MATERIAL COSTS CHAPTER 2
A Quick Review
IMPORTANT DEFINITIONS
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.
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.
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.
Material Requisition Note
Material Requisition is a document issued by a department incharge 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.
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.
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.
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 inwarded.
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.
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.
Economic Order Quantity: ‘The size of the order for which both ordering and carrying costs 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.
Normal wastages: It denotes 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.
Abnormal wastage: It 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.
OTHER IMPORTANT CONCEPTS
Different classes of stores:
1.
Centralized Stores
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
i. Better control can be exercised over stores because all stores are housed in one department. The risk of obsolescence of stores can be minimized.
ii. The economy of staff-experts, or clerical, floor space, records and stationery are available.
iii. Better supervision is certainly possible.
iv. Obsolescence of the store items can be kept under strict vigil and control.
v Centralized material handling system can be put into operation thus further economizing on space, personnel and equipments.
vi. Investment in stocks can be minimized.
Disadvantages of centralized stores
i. 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.
ii. If the user departments are far away from the stores there may be delay in receipt of the stores by those departments.
iii. 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.
iv. There is greater chance of losses through fire, burglary or some other unhappy incidents.
v. 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.
3. 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
i. It ensures the prompt issue of stores.
ii. It confines the advantages of centralized stores with sub-stores and at the same time it does not sacrifice the centralized control.
iii. It reduces handling cost of materials.
iv It avoids the maintenance of elaborate inventory records.
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.
Advantages of ABC Analysis:
i. Closer and stricter control of those items which represent a major portion of total stock value is maintained.
ii. 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.
iii. With greater control over the inventories, savings in material cost will be realised.
iv. It helps in maintaining enough safety stock for ‘C’ category of items.
v. 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 into 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.
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 into.
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:
i. 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.
ii 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.
iii. Reduces the working capital requirements, as very little inventory is maintained.
iv. Minimizes storage space.
v. Reduces the chance of inventory obsolescence or damage.
METHODS OF PRICING OF MATERIAL ISSUES
1.
Cost Price Method:
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.
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.
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.
2. 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.
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.
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.
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.
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.
3. Market Price Methods:
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.
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.
4. Notional Price Methods:
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.
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.
IMPORTANT FORMULAS
I. Economic Order Quantity = [2 × Annual Demand × Ordering Cost (per order)/Carrying Cost (per unit per annum)]1/2
II. Maximum Level = Reorder Level + Reorder Quantity – (Minimum Rate of Consumption × Minimum Reorder Period)
III. Minimum Level = Reorder Level – (Normal Rate of Consumption × Normal Reorder Period)
IV. Re-Ordering Level = Minimum Level + (Normal Rate of Consumption × Normal Reorder Period) or Minimum Level + Consumption during Lead Time or Maximum Rate of Consumption × Maximum Reorder Period (Lead Time)
V. Danger Level = Normal Rate of Consumption × Maximum Reorder Period for emergency purchases
VI. Average Level = ½ (Maximum Level + Minimum Level) or = Minimum Level + ½ (Reorder Quantity)
VII. Inventory Turnover Ratio = Value of material consumed during the period/ Value of average stock held during the period
PAST EXAMINATION QUESTIONS
OBJECTIVE QUESTIONS
Q.1. __________ Level of stores inventory is maximum usage multiplied by maximum lead time. [Dec. 2013, 1 Mark]
Ans. Reorder
Q.2. A company buys in lots of 6,250 units, which is a 3 month’s supply. The cost/unit is ` 2.40. Each order costs ` 45 and the inventory carrying cost is 15% of the average inventory value. Calculate the EOQ. (a) 3,000 units (b) 2,500 units (c) 2,000 units (d) None of these [June 2014, 1 Mark]
2 : MATERIAL COSTS
Q.3. The annual demand for an item is 3200 units. The unit cost is ` 6 and the inventory carrying cost is 25% per annum. If the cost of one procurement is ` 150, determine the time between two consecutive orders, assuming procurement is at EOQ. [June 2014, 2 Marks]
Ans.
C = 6 × 25% = ` 1.50
EOQ = (2AO/C)1/2
EOQ = (2 × 3,200 × 150/1.50)1/2
EOQ = 800 units
Time between two orders = 12 × 800/3200 = 3 months
Q.4. The opening stock, closing stock and purchases of materials were respectively 10,000, 16,000 and 84,000 during a production period. Compute the inventory turnover ratio. [June 2014, 2 Marks]
Ans.
Material consumed = 10,000 + 84,000 – 16,000 = 78,000 units
Average stock = (10,000 + 16,000)/2 = 13,000 units
Inventory turnover ratio = 78,000/13,000 = 6 times.
