Elements of Cost: Materials

Transcription

1 Course: Subject: Lesson: Authors Name: Reviewer s Name: COMMERCE (CBCS) Cost Accounting Elements of Cost: Materials Dr. Tonika Rana Daulat Ram College Dr. Gurmeet Kaur Fellow in Commerce, ILLL Associate Professor, Daulat Ram College, 1

2 Table of Contents: Lesson: Elements of Cost: Materials 1: Learning Outcomes 2: Introduction 3: Meaning of Material 3.1 Direct Material 3.2 Indirect Material 4: Inventory Control 5: Objectives of Inventory Control 6: Techniques of Inventory Control 6.1 ABC Analysis 6.2 Determination of Stock Levels 6.3 Economic Order Quantity 6.4 Inventory Turnover Ratio 6.5 Review of Slow and Non moving Items 6.6 Perpetual Inventory System and Continuous Stock Verification 6.7 Two Bin System 6.8 Just In Time purchases 7: Purchase of Materials 7.1 Meaning of Purchases 7.2 Objectives of Purchases 7.3 Functions of Purchase Department 7.4 Centralised Vs Decentralised Purchasing 7.5 Purchase Procedure 8: Storage of Materials 8.1 Objectives of Efficient Store Keeping 8.2 Functions of Store Department 9: Issue of Materials 9.1 Material Requisition 9.2 Bill of Materials 9.3 Transfer of Surplus Material 9.4 Return of Material to Store 10: Methods of Pricing of Materials Issues 10.1 First In First Out (FIFO) 10.2 Last In First Out (LIFO) 10.3 Simple Average Price Method 10.4 Weighted Average Price Method 10.5 Replacement price Method 10.6 Standard Price Method 11: Accounting of Material Losses Summary Exercises Glossary References 2

3 1. Learning Outcomes: After you have read this lesson you should be able to: Understand the concept of materials and distinguish it between direct and indirect materials. Learn the concept of Inventory Control, its objectives and various techniques like ABC Analysis, Economic Order Quantity etc. Know how stock levels are set to keep them at optimum level Understand the procedure of purchasing, storage and issue of materials. Understand the various methods of pricing, the material issues and their advantages and disadvantages. Describe various types of material losses, understand how to control them and comprehend their accounting treatment. 2. Introduction: Material is the substance which is consumed for the purpose of production of goods or services. It is defined as anything that can be stored. Material costs generally constitute a vital component of the cost of the end product for most of the manufacturing organisations. Also, materials are regarded as equivalent to cash. Hence, an efficient system for accounting and control of material is of paramount importance. This will help to minimise cost of materials through economy in purchasing, reducing storage cost, eliminating wastage and losses of materials in production and storage to the extent possible. This will ultimately help to keep the overall cost of the product in check. An adequate system for material cost control; the cost accounting system cannot be effective. A number of tools, techniques, methods and procedures have been evolved over a period of time for proper accounting and control of material cost. 3. Meaning of Material: Material includes any substance which is used for the purpose of production of goods or services. It is defined as 'anything that can be stored, stocked or stockpiled'. Materials are classified into direct materials and indirect materials. 3.1 Direct Materials Materials that are easily identified with specific production units are called direct materials. They usually become a part of the finished products. For example, plastic used in toy factory, wood pulp used in paper industry etc. 3.2 Indirect Materials Materials that cannot be conveniently identified with individual cost units are known as indirect materials. They are indirectly consumed in the conversion of finished products from raw materials. For example, adhesive used in the manufacturing of notebooks, threads used in the readymade garments, etc. 4. Inventory Control: Adequate and proper control of materials and supplies, work in progress, and finished goods is an important feature of a cost accounting system. Investment in inventory normally accounts for about one half of the product cost. Since this cost is 3

4 controllable, proper planning, purchasing, handling and accounting are of great importance. Inventory control is a system which ensures the provision of required quality of inventories of the required quality at the required time with the minimum amount of capital. Efficient inventory control keeps cost down and helps production run smoothly. 5. Objectives of Inventory Control: The purpose of inventory control or the control on the materials used in the production process aims at accomplishing the following objectives: 1. Ensure an uninterrupted supply of various components, materials and parts required for efficient and continuous production. 2. Minimise the investment in the inventories subject to the operating requirements. 3. Store materials with a minimum of handling time and cost and protect them from loss by fire, theft and damage through handling. 4. Derive maximum economy in the cost of purchasing and inventory holding. 5. Maintain the surplus, inactive and the obsolete items to a minimum level by systematic reporting of production changes which affects material requirements. 6. Techniques of Inventory Control: The techniques commonly used for inventory control are as follows: 1. ABC analysis 6.1 ABC Analysis 2. Fixation of stock levels. 3. Economic order Quantity. 4. Inventory turnover ratio. 5. Review of slow and non moving items. 6. Use of perpetual inventory system and continuous stock verifications. 7. Two-Bin system. 8. Just-In-Time (JIT) purchasing. ABC Analysis is an inventory control technique for exercising selective control over different types of items in the stock. Broadly the stock is classified on the basis of the investment involved into three categories based on their importance, i.e., their value and frequency of replenishment during a period. (i) A category It contains a small percentage of items say, about 10% of the total items in the stock but they require heavy investment say, about 70% of inventory value. These items have high prices and heavy requirements. The items belonging to category 'A' can be effectively controlled by employing a regular system of inventory control to avoid over-stocking as well as the shortage of the materials. Budgets are prepared for planning the total material requirements and the stocks are controlled by establishing certain levels like maximum level, minimum level and re-order level. Determining economic order quantity helps in the reduction of the costs of inventory management. 4

