MANAGEMENT AND CONTROL OF MATERIAL COST

AND LABOUR COST

INTRODUCTION

One of the main functions of cost accounting is to classify the costs. Costs may be classified according to its elements. We can distinguish three basic elements in the manufacturing cost of any product or services. They are material cost, labor cost and other overheads.

Material costs – The cost of commodities supplied to an undertaking.

Labor costs – The cost of remuneration of laborers.

Overheads – These are the other expenses incurred.

The expenditure on these various elements of costs may be either direct or indirect. A direct expenditure is one, the whole of which can be conveniently charged to a particular product, job or service whereas an indirect expense is an expense which cannot be identified with any particular product or job. Therefore, such expenses are allocated on suitable basis.

Elements of Costs – Examples and Chart

Examples: Direct materials - Raw materials used in manufacturing a product. Indirect materials - Lubricants and cotton waste used in maintaining machinery,Direct Labor - Wages of those workers who are engaged in production. Indirect Labor - Wages to those who are aiding manufacturing activities by way of supervision, maintenance, tools setting etc. Direct Overheads - The cost of special pattern, dyes drawings tools etc. made for specific product. Indirect Overheads- Office salaries, rent, electricity, advertisement expenses etc

[Ref: Management & Cost Accounting by Colin Drury 2004

In the proceeding chapter we will be discussing the various methods of control and management of two of the elements of costing, that is Labour costs and Materials costing

CONTROL AND MANAGEMENT OF MATERIAL COST

The term “Materials” generally used in manufacturing concerns, refers to raw materials used for production of goods and services, materials are also the substances or matters from which something is or can be made, or also items needed for doing or creating something. They include commodities which are supplied to the manufacturing industry in their crude or original form. They include direct and indirect materials.

Materials cost constitutes a prime part or substantial part of the total cost of production of manufacturing firms and because of this an effective control system over materials must be in place in order to prevent and detect materials losses. Proper accounting, for and control over materials purchase, consumptions, and storage are important for effective management of business firms.

[Ref: Cost Accounting by William K. Carter - 2007]

Materials are divided into two categories, i.e. direct materials & Indirect Materials

Direct materials are those which can conveniently be identified with the finished product. In other words, direct materials are all those materials, costs of which can conveniently be measured and charged directly to the cost of the product. Direct materials include:

- All materials specially purchased for a particular job, order of process

- All materials procured and subsequently requisitioned from stores for a particular job, order of process.

- Components purchased or produced and subsequently requisitioned from stores for a particular job, order or process.

- All materials and components transferred from one operation or process to another

- Primary packing materials such as cartons, etc., used to protect finished product from climate conditions or for easy handling inside the factory.Costs of direct materials are an element of ‘prime cost’.

Indirect materials are all those materials which cannot be classified under ‘Direct materials’. Examples of indirect materials are: consumables, like cotton waste, coolant, lubricants; materials for repairs and maintenance of fixed assets; high speed diesel used in power generator; paints for shop-floor painting; brooms, rags and cleaning materials, etc.

Indirect materials include those direct materials, which, because of their comparative small quantities and small value, cannot be linked to a particular job, order or process. Examples include; ordinary electrodes used in steel welding, thread used in making shoes, glue in making card board boxes etc.

Costs of indirect materials are treated as overhead.

Categorization of materials into direct and indirect facilitates control. Usually, direct materials are comparatively high value items and deserve stricter control. While direct materials costs should be subjected to critical analysis, simple control techniques are sufficient for indirect materials. Moreover cost reduction techniques (e.g. value engineering) usually bring tangible savings in respect of direct materials only and not in respect of indirect materials.

Accounting

Costs of direct materials are charged directly to the particular job, order or process. Documents which cover issues and transfers of direct materials bear the particular job number or order number or process details and are used as source documents for proper accounting of the transactions.

Costs of indirect materials are treated as overhead. Depending upon its use, cost of a particular item may either be classified as manufacturing, administration, selling or distribution overhead. Costs of indirect materials are accounted in exactly the same manner as any other element of indirect materials, each issue-document must indicate the cost-centre which has drawn the material. Costs of some of the small-value items are treated as expenses without routing the same through stores. Examples of such materials are low-cost stationary, soaps, etc.

MATERIALS CONTROL SYSTEM

This is a system which ensures the provision of a required quantity of materials (sufficient) which are needed at the required time with minimum amount of capital/funds tied up in materials stored and the system also aims at minimizing material costs in general. It ensures that materials are efficiently purchased, stored and used or consumed in the right quantities and quality

[Ref: Cost and Management Accounting by Mary Kamukama, 2001 – MUBS)

Material control consists of controls at three levels:

Quantity controls: These include policies and procedures put in place to ensure that the minimum amount of materials is used in production and service departments,

Financial controls: These controls ensure that minimum funds are invested in materials, such controls include the application budgets, monitoring of stock levels,

Quality controls: These cover procedures and policies put in place to ensure that material quality standards are complied with all the time.

In materials control, it’s always important to strike the balance between two opposing needs, that is, maintenance of sufficient inventory for efficient production and maintenance of investment in inventory at the lowest level.In attempt to achieve above opposing needs, material control system should endeavor to achieve the following specific objectives that make the system more sound or effective.

The material control system should therefore ensure that:

- Materials of the desired quality will be available when needed for efficient and uninterrupted production

- Materials will be purchased when need exists and in economic quantities- The investment in materials will be maintained at the lowest level consistent with

operating requirements.- Purchase of materials will be made at the most favorable prices under the best possible

terms- Materials are protected against loss by fire, theft, handling with the help of proper

physical controls

- Materials should be stored in such a way that they can provide minimum of handling time and cost

- Vouchers will be approved for payment if the material has been received and is available for issue

- Issues of material are properly authorized and properly accounted for, materials are, at all times, charged as the responsibility of some individual

- The above objectives may be achieved by the firm if the underlying controls are effectively implemented by the firm

Proper selection of suppliers: The firm should have in place a proper selection system or procedure of suppliers that are ready to meet the needs of the firm all the time.

