23 May 12 24 June 10 30 Total 1,000 2,000 4,000 2,000 3,000 2,000 19,000 Rs 2.21 2.31 2.41 2.29 2.14 2.04 2.00 2.02 2.19 Rs 2,210 2,310 4,820 9,160 4,280 4,080 6,000 4,040 41,700 2,000 4,000 1,000 16,000 Rs 2.10 2.10 @ 2.40 Rs 4,200 8,400 9,340 2,400 35,140 10,000 11,000 9,000 10,000 6,000 8,000 10,000 6,000 10,000 12,000 8,000 10,000 9,000 12,000 11,000 13,000 Rs 2.10 — --- — Rs 21,000 23,210 19,010 21,320 12,920 17,740 22,560 14,160 23,320 27,600 18,260 22,340 19,940 25,940 23,540 27,580 @ 1,0002.212,210 1,0002.312,310 2,0002.414,820 4,000—9,340

28. © www.paperhint.com Table 2 Inventory Valuation (Average Cost Method) DateReceiptIssueInventory QuantityCost*ValueQuantityCost**ValueQuantityCost**Value (1)(2)(3)(4)(5)(6)(7)(8)(9) January 1 9 12 27 February 10 16 March 3 17 29 April 4 18 23 May 12 24 June 10 30 Total 1,000 2,000 4,000 2,000 3,000 2,000 19,000 Rs 2.21 2.31 2.41 2.40 2.29 2.14 2.04 2.00 2.02 Rs 2,210 2,310 4,820 4,800 9,160 4,280 4,080 6,000 4,040 41,700 2,000 4,000 1,000 16,000 Rs 2.11 2.13 2.24 2.20 2.15 Rs 4,220 8,520 8,960 2,200 2,150 35,010 10,000 11,000 9,000 10,000 6,000 8,000 10,000 6,000 10,000 12,000 8,000 10,000 9,000 12,000 11,000 13,000 Rs 2.10 2.11 2.13 2.20 2.24 2.26 2.24 2.20 2.15 2.13 Rs 21,000 23,210 18,990 21,300 12,780 17,600 22,400 13,440 22,600 26,880 17,920 22,000 19,800 25,800 23,650 27,690 * Actual ** Average

29. © www.paperhint.com The Inflated Cost Method takes into account normal material losses caused due to transportation, material handling and storage losses. Inflated Cost Method The LIFO method is based on the assumption that the cost of inventory is computed on the basis of the inverse sequence of receipts. LIFO Method

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

31. © www.paperhint.com PART B Additions at average cost: Inventory (January 1) Receipts Total Inventory (June 30) Inventory (January 1) Added Inventory Cost of inventory issued 10,000 3,000 13,000 10,000 19,000 29,000 13,000 — 16,000 2,10 2,19 2.10 2,19 21,000 6,585 21,000 41,700 62,700 27,585 35,115 PART C Additional at FIFO cost: Inventory (January 1) Receipts Total Inventory (June 30) Inventory (January 1) Receipts (June 30) Receipts (May 24) Cost of inventory issued — 10,000 2,000 1,000 13,000 10,000 19,000 29,000 13,000 — 16,000 2.10 — 2.10 2.02 2.00 — 21,000 4,040 2,000 — 21,000 41,700 62,700 27,040 35,660 (Contd.)

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

33. © www.paperhint.com Implications of Different Inventory Valuation Methods   When prices are stable, all inventory valuation methods give the same figure of cost,   When prices are rising, the LIFO produces the highest cost flow and the lowest inventory,   When prices are falling, the LIFO method produces the lowest cost and the highest inventory. The impact of FIFO is exactly opposite,   The LIFO and the FIFO methods are extremes and the weighted average method falls in between. The implication of different inventory costing method is:

34. © www.paperhint.com Table 5: Impact of Inventory Valuation on Cost Flows/Profits LIFO with additions at FIFO Average cost LIFO Average FIFO Beginning inventory Rs 21,000 Add: Receipts41,700 Total62,700 Deduct: Ending inventory 27,56027,69027,93027,58527,040 Materials put into process 35,14035,01034,77035,11535,660 It is clear from the table that each method produces a different figure for the transfer of raw materials to work-in-process. Ultimately, when the goods are sold, the varying methods of inventory valuation will have their impact on cost of goods sold and, thus, on profits.

35. © www.paperhint.com Just-IN Time However, it is more than an approach to inventory management. It is a philosophy of eliminating non-value- added activities. JIT, as an innovative manufacturing system, refers to acquiring materials and manufacturing goods only as needed to fill customer orders. Also called lean production system, it is a demand-pull manufacturing system because each component in a production line is produced as soon as and only when needed by the next step in the production line.

36. © www.paperhint.com Financial Benefits The benefits of JIT are in addition to lower carrying cost of inventory, improved quality, reduced rework, faster delivery and so on. The measures of performance that managers use to evaluate and control JIT are personal observations, financial, and non-financial measures. The effects of JIT on costing system are reduced overheads and direct tracing of some indirect costs.