5 Figure 1: ABC Analysis of Inventory Source: (ii) B category It consists of the items that are relatively less important than category A items. Their quantity amounts to approximately 20% of the total items of material maintained in stores and they require around 20% of the total investment in inventories. Since a moderate amount is involved in the case of items belonging to the category 'B', degree of control required is not same as applied in the case of category 'A'. Periodical review of the items is done before ordering such items. (iii) C category It includes items that do not require much investment but are large in terms of the percentage of the items handled by the store. Their value may be just 10% of total value of the inventory but they are nearly 70% of the total items handled by a store. Constant control is not warranted for the items belonging to category 'C'. After ascertaining the consumption requirements of these items, orders may be placed either after six months or once in a year in order to economise the ordering and handling costs. 5

6 Value Addition 1: Activity Source: logistics/ module_03/how_to.html 6.2 Determination of Stock Levels The materials department determines the various levels of inventory for setting different stock levels in order to ensure smooth operation of the production process as well as the allocation of appropriate amount of monetary resources to different items in the inventory. These levels of stocks can be discussed as follows: (a) Maximum level It is the level of the maximum quantity of an item that can be held in the stock at any point in time. It is the level above which stock should not be allowed to rise. It is fixed after considering the following factors: Rate of consumption of materials Reorder quantity Requirement and availability of capital Availability of storage and cost of storing including insurance coverage. Keeping quality of material intact Price fluctuations Risk of obsolescence Restrictions, if any, imposed by the government or any other authority Maximum level can be calculated as: Maximum Level = Re-order level + Re-order quantity - (minimum consumption x minimum re-order period) 6

7 (b) Minimum Level It represents the quantity below which the stock of an item should not be allowed to fall. It is essentially a safety or buffer stock which acts as a cushion against stock outs. The minimum stock level is fixed by taking into account: Re-order level Lead time, i.e. time lag between the date of issuing order and the receipt of materials. Average rate of consumption of material. Minimum level is computed using the following formula: Minimum Level = Re-order level - (Normal consumption x Normal re-order period) (c) Re-order Level It is the level of inventory at which it becomes necessary to initiate purchase order for fresh supplies. The re-order level is generally a point between the maximum and the minimum level. Fresh orders must be placed before the actual stocks touch the minimum level, so as to take care of lapse in time in between placing the order and the receipt of materials. This level depends on: Rate of consumption Minimum Level Delivery Time i.e. lead time Variation in delivery time Ordering level is calculated using the formula: Ordering Level = Maximum consumption x Maximum re-order period (d) Danger or Safety Level The danger level is below the minimum level and represents a stage where immediate steps are taken for getting stock replenished. When the stock reaches danger level it is indicative that if no emergency steps are taken to replenish the stock, the stores will be completely exhausted and normal production stopped. Formula for Calculating Danger Level is: Danger Level = Average consumption x maximum delivery period for emergency purchases (e) Average stock level The average stock level is calculated as follows: 7

8 Average stock level = (Maximum stock level + Minimum Stock level) 2 OR (Minimum stock level + 1/2 of Re-order quantity Illustration 1: In a manufacturing company, a material is used as follows: Maximum consumption Minimum consumption Normal consumption Re-order quantity 12,000 units per week 4,000 units per week 8,000 units per week 48,000 units Time required for delivery: Minimum 4 weeks; maximum 6 weeks. Calculate: Solution: (a) Re-order Level (b) Minimum Level (c) Maximum Level (d) Danger Level (e) Average stock Level (a) Re-order Level = Maximum consumption x Maximum delivery period = 12,000 units x 6 weeks = 72,000 units (b) Minimum Level = Re-order level - (Normal consumption x Normal re-order period) (c) Maximum Level (d) Danger Level = 72,000 units - (8,000 units x 5 weeks) = 32,000 units = Re-order level + Re-order quantity - (minimum consumption x minimum re-order period) =72,000 units + 48,000 units - (4,000 units x 4 weeks) =1,04,000 units = Normal consumption x Delivery period for emergency purchases =8,000 units x 3 weeks = 24,000 units Note: It is assumed that delivery period for emergency purchase is 3 weeks (less than minimum time of delivery) (e) Average stock level = (Maximum stock level + Minimum Stock level) 2 = (32, ,04,000) 2 units = 68,000 units 8

