MATERIALS. Where A = Annual usage units O = Ordering cost per unit C = Annual carrying cost of one unit i.e. Carrying cost % * Carrying cost of unit

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1 MATERIALS Introduction This Chapter deals with Calculation & Control of Material Cost. Normally Stock of material is valued either at cost price or Market Price whichever is lower. Under the Cost Price criteria method like FIFO, LIFO, Weighted Average, Simple Average are used. The Above Approach are related to calculation & valuation of material stock. However it is equally important to control the material cost. For controlling the cost, it is necessary to decide how much should be purchased, when to purchased, what should be stock level, How much discount should be demanded from the supplier etc. 1. EOQ EOQ (Economic Order Quantity - Wilson s Formula) = 2AO/C Where A = Annual usage units O = Ordering cost per unit C = Annual carrying cost of one unit i.e. Carrying cost % * Carrying cost of unit It represent the most economical quantity of material which should be purchased each time in order to minimise the ordering and carrying cost. At this point Ordering and carrying cost are least as well as equal. Following formulas are also relevant for computing the economic order quantity: Carrying Cost = Average inventory * Carrying cost per unit pa * Carrying cost % (Or) Average Inventory * Carrying cost per order pa Average inventory = EOQ/2 Ordering Cost = Number of Orders * ordering cost Number of Orders = Annual Demand / EOQ Working tip: Never round off number of orders as it may violate matching concept but always round off EOQ. Also, any excise duty if paid on goods should be excluded from cost of purchases if documents relating to credit of such tax paid have been enclosed with goods. In this regard, note may be given in exam. Specific items to be included: 1. Purchase price- includes freight inwards, duties and taxes paid to government. 2. Ordering cost- includes order processing cost, inspection cost per lot, follow up cost for each order. 3. Carrying cost- interest on locked up capital, pilferage.

2 2. Stock level formulas: 1) Reorder level = Maximum usage * Maximum reorder period (Or) Minimum level + (Average usage * Average reorder period) It is the level at which fresh order should be placed for replenishment of stock. 2) Minimum level = Reorder level (Average usage * Average lead time) It represents the lowest figure of inventory balance, which must be maintained in hand at all times, so that there is no stoppage of production due to non-availability of inventory. 3) Maximum level = Reorder level + Reorder quantity (Minimum usage *Minimum reorder period) It indicates the maximum figure of inventory quantity held in stock at any time. 4) Average level = Minimum level +Maximum level (or) 2 Minimum level + ½ Reorder quantity It represent on an average how much stock quantity should be maintained. 5) Danger level (or) safety stock level = Average usage * Lead time for emergency purposes It is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made. 3.ABC Analysis ABC Analysis (or) Pareto Analysis :- categorized into In this materials are Particulars Quantity Value A Important material 10% 70% B Neither important nor unimportant 20% 20% C UN Important 70% 10%

3 4.Material Losses Various Material Losses a) Wastage: Portion of basic raw material lost in processing having no recoverable value b) Scrap: The incidental material residue coming out of certain manufacturing operations having low recoverable value. c) Spoilage: Goods damaged beyond rectification to be sold without further processing. d) Defectives: Goods which can be rectified and turned out as good units by the application of additional labour or other services. Treatment of Material losses: a) Wastage Normal Absorbed in cost of net output Abnormal Transferred to costing P&L A/C b) Scrap If scrap value is negligible If not identifiable to a particular process or job If identifiable with a particular job or process and its value is significant: c) Spoilage normal spoilage abnormal spoilage d) Defectives inherent in the process and are identified as normal the cost of scrap is borne by good units and income scrap is treated as other income. The sales value of scrap net of selling and distribution cost, is deducted from overhead to reduce the overhead rate. The scrap account should be charged with full cost. The credit is given to the job or process concerned. Transfer any gain or loss to costing P&L A/c included in costs either charging the loss due to spoilage to the production order or by charging it to production overhead so that it is spread over all products. charged to the Costing Profit and Loss Account. 1.Charged to good products i.e. absorbed by good units 2.Charged to general overheads if the defectives caused in one department are reflected only on further processing 3. Charged to the department overheads

