Material costing

Introduction
The production department requires raw materials and consumable stores for production. The purchasing department purchases these materials from different suppliers. The storage department stores them and then issues them ultimately to the production department. Hence there must be perfect co-ordination between these departments to control material cost.

Objectives of material control:

The main objectives of operating material control system are:
 To avail material needed so as to reduce instance of interrupted production.
 To ensure purchase of materials in economic quantities.
 To ensure that purchase of materials is made at the favourable price.
 To facilitate proper accounting for materials
 To ensure that the quality and specification of materials conform to the requirements of the product
 To reduce wastage and losses of materials

Essential requirements of material control system:
 Proper co-ordination and co-operation between different departments dealing with materials e.g. purchasing department, stores departments, quality control departments etc
 Centralization of all purchases under the control of a competent manager
 Classification, codification, standardization and rationalization of all stores and computerization of operations
 All issues of materials should be made against duly authorized requisitions
 Materials requirements should be planned properly
 Stock position should be updated continuously based available information from the relevant departments

 An efficient system of internal audit should be introduced for checking all material transactions

Benefits of material control
 Material control eliminates wastage in the use of raw materials
 It reduces the risk of loss due to fraud and theft
 It reduces capital investments in inventories
 It reduces cost of storage
 It ensures uninterrupted supply of materials of high quality for use in production
 It furnishes promptly and accurately the value of materials used in production

Centralized and decentralized purchasing
In a centralized purchasing, the task of purchasing all types of materials is entrusted to a separate purchasing department. However in a decentralized purchasing, each department purchases its own materials.

Advantages of centralized purchasing
 It eliminates duplication of effort and tasks
 It helps to achieve uniform purchasing policies
 It helps o reduce overall cost securing bulk purchase for all user units within the same organization
 It leads to specialized skill development in purchasing
 Better controls over purchasing is made possible since reckless purchases authorized persons is avoided
 It economizes on paperwork and accounting for purchase transactions
 Higher quality staff may be gainfully employed to handle material control issues

Disadvantages of centralized purchasing
 The creation and running of a special purchasing department leads to higher administration cost that small organizations cannot afford
 It may cause delays if user units are located far away over many different places
 There may be misunderstanding between the user departments and the purchasing department
 The initial cost of centralized purchases is very high since a separate purchase department has to be set up

Periodic inventory system
Under this system, the stocktaking of the physical quantities of materials of all kinds is done at a given date. In most cases it causes a lot of disruptions to the normal operations of the organization.

Perpetual inventory system
This is a system under which inventory records are continuously adjusted after every transaction involving issue or receipt of stock items. The records therefore show the physical balance of inventory items at any given point in time. Under this system any stock discrepancies must be investigated immediately and appropriate corrections made if the records are to be relied upon.

Setting stock levels
The following factors are considered when setting stock orders:-
i. Availability of the stock item i.e. if the stock item is readily available in the market, then low stock levels are maintained and vice versa.
ii. Lead time /re-order period i.e. refers to the period required to process an order and receive deliveries of the stock item. The longer the lead time, the higher the stock level and vice versa.
iii. Stock holding cost (storage cost)-The higher the storage cost incurred on the stock items, the lower the stock level should be maintained and vice versa.
iv. Consumption rate- if the consumption rate is high, then high stock levels should be maintained and vice versa.
v. Durability –highly durable stock items requires high stock levels whereas perishable items require low stock level.

Note- Investments in stock presents a major asset for most businesses and it‟s essential that stocks should be managed efficiently.

The costs relating to stock management are classified as follows:

i) Holding cost- this consists of the following:
a) Opportunity cost for the investment in stock i.e. what the amount would fetch if was not tied in stock but instead invested.
b) Incremental insurance cost.
c) Warehousing and storage cost.
d) Material handling cost.
e) Obsolescence and deterioration costs.
f) Stores operations and running cost.

ii) Ordering cost- This comprises;
a. Clerical cost of preparing a purchase order.
b. Delivery costs.
c. Remuneration of purchase department personnel.
d. Clearing charges.
e. Inspection for quality costs.

iv) Purchase cost- is the amount paid to the suppliers for supplying the stock item. It is relevant for inventory policy decisions only if there is a provision for quantity discounts.

The Economic Order Quantity (EOQ)
This is the order size or quantity which minimizes the total relevant cost i.e. the sum of the total ordering cost and total holding cost.