9 6.3 Economic Order Quantity (EOQ) Inventory management deals with an important decision of how much to order? Since the purchasing cost and the holding costs of materials are quite high, the purchase quantity cannot be too less or too high. Therefore the quantity purchased is according to the Economic Order Quantity (EOQ). EOQ is the optimum size of the lot to be purchased which is economically viable and costs minimum. It is the point at which the inventory carrying costs are same as the ordering costs. The basic assumption of ascertaining the economic order quantity is that the inventory cost consists only of two components viz., ordering costs and carrying costs. (a) Ordering Cost: It is the cost of purchasing or ordering the materials. It is made up of the following: (b) Carrying Costs Remuneration of the staff engaged in the ordering. They undertake the activities of processing the purchase order, placing the order with the suppliers, etc. Transportation costs incurred on goods purchased. Cost incurred on the stationery, postage, typing, telephone etc. These are the costs for holding the inventories. These costs will not be incurred if inventories are not carried. These costs include: The cost of capital invested in inventories. Cost of storage which could have been used for other purposes. The loss of materials due to deteriorations and obsolescence. Insurance costs. Costs of spoilage in handling of materials. Economic Order Quantity is the quantity ordered for which both the ordering and carrying costs are the minimum. The formula used for determining economic order quantity is as follows: EOQ = where, A = Annual Consumption of material (in units) O = Cost of placing an order C = Annual Cost of storage per unit Value Addition 2: Further Understanding Economic Order Quantity Click on the link below for better understanding of the topic. Source : 9

10 Diagrammatically, EOQ can be represented as follows: Figure 2: Components of Economic Order Quantity Source: Illustration 2: XYZ Ltd. manufactures a product, which requires 'Abc'. The following particulars were collected for the year Monthly demand of 'Abc' 7500 units Cost of placing an order Rs.500 Re-order period 5-8 weeks Cost per unit Rs.60 Carrying cost % p.a. 10% Normal usage 500 units per week Minimum usage 250 units per week Maximum usage 750 units per week Required: (i) Re-order quantity (ii) Re-order level (iii) Minimum stock level (iv) Maximum stock level (v) Average stock level 10

11 Solution: (i) Re-order quantity = 2 x A x O / C = 2 x 7500 x 12 x 500 / 60 x 10% = 3,873 units (ii) Re-order Level = Maximum consumption x Maximum delivery period = 750 units x 8 weeks = 6,000 units (iii) Minimum Level = Re-order level - (Normal consumption x Normal re-order period ) = 6,000 units - (500 units x 6.5 weeks) = 2,750 units (iv) Maximum Level = Re-order level + Re-order quantity - (minimum consumption x minimum re-order period) = 6,000 units units - (250 units x 5 weeks) = 8,623 units (v) Average stock level = (Maximum stock level + Minimum Stock level) 2 = (2, ,623) 2 units = 5,687 units 6.4 Inventory Turnover Ratio Inventory turnover ratios are calculated to indicate weather inventories have been used efficiently or not. The purpose is to ensure the blocking of only required minimum funds in inventory. The ITR also known as stock velocity calculated as raw material consumed / average inventory costs. Inventory conversion period may also be calculated to find the average time taken for clearing stocks. Inventory Turnover Ratio = Raw material consumed Average Inventory Where, Raw Material Consumed = (Opening stock of Raw Material + Raw Material Purchased - Closing Stock of Raw Material) Average Inventory = Opening Stock Of Raw Material + closing Stock Of Raw Material 2 Inventory Conversion Period = Days / Months / Weeks in a year Inventory Turnover Ratio 11

12 6.5 Review of Slow and Non-moving items When more money is blocked in inventories lesser amount available for Working Capital. It also increases the cost of carrying of the inventory. The manager has to ensure that the Stock turnover ratio is as high as possible and the losses occurring due to obsolescence of materials are either eliminated or the obsolete items are used profitably. The slow moving stock should be identified and disposed of speedily. Detection of Slow moving and Non-moving items: Slow moving and non-moving items of stores can be detected in the following ways: Preparing and scanning periodic reports showing the status of different items of stores, Calculating the stock holding of various items in terms of number of days/months of consumption, Computing ratios periodically, relating to the issues as a percentage of average stock held, Implementing the use of a well designed information system. 6.6 Perpetual Inventory System and Continuous Stock Verification The system of recording stock balances after every receipt and issue is known as the Perpetual Inventory system. This system facilitates regular checking of the stock and does not require closing down of the business for the purpose of stock-taking. Thus, the current balance of stock is always known in the records, all receipts of materials are added to the stock balance and any issues are deducted from it after each transaction. Perpetual inventory system is implemented as follows: (i)reconciliation of the Bin Cards and Stores Ledger Accounts Each item of the store is recorded simultaneously at two places viz., bin card and the stores ledger. They are the perpetual inventory records. The balances of an item of stock as shown in the bin card must match with its record as in the stores ledger. Any difference between these two figures occurs due to: (a) an arithmetic error in calculating the balance; and/or (b) incorrect recording or not recording a transaction in the bin card or stores ledger. The balances of the two records need to be reconciled after posting the requisite rectifying entries. (ii) Physical Stock Verification In a perpetual inventory system, the book balances as shown by bin cards and stores ledger should match with the actual physical balance in the store. This is best done by continuous stock taking, which is an integral part of perpetual inventory system. The primary objectives of continuous stock taking are to confirm that the perpetual inventory system is functioning properly and to bring records into line with the physical stocks. Under this system, a few items of stores are counted daily or at frequent intervals and compared with the bin cards and stores ledger by the stores auditor. Whenever there is a difference between the recorded balance and actual stocks, an enquiry is made and the difference is adjusted in the records to make them correspond with the physical count. Advantages of Perpetual Inventory System Perpetual Inventory System has the following advantages: 12