4 easily identifiable with specific jobs If the department responsible for defectives can be identified 4. Charged to Costing Profit and Loss Account If defectives are abnormal Rectification or rework costs are debited to the job. REVISION QUESTION: HS Company supplies plastic crockery to fast food restaurants in metropolitan city. One of its products is a special bowl, disposable after initial use, for serving soups to its customers. Bowls are sold in pack 10 pieces at a price of Rs. 50 per pack. The demand for plastic bowl has been forecasted at a fairly steady rate of 40,000 packs every year. The company purchases the bowl direct from manufacturer at Rs. 40 per pack within a three days lead time. The ordering and related cost is Rs. 8 per order. The storage cost is 10% per cent per annum of average inventory investment. Required: (i) Calculate Economic Order Quantity. (ii) Calculate number of orders needed every year. (iii) Calculate the total cost of ordering and storage bowls for the year. (iv) Determine when should the next order to be placed. (Assuming that the company does maintain a safety stock and that the present inventory level is 333 packs with a year of 360 working days. 5. Methods of pricing HINTS TO ANSWER (i) Economic Order Quantity= 400 packs. (ii) Number of orders per year=100 order per year (iii) Ordering and storage costs Rs. Ordering costs : 100 orders Rs. 8.00= 800 Storage cost : (400/2) (10% of 40) =800 Total cost of ordering & storage =1,600 (iv) Timing of next order: The next order for the replenishment of supplies has to be placed immediately. First-in-First out Method (FIFO): It is a method of pricing the issues of materials, in the order in which they are purchased. Suitability: 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. But, in the case of rising prices, if this method is adopted, the charge to production will be low as compared to the replacement cost of materials. Advantages : 1. It is simple to understand and easy to operate. 2. Material cost charged to production represents actual cost with which the cost of production should have been charged. 3. In the case of falling prices, the use of this method gives better results.

5 4. Closing stock of material will be represented very closely at current market price. Disadvantages : 1.If the prices fluctuate frequently, this method may lead to clerical error. 2.The costs charged to each job may vary from year to year due to the variations in the issue prices of materials to the job arising as a result of changes in purchase prices every year. 3.This method fails in case of rising prices as it will always depict the profit to be continuously falling. Last-in-First out method (LIFO): This method is based on the assumption that the items of the last batch (lot) purchased are the first to be issued. Therefore, under this method the prices of the last batch (lot) is used for pricing the issues, until it is exhausted, and so on. Suitability: During inflationary period or period of rising prices, the use of LIFO would help to ensure that the cost of production determined on the above basis is approximately the current one. This method is also useful specially when there is a feeling that due to the use of FIFO or average methods, the profits shown and tax paid are too high. Advantages : 1. The cost of materials issued will reflect the current market price. 2.Such a trend in price of materials enables the matching of cost of production with current sales revenues. 3. The use of the method during the period of rising prices does not reflect undue high profit in the income statement as it was under the first-in-first-out or average method. In fact, the profit shown here is relatively lower because the cost of production takes into account the rising trend of material prices. 3. In the case of falling prices profit tends to rise due to lower material cost, yet the finished products appear to be more competitive and are at market price. 4. Over a period, the use of LIFO helps to iron out the fluctuations in profits. 5. In the period of inflation LIFO will tend to show the correct profit and thus avoid paying undue taxes to some extent. Disadvantages : 1. Calculation under LIFO system becomes complicated and cumbersome when frequent purchases are made at highly fluctuating rates. 2. Costs of different similar batches of production carried on at the same time may differ a great deal. 3. In time of falling prices, there will be need for writing off stock value considerably to stick to the principle of stock valuation, i.e., the cost or the market price whichever is lower. 4. This method of valuation of material is not acceptable to the income tax authorities. Base Stock Method A minimum quantity of stock under this method is always held at a fixed

