Chapter 4

Material Costing

Prepared by Lim Ying Ying

 1.0 What is inventory control?
1.1 Introduction

2
1. Inventory control system include the functions of:
• Inventory ordering and purchasing
• Receiving goods into store,
• Storing inventory,
• Issuing inventory and controlling levels of inventory.

2. Inventories are classified into:

• Raw materials
• Work in progress
• Spare parts/consumables
• Finished goods

Prepared by Lim Ying Ying

 1.2 Importance of controlling inventory

3
1. The reasons we control inventory are:
• Holding costs of inventory may be expensive.
• Production will be disrupted if we run out of raw materials.
• Unused inventory with short self life may incur unnecessary
expenses.

Summary:
If manufactured goods are made of low quality materials, the end
product will also be of low quality.

Therefore, it is necessary to control the quality of inventory in order

to maintain good reputation with consumers.

Prepared by Lim Ying Ying

 2 The ordering, receipt and issue of raw materials

4 2.1 Ordering and receiving materials

Every movement of a material in a business should be documented
using the following:
• Purchase requisition
• Purchase order
• Goods received note (GRN)
• Materials requisition note
• Materials transfer note
• Materials returned note.

Prepared by Lim Ying Ying

5

Prepared by Lim Ying Ying

 2.2 Purchase requisition

2.3 Purchase order (PO)

6
Store
Purchasing
department
Current department is
issues
inventories drop authorized to
purchase
to reorder level order further
requisition
inventory
which is sent to

If accept the order, return a AccountA copy of PO must

Purchasing Issue copy of acknowledgement department
be sent to the
department PO Supplier & respective
to purchasing department
storekeeper
department

Prepared by Lim Ying Ying

 2.4 Quotations & Delivery note

2.5 Goods received note (GRN)

7
Purchasing The storekeeper signs a
department Selected delivery note for the
obtain a supplier then carrier. The packages
number of delivers the must be checked against
quotations to consignment the copy of purchase order
get the best of materials to ensure the correct
price. delivery of materials.

If delivery is A copy of GRN is The supplier’s

acceptable, sent to Accounts invoice is checked
storekeeper Dept to match with against PO & GRN
prepares GRN. the copy of PO and then make
payment to supplier.
 2.6 Materials requisition note (MRN)
8 • Materials can only be issued against MRN.
• This document record the quantity of goods issued, the cost centre or
job number for which the requisition is being made.

2.7 Materials transfers and returns

• Where materials have been issued to one job or cost centre and later are
transferred to a different job or cost centre without first returned to the
stores, a material transfer note should be raised. This note should
document the job from which it is transferred to enable appropriate
charges to be made to job or cost centres.

• Material returns must also be documented on a materials returned

note. It is the “reverse” of requisition note and it is almost identical with
requisition note except that it may be in distinctive colour such as red to
highlight that materials are being returned.
 3 The storage of raw materials

9 3.1 Recording inventory levels

The purpose of storekeeping is to maintain accurate records of
current inventory levels.

The most frequently encountered system for recording inventory

movements is the use of:
• Bin cards
• Stores ledger accounts

Prepared by Lim Ying Ying

 3.2 Inventory count (Stocktake)
10
• Inventory count (stocktake) involves counting the physical inventory on hand at a
certain date and then checking against the balance shown in the inventory records.

• The inventory count can be carried on a continuous or periodic basis.

• Why do firms do physical stocktake when they have computers to record how much
stock are on hand?
 Theft of stock/ Damage of stock/ Misplaced of stock/ Lost of stock

Prepared by Lim Ying Ying

 3.3 Inventory System
11
• It is not practical to do physical stock-taking as it consumes too
much time & money.
• Therefore, business need to come up with system to tell them:
- How much stock they have at the beginning of the period?
- How much stock they bought during the period?
- How much stock they sold during that period?
- How much stock are left at the end of the period?
• Hence, in order to cope with this sophisticated data, there are 2
types of inventory system which are Periodic & Perpetual

Prepared by Lim Ying Ying

12
A) Periodic Inventory System
• Count stock at the beginning of the period & at the end of the
period using a physical stock-take (example Year end stock
take/quarterly/monthly/half yearly)
• The difference must be how much stock was sold during the period

Prepared by Lim Ying Ying

 B) Perpetual Inventory System
13 • A system which uses the Stock Cards to keep record of all stock
movements continuously and without ceasing throughout the reporting
period as they occur.
• Valuable items or items with high turnover could be checked more
frequently.
• In order for Perpetual Inventory System to be implemented, a continuous
stock-taking is undertaken so that the stock record balances is the same
as the physical stock balances.