13 1. It ensures that physical checking of the entire stock of materials at the end of the year is avoided. 2. It also curtails the disruption in the production which occurs due to the periodic stock taking at the end of the year. 3. Stock figures are readily available which help in the preparation of the Profit and Loss account and Balance Sheet at interim periods. 4. Up-to-date records are maintained under the system which acts as a moral check on the staff of the stores department. 5. It ensures the operation of a system of internal checks at all the times. 6. It helps in finding and rectification of the discrepancies and preventing its future recurrence. 7. It also helps in maintaining the stocks within the limits decided upon by the management to prevent excessive working capital being sunk in the stocks. Bin Cards Bin means a rack, container or space where goods are kept. For each kind of material, an inventory tag is attached to the bin and a bin card is maintained. A bin card is a quantitative record of receipts, issues and closing balances of each item of stores. The bin cards are used not only for entering the receipts and issues but also for controlling the stock by watching the maximum and minimum levels stated on the card. When the ordering level is reached the store keeper has to send requisition for further supplies. For each entry, whether relating to issue or receipt, the balance quantity is calculated and recorded in the balance column. It should agree with the physical balance in bins and store ledger balances. Stores Ledger The cost office maintains a store ledger in which a separate account is opened for each kind of materials stocked in stores. It is generally maintained in the form of loose leaf cards because they can be removed or inserted in the ledger conveniently. The card is allotted to each item of materials. Entries made in the stores ledger are identical to those on bin cards except that money values are also shown in the stores ledger. The stores staff should have no connection with the writing up of the stores ledger otherwise it will fail to impose an internal check upon the stores staff to maintain accurate store record. Value Addition 3: Did You Know? Difference Between Bin Card and Stores Ledger Bin Card 1. The store keeper maintains the bin card in a store. 2. A bin card maintains the quantitative details of material received, issued and returned to the stores. 3. The entries are done in a bin card as and when the transactions take place. 4. Transactions individually posted in a bin card. 5. It does not contain any inter departmental transfers. Stores Ledger 1. It is maintained in the costing department. 2. It contains information both in quantity and value. 3. It is always posted after the transaction. 4. Transactions may be summarized and then posted in stores ledger. 5. Materials transfers from one job to another job are recorded for costing purposes. 13

14 6.7 Two Bin System The Two Bin System divides each of the bins into two parts. Part 1 is a smaller part which maintains the stock at the minimum level or the re-ordering level. Part 2 is used to keep the remaining quantity. The stocks are issued out of the larger part of the bin. A fresh order is placed when it is imperative to use the quantity out of the smaller part of the bin. This system supplements the record of respective quantities on the bin card and the stores ledger card. 6.8 Just in Time (JIT) purchases Just in Time involves the purchase of goods or materials such that delivery immediately precedes their use. This will ensure that stocks are as low as possible. Just in Time purchases in implemented by developing closer relationship with supplier so that the company and supplier work together cooperatively. In Just in Time purchasing, arrangement is made with supplier for more frequent deliveries of smaller quantities of materials so that each delivery is just sufficient to meet immediate production requirements. Advantages of Just in Time system: The system of Just in Time has the following advantages: 1. The suppliers cooperate with the company and supply requisite quantity of goods or materials as the order is placed before the start of production. 2. Investments in raw materials and WIP is substantially reduced. 3. It results in savings is factory space. 4. Just in Time purchases results in cost savings for example, the costs of stock out, inventory carrying materials handling and breakage are reduced. 5. Due to frequent purchases of raw materials, its issue price is likely to be very close to the replacement price. Consequently the method of pricing to be followed for valuing material issues become less important for companies using Just in Time purchases. 6. Just in Time purchasing extends daily deliveries to as many areas as possible to ensure that the goods spend less time in warehouses or on stores shelves before they are exhausted. 7. Purchase of Materials: 7.1 Meaning of Purchasing Purchasing means the procurement of materials, components, supplies etc. required for use in production and other department of an enterprise. 7.2 Objective of Purchasing The objective of purchasing is to procure the materials of the right quality, in the right quantity, at the right time, at the right price, from the right source. 7.3 Functions of the Purchase Department Purchase Department works under the supervision and control of Purchase Manager. The main functions of Purchase Department are as follows: 1. To receive the purchase requisition from the department which needs the material. 2. To select the supplier from whom the materials are to be purchased. 14

