COST ACCOUNTING & COST MANAGEMENT

ACCOUNTING FOR MATERIALS

Learning Objectives:
1. Recognize the two basic aspects of materials control.
2. Specify internal control procedures for materials.
3. Account for materials and relate materials accounting to the general ledger.
4. Account for inventories in a just-in-time system.
5. Account for scrap materials, spoiled goods and defective work.

MATERIALS CONTROL

Two Basic Aspects of Materials Control

1. Physical Control or safeguarding of materials. – Raw materials usually represent a significant
portion of a manufacturer’s current assets, a business must control its materials from the time they
are ordered until the time they are shipped to customers in the form of finished goods. In general,
to effectively control materials, a business must maintain:
a. Limited Access – Only authorized personnel should have access to materials storage areas.
Raw materials should be issued for use in production only if requisitions are properly
documented and approved. In addition, procedures should be established within each
production are for safeguarding work in process. Finished goods should be safeguarded in
limited access storage areas and not released for shipment in the absence of appropriate
documentation and authorization.
b. Segregation of duties – A basic principle of internal control is the segregation of employee
duties to minimize opportunities for misappropriation of assets. With respect to materials
control, the following functions should be segregated: purchasing, receiving, storage, use and
recording. The independence of personnel assigned to these functions does not eliminate the
danger of misappropriation or misuse because the possibility of collusion still exists.
However, the appropriate segregation of duties limits an individual employee’s opportunities
for misappropriation and concealment.
c. Accuracy in recording – An effective materials control system requires the accurate recording
of the purchase and issuance of materials. Inventory records should document the inventory
quantities on hand and cost records should provide the data needed to assign cost to
inventories for the preparation of financial statements. Periodically, recorded inventories
should be compared with a physical inventory count, and any significant discrepancies should
be investigated. Differences may be due to recording errors or to inventory losses through
theft or spoilage. Once the cause has been determined, appropriate corrective action should be
taken.

2. Controlling the investment in Materials. – Maintaining an appropriate level of raw materials

inventory is one of the most important objective of materials control.
An inventory of sufficient size and diversity for efficient operations must be maintained, but the
size should not be excessive in relation to scheduled production needs. Funds invested in
inventories are unavailable for other uses, management should consider other working capital
needs in determining inventory levels. In addition to the alternative uses of funds that otherwise
would be invested in inventories, management should consider the materials cost of handling,
storage, personal property taxes, and casualty insurance. Also, higher than needed inventory
 levels may increase the possibility of loss from damage, deterioration or obsolescence of
materials. The planning and control of the materials investment requires that all of these factors
be carefully studied to determine (1) when orders should be placed and (2) how many units
should be ordered.

Order Point. – a minimum level of inventory should be determined for each type of raw
material, and inventory records should indicate how much of each type is on hand. A subsidiary
ledger, in which a separate account is maintained for each materials is needed. The point at
which an item must be ordered is called the order point. This occurs when the predetermined
minimum level of inventory on hand is reached. Calculating the order point is based on the
following data.

a. Usage – the anticipated rate at which the material will be used

b. Lead time – the estimated time interval between the placement of the order and the receipt of
the material.
c. Safety Stock – the estimated minimum level of inventory needed to protect against stockouts
(running out of stocks). Stockouts may occur due to inaccurate estimates of usage or lead
time or various other unforeseen events such as the receipt of damaged or inferior materials
from a supplier or a work stoppage at a supplier’s plant.

Sample Problem: Safety Stock:

Maximum daily usage 100
Average daily usage 80
Lead time 12 days

Maximum Daily Usage 100

Average daily usage 80
Difference 20
X Lead Time 12 days
Safety Stock 240

Sample Problem. Order Point.

Assume that a company’s expected daily usage of an item of material is 100 lbs, the anticipated
lead time is 5 days and the desired safety stock is 1,000 lbs.