6 price as reserve in the stock, to meet a state of emergency, if it 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 FIFO or LIFO basis which will determine its merits and shortcomings. Simple Average Price Method - Under this method, materials issued are valued at average price, which is calculated by dividing the total of all units rate by the number of unit rate. Material issue price = Total number of purchases Total of unit prices of each purchase Suitability: 1. Materials are received in uniform lots of similar quantity, 2. Absence of huge fluctuations in purchase prices of materials Weighted Average Price Method: This method gives due weights to quantities purchased and the purchase price for determining the issue price. The average issue price here is calculated as follows: total cost of materials in the stock total quantity of materials prior to each issue Advantages : 1. It smoothens the price fluctuations 2. Issue prices need not be calculated for each issue unless new lot of materials is received. Disadvantage : 1. Material cost does not represent actual cost price and therefore, a profit or loss will arise out of such a pricing method. 2. It may be difficult to compute since every new lot received would require recomputation of issue prices. Periodic Simple Average Price Method: This method is similar to Simple Average Price Method except that the average price is calculated at the end of the concerned period. Weighted Periodic Simple Average Price Method: This method is like weighted average price method, except that the calculations of issue prices are made periodically (say, a month) Moving Simple Average Method: Under this method, the rate for material issues is determined by dividing the total of the periodic simple average prices of a given number of periods by the numbers of periods. Moving Weighted Average Price Method : Under this method, the issue, rate is calculated by dividing the total of the periodic weighted average price of a given number of periods by the number of periods. Replacement Price Method: Under this method, materials issued are valued at the replacement cost of the items.

7 Realisable Price Method: Realisable price means a price at which the material to be issued can be sold in the market. Standard Price Method: Under this method, materials are priced at some predetermined rate or standard price irrespective of the actual purchase cost of the materials. Such standard price is fixed after taking into consideration the Current prices, Anticipated market trends, and Discount available and transport charges etc. Inflated Price Method : In this method, issue price of the material is inflated to cover up the losses in weight due to natural or climatic factors, e.g., evaporation, 5.PERIODIC V/S PERPETUAL INVENTORY SYSTEM 6. SOME USEFUL DEFINITION S Re-use Price Method When materials are rejected and returned to the stores or a processed material is used for a purpose which is different from the purpose for which they were originally purchased,then such materials are priced at a rate quite different from the price paid for them originally. There is no final procedure for such valuation. Under the periodic system, merchandise purchases are recorded in the purchases account, and the inventory account balance is updated only at the end of each accounting period. With the help of inventory account balance thus obtained cost of goods sold is computed as follows: opening stock + purchases closing stock. Under the perpetual system, purchases, purchase returns and allowances, purchase discounts, sales, and sales returns are immediately recognized in the inventory account, so the inventory account balance should always remain accurate, assuming there is no theft, spoilage, or other losses. With the help of the above records we compute inventory balance at year end through the column of Balance stock at the year end. Material Requisition Note: Document used to authorize and record the issue of materials from stores to production department. Purchase Requisition Note: Document is prepared by the storekeeper to initiate the process of purchases. Bin Card: Bin cards are the quantitative records of stores showing quantities received, issued to production and balance stock available.

8 REVISION QUESTION The following information is provided by HS INDUSTRIES for the fortnight of April,2011: Material Exe : Stock on units at Rs. 5 per unit. Purchases units at Rs units at Rs units at Rs. 8 Issues units units units Required (A) Calculate using FIFO and LIFO methods of pricing issues: (a) the value of materials consumed during the period (b) the value of stock of materials on (B) Explain why the figures in (a) and (b) in part A of this question are different under the two methods of pricing of material issues used. You NEED NOT draw up the Stores Ledgers. HINTS TO ANSWERS (A)Total value of material Exe consumed during the period under FIFO method comes to (Rs. 1,400 + Rs. 2,650 Rs. 3,750) Rs. 7,800 and balance on is of Rs. 2,800. Total value of material Exe issued under LIFO method comes to (Rs. 1,500 + Rs. 2,800 + Rs. 4,000) Rs. 8,300 (B) MATERIAL CONSUMED CLOSING STOCK FIFO Oldest prices latest prices LIFO Latest prices Oldest prices