Maintenance of stock records: Proper record of materials in the store using documents like Bin cards, stock sheets, requisition notes, goods received notes, goods returns notes, materials transfer note, among others, is always expected.

Regular stocktaking and monitoring of stock items: This refers to a physical count of products actually held in stock as a basis for verification of the stock records and accounts. Stocktaking could take two forms, that is, Continuous stocktaking (physical counting is done on a continuous basis e.g. daily, weekly, monthly basis) and Periodic stocktaking (counting of stock is always done ounce and at the closure of a given period).

Provision of proper storage facilities: Depending on the materials used and maintained by the firm, appropriate storage facilities must be in place and used in keeping the materials.

Regular Monitoring of stock levels: There are must be J mechanism which should enable the monitoring of stock levels on a continuous basis. Stock levels that include, minimum level, maximum levels, re-order level their regular monitoring save the firm from stock excesses or shortages.

Segregation of duties/activities: Departments involved in purchasing, receiving and inspection, storage, dispatch and accounting should be separate, but have to be properly coordinated.

Centralized purchase function: the purchase or buying of materials or stock should be done by only one department which is headed by qualified person

Operation of perpetual inventory system: this refers to the maintenance of systematic stock or inventory record on a continuous basis to ensure that up-to-date information is available about the quantity of materials in stock. “The chartered Institute of Management Accountants, London” defines perpetual inventory system as “a system of records maintained by controlling department which reflects the physical movement of stock and their current balance.” The perpetual inventory system is generally supplemented by a program of continuous stock taking which ensures that physical stocks agree with book balances.

The object of perpetual inventory system is to ensure that production is not interrupted due to shortage of materials, to facilitate regular checking, to avoid closing down for stock-taking, and to provide basis for verification of physical quantity in stock

Regular material audit: This involves regular review of material control system reconciliation of physical stock against stock records so as to detect some loopholes in the system and shortages in stock balances.

THE MATERIAL CONTROL PROCESS

Fig. 0

The material control process

(Ref: Costing by T. Lacey – 1996)

Purchase and receiving functions

Purchasing functions or procedures vary with different business firms, but all of them followed a general pattern in the purchases and receipt of materials and payment of obligations. This function falls under the purchasing or procurement department which is a service support in an organization. The purchasing dept is headed by procurement manager who is in charge of ensuring that the right quantities and qualities of materials or components are procured at right time, price and source.

The control of purchase function is controlled or guided by the document called the “The purchasing manual” whose contents include purchasing procedures, purchase limits, assignment of activities within the purchasing department.

Purchasing procedure

Purchasing start when someone in an org requests for materials; The main steps in purchasing procedure include the following:

COSTING

SYSTEM

PURCHASING

RECEIPET

STORAGE

ISSUE

INVENTORY

CONTROL

COSTING

SYSTEM

1. Rising of purchase requisition:

A purchase requisition is a formal document raised by user departments or store keeper requesting the purchasing department to order goods or services. The purchase requisition serves three purposes:

- It automatically starts the purchasing process and informs the purchasing department of the need for the purchase of materials

- If fixes the responsibility of the department or personnel making the purchase requisition

- It can be used for future reference

The form of purchase requisition is given in fig 1. Bellow

Figure 1. Purchase Requisition

Number …………………………..

Date ………………………………..

Required by …………………………………… Dept. Date required ……………………………………………

Description of material Code Number Quantity required Remarks

Requisition by ………………………………………………….. Approved by: ………………………………………………………………

The purchase requisition is usually in triplicate and the routing is – one copy to the purchasing department, the second is retained by the department making the request and the third is sent to the authorizing authority or planning department.

2. Search of suppliers:

On receiving the purchase requisition, the purchase department starts exploring the sources of materials and supplies. The search for suppliers can be done through the use of the firm’s own records, News papers, trade journals, price lists, tenders, advertisements, trade fair, and inquiry letters among others.

3. Requests for quotations:

This involves inquiries and requests for quotations sent to potential suppliers fully specifying requirements such as quality, quantity and price. The request for quotations could also take form of advertisement. This is not possible to small procurement.

4. The receipt of quotation and supplier selection:

The quotations represent documents from suppliers showing their offer in terms of quantity, quality and price. The supplier is selected if the quotation is of the right description required by the firm as spelt out in the tender documents.

5. The purchase order:

A purchase order is a written request to the supplier to supply particular material at agreed upon prices. It is simply an order to a selected supplier to deliver the required materials. The request also stipulates terms of delivery and terms of payment. It is a legal document because it serves as evidence of the contract between the organization and the supplier. Coppies of purchase order are distributed to accounts department, the supplier gets the original copy, stores departments, receiving and inspection department, the department that has initiated the requisition and the copy is retained by the purchasing dept.

A specimen of a Purchase Order is given in Fig 2 below.

Figure 2.SS LTD

PURCHASE ORDER

Supplier’s name & address Date _______________________________________________________________________________________ Requisition No. ______________Please supply in accordance with the instructions given and attached conditions of purchase of the following items.

No of Items

Particulars Quantity Code No. Price Date of Delivery

Remarks

Per unit Total

Terms & Conditions. Signed ……………………………………………………………………………………………………………………………………………….. Purchase Manager……………………………………………………………………..……………………………………………………………………….