15 3. To place the purchase order with selected supplier. 4. To follow up the purchase order. 5. To check and pass the purchase invoice for payment. 6. To maintain a list of the names and addresses of suppliers for every group of materials generally required. 7. To maintain relations with the suppliers. 8. To co-ordinate and supervise the staff of the purchase department. 9. To maintain the purchase records. 10. To purchase the right quality of materials in the right quantity at right price and at right time. 7.4 Centralised Purchasing vs. Decentralised Purchasing Keeping in view the size and the requirements of an organisation, the function of the purchasing can be either centralised or decentralised. Centralised Purchasing In centralised purchasing, there is only one purchase department which is authorised to make all purchases. Decentralised Purchasing In decentralised purchasing, each department is authorised to make its own purchases. Advantages of Centralised Purchasing 1. It uses the specialised knowledge and skill by appointing specialised and expert purchasing staff. 2. To bring about economies of bulk purchases. 3. It facilitates the standardisation of materials. 4. It facilitates effective control over purchases, by maintaining an efficient system of ordering, receiving, inspection, accounting etc. 5. It ensures consistent policy with regard to purchases. (e.g. regarding terms of payment, cost of delivery etc.) 6. it brings about economies of centralised accounting of purchases. 7. it is suitable when there is only one plant or several plants are not located far away from each other and are using same materials. Disadvantages of Centralised Purchasing 1. It is expensive due to increase in administration cost of a separate purchase department. 2. It is not suitable when plants or departments are located far away from one another or are using different materials. 3. It may cause delay in placing the purchasing order or receiving the materials due to rigid purchase procedure. 4. It may create problems in emergent situations when local purchases are needed. 7.5 Purchase Procedure Depending upon the size and nature of the operations the purchase procedure may 15

16 differ from organization to organization. However, the main steps involved in purchasing procedure are as follows : 1. Receipt of Purchase Requisition Purchase requisition can be defined as a document containing the request to purchase department for purchasing the materials contained therein. It should be prepared by a person who is duly authorised to issue such request. The Purchase requisition is prepared by the store keeper for regular stock items and by the department head for materials not usually stocked. The purchase requisition contains the requisition number, date, department, code number, description and quantity of materials required, signature of the person initiating the requisition and signature one or more executives approving the purchase requisition. It can be prepared in triplicate, the original copy can be sent to the purchasing department, the second copy can be retained by the department initiating it and third copy can be sent to costing department. Value Addition 4: Image A Specimen Performa of Purchase Requisition Source : 2. Selection of supplier After receiving the duly authorised purchase requisition, the purchase department invites tenders or quotations for the supply of materials. On receipt of the quotations from the suppliers, a comparative statement known as ' schedule of quotations' is to 16

17 be prepared to select a supplier who offers most favourable terms and conditions of supply. Usually factors like price, quality, time of delivery, dependability of the supplier, discount, credit facility, terms of payment etc. should be considered while selecting a particular source of supply. 3. Purchase Order When a source of supply has been decided, the purchase officer prepares a purchase order, which is the evidence of the contract between the purchaser and his supplier. A purchase order is thus a order made by the purchaser to a supplier to supply the materials contained therein as per the terms and conditions agreed upon. It is a commitment on the part of the purchaser to accept supply and make payment as per the terms stated therein. The purchase order should contain such particulars as date, name and address of the supplier, description and specifications of the material, quantity ordered, date, time and place of delivery, price, terms of payment, transport charges, packing and shipping instructions, the name and address of the buyer and the signature of the purchase manager. 4. Receipt and Inspection of Materials The receiving department is responsible for taking delivery of supply and to get a physical verification of the content according to the suppliers invoice or the consignment note. After the contents of the supply have been checked, the details of the materials received are entered in a document called Goods Received Note (GRN). Hence, a goods received note provides a complete record of all materials received and the quantity thereof. Five copies of the note can be prepared. One copy is kept by the receiving department while the remaining copies are sent to the purchase department, the department initiating the purchase requisition, the store department and the accounts department. Goods received note can be combined with inspection note. 5. Checking and Passing of Purchase invoice for Payment Invoice is the document giving details of goods supplied and the amount to be paid. Invoice received by the purchase department is forwarded to the accounting department to check the authenticity as well as the arithmetical accuracy. The quantity and the price mentioned in the invoice are checked with reference to goods received note and the purchase order respectively. For adjustment of discrepancies, the inspection report and goods returned note should be compared with the invoice. if the contents of the invoice are found to be correct, an endorsement to that effect is made on it. With the signature of the purchase manager, the invoice is passed on to the accounts department for payment. 6. Making payment to supplier On receipt of purchase invoice, the accounts department checks the authenticity and the arithmetical accuracy of the invoice, then prepares a voucher authorising payment, enters the same in records and makes the payment of the invoice as per terms of payment. 8. Storage of Materials After the purchase, receipt and inspection of materials, the next most important function in the process of material control is concerned with the storage and issue of materials. This function is termed as storekeeping. It consists of the function of receiving, classifying and codifying of materials, storing and issuing them to the departments against duly authorised document. For carrying the task of storekeeping, a separate stores department under the charge of a competent storekeeper is set up. 17