Prepared by Lim Ying Ying

14 Advantages of continuous stocktaking compared to periodic stocktaking

1. Annual stocktaking is unnecessary and the disruption it causes is

avoided.
2. Regular skilled stocktakers can be employed, thus reducing likely
errors.
3. More time is available, reducing errors and allowing investigation.
4. Deficiencies and losses are revealed sooner than they would if
stocktaking were limited to an annual check.
5. Staff morale is improved and standards raised.
6. Control order inventory levels is improved and there is less chances of
overstocking or running out of inventory.

Prepared by Lim Ying Ying

 4. Inventory control levels
15
4.1 Inventory costs include purchase costs, ordering costs, holding
costs and costs of running out of inventory.

4.1.1 Reasons for holding inventories

1) Ensure sufficient goods are available to meet expected demand
2) Provide a buffer between processes
3) To meet any future shortages
4) To take advantage of bulk purchasing discounts
5) To allow production processes to flow smoothly and efficiently
6) To absorb seasonal fluctuations and any variations in usage and
demand

Prepared by Lim Ying Ying

 4.1.2 Holding costs
16
If inventories are too high, holding costs will be incurred unnecessarily.

Such costs occur for a number of reasons:

• Cost of storage and stores operations: Larger inventories require
more storage space and possibly extra staff and equipment to control
and handle them.
• Interest charges: Holding inventories involves tying up of capital (cash)
on which interest must be paid.
• Insurance costs: The larger the value of inventories, the greater the
insurance premiums are likely to be.
• Risk of obsolescence: The longer the inventory item is held, the
greater the risk of obsolescence.
• Deterioration: When materials in store deteriorate, they must be
thrown away with the chances that disposal costs would be incurred.

Prepared by Lim Ying Ying

 17 4.1.3 Ordering costs
If inventories are kept low, small quantities of inventory will have to be
ordered more frequently, hence increasing the following ordering
costs:
• Clerical and administrative costs associated with purchasing,
accounting for and receiving goods.
• Transport costs
• Production run costs for inventory which is manufactured internally
rather than purchasing from external sources

Prepared by Lim Ying Ying

 18 4.1.4 Stockout costs (running out of inventory)
If inventories are kept too low, additional costs may be incurred.

The causes of stockout costs:

• Lost contribution from lost sales
• Loss of future sales due to dissatisfied customers
• Loss of customer goodwill
• Cost of production stoppages
• Labour frustration over stoppages
• Extra costs of urgent, small quantity, replenishment orders

Prepared by Lim Ying Ying

 19
4.2 Inventory control levels
Definition: can be calculated in order to maintain inventories at
optimum level (in other words, a level which minimizes costs). The 3
critical control levels are reorder level, minimum level and maximum
level. These levels will determine ‘when to order’ and ‘how many to order’.

4.2.1 Reorder level

Definition: When inventories reach this level, an order should be placed
to replenish inventories.

Formula:
Reorder level = Maximum usage x maximum lead time

*Lead time is the time between placing an order with a supplier and
the inventory becoming available to use

Prepared by Lim Ying Ying

 4.2.2 Minimum level
20
Definition: this is a warning level that draws management attention to the
fact that inventories are approaching a dangerously low level and that
stockouts are possible.
Formula:
Minimum level = Reorder level – (Average usage x Average lead time)

4.2.3 Maximum level

Definition: this also acts as warning level to signal management that
inventories are reaching a potentially wasteful level.

Formula:
Maximum level = Reorder level + Reorder quantity – (Minimum usage x minimum lead
time)

Prepared by Lim Ying Ying

 4.2.4 Reorder quantity
21
Definition: this is the quantity of inventory to be ordered when
inventory reaches the reorder level.

If it is set to minimize the total costs (holding cost and ordering costs), it
is known as economic order quantity (EOQ).