Receiving and inspection of materials:

The materials are always received from the supplier with the delivery note. The received materials are inspected and tested to confirm where the physical units supplied conform to the specifications of the purchase order. After the materials have been inspected the officer(s) in charge prepare(s) goods received note and an inspection note. An inspection note/report indicates the items accepted or rejected, with reason. Materials received reports are prepared and routed as follows:

- The original copy is sent to the stores department

- One copy will be sent to the cost and account department for the use of

- posting in the stores ledger

- One copy to the purchase department for comparing it with the purchase order

- The fourth copy is retained by the receiving department for future reference.

Figure 3.

GOODS RECEIVED NOTE

Purchase order

No. and date …………………………………. Number …………………………..

Date …………………………………

Received from M/s ……………………………………………………………………………………………………………………………..

Serial No. Description Code No.

StockCode No.

Quantity Rate inUGX

Amount (UGX)

Counted by …………………………………………………………….

Inspected by …………………………………………………………. Approved by ………………………………………..

Receipt and payment of bills:

Preparation and payment of bills is the last step of purchase routine. As soon as the supplier's invoice is received, its authenticity and accuracy is checked with reference to the purchase order and materials received note by accounting and stores departments.

Figure 4.0 Reception and inspection procedures

Reception of GoodsIn Materials reception

Quantities received checked and Goods Received Note

(GRN) raised, Details of goods received checked with

Purchase Order

Inspection of goods for quality, specification etc.

Inspection Note raisd

Goods taken into stores and GRN & or Inspection note

signed

GRN copies to:Accounts PayablePurchase OfficeProduction Control InspectionStoresFiles

Inspection Note copiewAccounts PayablePurchase OfficeProduction Control InspectionStoresFiles

STORE - KEEPING

This is another important step in material control system after purchasing procedure. The store keeping function in an industry involves both keeping the store of materials and keeping the record of stores. Store keeping involves the following activities:

• Issue requisitions for the purchase of materials

• Receipt of purchased materials from the receiving department

• Storing of materials in proper places so as to identify and locate items without delay

• Issuing of materials to production and service departments and ensure that material issues are properly authorized and accounted for

• Regular taking of physical stock count and stock control

• Classification and identification of materials by their nature, size and value.

• Protection of materials against fire, theft, damage and other threats.

• Maintaining proper record of inventory

Good store keeping involves storing materials in order to achieve the following objectives

- Speedy receipts and issues of materials

- Immediate location of required materials

- Full identification of all materials at all times

- Ability to give details on request of quantities held in store

- Protection of materials from damp, evaporation among others

- Economical use of storage space

- Avoiding over-stocking and under-stocking

Storage issues and returns

The materials must be appropriately authorized and amount issued recorded so that the appropriate charge can be made to production or to the receiving cost center. The usual way this is done is by a materials requisition (MR) [Costing by T. Lacey – 1996)

An MR would contain:

Quality – Part No – Description – Job or Centre to be charged – Authorisation

On presenting an MR to the storeman, it would be checked for correctness and authorization and if satisfactory, the issue would be made. The MR would be retained by stores who would insert date of issue and forward the MR to stores records (for updating the stock records) and thence to the cost department (for pricing and charging). The storeman must ensure that the MR is amended when the issue is made or an alternative material is accepted when the originally requested in unavailable.

The procedure for goods returned to store is similar to that outlined above except that the document involved is termed as a material return note and, of course, the goods are taken into stores rather than issued.

Stocktaking

There are two approaches to the task of stocktaking – Periodic (usually annual) and Continuous.

Periodic Stocktaking

The objective of periodic stocktaking is to find out the physical quantities of materials of all types (raw materials, finished goods, W-I-P, e.t.c.) at a given date. This is a substantial task even in a modest organization and becomes difficult if not impossible task in a large firm. The following factors need to be considered:

a. Adequate numbers of staff should be available; they should receive clear and precise instructions on the procedures.

b. Ideally the stocktaking should be done at a weekend or overnight so as not to interfere with production.

c. The stocktaking should be organized onto clearly defined physical areas and the checkers should count or estimate all materials in the area.

d. Adequate technical assistance should ne available to identify materials, part no’s etc. Far greater errors are possible because of wrong classification than wrong counting.

e. Great care should be taken to ensure that only valid stock items are included and that all valid items are checked.

f. The completed stock sheets should have random, independent checks to verify their correctness.

g. The quantities of each type of material should be checked against the stock record to exposed any gross errors which may be due to stocktaking errors or faults or errors in recording system. Small discrepancies are inevitable.

h. The pricing and extension of the stock sheets, where done manually, should closely controlled. Frequently the pricing and value calculation are done by computer, the only action necessary being to input quantities and stock and part numbers.

Continuous stock taking

To avoid some of the discrepancies caused by periodic stocktaking and to be able to use better trained staff, many orgs operate a system whereby a proportion of stock is checked daily so that over the year all the stock is checked at least once and many items, particularly the major value or fast moving items, would be checked several times. Where continuous stocktaking is adopted, it is invariably carried out by staff independent from the storekeepers.

Continuous stocktaking is absolutely essential when an org uses what is known as perpetual Inventory system, this is a stock recording system whereby the stock balance is shown on the record after every stock movement, either issue or receipt. Whit this system the balances on the

stock record represent the stock on hand and balances would be used in monthly and annual accounts as the closing stock.

Continuous stocktaking is necessary to ensure that the perpetual inventory system is functioning correctly and that minor stock discrepancies are corrected. [COSTING BY T. LUCY – 1996]

Organization of stores: Centralized Vs Decentralized storage

The type of organization suited for any stores department depends upon the nature of the business organizations, size and layout of the factory, nature of materials required to be stored and the frequency of purchase and issue of materials.

Centralized storage is where the storage of materials is confined to one central store in an organization whereas decentralized storage refers to a situation where materials are kept at different stores (sub-stores) in an organization.