18 The storekeeper should have the technical knowledge and experience in all stores routine. Value Addition 5: Image A specimen Performa of Purchase Order Source : 18

19 Value Addition 6: Image A specimen Performa of Goods Received Note is given below : Source: jpg 8.1 Objectives of Efficient Store Keeping The objectives of an efficient system of storekeeping are as follows It should ensure uninterrupted supply of all types of materials and stores at the required time to various production and service departments of the organization. It should avoid both overstocking and under stocking of materials. It should minimise the costs involved in storekeeping function. It should prevent all kinds of materials from theft, deterioration, evaporation and pilferage. It should ensure an effective utilisation of available storage space and human resources engaged in the process of storekeeping. It should develop a system of providing necessary information about the material items in the stores as and when required. 8.2 Functions of Stores Department The following functions are performed by the stores department: Receipt of material from the goods receiving department. It must be ensured that every item of stores received by a storekeeper should be supported by a valid document like a purchase order, goods received note, and an inspection note. Proper classification and codification of all type of material. Issue purchase requisition to the purchase department as and when the stock of material reaches the re-order level. 19

20 Maintain proper record of receipt, issue and balance of all items of materials, and check the bin card balances with the physical quantities in the bins on continuous basis. Placing and arranging materials received at proper and appropriate places so as to prevent losses due to defective storage and handling. Issue stores, against proper authorisation, in right quantity of right specification, and at the right time. Minimising the storage handling and maintaining costs. Ensuring that the stocks neither exceed the maximum level nor fall below the minimum level at any point of time. Preventing the entry of unauthorised persons into the stores. Carrying out a regular review of the items of stores in hand for identifying slow moving, non-moving and obsolete items. 9. Issue of Materials: The following two documents are used for issue of materials to production department. 9.1 Material requisition Material requisition is a document which is used to authorise and record the issue of materials from the store. It is usually prepared by a foreman but in case of costly materials or large quantity of materials, an approval by some higher authority may be required. Usually three copies of material requisition are prepared viz., one copy for the store keeper, one copy for the cost accounting department and one copy for the department initiating it. Value Addition 7: Image A Specimen Performa of Material Requisition Note Source : 20

21 9.2 Bill of Materials Bill of materials is a list of standard quantities of all materials required for a particular job or work order or a process. It is prepared by engineering or planning department in a standard form on receipt of an order. Usually four copies of the bill of material are prepared. One copy for the production department, one copy for the stores department, one copy for the cost accounting department and one copy is retained by the engineering or planning department. Value Addition 8: Image A Specimen Performa of Bill of Materials Source: jpg /clip_image 9.3 Transfer of Surplus Materials Direct transfer of material from one job to another may be allowed if the purpose is to avoid the delay, to avoid unnecessary transportation cost and to avoid unnecessary material handling costs. Such direct transfer of materials should be done through Material Transfer Note. Material Transfer Note is a document that contain details as to what is transferred from where to where. Transferor department prepares three copies of Material Transfer Note, signs all the three copies and sends two copies to receiving department and retains one copy for its own reference. Receiving department sends one copy after signature to the cost accounting department. 21

22 Value Addition 9: Image A specimen Performa of Material Transfer Note Source: jpg 9.4 Return of Materials to Store Whenever materials supplied to a job are in excess of its requirement or are found defective, such materials are returned to the stores. Such materials should be returned with 'Material Returned Note'. Material Returned Note is a document which contains details regarding the materials returned to stores. Returning department prepares three copies of material returned note and sends two copies to the stores department and retains one copy for its own reference. Stores department records in the bin card and sends one copy after signature to the cost accounting department. 10. Method of Pricing of Material Issues: When materials are issued to production department, a difficulty arises regarding the price at which materials issued are to be charged. The same type of material may have been purchased in different lots at different times at several different prices. This means that actual cost can take on several different values and same method of pricing the issue of materials must be selected. There are numerous methods of pricing issue which can be discussed as follows: 10.1 First in First Out (FIFO) Method It is based on the assumption that the goods which are received first are issued first. This assumption is made for the purpose of assigning costs and not for the purpose of the physical flow of the goods. It uses the price of the first lot received for all the issues until all units from this lot 22