4.2.5 Average inventory

Formula:
Average inventory = ½ x Reorder quantity/ Economic order quantity

Prepared by Lim Ying Ying

 Example:
22
The following information is available for Component A101:
Maximum usage : 420 per day
Minimum usage : 180 per day
Lead time for replenishment : 11 – 15 days
Reorder quantity : 6,500 units

Calculate the following:

a) Reorder level;
b) Minimum stock level;
c) Maximum stock level;
d) Average inventory.

Prepared by Lim Ying Ying

 Answers:
23
a) Reorder level = Maximum usage x Maximum lead time
= 420 x 15
= 6,300

b) Minimum stock level = Reorder level – (Avg. usage x Avg. lead time)
= 6,300 – [(420+180)/2) x (11+15)/2]
= 2,400 units

c) Maximum stock level = ROL+ ROQ – (Minimum usage x minimum lead time)
= 6,300 + 6,500 – (180 x 11)
= 10,820 units

d) Average stock level = ½ ROQ

= ½ x 6,500
= 3,250 units
 4.3 Economic order quantity (EOQ)
24
Definition: the order quantity which minimizes inventory costs (holding
costs and ordering costs)

It can be calculated using a table, graph or formula:

Prepared by Lim Ying Ying

25 4.3 Economic order quantity (EOQ)
Example of EOQ calculation using a table:
A company purchases raw material at a cost of RM16 per unit. The
annual demand for the raw material is 25,000 units. The holding cost
per unit is RM6.40 and the cost of placing an order is RM32.

We can tabulate the annual relevant costs for various order quantities
as follows:

Prepared by Lim Ying Ying

 4.3 Economic order quantity (EOQ) using table
26
Order quantity (units) 100 200 300 400 500 600 800 1000
Average inventory (units) (a) 50 100 150 200 250 300 400 500
Number of orders (b) 250 125 83 63 50 42 31 25

RM RM RM RM RM RM RM RM
Annual holding cost (c) 320 640 960 1,280 1,600 1,920 2,560 3,200
Annual ordering cost (d) 8,000 4,000 2,656 2,016 1,600 1,344 992 800
Total costs of inventory 8,320 4,640 3,616 3,296 3,200 3,264 3,552 4,000

Notes:
(a) Average inventory = Order quantity ÷ 2
(b) Number of orders = Annual demand ÷ Order quantity
(c) Annual holding cost = Average inventory x Purchase price of material per unit (RM6.40)
(d) Annual ordering cost = No of orders x Cost per order (RM32)

Conclusion: The company should order at order quantity of 500 units (EOQ) because at this point ,
the total annual costs of inventroy are at a minimum.
 4.3 Economic order quantity (EOQ) using formula
27

NOTE!!!
Alternatively,
Ch = Average inventory x Purchase
price of material per unit

EOQ = √ 2 x RM32 x 25,000

RM6.40
= 500 units
 4.3 Economic order quantity (EOQ) using graph
28

Total cost line is a minimum for

order quantity of 500 units and
occurs at the point where
ordering cost curve and
holding cost curve intersect.
The EOQ is therefore found at
the point where holding costs
equal ordering costs.
29

Prepared by Lim Ying Ying

 Question 2:
If raw materials are purchased at larger quantities than the economic order quantity (EOQ), the firm
30 will experience
a) Lower holding costs but higher stockout costs
b) Lower holding costs but higher ordering costs
c) Higher holding costs but lower ordering costs
d) Higher ordering costs but lower stockout costs

Question 3
Which of the following methods of stock valuation will result in the highest gross profit at times when
prices are increasing?
e) LIFO
f) FIFO
g) Weighted average
h) Standard cost

Question 4
Which of the following calculates the reorder level?
i) Minimum consumption in minimum lead time
j) Maximum consumption in maximum lead time
k) Reorder quantity minus maximum usage in maximum lead time
l) Reorder quantity plus reorder level minus minimum usage in minimum lead time
 Question 5
The following information has been extracted from the inventory control system of Restu
31 Sdn Bhd in relation to material AB123:

Cost of raw materials RM20 per unit

Usage per day 50 units
Lead time 10 – 15 days
Cost per order RM1,152
Annual cost of holding stock as a % of cost 30%

Assume that each year consists of 50 weeks of 6 days per week.

