MATERIAL COSTING

Part Topic Page

I Introduction to Material costing
Introduction
Relevant cost for inventory management
Factors influencing stock levels

II The inventory models

The EOQ Model
The EBQ Model
The ABC System
Illustrations

III Valuing inventory issues

Methods of pricing material issues
Preparing operating income statements
Reconciliation of operating income
Illustrations

IV Activities

Objectives
After studying this chapter, you will:
 Know the objectives of material control
 Understand the essential requirements of material control system
 Appreciate the advantages of material control
 Understand the distinction of centralized and decentralized purchasing
 Know how to determine the various stock levels
 Know how to price material issues

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 by 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 by
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.

ii) 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.
ix. It assumes that there is no safety stock

2 xDxT
EOQ= Q=
H

QH
Total holding cost = i.e. Average stock x Holding cost per unit
2
 DT
Total ordering cost = i.e. No. of orders x ordering cost per order
Q
Total cost =total holding cost + total ordering cost

QH DT
TC = +
2 Q

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

Solution

2 xDxT
a) EOQ= Q=
H
2 x 25,000 x 400
EOQ = = 200 tons
25% x 2,000
QH 200x500
b) The total holding cost = = = ksh. 50,000
2 2
DT 25,000 x 400
c) Total ordering cost = = = ksh 50,000
Q 500
QH DT 200x500 25,000 x 400
d) Total relevant cost = + = + = ksh. 100,000
2 Q 2 500

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
Graphically the EOQ model can be represented as follows:-

Cost
Total relevant
cost

Total holding
cost

Total ordering
cost

EOQ Order Quantity

Activity
The Company has an annual demand of a product amounting 60 000 units. The price per
1
unit is Ksh. 4500 and the stock holding cost is 33 of stock value. Delivery cost per order
3
is ksh. 320

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 by people having sound knowledge in stock management.

QUALITY 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.

2 xDxT
EOQ= Q=
H

2 x9,000 x5
Q= = 150 units
4

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

Order Purchase Cost (ksh) Total Ordering Total Holding Total Cost
Quantity (D x Price)(1-d) Cost (ksh) cost (ksh) (ksh)
DT QH
Q 2
150 9,000x 7=63,000 9,000x5/150 150x4/2 = 300 63,600
=300
1,000 (9,000 x 7)x(100%- 9,000x5/1000=45 1000x4/2=2000 63,155
3%)=61,110
Savings(cost) 1,890 255 (1,700) 445

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 by 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

Order unity Total ordering Total holding Purchase cost Total cost
cost cost (D x Price)(1-d)
DT QH
Q 2
100 2400x5/100= 100x0.25/2= (2400x0.80)= 120+12.5+1920=
120 12.5 1,920 2,052.5
200 2400x5/200= 200x0.25/2= 2400x0.80= 60+25+1920=
60 25 1,920 2,005
600 2400x5/600= 600x0.25/2= 2400x0.8x(100%- 20+75+1824=
20 75 5%) =1,824 1,919
1,200 2400x5/1200= 1200x0.25/2= 2400x0.8x(100%- 10+150+1728=
10 150 10%)=1,728 1,888*
2,400 2400x5/2400= 2400x0.25/2= 2400x0.8x(100%- 5+300+1728=
5 300 10%)= 1,728 2,033

*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

Max. stock level  Min. stock level

Average stock level=
2

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

(i) ROL= Max. Consumption Rate x Max. LT

= 1,200x6
= 7,200 units

(ii) Maximum stock level = 7,200- (4x600) + 6,000

= 10,800 units

(iii) Minimum stock level = ROL– (Average Consumption x Average LT)

= 7,200- (5x900)
= 7,200- 4500
= 2,700 units

Max. stock level  Min. stock level

(iv) Average stock level =
2

=2,700 + 10,800
2
= 6,750 units
Graphically, this can be represented as follows:

Max. stock
level

ROL

Buffer stock
ABC ANALYSIS (PARETO ANALYSIS)
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 by 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 by 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
by 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 by
general Products Kenya Limited for the month of October 2010. The following was
entered in the Company stock ledger

Oct 2010 Receipt (units) Issue (units) Unit cost (Ksh)

4 2,800 18
6 3,300
12 2,700 21
15 2,800
18 3,100 22
19 2,800 21
22 2,250
25 2,750 22
26 3,950
27 3,200 23
28 2,600
29 3,250 24
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)

Date RECEIPTS ISSUES BALANCE

OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,000 20 60,000 2,800 50,400
300 18 5,400 2,500 45,000
12 2,700 21 56,700 5,200 101,700
15 2,500 18 45,000 2,700 56,700
300 21 6,300 2,400 50,400
18 3,100 22 68,200 5,500 118,600
19 2,800 21 58,800 8,300 177,400
22 2,250 21 47,250 6,050 130,150
25 2,750 22 60,500 8,800 190,650
26 150 21 3,150 8,650 187,500
3,100 22 68,200 5,550 119,300
700 21 14,700 4,850 104,600
27 3,200 23 73,600 8,050 178,200
28 2,100 21 44,100 5,950 134,100
500 22 11,000 5,450 123,100
29 3,250 24 78,000 8,700 201,100