23 have been issued after which the price of the next lot received is used for pricing and so on. Value Addition 10: Image A Specimen Performa of Material Returned Note Source : Advantages of FIFO method It is simple to understand and easy to operate if prices of materials do not fluctuate frequently. No unrealised inventory profits / losses are made by using this method because it is based on cost. The value of closing stock tends to be nearer current market prices because it represents the cost of recent purchases. In periods of falling prices, lower income is reported since old costs are matched with current revenue. As a result, income tax liability is reduced. Disadvantages of FIFO method This method involves a lot of calculation work in case there are violent fluctuations in the prices of the materials. In a period of the fluctuating prices, the cost of issues do not represent the current market prices. In periods of rising prices, higher income is reported since old costs are matched with current revenues. As a result, income tax liability increased Last in First out (LIFO) Method It is based on the assumption that the goods which are received last are issued first. This assumption is made for the purposes of assigning costs and not for the purposes of the physical flow of goods. It uses the price of the last lot received for all the issues until all units from this lot have been issued after which the price of previous lot received is used for pricing 23

24 and so on. Advantages of LIFO Method The cost of inventory issued tends to be nearer to the current market price because it represents costs of recent purchases. In periods of rising prices, lower income is reported since current costs are matched with current revenue and it results in reducing the income tax liability. No unrealised inventory profits/losses are made by using this method because it is based on costs. Disadvantages of LIFO Method It involves a lot of calculation work in case there are violent fluctuations in the prices of the materials. This method does not conform to the physical flow of goods. The value of closing stock does not tend to be nearer current market prices because it represents the costs of earlier purchases. In periods of falling price, higher income is reported since current costs are matched with current revenues as a result income tax liability increase Simple Average Price Method It is based on the assumption that the identity of materials, when put in stores, is lost and the materials are received in uniform lots of same quantity. It uses an average price for pricing the issue of materials until either an old lot is exhausted or a new lot is purchased when a new average price will be calculated. Average price is calculated as follows: Average Price = Total of Unit Prices of all lots in Stores Total Number of Unit Prices Advantages of Simple Average Price Method It is simple to understand and easy to operate. Disadvantages of Simple Average Price Method It is not scientific method because it ignores the quantity of materials purchased while calculating average price. There may be unrealised profit/loss because it is based on average price and not on actual cost. It increases the clerical work. The average price will have to be calculated on the occasion of each issue of material. It will give incorrect results in the prices of materials fluctuate considerably Weighted Average Price Method It is based on the assumption that each issue of goods consists of a due proportion of the earlier lots. It uses a weighted average price for pricing the issue of materials until a new lot is purchased when a new weighted average price will be calculated. Weighted Average Price is calculated as follows: Weighted Average Price = Total Cost of Materials in Stock Total Quantity of Materials in Stock 24

25 Advantages It averages out the effect of price fluctuations. It can be advantageously used in process industries. Disadvantages There may be unrealised profits/losses because it is based as weighted average price and not on actual cost. It increases the clerical work because a new weighted average price is required to be calculated on the receipt of a new lot. It cannot be used in job order industry where each individual order must be priced at each stage up to completion. The closing stock does not correspond to the conventional accounting of valuation of stock Replacement Price Method Under this method of pricing, materials issued are valued at the replacement cost of the items. Replacement cost is the cost at which the identical materials could be currently purchased or reproduced. This method is used when it is desired to reflect the current price in costs. Advantages It is simple to operate. Product cost reflects the current price levels. It enables the enterprise to take the advantages of rising prices. It enables the enterprise to set competitive selling price. Disadvantages It is difficult to have op-to-date replacement prices at all times. In a period of rising prices, the value of the closing inventory may be negligible or even negative under this method. On the other hand, the value of closing inventory may be exceedingly high in a period of falling prices. As issues are not priced at actual cost, it results in unrealised profit or loss Standard Price Method This method of pricing issues is based upon a standard price for a specified period. The standard price is a predetermined price or notional price and is fixed after taking into consideration factors like quantity discount, anticipated price fluctuations, transportations costs, etc. This method is specially designed where standard costing is in use. The standard price is applied while recording the cost of materials issued. Any difference between the standard and actual price of purchase is transferred to 'material price variance account'. Advantages It is simple to apply because all issues are priced at the same standard rate. It reduces clerical work because repeated cost calculations are not required to be made on the receipt of each new lot of material. The efficiency of the purchase department can be determined by comparing the actual price paid with the standard price. 25