Required:
Calculate the following:
a) Annual demand in units
b) EOQ
c) Number of order(s) per annum if the size of each order is the EOQ, and
d) Additional costs per annum if company orders at 5,000 units instead of ordering at
EOQ.
Prepared by Lim Ying Ying
 Answer to Q5
a) Annual demand = 50 x 50 x 6
32 = 15,000 units
b) EOQ= √ 2COD/Ch
= √ [2(1,152 x 15,000) / (30% x 20)]
= 2,400 units
c) No of orders if order at EOQ = Annual demand / EOQ
= 15,000 units / 2400 units
= 6.25 times
d) ROQ EOQ
5,000 units 2,400 units
Ordering costs
= No of order x Cost per order =(15,000 / 5,000) x 1,152 = 6.25 x 1,152
=RM 3,456 =RM 7,200
Annual demand / EOQ (ROQ)
Holding costs =(1/2 x 5,000) x (30% x 20) =(1/2 x2,400) x (30% x 20)
=Average inventory x Ch =RM15,000 =RM 7,200
Total inventory costs
=Ordering + holding costs RM18,456 =RM 14,400

Therefore the cost increases by (RM18,456 - RM14,400) = RM 4,056 if company

order at 5,000 units
 6 Inventory Valuation
33
• Correct pricing of issues and valuation of inventory are the
utmost importance because they have a direct effect on the
calculation of profit. Several different methods can be used in
practice.

• In Financial Accounting purposes, inventories are valued at

the lower of cost and net realisable value.

• Methods of stock valuation:

1. First in, first out (FIFO)
2. Last in, first out (LIFO)
3. Cumulative weighted average pricing (AVO)
4. Periodic weighted average

Prepared by Lim Ying Ying

 Example:
34 Transactions during May 2020:
Unit Total Market value per unit on
Quantity cost cost date of transaction
(units) RM RM RM
Opening balance, 1 May 100 2 200

Receipts, 3 May 400 2.1 840 2.11

Issues, 4 May 200 2.11
Receipts, 9 May 300 2.12 636 2.15
Issues, 11 May 400 2.2
Receipts, 18 May 100 2.4 240 2.35
Issues, 20 May 100 2.35
Closing balance, 31 May 200 2.38
1916
Prepared by Lim Ying Ying
 7.1 FIFO (First in, first out)
35 Answer Option 1:
 Receipts Issues Inventory

Quantity Unit cost Amount Quantity Unit cost Amount Quantity Unit cost Amount
36 Date (RM) (RM) (RM) (RM) (RM) (RM)
1-May 100 2.00 200

3-May 400 2.10 840 100 2.00 200

400 2.10 840 Answer
500 1040 Option 2:
4-May 100 2.00 200 using
100 2.100 210 300 2.10 630 perpetual
inventory
9-May 300 2.12 636 300 2.10 630
300 2.12 636 system
600 1266

11-May 300 2.10 630

100 2.12 212 200 2.12 424

18-May 100 2.40 240 200 2.12 424

100 2.40 240
300 664

20-May 100 2.12 212 100 2.12 212

100 2.40 240
31-May 200 452
Closing balance
Total Purchases 1,716 Total Sales 1,464
 7.2 Advantages & Disadvantages of FIFO method
37
Advantages Disadvantages

1. Logical pricing method which 1. FIFO can be complex to operate

probably represents what is physically because of the need to identify each
happening: in practice the oldest batch of material separately.
inventory is likely to be used first.

2. It is easy to understand and explain 2. Managers may find it difficult to

to managers. compare costs and make decisions
when they are charged with varying
prices for the same materials.

3. The inventory valuation can be near 3. In a period of high inflation, inventory

to a valuation based on replacement issue prices will lag behind current
cost. market value.