Q.5. In a factory the monthly requirement for a material is 20,000 units, ordering cost ` 225 per order, purchase price ` 20 per unit and annual carrying cost is 15%, then economic order quantity will be:
(a) 3,000 units (b) 2,683 units (c) 6,000 units (d) 1,732 units.
[Dec. 2014, June 2015, 1 Mark]
Ans. (c) 6,000 units
C = 20 × 15% = ` 3
A = 20,000 × 12 = 2,40,000 units
EOQ = (2AO/C)1/2
EOQ = (2 × 2,40,000 × 225/3)1/2
EOQ = 6,000 units
Q.6. For identifying slow moving stocks, it is necessary to compute the _______________ratio. [Dec. 2014, 1 Mark]
Ans. Inventory or stock turnover ratio.
Q.7. Material with invoice value ` 10,000 was received in the Stores Dept. The transport cost was ` 200. Since the material leaked in transit, damage to other goods of ` 350 had to be paid to the transporter. What would be the material cost? [Dec. 2014, 2 Marks]
Ans.
Material Cost = 10,000 + 200 = 10,200.
As per CAS, material cost includes purchase cost, transport inwards and excludes any damages or penalty paid to any authority.
Q.8. ` 3,000 and ` 60,000 are written off raw materials and finished goods respectively for obsolescence. How should these be treated in Cost Accounts? [Dec. 2015, 2 Marks]
Ans.
Obsolete inventory- Cost of Raw Material and Finished goods should be directly written of in the Profit & Loss A/c. No charge is made to cost of production. ` 63,000 (` 3,000 + ` 60,000) should be written off to Profit & Loss A/c.
Q.9. In a certain melting process, a material called ‘coke’ is put into the furnace along with other materials. Coke is also used as fuel to heat the furnace. How will you treat the cost of coke in the final product according to Cost Accounting Standards? [Dec. 2015, 3 Marks]
Ans.
Cost of Coke to the extent it is put into the furnace, subject to if being significant in value compared to other raw materials and measurable, should be taken as raw material cost under CAS.
If it is insignificant in quantity or value, it should be taken as production overhead. The quantity and value of coke used as fuel should be treated as indirect material and classified as production overhead.
Q.10. The average annual consumption of a spare part 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. Find out the quantity required to be purchased at a time. [Dec. 2015, 2 Marks]
Ans.
C = 36.50 × 20% = ` 7.3
EOQ = (2AO/C)1/2
EOQ = (2 × 18,250 × 50/7.3)1/2
EOQ = 500 units
Q.11. Calculate the reorder level from the following date:
Lead time: 3 weeks; Safety stock: 100 units; Annual uniform usage: 2,600 units. [June 2016, 2 Marks]
Ans.
Reorder Level = Safety Stock + lead time consumption = Units (2600/52) × 3 + 100 = Units 150 + 100 = 250 units.
Q.12. X factory outsources the manufacture of a major component to a contractor. The transportation of the component of X factory’s premises is borne by X. This transportation cost will be treated as_________cost (give the element of cost). [June 2016, 1 Mark]
Ans. Material Cost
Q.13. In the ______________ method of pricing material issues, where the prices are falling, profits will rise. [June 2016, 1 Mark]
Ans. LIFO (Last in First Out)
Q.14. The average quarterly consumption of a material is 5,200 units. Unit cost is ` 65. Storage cost is 15% p.a. and the ordering cost is ` 150 per order. Find the Economic Order Quantity (EOQ). [Dec. 2016, 2 Marks]
Ans.
C = 65 × 15% = ` 9.75
Annual consumption = 5,200 × 4 = 20,800
EOQ = (2AO/C)1/2
EOQ = (2 × 20,800 × 150/9.75)1/2
EOQ = 800 units
Q.15. While working out the EOQ, carrying cost has the element of interest cost. Hence it can be stated that interest cost is treated as part of material cost under CAS-6. (True/False) [Dec. 2016, 1 Mark]
Ans. False. (Only to determine EOQ, interest is taken. Interest is not a part of material cost under CAS).
Q.16. In a textile factory, yarn is starched before it is made into textile. The cost of starch is ____________ (give the element of cost).
[Dec. 2016, 1 Mark]
Ans. Direct material cost
Q.17. At EOQ total ordering cost per annum is ` 4,000. Find EOQ in units if carrying cost per unit per annum is ` 2. [Dec. 2016, 2 Marks]
Ans.
At EOQ,
Ordering cost = Carrying cost
4,000 = EOQ × 2 × 1/2
EOQ = 4,000 units