Usage [100 lbs (daily usage x 5 days (lead time)] 500 lbs
Safety stock 1,000
Order Point 1,500
Sample Problem: Order Point, Inventory Levels, Ordering Cost. Charleston Company has developed
the following data to assist in controlling one of its inventory items:

Economic order quantity ................................................................................. 1000 liters

Average daily use ........................................................................................... 100 liters
Minimum Daily use 70 liters
Maximum daily use ........................................................................................ 120 liters
Working days per year .................................................................................... 250 days
Safety stock .................................................................................................... 140 liters
Cost of carrying inventory .............................................................................. P1.00 per liter per year
Lead time ....................................................................................................... 7 working days

Required: Compute the following:

(1) Order point

(2) Average inventory
(3) Maximum inventory assuming normal lead time and usage
(4) Absolute maximum inventory
(5) Cost of placing one order

SOLUTION
(1) Order point: 140 + (100 x 7 days) = 840 liters
(2) Average inventory: 140 + (1000/2) = 640 liters
(3) Normal maximum inventory:
Order Point 840
Less: Average(normal) daily use during lead time (100 x 7) 700
Balance 140
Add: Order Quantity 1,000
Normal maximum inventory 1,140

(4) Absolute maximum inventory

Order Point 840
Less: Minimum daily use during lead time (70 x 7) 490
Balance 350
Add: Order Quantity 1,000
Absolute maximum inventory 1,350

(5) Cost of Placing An order

1,000 = √ 2 x (250 days x 100 units per day) x Cost per Order
P1
Cost per Order = 1,000,000/50,000 = P 20 per order

Economic Order Quantity. The order point established the time when an order should be placed
but it does not indicate the most economical number of units to be ordered. To determine the
quantity to be ordered, the cost of placing an order and cost of carrying inventories in stock must
be considered.
 Order Costs
• Purchasing receiving and inspection
wages
• Telephone, fax, internet, software,
postage and stationary.
• Accounting and record keeping
Carrying Costs
• Storage and handling costs
• Interest, insurance, property taxes on
inventory
• Loss due to theft, spoilage or
obsolescence
• Accounting and record keeping.

Ordering cost and carrying cost move in opposite directions – annual order costs decrease
when the order size increases, while annual carrying costs increase when the order size increases.
The optimal quantity to order at one time is called the economic order quantity. It is the order size
that minimizes the total order and carrying costs over a period of time.

EOQ = 2 x Annual requirement x Cost per order

Carrying cost per unit

Sample Problem: Determination of Optimal Order Quantity.

Micro Corp. uses 1,000 units of Chip annually in its production. Order costs consist of P10 for
placing a long-distance call to make the order and P40 for delivering the order by truck to the company
warehouse. Each Chip costs P100, and the carrying costs are estimated at 15.625% of the inventory cost.

Required:

(1) Compute the economic order quantity for Chip and the total order costs and carrying costs for the
year.

Solution:
(1)

EOQ = 2 x 1000 x 50
100 x .15625

= 80

Ordering Cost = Annual Requirement x Cost per order

EOQ

Carrying Cost = EOQ + Safety Stock x Carrying cost per unit

2

Ordering Cost = 1000/80 x 50 = P 625

Carrying cost = 80/2 x 15.625 = 625
Total ordering and Carrying cost 1,250
Material cost (1,000 units x P 100) 100,000
Total Relevant Cost P 101,250
Inventory Models
1. Two-Bin System –
2. Min-Max Method – sets definable limits in inventory balances. In this method the minimum
inventory level serves as the reorder point. It includes normal quantity to be used from the time
an order is placed up to the time the materials are received (Lead Time). The safety stock
quantity to minimize the occurrence of stockkout is also included. The maximum inventory level
is the sum of stockout quantity and the order size.
a. Two-Bin System – Materials are stored in bins, piles, bundles or specific stocking area.
Two bins are used; one bin contains the quantities to used from the date the materials are
received up to the time an order is be placed, and the other bin contains the quantities to be
used during the waiting time and the safety stock. Once the first bin is consumed, an order
for two(2) bins is automatically placed

3. ABC Model - or selective control model classifies inventories into three classes, A, B and C.
Class A includes the high value, critical items; class B the middle value items; and class C the
low value items. The ABC model is related to the Pareto’s Law or the 80-20 rule. That is 80% of
the inventory value are concentrated in class A, high value inventory classification, and the
remaining 20% are clustered in Class B and Class C classification. Relevant principles and
practices with regard to these inventory classes are summarized below.

