CHAPTER TWO

The Costing of Resource Inputs

 Materials

• Materials: refers to the tangible, physical

inputs used in production of a product.
• Direct Material: It refers to the material which
forms part of the finished product. Examples
of Direct Material are:
 Cotton used in manufacture of textiles
 Wood used in manufacture of pencil
 Fruits used in making juices
Indirect Material: It refers to material
used in the process of production but
does not form part of the finished
product.
Examples of indirect materials are:
Stationery used in office
Items used in maintenance of machinery
like cotton waste, etc.
In relation to material, the following are the
costs involved:
procurement Cost It refers to the cost of
purchasing the raw materials.
holding cost or Carrying Cost It refers to the
cost of storing the material till they are issued
for production.
Ordering Cost It refers to the cost of
placing an order for purchase of
materials.
Set-up Cost It refers to the cost of
setting up the facility for producing the
materials, in case the materials are
made, instead of purchasing them.
Shortage Cost It refers to the fines, penalties, loss
of demand, loss of goodwill, etc. associated with
shortage of material.
 In case, a business enterprise is not able to meet
the customers’ demand within the assured time due
to shortage of raw material,
 The fines and penalties to be paid, loss of potential
demand, etc. suffered by the enterprise are
considered as shortage costs.
• Management needs to establish
procedures to ensure that:
A. The correct quantities of materials are ordered
at the right price and the right time;
B. The correct materials are delivered;
C. Adequate arrangements exist to store
materials until they are required;
C. materials are issued from stores only with proper
authorisation,
D. To charge the appropriate department with the cost
of materials used.
 Procedures and Documentation of materials
• When an entity purchases materials from
a supplier, the purchasing process should
be:
 properly documented.
 properly authorised and
 approved at the appropriate management
level.
• Documentation of the purchasing process
provides evidence that approval has been
obtained.
• The receipt of materials from a supplier
should also be documented, to make sure that
the goods that were ordered have actually
been delivered.
• There should be an invoice from the supplier
for the goods that have been delivered.
• Documentation of materials is therefore
needed:
to ensure that the procedures for ordering,
receiving and paying for materials has been
conducted properly, and there is no error or
fraud
to provide a record of materials purchases for
the financial accounts
to provide a record of materials costs for the
cost and management accounts.
 Purchasing procedures and documents
• In a large company the procedures for purchasing
materials might be as follows:
 The store department identifies the need to re-order
an item of raw materials for inventory.
 It produces a request to the purchasing department.
This request is called a purchase requisition.
 It should be properly authorised by a manager.
A buyer in the purchasing department
selects a supplier and provides the
supplier with a purchase order, stating:
 the identity of the item to be purchased,
 the quantity required and
 possibly also the price that the supplier
has agreed.
The purchase manager is responsible for
ensuring that the items ordered:
A. Meet the quality standards,
B. Are acquired at the lowest price and
C. Are delivered on a timely basis.
• A purchase invoice is received from the
supplier, asking for payment.
• The accounting department checks the
invoice details with:
- purchase order and
- goods received note,
to confirm that the correct items have been
delivered in the correct quantities.
▪ The purchase invoice is used to record the
purchase in the accounting records.
 Inventory
• An entity should keep an up-to-date record of
the materials that it is holding in inventory.
o In the stores department, the materials should
be kept secure, to prevent loss, theft or
damage.
o The stores department should keep a record
of the quantity of each item of material
currently held in inventory.
• For each item of material, there might be
an inventory record card, or ‘bin card’.
• This card is used to keep an up-to-date
record of the number of units of the
material currently in the stores
department.
• This process of continuous record-
keeping is known as perpetual inventory.
• The inventory ledger record is a record of the
quantity of the materials:
- currently held in inventory,
- received from suppliers and
- the quantities issued to operational departments.
 Inventory Control
• Is the function of ensuring that sufficient
goods are retained in the stock to meet all the
requirements without carrying unnecessary
large stock.
 OBJECTIVES OF INVENTORY CONTROL
• Scientific control of materials should serve the
following purposes:
 To provide continuous flow of required materials.
 To minimise investment in inventories.
 To provide for efficient store of materials
 To keep surplus and obsolete items to minimum.
 Techniques of Inventory Control
• A number of techniques and mathematical
models are employed in the process of inventory
control.
• The main aim of inventory control is to maintain
optimum level of inventory. For this, an
organization has to determine:
1. The quantity that they should be ordered
2. The time when they should be ordered.
 Inventory control by Setting stock level