Advantages of centralized storage include the following:

1. Minimum investment in stocks since the requirements of all departments can be pooled for determining the stock levels to be held

2. Closer control is possible on a central store3. Economy in clerical cost, stationary expenses and record keeping4. Specialized functions with better supervision and better control over stocks5. A smaller overall store keeping staff is probably required as opposed to numerous

departmental stores.6. Better supervision and control is achieved7. Material items will be acquired at cheaper purchase prices because of bulk purchases

that may attract trade discounts.

Disadvantages of centralized storage include the following:

I. High costs of transporting heavy and bulky to the user departments

2. Delays and inconveniences of obtaining supplies by the production departments because requisition passes through many hands at the head office

3. It’s risky to keep all materials in one central store in case of losses by fire, floods and theft among others.

Advantages & Disadvantages of decentralized:

It is important to note that the advantages of centralized stores are the disadvantages of decentralized and the reverse is true for the disadvantages.

TECHNIQUES OF INVENTORY CONTROL

The main aim or material / stock control techniques are to ensure that costs associated with stock/inventory are minimized. These costs include holding/carrying costs, ordering costs and purchase costs which make a sum of total stock costs.

Carrying/holding costs include those costs associated with the maintenance of inventory in the stores such as salaries and wages paid to ware house staff, lighting and heating costs, rent and rates and insurance costs while ordering costs include costs of buying inventory from the suppliers, examples include among others transport/carriage inwards costs, postage costs, inspection costs, insurance costs.

Handling and ordering costs can be kept at minimum amounts or controlled if the techniques in place could enable the organization to overcome the problems of overstocking and under stocking of material items.

Costs associated with overstocking include opportunity costs, security costs, insurance costs, storage costs, stock taking costs, pilferage, and obsolescence costs among others.Costs (stock out costs) associated with under stocking include, loss of customers (reduction in market share),redundancy costs/expenses, stoppage costs, lost reputation and lost contribution as a result of lost sales.

It is therefore important to apply appropriate inventory/stock techniques that may help in containing the above problems.Different business concerns may apply different inventory techniques to meet specific requirements and circumstances.However, the following techniques are commonly used by firms for inventory control.

1. Two-bin system2. ABC analysis/classification3. Order cycling system4. Determining of stock/inventory5. Economic order quality6. Inventory turnover ratios7. Perpetual inventory system8. Just-in-time (JIT) purchasing9. Material requirements Planning (MRP)

Two-bin system: This method is commonly used when materials are relatively inexpensive or non-essential. The material inventory is divided and placed in two separate compartments or bins. The first bin contains quality of items that will be used between the time an order is received and the the next order is placed. The second bin contains enough stock to cover the usage between the dates of placing an order to the date of delivery. New supply is ordered as soon as the first bin is empty

ABC Analysis: this is also regarded as a material control tool. It is an approach based on the principle of selective control. The maxim is “put your efforts where the results are maximized”

Order cycling system: Order cycling is a method in which a review of materials on hand on a regular basis or periodic cycle is done. For example, materials inventory might be reviewed every 15 days. This will vary depending on the type of materials being reviewed. Essential items have a shorter review cycle than less important items. Inventory turnover ratios: Business firms

can analyze the turnover of different items of stock to find out which stock are slow moving. Inventory turnover ratio enables the management to avoid capital being locked up In undesirable stocks. The stock turnover ratio is calculated as follows:

Stock/inventory turnover ratio = Cost of materials consumed Average stock of materials held during the period.

The average stock is taken to be the average of opening and closing stocks. Stock turn over can also be calculated as under:

Stock turnover = Days during the periodStock turnover ratio

According to the turnover rate of different items, materials can be classified into five categories which include fast-moving materials, materials with average turnover, slow- moving materials, dormant materials (materials that have no recurring use but may be required in future) and obsolete materials (materials which are no longer used due to reasons like substitution by another materials, change in product line. Obsolete materials should be disposed.

Just-in-time method: This is a purchasing and control method in which materials are obtained just in time for production to provide finished goods just in time for sale. A just-in-time manufacturing system requires making goods or service only when the customer, internal or external, requires it. JIT requires better coordination with suppliers so that materials arrive immediately prior to their use. Where this technique is applied, there is no need to have stores or ware houses and hence the costs associated with storage are saved. The fundamental objective of JIT is to produce and deliver what is needed, when needed, at all stages in the production process.

Materials requirements planning (MRP): This is a production planning technique which spells out or provides a list of materials that will be required at different production stages. It is an approach for coordinating the planning of materials acquisition and production. MRP is flow-control systems in the sense that it orders only what components are required to maintain the manufacturing flow. The approach begins by establishing the quantity and timing of finished goods demanded and then bases on this to determine the materials units that will be needed at different stages in the production process. The master production schedule provides the list of finished goods that will be demanded at different periods. The production schedule therefore, enhances the production of the materials requirement plan. This control approach helps managers not replenish raw materials when they are not actually desired.

Economic order quantity (EOQ) or reorder quantity: The two main problems connected with procurement of materials are: (i) The quantity to purchase- how much to buy, (ii) The time to buy. If more units are ordered at one time, fewer orders will be required in a year. This will mean a reduction in the total ordering costs. However, when fewer orders are placed, larger average stocks must be maintained, which leads to an increase in carrying costs/holding costs. The problem is therefore, one of trading off the costs of carrying large stocks against costs of placing more orders. It is the optimum order size that will help in minimizing such costs.The optimum order size is therefore, the order quality which will result in the total amount of ordering and carrying costs being minimized. The optimum size in this case is the economic order quantity (EOQ).

The EOQ is the optimum or the most favorable quantity that should be purchased each time the purchases are to be made.The EOQ is where the costs of carrying inventory is equal to the ordering costs and be determined by using three methods: equation, tabulation and graphic.