Therefore the closing stock is 8,700 units worth ksh. 201,100

Stores ledger (LIFO-method)

Date RECEIPTS ISSUES BALANCE

OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 2,800 18 50,400 3,000 60,000
500 20 10,000 2,500 50,000
12 2,700 21 56,700 5,200 106,700
15 2,700 21 56,700 2,500 50,000
100 20 2,000 2,400 48,000
18 3,100 22 68,200 5,500 116,200
19 2,800 21 58,800 8,300 175,000
22 2,250 21 47,250 6,050 127,750
25 2,750 22 60,500 8,800 188,250
26 2,750 22 60,500 6,050 127,750
550 21 11,550 5,500 116,200
650 22 14,300 4,850 101,900
27 3,200 23 73,600 8,050 175,500
28 2,600 23 59,800 5,450 115,700
29 3,250 24 78,000 8,700 193,700

Therefore the closing stock is 8,700 units worth ksh. 193,700

Stores ledger (Simple average-method)

OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18.0 50,400 5,800 110,400
6 3,000 19.0 57,000 2,800 53,400
300 19.0 5,700 2,500 47,700
12 2,700 21.0 56,700 5,200 104,400
15 2,500 19.5 48,750 2,700 55,650
300 19.5 5,850 2,400 49,800
18 3,100 22.0 68,200 5,500 118,000
19 2,800 21.0 58,800 8,300 176,800
22 2,250 21.3 48,000 6,050 128,800
25 2,750 22.0 60,500 8,800 189,300
26 3,950 21.5 84,925 4,850 104,375
27 3,200 23.0 73,600 8,050 177,975
28 2,600 21.8 56,680 5,450 121,295
29 3,250 24.0 78,000 8,700 199,295

Therefore the closing stock is 8,700 units worth ksh. 199,295

Stores ledger (Standard cost-method)

1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,300 22 72,600 2,500 37,800
12 2,700 21 56,700 5,200 94,500
15 2,800 22 61,600 2,400 32,900
18 3,100 22 68,200 5,500 101,100
19 2,800 21 58,800 8,300 159,900
22 2,250 22 49,500 6,050 110,400
25 2,750 22 60,500 8,800 170,900
26 3,950 22 86,900 4,850 84,000
27 3,200 23 73,600 8,050 157,600
28 2,600 22 57,200 5,450 100,400
29 3,250 24 78,000 8,700 178,400

Therefore the closing stock is 8,700 units worth ksh. 178,400

Stores ledger (Weighted average cost-method)

1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,300 19.0 62,814 2,500 47,586
12 2,700 21 56,700 5,200 104,286
15 2,800 20.1 56,154 2,400 48,132
18 3,100 22 68,200 5,500 116,332
19 2,800 21 58,800 8,300 175,132
22 2,250 21.1 47,476 6,050 127,657
25 2,750 22 60,500 8,800 188,157
26 3,950 21.4 84,457 4,850 103,700
27 3,200 23 73,600 8,050 177,300
28 2,600 22.0 57,265 5,450 120,035
29 3,250 24 78,000 8,700 198,035

Therefore the closing stock is 8,700 units worth ksh. 198,035

Stores ledger (NIFO-method)

1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,300 21 69,300 2,500 41,100
12 2,700 21 56,700 5,200 97,800
15 2,800 22 61,600 2,400 36,200
18 3,100 22 68,200 5,500 104,400
19 2,800 21 58,800 8,300 163,200
22 2,250 22 49,500 6,050 113,700
25 2,750 22 60,500 0 8,800 174,200
26 3,950 23 90,850 4,850 83,350
27 3,200 23 73,600 0 8,050 156,950
28 2,600 24 62,400 5,450 94,550
29 3,250 24 78,000 8,700 172,550

Therefore the closing stock is 8,700 units worth ksh. 172,550

Assignment 2
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:
Date Purchases Sales
June 2 5,000 @ ksh.48
4 6,000 @ ksh. 60
5 5,500 @ ksh. 49
7 4,000 @ ksh. 50
11 7,000 @ ksh. 61
12 5,000 @ ksh. 50
13 6,000 @ ksh. 47
18 7,000 @ ksh. 62
19 8,000 @ ksh. 64
20 6,000 @ksh. 49.50
21 5,000 @ ksh. 65
22 7,000 @ ksh. 50
25 6,000 @ ksh. 49
26 2,000 @ ksh. 47
28 500 @ ksh. 60
29 14,000 @ ksh. 64

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.