Inventory Class
A B C
Money value High value Middle value Low-value
Quality of control Very strict Not too strict Strict
Inventory movement (flows) slow Relatively fast Fast
Level of safety stock low moderate High
Quality of personnel Best available average Fair
Quality of records Error- free Highly reliable Reliable
Replacement time ASAP normal Can be long
Inventory turnover low average High

Stockout Costs

Inadequate inventory levels carried by a business have the following costs:

a. Extra purchasing, handling and transportation costs
b. Lost sales and lost of customer goodwill
c. Additional clerical costs due to keeping customer-back order records
d. Inflation oriented increases in prices when inventory purchases are deferred
e. Frequent stockouts leading to disruptions of production schedules, overtime and extra set-up time
f. Higher price due to small quantities
g. Foregone supplier discounts

Total Stockout Costs = Cost of Carrying SSQ + Cost of stockout occurrence

Cost of Carrying SSQ = SSQ x Carrying cost per unit
Cost of stockout occurrences = stockout cost per occurrence x Probability of occurrence x No of
occurrence

Where SSQ = Safety Stock Quantity

Illustrative Problem: Determination of Safety Stock Using Probabilities

Assume a company uses an inventory where it places 12 orders per year, the cost of the stockout is P 200
per occurrence, the carrying cost per unit is P 2 per year, and the probabilities of stockouts have been
estimated for various levels of safety stock as follows:

Safety Stock (Units) Probability of Stockout

0 60%
100 50
200 40
400 20
600 10

Solution:

Safety Cost of Carrying Expected Stockout Cost of Stockout Total Stockout

Stock SSQ (a) per year Occurences (b) Costs
(a + b)
0 ( 0 x P2) P 0 (12 x 60%) 7.2 (7.2 x P200) P P 1,440
1,440
100 (100 x P2) (12 x 50%) 6.0 (6 x P 200) 1,400
200 1,200
200 (200 x P2) (12 x 40%) 4.8 (4.8 x P200) 1,360
400 960
400 (400 x P2) (12 x 20%) 2.4 (2.4 x P200) 1.280
800 480 (optimal
SSQ)
600 (600 xP2) (12 x P10%) 1.2 (1.2 x P200) 1,440
1,200 240

Sample Problem. EOQ with Discounts

Cost Saving by Use of EOQ. Warner Co. uses 6,000 units of material per year at a cost of P4 per unit.
Carrying costs are estimated to be P1.125 per unit per year, and order costs amount to P60 per order. As
an incentive to its customers, Warner will extend quantity discounts according to the following schedule:

Minimum List Net

Order Price Discount Price
500 P4 2% P3.92
1,000 4 4 3.84
2,000 4 6 3.76

Required:

(1) Determine the economic order quantity (ignoring quantity discounts) and the total annual order
cost, carrying cost, and materials costs at EOQ (considering quantity discounts).
(2) Compute the annual order cost, carrying cost, materials cost, and total cost at each discount level.
(Round to the nearest dollar.)
(3) Identify the order size, choosing from one of the three discount levels, that will minimize the total
cost.

SOLUTION

(1) EOQ = Square Root [ 2 x 6,000 x P60] = 800 units

2

Ordering Cost [6,000/800] x P 60 450.00

Carrying Cost [800/2] x P 1.125 450.00
Materials Cost [ 6,000 x 3.92] 23,520.00
Total Relevant material Cost 24,420.00

(2) Size of order................................................................. 500 1,000 2,000

Number of orders per year ........................................... 12 6 3
Average inventory........................................................ 250 500 1,000

Order cost .................................................................... P 720 P 360 P 180

Carrying cost (P1.125 per unit) .................................... 281 563 1,125
Materials cost:
6,000 x P3.92......................................................... 23,520
6,000 x P3.84......................................................... 23,040
6,000 x P3.76......................................................... 22,560
Total cost ........................................................ P 24,521 P 23,963 P 23,865

(3) The order size that will minimize the total cost is 2,000 units therefore this is the most economical
order quantity
EXERCISES

Problem 1: Safety Stock with Stockouts

X Company uses an item for which it places 10 order per year. The cost of a stockout is P
30, the carrying cost is P 0.50 per year per unit, and the following probabilities of a stockout have
been estimated for various levels of safety stock:
Safety Stock(units) Probability of Stockout
0 40%
50 20
100 10
200 5

Problem 2
A material is purchased for P 3 per unit. Monthly usage is 1,500 units, the ordering cost is
P 50 per order and the annual carrying cost is 40%

Required: Compute the (a) economic order quantity, (b) Determine the proper order size
if the material can be purchased at a 5% discount in lots of 2,000 units.

Problem 3
Pilot Company obtained the following costs and other data pertaining to one of its
materials:

Order quantity……………………… 3,500 units

Normal use per day…………………. 500 units
Maximum use per day………………. 600 units
Minimum use per day……………….. 100 units
Lead time……………………………. 5 days

Required: Compute the following

a. Safety stock (maximum)
b. order point
c. normal maximum inventory
d. absolute maximum inventory