For EOQ purpose, the total relevant cost is given as:

Total relevant cost = total holding cost +total ordering cost

Basic assumptions of the EOQ model
i. Holding cost per unit per annum remains constant.
ii. The average balance in stock is assumed to be equal to ½ of the order quantity.
iii. It is assumed that the annual demand is known and is constant.
iv. Replenishment of stock is assumed to be done in equal batches.
v. Ordering costs per order is fixed irrespective of the order quantity.
vi. Purchase cost per unit is assumed to be constant throughout the year.
vii. There‟s no provision for quantity discount.
viii. It assumes that the lead time is known and is constant throughout the year.

Where: D- is annual demand
T- is cost per order
H- is annual holding cost (usually but not always) expressed as a percentage of purchase price per unit.
Q –order quantity.

Illustration
A Company has an annual demand for its material amounting to 25,000 tons Pa. The purchase price per ton for the stock item is ksh. 2,000 and the stock holding cost is 25% of the purchase price. The ordering cost is ksh. 400 per order.

Required:
Calculated:
a) The EOQ
b) The total holding cost
c) The total ordering cost
d) The total relevant cost


Confirm from the above illustration that the total relevant cost would be higher at all other order quantities e.g. (i) 100 tons (ii) 250 tons
Activity
The Company has an annual demand of a product amounting 60 000 units. The price per

unit is Ksh. 4500 and the stock holdog cost is is ksh. 320

331 of stock value. Delivery cost per order
3

Limitations of the EOQ model
1. It assumes that the purchase price per unit is constant through the year which is unrealistic.
2. Assume that annual demand remains constant which is unrealistic.
3. It doesn‟t apply in cases where there are quality discounts.
4. It can only be operated people having sound knowledge in stock management.

Quantity discounts
Circumstance frequently occurs where firms are able to obtain quantity discounts for large purchase orders. Buying in large quantities to take advantage of quantity discounts leads to the following cost savings:
 Savings in the purchase cost. This consists of the amount on the discount itself.
 A reduction in the total ordering cost because fewer orders are made.

Note: These cost savings must however be balanced against the increased holding cost arising from bulk stock. To determine whether or not the discount offer is worthwhile, the benefits (cost savings) must be compared against the additional holding cost arising from bulk purchase.

Illustration
A Company purchases raw materials from an outside supplier at a cost of ksh.7 per unit. The total annual demand for this product is 9,000 units. The holding cost is ksh. 4 per unit per annum and the ordering cost is ksh. 5 per order.

A quantity discount of 3% of the purchase price is available for orders in excess of 1,000 units.

Required
Should the Company accept the discount offer? (Show all your workings)
Solution:
D-9,000 units Discount rate = 3% = 0.03 T- Ksh. 5
H- Ksh. 4 Q =?
Price = Ksh. 7 per unit

Note: Purchase cost forms part of the total relevant cost whenever there‟s a provision for quantity discount.

The alternative order quantities are therefore at the EOQ and at 1,000 units. This will result into the following costs:

Therefore; the Company should take the discount offer because it leads to an overall cost savings of ksh. 445.

Illustration: 2
A Company is revising its stock policy and has the following alternatives available for the evaluation of its stock;
i) Purchase stock twice monthly of 100 units.
ii) Purchase stock monthly of 200 units
iii) Purchase every 3 months of 600 units
iv) Purchase stock every 6 months of 1,200 units
v) Purchase stock every 12 months 2,400 units

It‟s ascertained that the purchase price per unit is ksh. 0.80 for the whole order where deliveries are up to 500 units. A 5% discount is offered the supplier on the total order for deliveries between 500-1,000 units and 10% discount for deliveries in excess of 1,000 units. The holding cost is ksh. 0.25 per unit of average stock held per annum and the ordering cost per order is ksh. 5.

Required
Advise the management on the optimum order quantity

Solution:
Since the purchase price is not constant, the EOQ analysis would be inappropriate;

H- Ksh 0.25 per unit
Disc -5% for 500 -1,000 units and 10% for 1,000 units and above
D= 2,400 units

*The company should purchase the stock semi-annually thus implement the 10% discount policy because it‟s the cheapest alternative.

Re-order level
This is the level at which an organization places an order to replenish its stock. It depends on the lead time and the rate of demand during the lead time.

Re-order level= Demand During Lead Time + Safety Stock i.e. ROL = DDLT +SS
Or.
ROL= Maximum Consumption rate x maximum lead time.