Using the Equation method

Using the equation method, economic order quality (EOQ) can be determined mathematically as follows

EOQ = 2 x D x C M

Where, D – total demand in year or annual usage in units

C – total ordering costs per order

M – total carrying per unit per annum

The formula is based on the following assumptions.

- Price will remain constant throughout the year and quantity discount is not removed

- Pattern of consumption, variable ordering costs per order and variable inventory carrying cost per unit per annum will remain the same throughout

- Economic order quantity will be delivered each time the stock balance excluding safety stock is just reduced to nil

- The rates of demand are known and constant, and,

- The replenishment is made instantaneously, i.e. the whole batch is delivered at ounce.

Material Losses

Some materials may be lost during the production process because of the nature of the products or because of factors that cannot be influenced by the firm. The losses may be waste, scrap, spoilage and defective among others.

Waste: This represents some of the materials that arc lost in manufacturing process, storage and handling, and such amounts have no disposable value or recoverable value. Waste could be either normal or abnormal. Normal waste in uncontrollable and expected, and it is normally treated as a production cost, hence makes the cost of the final product. Likewise, abnormal waste is unexpected and controllable. It is valued on the basis of cost of materials or the calculated cost of the product and the resulting amount is treated as operating loss (i.e. debited to profit &1055 account).

Scrap: This refers to incidental residue from manufacturing processes that has insignificant or minor recoverable value. The scrap does not require further processing and it may result from obsolete stock, defective and broken parts and processing of materials. Scrap may be treated in accounts using any of the following approaches.

- The net scrap value (sales value minus cost of selling scrap) can be credited to profit and loss account as other income

- The net scrap value (sales value minus cost of selling scrap) can be deducted from material costs incurred in production process.

Spoilage: This refers to materials that do not meet production standards because of being badly damaged. Such goods are either disposed off at their scrap value or discarded without further processing. The cost of spoiled goods (the difference between costs incurred up to the point of rejection less the disposal value) may be treated by either of the fallowing methods:

- If spoilage is normal in the manufacturing process, the cost of such spoilage will be borne by good units.

- In case of abnormal spoilage, cost of spoilage is transferred to profit and loss account

Defectives: These represent goods that do not meet production standards but which can be processed further so as to be ready for sale. That is to attain saleable condition. Defectives may be due to imperfections in manufacturing process which may arise because of bad workmanship, poor quality of raw materials, careless in running the entire process and laxity in inspection. The major difference between spoilage and defectives is that spoilages are sold without further processing, whereas defectives can be reconditioned or reworked by the application of additional materials, labour and overheads, and brought to the point of standard before they are sold as 'firsts' or 'seconds'.

Determining of stock level / inventory levels

Stores control is based on predetermining for each item of material for critical levels which include maximum, minimum re-order and re-order quantity. Since these levels are used for control purposes, they are expected to be monitored regularly. However, these levels are not fixed once and for all, they need to be adjusted as circumstances demand.

Re-order level (when to order)

This provides amount when the economic order quantity should be ordered. This represents a level at which it becomes necessary to initiate purchase orders for fresh supplies. It is the key important decision point that triggers a new order. The re-order level must be sufficient to cover the maximum possible consumption of stock during the re-order period. It is set after considering the following matters:

1. Expected usage or rate of consumption2. The time interval between initiating an order and its receipt, referred to as lead-time3. The minimum inventory or safety stock

Minimum stock level or safety stock

This is maintained to prevent stock outs. 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. This safety stock should be used only in abnormal circumstances. If

usage pattern is known with certainty and the lead time is also known accurately, then no safety stock would be needed. However, if either usage or lead time is subject to variation then it is necessary for business firms to maintain safety stock levels equal to the difference between the expected usage over lead time and minimum usage over lead time that the firm feels is necessary for cost minimization. It is important to note that in order to minimize cost, the amount of safety stock to be maintained should cause costs exactly equal to the costs will be incurred in case the firm runs out of stock (stock out costs)

Minimum stock level/ safety stock = re-order level (average rate of consumption x average lead time)

Or

=( Max rate of consumption – av. Rate of consumption) x lead time

Maximum stock level

This represents the uppermost amount of stock the company can maintain at any time. Maximum level indicates the level above which stock should not be allowed to rise. Fixation of a maximum level requires the consideration of the following factors:

- Rate of consumption of materials

- Reorder quantity

- Availability of storage and cost of storing including insurance costs

- Price fluctuations

- Risk of obsolescence

Maximum stock level = Re- order level + EOQ – (minimum usage x minimum Lead time)

Danger level:

This level is below the minimum / safety stock level. It represents a stage where immediate steps are taken for getting stock replenished. The moment stock reaches this level; it is a sign that if no emergency steps are taken to replenish the stock the stores will be completely exhausted which results in production stoppage.

[Ref: Principles & Practice of Cost Accounting – Asish K. Bhattacharyya – Vol.2 1992]

LABOUR COST MANAGEMENT & CONTROL

INTRODUCTION

Labor cost is an important element of cost. Till recently it constituted a significant portion of total cost of production. However, the proportion is reducing fast with more and more firms adopting advanced manufacturing technologies. However, in knowledge based industries employee- compensation is the single most important element of cost of production or service. Therefore, it is important for every firm to establish an efficient system for managing employee-time and select the most appropriate method of remunerating employee. The productivity of all other resources is linked to the productivity of employees who energize the otherwise dumb assets. A wrong selection of method demotivates employees, resulting in loss of productivity. There are many industries which are still labor intensive. For those industries, reduction in labor cost itself significantly improves competitiveness.

In this chapter we shall discuss different systems of timekeeping and time booking. We shall also discuss different methods of remunerating employees- their advantages and disadvantages.

