MEANING

CLASSIFICATION OF MATERIALS

INVENTORY CONTROL

ABC TECHNIQUE

STOCK LEVELS

ECONOMIC ORDER QUANTITY

INVENTORY SYSTEMS

MATERIAL LOSSES

METHODS OF PRICING MATERIAL ISSUES

The term ‘material’ refers to all commodities consumed in the process of manufacturing.

According to CIMA of UK, material cost is “the cost of commodities supplied to an undertaking.”

Material is the largest single item of cost in almost every manufacturing business.

DIRECT MATERIALS

Become part of the finished product

Can be conveniently identified with and allocated to cost units

Examples, leather in shoes, timber in furniture, steel in machines, etc.

INDIRECT MATERIALS

Cannot be conveniently identified with individual cost units

Less important, small, relatively inexpensive

May or may not become part of the finished product

Examples, pins, screws, coal, lubricating oil, etc.

SUPPLIES Indirect materials used in production which do not

become part of the finished product Examples, oil, grease, soaps, towels, sand paper, etc.

FINISHED OR COMPONENT PARTS In assembly type production, component parts may

be purchased or produced within the organization Examples, Tyres and tubes in car manufacturing,

picture tube in TV manufacturing, etc. STORES Wide term which includes raw materials,

component parts, tools, maintenance materials, consumable stores, work-in-progress, finished goods, etc.

INVENTORY Covers stock of raw materials, work-in-progress and

finished stock.

Means control over purchases, storage and consumption of materials and determining the optimum level for each item of inventory

OBJECTIVES:

No Under-stocking- material control ensures no shortage of materials

No Overstocking- investment in materials is kept as low as possible as overstocking locks up the capital and causes high storage costs thereby adversely affecting the profits

Minimum Wastage- proper storage conditions to prevent loss of materials due to deterioration, obsolescence, theft, evaporation, etc. (Cont…)

Economy in Purchasing- facilitates purchasing materials at most favorable prices

Proper Quality of Materials- purchasing needed quality for each type of material

Information About Materials- ensures complete and up-to-date accounting information about the stock of materials

Material Reports to Management- provides accurate and up-to-date reports to management about purchase, consumption and stock of materials

Value-based system of material control

In this technique of selective control, materials are analyzed according to their value so that costly and more valuable materials are given greater attention and care

All items of materials are classified according to their value, i.e., high, medium and low values, which are known as A,B and C items respectively

ABC technique is sometimes called Always Better Control method.

(Cont…)

A’ Items- high value items representing only a small percentage of total items handled, requires strict control and is the responsibility of most experienced personnel

‘B’ Items- medium value materials which should be under the normal control procedures

‘C’ Items- low value materials representing very large number of items, requires simple and economic methods of control

One of the major objective of inventory control is to ensure that there is no ‘under-stocking’ and ‘overstocking’.

A scientific approach to achieve this objective is to adopt a system of stock levels.

These levels are maximum level, minimum level, re-order level and re-order quantity

By adhering to these levels, material stocks will be at the optimum level

These levels are not fixed permanently but can be changed as and when required.

Maximum Level

Level above which stocks should not normally be allowed to rise.

Maximum quantity that may be held in store

Maximum Level= Re-order Level+ Re-order Quantity- (Minimum Consumption * Minimum Re-order Period)

Minimum Level

Level below which stock should not normally be allowed to fall

If materials fall below this level, there is a danger of stoppage in production

Minimum Level= Re-order Level- ( Normal Consumption * Normal Re-order Period)

Re-order Level

Level at which a new order for material is placed

At this level, purchase requisition is made out.

This level is above minimum level but below maximum level

Re-order level= Maximum Consumption * Maximum Re-order Period

Danger Level

Level at which normal issues of materials are stopped and urgent action is taken for purchase of materials so that production is not interrupted due to shortage of materials.

Danger Level= Average or Normal Consumption * Maximum Re-order Period for emergency purchases

Average Stock Level

• Average Stock Level= Minimum Level+ Maximum Level

2

Or

• Average Stock Level= Minimum Level+ ½ (Re-order quantity)

Ques- In a manufacturing company, a material is used as follows:

Calculate-

(a)Re-order Level (b)Minimum Level (c)Maximum Level (d)Danger Level (e)Average Stock Level

Maximum Consumption 12000 units per week

Minimum Consumption 4000 units per week

Normal Consumption 8000 units per week

Re-order Quantity 48000 units

Time required for delivery Minimum: 4 weeks Maximum: 6 weeks

(a) Re-order Level= Maximum Consumption * Maximum Re-Order Period

= 12,000 * 6 = 72,000 units

(b)Minimum Level= Re-order Level –(Normal Consumption * Normal Re-order Period)

=72,000 – (8000*5)= 32,000 units

(c)Maximum Level= Re-order Level+ Re-order Quantity-(Minimum Consumption*Minimum Re-order Period)

= 72000+48000-(4000*4)

=104000 units

(d)Danger Level= Average Consumption*Maximum Re-order period for emergency purchases

=8000*2 weeks(assumed)

=16000 units

(e)Average Stock Level=Minimum Level+1/2 of Re-order Quantity

=32000+1/2(48000)=56000 units

Re-order quantity is the quantity to be ordered whenever materials are to be purchased

Re-order quantity is sometimes known as Economic Order Quantity because it is the quantity which is most economic to order.