Prepared by Lim Ying Ying

 8 LIFO (Last in, first out)
38 Answer (Option 1):
 8 LIFO (Last in, first out)
Answer (Option 2): using perpetual inventory system
Receipts Issues Inv entory
39 Unit
Quantity cost Amount Quantity Unit cost Amount Quantity Unit cost Amount
Date (RM) (RM) (RM) (RM) (RM) (RM)
1-May 100 2.00 200

3-May 400 2.10 840 100 2.00 200

400 2.10 840
500 1040

4-May 200 2.10 420 100 2.00 200

200 2.10 420
300 620

9-May 300 2.12 636 100 2.00 200

200 2.10 420
300 2.12 636
600 1256

11-May 300 2.12 636 100 2.00 200

100 2.1 210 100 2.10 210
200 410

18-May 100 2.40 240 100 2.00 200

100 2.10 210
100 2.40 240
300 650

20-May 100 2.40 240 100 2.00 200

100 2.10 210
31-May 200 410
Closing balance
Total Purchases 1,716 Total Sales 1,506
 8.2 Advantages & Disadvantages of LIFO method
40
Advantages
1. Inventories are issued at a price
which is close to current market value
2. Managers are continually aware of
recent costs when making decisions,
because costs being charged to their
department or products will be current
costs.
Prepared by Lim Ying Ying
Disadvantages
1. LIFO can be complex to operate
because it sometimes results in several
batches being only part-used in the
inventory records before another batch
is received.
2. LIFO is often opposite to what is
physically happening and there can be
difficult to explain to managers.
3. As with FIFO, decision making can be
difficult because of variation in prices.
 8.3 Changing from LIFO to FIFO or from FIFO to LIFO
41
It will have impacts on:
• Closing inventory values or
• Gross profit

Example:
4 barrels of inventory are purchased during a month of rising prices, and
two are used. There is no opening inventory.

Prepared by Lim Ying Ying

42
8.3 Changing from LIFO to FIFO or from FIFO to LIFO
Cost
1-Jan RM100 per barrel LIFO - these barrels would be FIFO- these barrels would be
left as closing inventory RM250 issued to production first
(and charged to cost of sales
19-Jan RM150 per barrel RM250)

20-Jan LIFO- these barrels would be FIFO - these barrels would be

RM200 per barrel issued to production first left as closing inventory RM450
(and charged to cost of sales
31-Jan RM450)
RM250 per barrel

Notice the rising prices

Conclusion:
• During period of rising prices, closing inventory value using LIFO would be RM250 and
using FIFO would be higher at RM450.
• The charge to cost of sales will be lower using FIFO and therefore gross profit will be
higher.
 9 Cumulative weighted average pricing (AVCO)
43
• AVCO calculates a weighted average price for all units in
inventory.
• Issues are priced at this average cost and balance of
inventory remaining would have same unit valuation.
• The average price is determined by dividing total cost by
total number of units.
• A new weighted average is calculated whenever a new
delivery of materials is received into store.

Prepared by Lim Ying Ying

 44

Answer:
Option 1

Prepared by Lim Ying Ying

 Total
inventory Unit cost
Received Issued Balance value
45 Date Units Units Units RM RM RM
1-May 100 200 2.00
3-May 400 840 2.10
*500 1,040 2.08
Answer:
4-May 200 - 416 2.08 416
Option 2 300 624 2.08
9-May 300 636 2.12
*600 1,260 2.10
11-May 400 - 840 2.10 840
200 420 2.10
18-May 100 240 2.40
*300 660 2.20
20-May 100 - 220 2.20 220
1,476
31-May 200 440 2.2 440
Closing 1,916
inventory
value
* A new inventory value per unit is calculated whenever a new receipt
of materials occurs
 9.2 Advantages & Disadvantages of AVCO method
46
Advantages Disadvantages

1. Fluctuations in prices are smoothed 1 The resulting issue price is rarely an

out, making it easier to use the data for actual price that has been paid, and can
decision making. run to several decimal places.

2. It is easy to administer than FIFO and 2. Prices tend to lag a little behind
LIFO because there is no need to market values when there is gradual
identify each batch separately. inflation.

Prepared by Lim Ying Ying

 9.3 Periodic weighted average pricing
47
• Calculates an average price at the end of the period based on
total purchases (receipts) in that period.

Periodic weighted = Cost of opening inventory + total cost of receipts

average Units of opening inventory + total units received

Prepared by Lim Ying Ying

Answer:
48

Prepared by Lim Ying Ying