NEED FOR LABOR COST CONTROL

Objective of Labor Control

Direct and indirect payments to workers and other personnel engaged in manufacturing activities, as compensation for their services, constitute labor cost. Labor cost represents the cost of purchasing the employees’ service. Control of labor cost is an important management function. Improvement in labor productivity results in the reduction of fixed overheads per unit.

Take an example. At present 100 workers are paid at the rate of $40 per day. They have submitted a demand at an increase in pay to $ 50 per day. The proposal includes an increase in output to 5000 units per day from the present level of 4000 units per day. Fixed overhead is $4000 per day. There is no variable factory overhead. The following analysis will be helpful in deciding whether or not to agree to the demand of the workers.

Present cost

structure

Proposed cost

structure

Labour cost

Fixed factory overhead

Output (units)

Labour-cost per unit

Fixed overhead per unit

Conversion cost per unit

100 x $ 40

$ 4,000

4,000

$ 4,000

4,000

= $ 4,000

$ 4,000

4,000

= Re. 1.00

= Re. 1.00

$ 2.00

100 x $ 50

$ 5,000

5,000

$ 4,000

5,000

= $ 5,000

$ 4,000

5,000

= Re. 1.00

=Re. 0.80

$ 1.80

Although labor cost per unit will remain the same, acceptance of the demand will reduce the fixed overhead per unit. Consequently the conversion cost per unit will reduce. Labor cost per unit will not change, because proposed increase in wage rate is in direct proportion to expected increase in productivity. Usually, benefits of increased productivity are shared between employees and owners. The sole objective of management in employee- time and employee- cost is to maintain labor cost and conversion cost per unit at the minimum.

[Ref: Cost Accounting for Business Managers – Asish K. Bhatacharyya – Elsevier 2009]

Importance of Labor Cost control

Labor cost requires constant measurement, control and analysis because:

a) It represents human contribution to production.

b) Labor is different from other factors of production in the sense that it is not subject to any technical limitations which restrict productivity.

c) In view of present labor laws, labor cost should be perceived as ‘committed cost’ rather than as a ‘discretionary cost’.

d) Labor productivity significantly influence conversion cost per unit.

Accounting and control of labor cost requires:

a) Strict control on labor engagement

b) Correct time keeping i.e. recording the total time spent by employees in the work place.

c) Time booking i.e. analysis of time in terms of departments, operations and production orders or jobs, which used the employee time.

d) Generation of adequate and effective manpower performance reports improvement in the methods of remunerations, conversion of indirect labor into direct labor better planning and control and improvements in the method of production.

Departments Involved

a) The Human Resource department. It is responsible for manpower planning, hiring and firing of personnel on the recommendations of other functional heads. It is also

responsible for management of human resource including training and deployment of people.

b) The engineering and work study department. It is responsible for preparation of production plans and specification for each job, supervision of all the production activities, time and motion studies, and job analysis.

c) Time keeping department. It primarily responsible for collecting data in respect of total and specified time worked on a job, product, and process or in a department.

d) Payroll department. It is responsible for computing total and net earnings of each worker, preparation of payroll and maintenance of relevant records.

e) Cost accounting department. It collects and classifies all costs including labor cost. It assigns costs to jobs, products, processes or departments based on records.

Direct and Indirect Labor

Direct labor cost is the employee compensation assigned directly to a cost unit, job batch, process or any other cost object. Employee compensation that cannot be assigned directly to the cost object is indirect labor cost. Usually employees whose time is booked against a particular cost unit, job, batch, process or any other cost units are classified as direct workers. Compensation to those employees is classified as direct labor cost. However, in some situations, some components of compensation to direct workers are classified as indirect labor cost. Examples of such components are: wages of unproductive hours, overtime premium, bonus and holiday pay. There are times when it is not clear whether those components are direct cost or indirect cost. The classification of costs into direct and indirect costs is not a question of principle; rather it is a question of convenience. As in the case of material cost, when compensation to employees forms only a very small part of the cost of production or service, often the total compensation is treated as indirect cost.

[Ref: Principles & Practices of cost accounting – Asish K Bhatacharyya – 3rd ed - Prentice-hall Of India Pvt Ltd (2008)]

Examples of direct workers are: machine operators and assemblers.

Examples of indirect workers are: workers supporting direct workers, supervisor, foreman, inspectors, office staff in factory administration and employees responsible for support services.

Appropriate classification of employees into direct workers and indirect workers is important because:

a) It is easier to control direct workers than indirect workers.

b) It facilitates measurement of labor efficiency.

c) It facilitates assignment of overhead based on direct labor cost or direct labor hours.

d) It improves the accuracy of the product cost.

It is wrong to perceive direct workers as productive workers and indirect workers as non- productive workers. Indirect workers contribute by supporting production activities.

Hiring Labor

Employees are hired for replacement of existing employees or to meet additional requirements arising from the expansion of the organizational activities. Replacement may be for someone who has left the firm or for someone who has been elevated to a higher position or transferred to another activity.

The Human Resource (HR) department initiates actions for recruitment on receipt of proper authorization from a functional head against a departmental manager’s specific recruitment need, provided a vacancy exists in the stated position. The department locates prospective candidates through advertisements or through employee- exchange bureaus. It arranges tests and interviews and issues appointment letters to the selected individuals. Some firms engage specialized agencies to recruit employees. Soon after the candidates joining the organization, the HR department informs the concerned departmental head, payroll department and shop steward of the appointment and also organizes induction training of the employee.

It is the responsibility of the HR department to maintain permanent records of all the employees showing a detailed history of each of the employees including details of promotions and transfers, commendations and disciplinary actions and movements in wages. A specimen ‘Service history card’ is shown below:

Service History Card

Name………………………………Date Of Birth…………………………………..Identification mark………………………………….