26 Disadvantages It is difficult to fix standard price when prices fluctuate frequently. Unrealised profit or loss may arise because it uses standard price and not actual cost. 11. Accounting of Material Losses: Losses of materials may arise during handling, storage or during process of manufacture. Such losses may be classified into two categories, i.e., normal loss and abnormal loss. Normal Loss Normal loss is that loss which has necessarily incurred and thus is unavoidable. For Example: Loss by evaporation. Loss due to loading and unloading. Loss due to breaking the bulk, etc. Normal losses of material cannot be completely avoided but may be controlled to a limited extent. Abnormal Loss Abnormal loss is that loss which arises due to inefficiency in operations, mischief, carelessness, etc. For example: Theft or pilferage. Breakage. Fire, accident, flood etc. Use of inaccurate instruments. Improper storage, etc. Accounting Treatment As a principle, all normal losses which are necessarily incurred are treated as a part of the cost and abnormal losses should not be included in the cost. in order to absorb normal material losses in cost, the rates of usable units are inflated so that such losses are absorbed. Alternatively, normal material loss is transferred to factory overhead. However, abnormal loss of material is charged to Costing Profit and Loss Account. Material losses may arise in the form of waste, scrap, spoilage or defectives. Waste Waste is the portion of basic raw material lost in processing, having no recoverable value. Waste may occur due to evaporation, breaking the bulk, loading and unloading, leakage, inefficient handling, fire, etc. It may be visible or invisible, for example, gases, dust, smoke and unsalable residues. The effect of waste is to increase the unit cost of production, since the total cost is spread over a smaller number of good units. Accounting Treatment The accounting treatment of waste depends upon whether the waste is normal or abnormal. For normal waste arising from breakage, evaporation, deterioration, shrinkage in 26

27 production, the total cost incurred is distributed over the good output. The treatment is based on the principle that normal losses should be borne by good output. Abnormal Wastage of material arising due to abnormal reasons, i.e., theft, fire, careless handling, etc., is not added to the cost of production but is transferred to costing profit and loss account. This is necessary to avoid any fluctuation in cost of production. Control of Waste In order to control waste in manufacturing industries, a waste report is prepared at regular intervals. The actual percentage of waste is compared with the standard percentage and remedial measures are taken to remove any abnormal waste. Scrap Scrap has been defined as the incidental residue from certain types of manufacture, usually of small amount and low value, recoverable without further processing. Accounting Treatment Scrap may be treated in cost accounts in the following ways: Where the value of scrap is negligible, it may be excluded from costs. In other words, the cost of scrap is borne by good units and income from 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. When scrap is identifiable with a particular job or process and its value is significant, credit is given to the job or process concerned. When scrap is occurring due to abnormal reasons, profit and loss in the scrap account, on realisation, will be transferred to the Costing Profit and Loss Account. Control of Scrap Control of scrap really means the maximum effective utilization of raw material. Scrap control does not, therefore, start in the production department, it starts from the stage of product designing. Thus the most suitable type of materials, the right type of equipment and personnel would help in getting maximum quantity of finished product from a given raw material. Spoilage It is the term used for materials which are badly damaged in manufacturing operations, and they cannot be rectified economically and hence taken out of process to be disposed of in some manner without further processing. Accounting Treatment Spoilage may be either normal or abnormal. Normal spoilage (i.e., which is inherent in the operation) costs are included in costs either by charging the loss due to spoilage to the production order or charging it to the production overhead so that it is spread over all products. Any value realised from spoilage is credited to production order or production overhead account, as the case may be. The cost of abnormal spoilage (i.e., arising out of causes not inherent in manufacturing process) is charged to costing profit and loss account. Control of spoilage To control spoilage, allowance for normal spoilage should be fixed and actual spoilage 27

28 should be compared with standard set. A systematic procedure of reporting would help control over spoilage. A spoilage report should highlight the normal and abnormal spoilage, the department responsible, the causes of spoilage and the corrective action taken, if any. Defectives Defective work represents unit of output which fail to comply with a set quality standard and are subsequently rectified, sold as sub-standard or disposal as scrap. Defective work may be the result of a number of factors like poor quality of materials, incompetent supervision, etc. Defective units are subsequently reworked and transformed into 'firsts' and 'seconds' category. Accounting Treatment When defective work has a nominal value, the loss is completely absorbed by good units. Alternatively, the cost of defective work can be charged as general factory overhead or it is charged directly to departments responsible for it. If defective work has occurred due to abnormal reasons, the cost of defective work shall be charged to the costing profit and loss account. Control of defectives On the receipt of defective work report, a decision is taken whether to rectify or not to rectify the work. All costs of rectification are collected against the rectification work order. Adequate steps should be taken to see that defective work remains within standard limits. Summary: The success of a business firm is largely dependent on efficient system of inventory control. The term 'Material' refers to all the commodities consumed in the process of manufacturing. Material may be direct or indirect. The three dimensions of material control are control over purchase, storage, issue. the purchase process starts from purchase requisition and then purchases order, receipt, inspection and payment of invoices. The principal methods of pricing issues of material are: FIFO, LIFO, Simple Average, Weighted Average, Replacement price and Standard price. Inventory control may be defined as a system which ensures the provision of the required quantity of inventories at the required time with the minimum amount of capital. Efficient inventory control keeps costs down and ensures smooth production. Of the techniques of the inventories control, the most important are the ABC Analysis, Economic Order Quantity, Perpetual Inventory System and Just in Time purchases. Material losses may take the form of waste, scrap, spoilage and defectives. Exercises: I. Objective Type Questions A. State whether the following statements are True/False: 1. The Economic Order Quantity is that order quantity in which the total carrying cost is equal to total ordering cost. 2. Stock out costs are incurred when a sale is lost because inventory is not available. 28