Chapter 2

Accounting for Materials

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Effective Cost Control
 The major function of a cost control system is
to keep expenditures within the limits of a
predetermined plan.
 The control system should also encourage cost
reductions by eliminating waste and
operational inefficiencies.

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Effective Cost Control
 An effective system of cost control is designed
to control the actions of people responsible for
the expenditures, because people control
costs. Costs do not control themselves.
 An effective cost control system should include
the following:

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Effective Cost Control
 Specific assignment of duties and
responsibilities.
 A list of individuals who are authorized to
approve expenditures.
 An established plan of objectives and goals.
 Regular reports showing the differences
between goals and actual performance.
 A plan or corrective action designed to prevent
unfavorable differences from recurring.
 Follow-up procedures for corrective measures.

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Materials Control
 The two basic aspects of materials control are
(1) the physical control or safeguarding of
materials and (2) control over the investment in
materials

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Physical Control of
Materials
 Assets, must be protected from
unauthorized use or theft.
 Effectively control materials, a business
must maintain:
1.Limited access to materials storage areas.
2.Segregation of duties.
3.Accuracy in recording.

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Controlling the Investment
in Materials
 Maintaining the appropriate level of raw
materials is one of the most important
objectives of materials control.
 Inventory of sufficient size and diversity must
be maintained.
 Management must determine working capital
needs in determining inventory levels.
 Adequate planning and control is required.

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Order Point

 A minimum level of inventory should be

determined for each type of raw material,
and inventory records should indicate the
cost and quantity of items on hand.
 Order point is the point at which an item
should be ordered.

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Order Point (cont.)

 The following items need to be taken into

consideration when ordering:
 Usage – anticipated rate at which the material will be
used.
 Lead time – estimated time interval between the
placement of an order and the receipt of material.
 Safety stock – estimated minimum level of inventory
needed to protect against stockouts.
 (Daily usage X Lead time) + Safety stock = Order point

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Order Point (cont.)
 Assume that a company’s expected daily usage of
an item of material is 100 lb, the anticipated lead
time is five days, and the desired safety stock is
1,000 lb. The following calculation shows that the
order point is reached when the inventory on hand
reaches 1,500 lb:

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Economic Order Quantity
(EOQ)
 The optimal quantity to order at one time.
 Minimizes the total order and carrying costs
over a period of time.
 Ordering costs may include the salaries and wages
of purchasing personnel, communication costs, and
materials accounting and record keeping.
 Carrying costs are the costs that a company may
incur in storing materials. These costs may include
materials storage and handling costs, interest,
insurance, and property taxes, loss due to theft,
deterioration, or obsolescence, and records and
supplies associated with carrying inventory.

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Economic Order Quantity
(EOQ)
 The optimal quantity to order at one time, called
the economic order quantity, is the order size that
minimizes the total order and carrying costs over a
period of time, such as one year

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Calculating EOQ
 EOQ = Economic
Order Quantity
 C = Cost of placing
EOQ =
2CN
an order
 N = Number of units K
required annually
 K = Carrying cost per
unit of inventory

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Calculating EOQ

 For Pacific Paint Company:

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Calculating EOQ

 The EOQ can also be determined by

constructing a table using a range of
order sizes. A tabular presentation of the
data from the previous example,
assuming no safety stock, follows:

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Calculating EOQ

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Calculating EOQ
 The total annual order cost decreasing as the
order size increases because the order cost is
a function of the number of orders placed, not
the number of units ordered.
 Meanwhile, the total annual carrying cost
increases as the order size increases because
of the necessity to maintain a large quantity of
inventory in stock.

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18
Calculating EOQ
 Assume in the preceding example that the
company desires a safety stock of 400 gallons to
protect against stockouts. The average number of
gallons in inventory and total carrying cost then
would be calculated as follows:

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Limitations of Order Point
and EOQ Calculations.