 Re-order level ………

 When to Order
 Re-order quantity…..
 How much to order
 Min. stock level…….
 Up to how much to stock
 Max. stock level…..
 At least how much to stock
 Average stock level...
 Stock normally kept
 Danger stock level….  Kept for emergency requirement
 Buffer stock……..  To mitigate sudden demand
• The first aspect—the quantity—how much to
order is associated with the determination of
economic order quantity.
• The second one—the time—when they should
be ordered is associated with the determination
of re order level
 Determination Of Optimum Purchase
Quantities
Total materials costs, for any item of materials, consist
of:
 Cost of purchasing
 Ordering costs
 Costs of holding inventory
 Economic Order Quantity (EOQ)
• This method makes an attempt to resolve the issue:
How much to order at a time?
• EOQ refers to the quantity of order which gives
maximum economy in acquiring materials.
• At this point carrying cost and ordering costs are at
minimum level
• Carrying costs: These are “costs of holding”
the inventory in store.
• Example:
• Storing costs, insurance costs etc.
• Ordering costs: are the costs of placing an
order and receiving the supplies.
• Example:
• raising of stores requisition, follow-up,
transportation, receipt in store, etc
•  
 Bill of Materials (BOM)
• BOM- Is a list of items used to manufacture a product
• Purpose of bill of materials:
[A] It serves as a basis for the computation of direct
material cost.
[B] It serves as a guideline to production
department.
[D] It facilitates accounting of materials consumed as
needed
[E] It functions as a controlling technique.
 When to Order (Reorder Level)
• The EOQ determines how much to buy at a
particular time. But the question “when to buy” is
equally important for business firms.
• This question is easy to answer only if we know:
 The lead time-the time interval between placing an
order and receiving delivery
 The EOQ, and
 The consumption pattern during lead time.
• The order point or re-order level is a point
or quantity level at which if materials in
stores reach, the order for supply of
materials must be placed.
• This point automatically initiates a new
order.
• The order point is calculated from three factors:
1) The expected usage.
2) The lead time.
3) The minimum inventory, or safety stock.
Some business firms fix re-order level taking
into account maximum usage and maximum
lead time so that the stock will not reach the
zero level.
• The formula for computing re-order level is:
𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐥𝐞𝐯𝐞𝐥 = Min. stock Lev. + (𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐮𝐬𝐚
𝐠𝐞 𝐗 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐥𝐞𝐚𝐝 𝐭𝐢𝐦𝐞)
• In terms of maximum usage and maximum
lead time, the formula for re-order level is as
follows:
𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐥𝐞𝐯𝐞𝐥 = 𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐫𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐩𝐞𝐫𝐢𝐨𝐝 𝐗
𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐮𝐬𝐚𝐠𝐞
•
• It is advisable to use the first formula given
above to calculate re-order level.
• However, when adequate information is not
given about the factors of this formula, the
second formula can be used if information is
available about the factors of this formula.
 Example, 1
• If daily usage is 400 units of material which
have a lead time of 20 days and the safety
(minimum) stock is 500 units, the order point
will be calculated as follows:
Reorder level without safety stock
• Example 2
• The David IT Store sells 500 laptops on an average
in a week. The maximum demand in a week is 523
laptops. If, the lead time is 4.5 week then the reorder
level would be:
• Reorder level = Maximum weekly usage × Lead time
in weeks
= 523 units × 4.5 weeks
= 2,354 units
• It means that every time the number of laptops
decreases to 2,354, the David IT Store must place a
new order.
Determination of Safety or Minimum Stock Level
• It is advisable to carry a reserve or safety stock to
prevent stock-out.
• Therefore, for normal working conditions, the stock
should not be allowed to fall below the safety limit.
• If the usage pattern is known with certainty, and
the lead time is also known accurately, then no
safety stock would be needed.
• However, if either usage or lead time is subject
to variation then it is necessary for a business
firm to maintain safety stock levels.
• The safety stock level can be computed by
using the following formula:
• 𝐒𝐚𝐟𝐞𝐭𝐲 𝐨𝐫 𝐦𝐢𝐧𝐢𝐦𝐮𝐦 𝐬𝐭𝐨𝐜𝐤 𝐥𝐞𝐯𝐞𝐥 = 𝐎𝐫𝐝𝐞𝐫𝐢𝐠 𝐋𝐞𝐯𝐞𝐥 −
(𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐫𝐚𝐭𝐞 𝐨𝐟 𝐜𝐨𝐬𝐮𝐦𝐩𝐭𝐢𝐨 𝐗 𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐩𝐞𝐫𝐢𝐨𝐝
Or
 Example 3
• In a manufacturing operation, a particular material
is used as follows:
• Maximum consumption = 9,000 units per week
• Minimum consumption = 3,000 units per week
• Normal consumption = 6,000 units
• Time required for delivery = 4 to 6 weeks
• Time required for emergent supplies: 1 week
Required
• Calculate the minimum stock level.
 Solution
• Reorder Level = Maximum Consumption per week x
Maximum time required to obtain suppliers
= 9,000 units x 6 weeks
= 54,000 units
As the next step, we can calculate minimum stock
level as follows:
• Minimum Stock Level = 54,000 units – (6,000
units x 5 weeks)
= 54,000 – 30,000
= 24,000 units
• Note: The average time required to obtain
suppliers was calculated in the following way:
AT = (Minimum period + Maximum Period) / 2
= 4 weeks + 6 weeks / 2
= 5 weeks
 Example 4
• Suppose we have the following information:
- Normal consumption = 300 units per week
- Normal delivery time = 7 weeks
- Reorder level = 2,400 units
• Calculate the minimum stock level.
 Solution