Minimum stock (safety /Buffer stock)
The safety stock refers to that stock level that should be maintained to take care of eventualities regarding lead time and usage. It is a stock allowance meant to cover errors in forecasting the lead time and demand during the lead time.

Minimum stock level = ROL – (Average Consumption x Average Lead Time)

Maximum Stock level
This refers to the maximum investment that should be made in stock if the business is to make good use of its working capital.

Maximum Stock level = ROL +EOQ – (Minimum consumption x Minimum Lead time)

Average stock level
Is the average of the minimum and maximum stock level

Illustration
The Company has provided the following data in respect of its major raw materials.

Max. Consumption 1,200 units Ave/Normal consumption 900 units Minimum consumption 600 units
Lead time 4-6 wks
Re-order Quantity 6,000 units

Required
i) Reorder level
ii) Max stock level
iii) Min. stock level
iv) Average stock level

Graphically, this can be represented as follows:

ABC ANALYSIS (PARETO ANALYSIS)

Time

Usually a firm has to maintain several types of inventory. It‟s not desirable to keep the same degree of control over all items. The firm should pay a lot of attention to those items whose value is the highest. Therefore they should classify them to identify which items should receive the most attention in controlling and hence the analytical approach called ABC analysis. It tends to measure the significance of each item in terms of its value.

High value items are termed as “A- items‟ and would be under the tighest control. “C-items” represent relatively low value items and would be under minimal control.
“B-items” fall between these two categories and require reasonable attention of the management.
The following steps are involved in implementing an ABC inventory plan:
 Classify the items of inventories determining their relative value.
 Rank them in accordance with their value; 1st rank- “A-items‟ high value items; 2nd rank- “B-items” and 3rd rank- “C-items”.
 Compute the percentage of the number of units in each class and the percentage of the value in each class.

PRICING AND COSTING OF MATERIAL ISSUES
When materials are issued from stores, they are valued in order to determine the material cost of the products. The following methods are used in valuing material assets.
i) First in- first out (FIFO)
ii) Last in-fast out (LIFO)
iii) Simple average
iv) Weighted average
v) Standard cost method
vi) Next in-first out (NIFO) or replacement cost method.
FIFO
This values materials issued on the basis of sequence/order in which they were bought
i.e. on the premise that the first items to join are first to be released.

LIFO
This method assumes that materials issued at any time are those that are most recently required.

Simple average
Simple average of prices of all consignment of stock is calculated and the average price is used in valuing materials issued. When the first consignment is exhausted then the price of that consignment is eliminated from the calculation of the simple average price. Therefore in some sense, this method follows FIFO method.

Weighted average
The total value of materials in stock is divided number of units in stock and the resulting figure is the weighted average price.

Standard cost method
Material issues are valued on the basis of the pre-determined standard cost which is set management and therefore it ignores the market price at which stock items were acquired.

Next in first out (NIFO)
Stock issues are valued on the basis of the prevailing market prices that would be incurred to purchase the next consignment of stock.

Specific or unit price method
Where the item issued can be identified with the relevant invoice, the actual cost can be charged. This is usually only possible with special purpose items bought for a particular job.

Illustration
The following transactions relate to item X15 which is regularly acquired and stocked general Products Kenya Limited for the month of October 2010. The following was entered in the Company stock ledger


The closing balance for September 2010 was 3,000 units received at a unit cost of Ksh 20.

Required;
Prepare stores ledger for October using:-
i) FIFO
ii) LIFO
iii) Simple average
iv) Standard cost method (assume a standard cost of ksh. 22 per unit)
v) Weighted average
vi) NIFO

Solution
Stores ledger (FIFO-method)

Therefore the closing stock is 5,450 units worth ksh. 123,100
Therefore the closing stock is 5,450 units worth ksh. 115,700

Stores ledger (Simple average-method)

Therefore the closing stock is 5,450 units worth ksh. 120,775
Therefore the closing stock is 5,450 units worth ksh. 100,400
Therefore the closing stock is 5,450 units worth ksh. 120,035

Therefore the closing stock is 5,450 units worth ksh. 94,550

Activity
Tindo ltd buys and sells product Q-3. It values stock on the basis of last in first out (LIFO). On 1 June 2010, stock in hand consisted of 4,500 units which were acquired at ksh. 50 per unit. The operations for the month were as follows:

The company incurred operating cost of ksh. 450,000 during the month.

Required:
a) Prepare the stores ledger card.
b) Determine the closing stock valuation.
c) Prepare the trading account for the month.

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