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Materials Control
Procedures
 Materials Control Personnel
 Purchasing Agent – employee who does the buying
of raw materials.
 Receiving Clerk – employee who is responsible for
the receipt of incoming shipments.
 Storeroom Keeper – employee who has charge of
the materials after they have been received.
 Production Department Supervisor – employee who
is responsible for the operational functions within the
department.
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Control During
Procurement
 When the order point is reached the
procurement process begins.
 Supporting documents are essential to
maintaining control during the
procurement process.

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Documents Common to
the Procurement Process
 Purchase requisition – the form used to notify the
purchasing agent that materials are needed.
 Purchase order – requisition that gives the purchasing
agent authority to order the materials.
 Vendor’s invoice – invoice from the vendor that
should be compared to the purchase order.
 Receiving report – form that the receiving clerk uses
to count and identify the materials received.
 Debit-Credit memorandum – document that is used
when the shipment of materials does not match the
order and the invoice.

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Control During Storage
and Issuance
 Materials Requisition
 Prepared by the authorized factory
personnel to withdraw materials from the
storeroom.
 Returned Materials Report
 Describes the materials being returned to
the storeroom and the reason for the return.

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Accounting for Materials

 A company’s inventory records should show

 (1) the quantity of each kind of material on
hand and
 (2) its cost.
 The most desirable method of achieving this
result is to integrate the materials
accounting system with the general ledger
accounts.
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Accounting for Materials
 The materials account is a control account that
is supported by a subsidiary materials ledger
containing an individual account for each type
of material carried in stock. Periodically, the
balance of the control account and the total of
the subsidiary ledger accounts are compared,
and any significant variation between the two is
investigated.

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Accounting for Materials
 To keep this information current, it is necessary
to record in each individual account, on a
timely basis, the quantity and the cost of
materials received, issued, and on hand. The
materials ledger accounts are usually
maintained on computer files similar in design
to the one shown in Figure 2-10.

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Determining the Cost of
Materials Issued
 In selecting the method to be used, the
company should review their accounting
policies and the federal and state tax
regulations.
 The flow of materials does not dictate the flow
of costs.
 Flow of materials – the order that materials are
issued for use in the factory.
 Flow of costs – the order in which unit costs are
assigned to materials.

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Cost Flow Methods
 First – In, First – Out Method (FIFO)
 Assumes that materials used in production are
costed at the prices paid for the oldest materials and
the ending inventory is costed at the prices paid for
the most recent purchases.

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Cost Flow Methods
 The FIFO method can be illustrated using the data below. (Note
that, for simplicity, the ‘‘On Order’’ columns were omitted from the
following materials ledger accounts.)
 Dec. 1 Balance, 1,000 lb @ $20
 10 Issued 500 lb
 15 Purchased 1,000 lb @ $24
 20 Issued 250 lb
 26 Issued 500 lb
 28 Purchased 500 lb @ $26
 30 Issued 500 lb
 31 Balance, 750 lb
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First – In, First – Out
Method (FIFO)

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Cost Flow Methods
 Last – In, Last – Out Method (LIFO)
 Assumes that materials used in production are
costed at the prices paid for the most recently
purchased prices, and the ending inventory is
costed at prices paid for the earliest purchases.

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Last – In, Last – Out
Method (LIFO)

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Cost Flow Methods (cont.)

 Moving Average Method

 Material issued and the ending inventory are
costed at the average price. This average
unit price is computed every time a new lot
of materials is received and it continues to
be used until another lot is purchased.

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Moving Average Method

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Accounting Procedures

 The purpose of materials accounting is to

provide a summary from the general
ledger of the total cost of materials
purchased and used in manufacturing.
 All materials issued during the month and
materials returned to stock are recorded
on a summary of materials issued and
returned form.
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Accounting Transactions
 Purchase of materials from vendor.
Materials XX
Accounts Payable XX

 Materials issued to production.