Minimum Stock Level=  2,400 – (300 x 7)

= 300 units
 Maximum Stock Level
• The maximum level ensures that the stocks
will not exceed this limit although there may
be low demand for materials or quick delivery
from the suppliers. Maximum stock level can
be computed as follows:
𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐒𝐭𝐨𝐜𝐤 𝐋𝐞𝐯𝐞𝐥 = 𝑹𝒆𝐨𝐫𝐝𝐞𝐫𝐢𝐠 𝐋𝐞𝐯𝐞𝐥 +
𝐄𝐎𝐐 − (𝐌𝐢𝐧𝐢𝐦𝐮𝐦 𝐜𝐨𝐧𝐬𝐮𝐦𝐩𝐭𝐢𝐨𝐧 𝐗 𝐌𝐢𝐧𝐢𝐦𝐮𝐦
𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐩𝐞𝐫𝐢𝐨d)
 Example

• ZEE is a product manufactured from three raw

materials: M, N, and Q. Each unit of ZEE requires
10 kg, 8 kg, and 6 kg of M, N, and Q respectively.
• The reorder levels of M,N and Q are 15,000 kg and
10,000 kg, 25,000 kg respectively.
• The weekly production of ZEE varies from 300 to
500 units, while the weekly average production is
400 units.
• Required: Calculate the following:
1. Maximum stock level of N
• Materials M N Q
• Each unit requires 10 kg 8kg 6kg
• Re-order level 15,000 kg 10,000kg 25,000kg
• Weekly Prodn. Level 300 - 500 units
• Weekly Average prodn. 400 units
• Required: Calculate the following:
1. Maximum stock level of N
The following additional data are given:
 Solution