In other words, EOQ is the size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the material at the optimum level and at the minimum cost.

It equates the cost of ordering with the cost of storage of materials.

(Cont…)

Ordering cost includes cost of stationery, salaries of those engaged in receiving, inspecting and preparing purchase orders, etc.

Storage cost or cost of carrying inventory includes cost of storekeeping, interest on capital locked up in stores, insurance cost, evaporation, wastage of materials, etc.

EOQ= 2*A*B

S

Where,

A=Annual Consumption

B=Buying or ordering cost per order

S=Storage cost per unit per annum

Ques: Calculate the economic order quantity for material X from the following particulars-

Soln: EOQ= 2*A*B = 2*90000*10

S 50*10%

= 600 units

Annual Usage 90,000 units

Buying cost per order Rs. 10

Cost of carrying inventory 10% of cost

Cost per unit Rs. 50

BASIS FOR

COMPARISON

PERPETUAL

INVENTORY SYSTEM

PERIODIC

INVENTORY SYSTEM

Meaning The inventory system

which traces every

single movement of

inventory, as and

when they arise is

known as Perpetual

Inventory System.

The Periodic

Inventory System is

an inventory record

method whereby, the

inventory records are

updated at periodic

intervals.

Basis Book Records Physical Verification

Updations Continuously At the end of the

accounting period.

(Cont…)

BASIS FOR

COMPARISON

PERPETUAL

INVENTORY SYSTEM

PERIODIC

INVENTORY SYSTEM

Information about Inventory and cost of

sales

Inventory and cost of

goods sold

Balancing Figure Inventory Cost of Goods sold

Possibility of

Inventory Control

Yes No

Affect on business

operation

This method does not

influence the

business operation.

Under this system the

business operations

need to be stopped

during valuation.

Normal Loss Losses which are unavoidable are called Normal losses. Normal losses of material can not be completely avoided

but may be controlled to a limited extent . These losses are transferred to factory overheads. Examples- Losses by evaporation, Loss due to loading

and unloading, Losses due to breaking the bulk etc.

Abnormal Loss Losses that arises due to inefficiency in operations,

carelessness etc. is called as abnormal losses. These losses are charged to coasting profit and loss

account. Examples- Breakage, Fire, accident, flood, Improper

storage, Theft, etc.

Material losses could arise in the form of waste, scrap, spoilage and defectives. Waste: It comprise of all visible, invisible losses that can not be

collected and also unsalable portion of the collected loss. Examples of waste are dust, smoke, gases etc.

Scrap: It represents the unusable loss which can be sold. It is measurable and has a minor value .Scrap may arise in the form of turning’s, filing etc. from metal; off-cuts and cut pieces in leather & cloth industry .

Spoilage: Spoilage is those materials or components which are so damaged in the manufacturing and operation process that they can not be repaired or reconditioned. Spoiled units do not attain the quality required and it is not economic to correct them.

Defectives: A good in which there is a manufacturing fault or defect is called Defective good. This fault can be removed by applying additional cost called rectification cost.

First-in First-out (FIFO)

Last-in First-out (LIFO)

Simple Average

Weighted Average

Replacement Price

Standard Price

Basis FIFO LIFO 1. Assumption It assumes that

materials which are

received first are

issued first.

It assumes that

materials which are

received last are

issued first.

2. Cost of materials Cost of materials

issued at the older

prices.

Cost of materials

issued is at the latest

prices paid.

3. Value of closing

stock

Closing stock is

valued at the latest

prices paid.

Closing stock is

valued at the prices

of oldest materials in

stock.

Basis FIFO LIFO

4. When prices are

rising

When prices show a

rising trend, FIFO

reports higher profit

and resultantly higher

tax liability.

When prices are rising,

LIFO shows lower

profits because higher

costs are matched

against current

revenues. Tax liability

is thus reduced.

5. When prices are

falling

When prices of

materials are declining,

FIFO shows lower

profits and thus lower

tax liability.

When prices are

declining, LIFO shows

higher profits and thus

higher tax liability.

Simple Average Method

Simple average price is calculated by adding all the different prices and dividing by the number of such prices.

It does not take into account quantities of materials while computing average price.

Example, when 100 units are purchased @ Rs.9 per unit and 900 units are purchased @Rs.7 per unit, the simple average price will be = (9+7)/2= Rs.8

Weighted Average Method

This method gives due weight to the qualities held at each price when calculating the average price.

The weighted average price is calculated by dividing the total cost of material in stock from which the material to be priced could have been drawn, by that total quantity of material in that stock.

Weighted average price = Total cost of materials in stock

Total quantity of materials in stock

Replacement Price Method

Replacement price is the price at which materials would be replaced, i.e. the market price on the date of issue.

This method is used when it is desired to reflect the current prices in cost.

It is most suitable for businesses that buy large quantities of materials well in advance of requirements to take advantage of cheap prices, the benefit of which is not desired to be passed on to the customer.

Standard Price Method

Standard price is a pre-determined price which is fixed for a definite period, such as a year.

It takes into account factors like probable trend of prices over that period, market conditions, discounts, etc.

Under this method, all receipts are posted in the Stores Ledger Account at actual cost and issues are priced at standard price. The difference between actual and standard prices, is transferred to Material Price Variance Account.