Permanent address……………………………………………………….Present address………………………………………………….

E.S.I. card no. ……………………………………….P.F. account no. ……………………………Clock no. …………………………….

Educational qualification……………………………………………………………………………………………………………………………

Interviewed on…………………………………..Joined on…………………….Grade…………………..Dept…………………………..

Discharged on……………………………………………………….Reasons for discharge…………………………………………………

Change in pay and service

Date of change New grade New department Remarks

TIME KEEPING

Time keeping is the method of accurately recording the employee time will be paid by the firm. Time keeping is essential in order to: (a) comply with statutory requirement; (b) maintain discipline in attendance; (c) prepare pay- roll, and (d) provide internal control over employee payments. The following are some of the popular methods of recording time.

The check or Disc Method

Each worker is allotted a unique employment number by the HR department. Metal discs bearing employee’s numbers are placed on hooks on a board located at the entrance of the factory. On entering the factory the worker removes the disc bearing the reporting time is over. A worker who comes late takes his disc to the department concerned and puts it in the particular drawer provided by the foreman from among the drawers kept in a series. Usually, the departmental foreman replaces the available drawer by a new one at an interval of half an hour because wages are deducted uniformly for every step of half an hour. The time keeper records the attendance on the basis of these discs. Many variations of the system are in practice.

Clock Card

Clock cards produced by mechanical devices provide unquestionable evidence of the presence of an employee inside the plant and the time of his entry and departure.

Time clocks, installed at the entrance of the plant, record ‘in’ and ‘out’ time for every employee on a card with his name, employee number and department code printed on it. The card provides space for printing in and out times in a single color. (e.g. black) only, but others automatically print late arrival, overtime and similar data in red to draw management’s attention to these exceptions. Some of the most modern time clocks, which are hooked with mainframe computer, automatically feed input data to the computer which produces daily reports on attendance of workers, and at the end of the wage period prints out the payroll.

It is customary to provide racks, one marked ‘out’ and the other marked ‘in’ near the clock, from which a worker removes his card, inserts it in the clock, gets the time printed and places the card on another rack to enable the time keeper to record his attendance.

It is necessary that the time keeping staff is preset at the time of punching the card to supervise and ensure smooth and rapid movement of employees and also to ensure that proper clock card procedure is observed.

At the end of the wage period, clock cards are collected and a new set of cards is placed for the next wage period.

It is however a usual practice in many organizations to collect clock cards on a daily basis, and the time keeping staff records the details.

The use of clocks minimizes manipulation, provided time keepers are able to effectively check and control frauds by employees.

Specimen clock card

Date In Out In Out In Out Total

800

800

1200

1200

100

100

500

500

530 730 10

8

Ordinary

Overtime

Hour Rate Amount

Days worked Total Hours Gross earnings

TIME-BOOKING

Time booking refers to the analysis of time in terms of departments, operations and production orders or jobs. Time booking is essential to:

(a) Ensure proper utilization of direct workers

(b) Calculate labour costs of units produced: and

(c) Assign overheads to cost units.

The following are the methods which are commonly used for time booking

1. Time Ticket (Job Ticket)

Prepare accounting for labour costs requires a detailed analysis of time purchased as evidenced by clock cards. Usually, time tickets or job tickets, which show the specific use of the time purchased, are used for time-booking

When individual time ticket is used, only one ticket is issued to a worker at a time. The worker normally collects the ticket from the foreman’s office. Time tickets serve dual purposes. It provides instructions for operations to be performed and records time spent in performing them. On completion of the operation the worker records time of completion on time ticket, submits the same to the foreman and collects a new ticket for the next job to be worked on.

2. Piece Work Tickets

Payment to workers on the basis of the number of units produced does not obviate the necessity of recording the time spent on a particular job. Time-booking is necessary because in the ultimate analysis, overheads are apportioned on the basis of time spent on each job and also because when a premium or bonus is paid for time saved, both quantities of output and the time spent must be available. Further, time-keeping and time-booking of piece-rate workers’ is necessary from administrative point of view

Reconciliation of time purchased as per time-keeping records and time booked

Time recorded at the entry point as evidenced by clock card of an employee must be reconciled with his time booked on various jobs/ products/ operations. This helps to control wastage of labor hours, and prevents inclusion of dummy workers on the payroll.

If clock card shows more hours as compared to the total time booked on various jobs/ products/ operations, the difference is reported as idle time. If the total hours booked are more than hours recorded on clock card, the error is corrected in consultation with the foreman and the worker concerned.

CASUAL WORKERS, HIRED LABOR AND OUT- WORKERS

Casual Workers

In some organizations workers are often appointed on a purely temporary basis for short periods in order to cope with increased production. Some organizations follow the practice of employing casual workers to work as replacement for absentee workers. Firms follow the following procedure in dealing with such appointments:

a) Personnel department maintains a panel of casual workers. Casual workers are engaged from the list of persons empanelled with the Personnel department.

b) Personnel department engages casual workers at the request of the user department. Approval of a competent authority is obtained before recruiting such workers.

c) Personnel department maintains proper records regarding the appointment and discharge of casual workers.

d) Accounts department receives a copy of the appointment letter for calculation of wages.

e) Such workers are covered under the regular system of time- keeping and time- booking.

f) As is the case with regular workers, job time is reconciled with attendance time for casual workers.

g) Personnel department ensures that casual workers are discharged on the expiry of the period for which they are engaged. If casual workers are required for an extended period, a different person is engaged after obtaining the prior approval of the competent authority.

Extra vigilance is needed when casual workers are engaged at a site away from the factory. The site-in-charge is responsible for proper time-keeping. The actual method employed depends on the number of workers. Spot checking of the number of workers actually working is required to ensure that the number is not larger than what is absolutely necessary.