• Maximum Stock Level of N

= Reorder level + Reorder quantity – (Minimum
consumption per week x Minimum time required to
obtain supplies)
= 10,000 kg + 15,000 kg – (300 units x 8 kg x 4 weeks)
= 25,000 kg – 9,600 kg
= 15,400 kg
 Danger level
• Generally, the danger level of stock is
indicated below the safety or minimum
stock level.
• It is a level at which normal issue of raw
material inventory are stopped and
emergency issues are only made.
DL = Aver.consmn. X Lead time for emergency
purchase
Average stock level
• The different stock levels will be as follows:
Re-order level =normal usage X normal lead time + minimum level
= (500 X 30) + 5,000 = 20,000 Units
Maximum level = Re-order level + EOQ - Minimum quantity used
in re-order period
= 20,00 + 75,000 – (300*25) = 87,500 Units
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐒𝐭𝐨𝐜𝐤 𝐋𝐞𝐯𝐞𝐥 = Minimum + Maximum Stock
2
= 87,500 + 5,000
2
= 𝟒𝟔, 𝟐𝟓𝟎𝐔𝐧𝐢𝐭𝐬
 Comprehensive Illustration
• Re-order quantity …….. 1,500 units
• Re-order period ……… 4-6 weeks
• Max. consumption …… 400 units/week
• Normal Consumption ….300 units/week
• Minimum consumption….250units/week
• Required
1. Re-order Level
2. Maximum Level
3. Minimum Level
4. Average Level
 Solution
• Check Photo inside folder
 Accounting For Stock (Inventory) Movements

• In a system of cost accounting, a separate

record is kept for each inventory item.
• This record – an inventory account – is used
to maintain a record of all movements in the
materials, in terms of both quantities and cost.
 Accounting For Labour Costs
• Factory payroll costs are divided into two
categories: direct labour and indirect
labour.
• Direct labour costs include the wages of
machinists, assemblers, and other
workers who physically convert raw
materials to finished.
• Procedures for recording payroll costs
include :
1. Recording the hours worked
2. Analysing the hours worked by employees
3. Charging payroll costs to jobs, processes etc.
4. Preparing the payroll
 Wage Plans
• Employees’ wages are based on plans that
have been established by management.
• A manufacturer may use many variations
of wage plans.
• This chapter covers the wage plans most
frequently encountered, including hourly
rate, piece-rate, and modified wage plans.
 Hourly Rate Plan (Time-based systems)

• An hourly rate plan establishes a definite

rate per hour for each employee.
• An employee’s wages are computed by
multiplying the number of hours worked
in the payroll period by the established
rate per hour.
• The hourly rate plan is widely used and
is simple to apply.
• Critics argue that it provides no incentive
for the employee to maintain or achieve
a high level of productivity.
• An employee is paid for merely ‘‘being
on the job’’ for an established period of
time.
• The plan gives no extra recognition or
reward for doing more than the
minimum required of the position.
 Illustration
• Assume that an employee earns birr 15
per hour and works 40 hours per week.
• The employee’s gross earnings would be
birr 600 (40 * birr 15 per hour).
Basic pay = hours worked x Hourly rate
 Piece-Rate Plan
• A company that gives a high priority to the
quantity produced by each worker should
consider using an incentive wage plan, such as
a piece-rate plan.
Illustration
• Assume that a machine operator will earn birr
0.30 for each part (or ‘‘piece’’) finished.
• If the operator finishes 2,200 parts in a week,
he or she will earn birr 660 (birr 0.30 2,200
parts).
• The plan provides an incentive for employees to
produce a high level of output, thereby
maximizing their earnings and company’s
revenue.
• However, a serious shortcoming of such plans is
that they may encourage employees to sacrifice
quality in order to maximize their earnings.
• Basic Pay = Units produced x Rate paid per unit
produced
 Modified Wage Plans
• Modified wage plans combine some
features of the hourly rate and piece
rate plans.
• An example of a modified wage plan
would be to set a base hourly wage
that the company will pay if an
employee does not attain an
established quota of production.
• If the established quota is exceeded,
an additional payment per piece
would be added to the wage base.
• This type of plan rewards high-
performing employees and directs
management’s attention to
employees unable to meet the
established quotas.
 Controlling Labour Cost
• The timekeeping and payroll departments
have the responsibility of maintaining
labour records.
• Increasingly, automated timekeeping
technology has replaced ‘‘timekeeping’’ as
a separate department.
• For example, many companies issue
magnetic cards to direct labourers who use
them to ‘‘log on’’ and ‘‘log off’’ to specific
job assignments.
 Accounting for Labour Costs and Employers’
Payroll Taxes
• For all regular hourly employees, the
hours worked should be recorded on a
labour time record.
• The payroll department enters pay rates
and gross earnings and forwards the
reports to accounting.
• The accounting department records the
earnings on the labour cost summary
and in factory overhead ledger accounts.
Work in Process (Direct Material)……. xx
MOH (Indirect Material) …………………..xx
Salaries and Wages Payable ……….. xx
Labour Efficiency Ratio (productivity ratio)
• Non-financial information might be provided
to management about labour performance.
Performance measurements include the
labour efficiency ratio or productivity ratio:

When output is produced in exactly the time

expected, the efficiency ratio is 100%. .
When output is produced more quickly than
expected, the efficiency ratio is above 100%.
 Example:
• During July, a factory produced 3,600 units
of a product.
• The expected production time is 3 direct
labour hours for each unit.
• The actual number of direct labour hours
worked in the month was 10,000 hours.
 Labour turnover rate
• Labour turnover occurs when employees
leave their job and have to be replaced.
• The labour turnover rate is a measure of the
rate at which employees are leaving and have
to be replaced
 Costs and causes of labour turnover
• Labour turnover can be very costly for an
employer.
 When employees leave, their experience
is lost.
New employees might make many more
mistakes, and so there will be additional
costs of correcting faulty work.
New employees might have to be
trained, and there will be additional
training costs.
A very high labour turnover rate could
have an adverse effect on the morale
and efficiency of the employees who
remain in their jobs.
 Accounting for Manufacturing (Factory)
Overhead
• All costs incurred in the factory that are
not chargeable directly to the finished
product are called factory overhead
• These operating costs of the factory
cannot be traced specifically to a unit of
production.
• These costs are also referred to simply as
‘‘overhead’’ or ‘‘burden.
• All indirect factory expenditures are factory
overhead items. Factory overhead includes
1. Indirect materials consumed in the factory,
such as glue and nails in the production of
wooden furniture
2. Indirect factory labour, such as wages of
janitors, forklift operators, and supervisors etc.
3. All other indirect manufacturing expenses,
such as insurance, property taxes, and
depreciation on the factory building and
equipment.
• Accounting for factory overhead involves the
following procedures:
1. Identifying cost behaviour patterns.
2. Budgeting factory overhead costs.
3. Accumulating actual overhead costs.
4. Applying factory overhead estimates to
production
5. Calculating and analysing differences
between actual and applied factory overhead
 Financial Statement for Manufacturing
Organization

• Financial statement of a manufacturing

company is more complex as compared
to financial statement of merchandising
and service giving companies.
 Balance Sheet of a Manufacturing and
Merchandising Firm
• The Balance sheet of a manufacturing firm
differs from the balance sheet of a
merchandising firm principally by the type of
inventories reported.
• A manufacturing firm carries three types of
inventory. Namely, Raw material inventory,
work-in-process inventory and finished Goods
inventory.
Income statement of a Manufacturing Firm
• The income statements for merchandising and
manufacturing businesses differ primarily in the
reporting of the cost of merchandise (goods)
available for sale and sold during the period. These
differences are shown below.
In general, the following four steps are required to
prepare income statement of a manufacturing firm.
Step 1: The Schedule of Direct Material Used
In Production
Step 2: The Schedule of Cost of Goods
Manufactured
Step 3: The Schedule of costs of Goods Sold
Step 4 Income statement
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