Work in Process XX
Materials XX

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Accounting Transactions
(cont.)
 Payment to vendor for invoice.
Accounts Payable XX
Cash XX

 Transfer finished work to finished goods.

Finished Goods XX
Work in Process XX

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Accounting Transactions
(cont.)
 Sale of finished goods on account.
Accounts Receivable XX
Sales XX
Cost of Goods Sold XX
Finished Goods Inventory XX

 Collection of cash from customer.

Cash XX
Accounts Receivable XX

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Just-In-Time (JIT)
Materials Control
 Materials are delivered to a factory
immediately prior to their use in
production.
 Reduces inventory carrying costs.
 Reducing inventory levels through JIT
may increase processing speed.
 Backflush accounting is the accounting
system used by JIT systems.
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Just-In-Time (JIT)
Materials Control
 ‘‘push’’ manufacturing systems, which
produce goods for inventory with the
hope that the demand for these goods
then will be created.
 Disadvantages:
 too many dollars invested in inventory;
 obsolete products due to the long lead
time from start to finish.
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Just-In-Time (JIT)
Materials Control

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Just-In-Time (JIT)
Materials Control
 The JIT ‘‘pull’’ manufacturing system
credo is, ‘‘Don’t make anything for
anybody until they ask for it.’’
 A high degree of coordination and
cooperation must exist between the
supply chain management

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Just-In-Time (JIT)
Materials Control

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Just-In-Time (JIT) and
Cost Control
 If the velocity of production is quadrupled, the
inventory carrying costs can be reduced
 For example, assume
 annual inventory carrying cost is 20%
 average work in process inventory $400,000,
 resulting in annual carrying costs of $80,000
(20% * $400,000).

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Just-In-Time (JIT) and
Cost Control
 Further assume that through the use of JIT
production techniques, the velocity of
production is quadrupled without changing the
total annual output, thus necessitating only
one-fourth as much work in process (WIP). The
new annual carrying costs would be calculated
as follows:

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Accounting for Scrap
Work
 Scrap may be considered waste
materials from the production process.
These are materials that can not be used
in the production process.

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Accounting for Scrap
Work
 Journal entry if the value of scrap is relatively high
Scrap Materials XX Transferred scrap
to inventory
Scrap Revenue XX
Cash XX Sold
scrap
Scrap Materials XX
 Journal entry if the value of scrap is unknown.
Cash XX Sold
scrap
Scrap Revenue XX

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Spoiled Work

 Spoiled work has imperfections that

cannot be economically corrected. The
loss can be treated as part of the cost of
the job or charged to Factory Overhead.
 To illustrate, assume a garment
manufacturer using job order costing
completes an order for 1,000 jackets (Job
350) at the following unit costs:
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Spoiled Work

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Spoiled Work
 During the final inspection, 50 jackets are
found to be inferior and are classified as
irregulars or seconds. They are expected to
sell for $10 each. If the unrecovered costs
of spoilage are to be charged to Factory
Overhead, the following entry is recorded:

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Defective Work

 Defective work has imperfections that are

correctable. The extra costs are either
charged to the job or Factory Overhead.

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Defective Work
 assume that it costs $50 to manufacture each
jacket. Upon final inspection of the 1,000 jackets
completed, 50 jackets are defective because one
sleeve is a slightly different shade of blue than the
other parts of the jacket. Management decides to
recut the sleeves from a bolt of material identical in
color to the rest of the jacket. The costs of
correcting the defect on the 50 jackets are $500 for
materials, $400 for labor, and $300 for factory
overhead, representing a total cost of $1,200
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Defective Work

 If the additional costs are charged to

Factory Overhead, the cost of correcting
defective work is spread over all jobs that
go through the production cycle. The journal
entry is as follows:

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Defective Work

 If the order for 1,000 jackets was a

special order and the defects resulted
from the exacting specifications of the
order, the additional costs would be
charged to the specific job as follows:

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