Hired Workers

Some organizations hire workers through contractors. In such a case all payments are made to the contractor. Payments are not made directly to workers. Contractors are often paid on the basis of attendance records of hired workers. However, time booking is, usually, not required because such workers are seldom engaged in production. Spot checking prevents the possibility of overbilling by the contractors.

Out- Workers

In certain cases work is performed by the workers on their own premises using their own tools and equipment. Time records are not maintained for those workers. Payment is made according to the work done. However, the firm exercises a rigid control over the following:

a) Issue of materials and reconciliation between material issued and the output received.

b) Inspection of the output

c) Delivery of the output as per stipulated delivery schedule.

d) Periodic physical verification of materials at worker’s premises.

COMPUTER AND PAYROLL

With the advent of the computer, most organizations have computerized the payroll. Time keeping has also been computerized in many firms through installation of time clocks, which are hooked with computers. This has increased the accuracy in time keeping and preparation of the payroll. Data on daily time sheets are entered in the computer which inter- alia generates:

a) Reconciliation statement

b) Incentive payment sheets

c) Labor productivity

Computerization of time keeping and payroll accounting does not automatically improve labor productivity. Productivity improvement is possible only through managerial actions.

WORK STUDY

IntroductionWork study consists of method study and work measurement in order to improve productivity. Productivity is the quantitative relationship between output (the produce) and input (the resources). Improvement in productivity results in lower unit cost.Corollaries that apply to the principal objective of improving productivity are:

a) Minimize the time required to perform tasks.b) Conserve resources and minimize cost by specifying the most appropriate direct and

indirect materials for the production of goods and services.c) Produce with regard to availability of powerd) Provide an increasingly reliable and high quality product.e) Maximize the safety, health, and well being of all employees.f) Produce with an increasing concern to protect the environment.g) Follow a humane program management

In other words, work study is a scientific observation of work in its total context in order to find out easier, quicker and cost effective ways of doing the work.

MOTION STUDYFrank B. Gilbreath was the founder of the modern motion study technique. Motion study is the study of the body motions used in performing an operation, with the thought of improving the operation by eliminating unnecessary motions and simplifying necessary motions and then establishing the most favorable motion sequence for maximum efficiency.Motion study has the following advantages:

a) It helps in faster and better working.b) It helps in better distribution of work, and better arrangement of work place and tools.c) It helps in planning and operations in a scientific manner.d) It ultimately results in increased productivity and reduced costs.

The limitations are:a) It is costly and time consuming.b) It is likely to be misunderstood by workers and may put a strain on an otherwise

harmonious worker- management relationship, unless the objectives are properly explained.

TIME STUDY“Time study involves the technique of establishing an allowed time standard to perform a given task, based upon measurement of the work content of the prescribed method, with due allowance for fatigue and for personal and unavoidable delay.”Time study endeavors to find out time taken by an average worker, possessing average skill, working under average conditions, exerting average effort and maintaining this effort with average consistency. In short, time study aims at the determination of standard time required by a worker of average ability, under normal conditions, to perform a task. The main advantages are:

a) It helps to establish an incentive wage payment scheme.b) It helps to set production quotas for hourly rated workers.c) It helps to calculate the cost of production.d) It is essential to set standard labor cost under standard costing system.e) It helps the process of production scheduling, budgeting and manning.

The limitations are:a) It lacks mathematical accuracy because of complexity in breaking up a task into various

elements and also because of the presence of subjective element in leveling or performance rating.

b) It fails to provide for adequate measurement for jobs/ tasks where quality is of prime importance.

c) Trade unions generally consider time study as infringement on a worker’s freedom of action.

d) It is inapplicable to jobs which are not repetitive in nature.

METHOD STUDY

Time and motion study is incomplete without method study. All the three are parts of the total work study which helps management in;

a) The optimum and effective use of plant and equipment.b) The optimum and effective use of human efforts.c) The evaluation of human work.

A simple framework for method study is to:a) Select the work to be studiedb) Record all the relevant facts of the present or proposed methodsc) Examine the facts critically and in sequenced) Develop the most practical, economic and effective method having due regard to all

contingent circumstances.e) Install the method as a standard practicef) Maintain the standard thorough regular routine checks.

The practice of time and motion study involves the following steps:a) The task is broken down into elements.b) For each element, consult previously established basic time, (i.e. the time for carrying

out the element at the standard rate of working).c) If basic time is not available for any element, it is constructed by appropriate time and

motion study.d) A percentage to cover relaxation time is added to the basic times individually or to the

total of basic times in order to work out the content of the job.e) Values of human work, technical data and any other appropriate allowance are

combined to arrive at the standard time for the job/ task.

Conclusion

In management accounting, cost accounting establishes budget and actual cost of operations, processes, departments or product and the analysis of variances, profitability or social use of funds. Managers use cost accounting to support decision-making to cut a company's costs and improve profitability. As a form of management accounting, cost accounting need not to follow standards such as GAAP, because its primary use is for internal managers, rather than outside users, and what to compute is instead decided pragmatically.

Material cost and Labour cost are the most important elements of costing and it is as much as important to control and manage the two elements in an organization. The previous chapters have clearly shown the methods that were used and some that are used today in controlling and effective management of the two elements of Costing.

References

1. Principles & Practices of Cost Accounting Vol 2, By Asish K. Bhatacharyya - 1992

2. Principles & Practices of cost accounting – Asish K Bhatacharyya – 3rd ed - Prentice-hall Of India Pvt Ltd (2008)

3. Management & Cost Accounting by Colin Drury 20044. Costing by T. Lacey – 1996

5. Cost Accounting by William K. Carter – 2007

6. Cost Accounting for Business Managers – Asish K. Bhatacharyya – Elsevier 2009