Accounting for Materials Costs
1 Introduction
This chapter looks at how material costs are accounted for and how inventory can be valued.
2 Raw material, work-in-progress, finished goods
Raw materials are purchased and then undergo further processing or are incorporated into products. Raw materials can be basic materials such as chemicals, flour, or lengths of wood. Or raw materials can be items which have been manufactured by the supplier, such as components and parts for use in production.
Work in progress refers to partly made products. They have progressed from the bought in stage (raw materials) but are not yet complete.
Finished goods are complete and are ready for sale.
Raw material has not yet been processed; work in progress has been partly processed; finished goods are complete and ready for dispatch or sale. Do not combine categories simply because they relate to the same final product.
3 Accounting for material costs
Materials progress through a factory as follows:
Movement of the material between each stage has to be accounted for in a series of ‘T’ accounts.
As material moves into a department or category, the T account is debited with the cost.
As material moves out of a department or category, the T account is credited with the cost.
It can be useful to record units of material as well as value.
Assume there is no opening inventory at any stage.
1,000 units of raw material are bought for $5 per unit
800 are issued to production where labour worth $2 per unit and production expenses of $1 per unit are added. 700 of the units are transferred out to Finished goods at the end of the period. Although finished, 100 units are still in work in progress at the end of the period.
500 finished units are sold.
Raw materials | |||||
Units | $ | Units | $ | ||
Payables | 1,000 | 5,000 | To WiP | 800 | 4,000 |
C/f Closing inventory | 200 | 1,000 | |||
1,000 | 5,000 | 1,000 | 5,000 | ||
Work-in Progress | |||||
Units | $ | Units | $ | ||
From raw materials | 800 | 4,000 | To Finished goods | 700 | 5,600 |
Labour | 1,600 | ||||
Overheads | 800 | C/f Closing inventory | 100 | 800 | |
800 | 6,400 | 800 | 6,400 | ||
Note: finished goods and closing inventory are valued at:
Material $5 + Labour $2 + Overheads $1 = 8 per unit
Finished goods | |||||
Units | $ | Units | $ | ||
From WIP | 700 | 5,600 | Cost of sales | 500 | 4,000 |
C/f Closing inventory | 200 | 1,600 | |||
700 | 5,600 | 700 | 5,600 | ||
4 Material requirements making allowance for sales and product/material inventory changes
The raw materials purchased are not necessarily the same as the raw materials that will be used in production. This is because there might be changes in raw material inventory. It would, for example be possible to use raw materials in a period without having to purchase any if there were already enough raw materials in inventory.
The adjustments needed are:
Raw material purchased | = | Raw material used | + | Closing inventory | – | Opening inventory |
The company has to buy enough to cover usage and to provide enough for closing inventory, but it gets a ‘head start’ because there is already some in opening inventory.
Similarly:
Units produced | = | Units sold | + | Closing inventory (finished goods) | – | Opening inventory (finished goods) |
For a material-use calculation, adjust sales for finished-goods opening and closing inventory to find production, then apply the material requirement per unit. Only after that should raw-material inventory be used—if the question asks for purchases rather than usage.
5 Different methods used to price materials issued from inventory and to value closing inventory
Consider the following:
12 March 20X4: buy 1000 units at $5 each
21 March 20X4: buy 500 units at $6 each
31 March 20x4: sell 800 units at $12 each.
Clearly revenue will be 800 x $12 = $9,600, but what is the cost of the units sold? Which have been sold? What is their value and the value of the inventory left?
You have to know four approaches:
FIFO
LIFO
Cumulative weighted average
Periodic weighted average
5.2 FIFO (First-in, first out)
This method assumes that the goods that arrive first are the first to be used. It is only an assumption: apart from their price all goods of a given type are identical and therefore you don’t know, or care, how they are physically used.
So, in the above case, all 800 units sold would be assumed to be those delivered on 12 March. They would have a cost of 800 x $5 = $4,000 and the value of the inventory remaining would be 200 x $5 + 500 x $6 = $4,000.
Note that receipts and sales are handled on a strict time basis.
5.3 LIFO (Last-in, first out)
This method assumes that the goods that arrive last are the first to be used. As before It is only an assumption: apart from their price all goods of a given type are identical and therefore you don’t know, or care, how they are physically used.
So, in the above case, the 800 units sold would be assumed to be all 500 of those delivered on 21 March plus 300 from the March 12 delivery. They would have a cost of 500 x $6 plus 300 x $5 = $4,500, and the value of the inventory remaining would be 700 x $5 = $3,500.
Note that receipts and sales are handled on a strict time basis.
5.4 Cumulative weighted average
Every time units are added, a new average price is calculated. Any time goods are removed they are removed at the prevailing average.
12 March 20X4: buy 1000 units at $5 each
21 March 20X4: buy 500 units at $6 each
31 March 20x4: sell 800 units at $12 each.
$ | |||
12 March 20X4 | 1,000 | @ $5 | 5,000 |
21 March 20X4 | 500 | @ $6 | 3,000 |
$5.33 = average cost | 1,500 | @ $5.33 | 8,000 |
31 March 20X4 | (800) | @ $5.33 | (4,267) |
Closing inventory | 700 | @ $5.33 | 3,733 |
Note:
Sales do not alter the average cost.
Receipts and sales are handled on a strict time basis.
5.5 Periodic weighted average
Here, a new inventory value is calculated at the end of a set period. The cost of goods used is given by:
Cost of opening inventory + cost of purchases in the period |
Units in opening inventory + units purchased in the period |
So, all units used in the period will have the same cost.
In the above simple example this method would give the same result as the cumulative weighted average approach
The following inventory movements took place during April:
Date | Units | Unit | ||
1 April | Opening inventory | 1,000 | 5.00 | |
5 April | Purchased | 500 | 6.00 | |
9 April | Sold | 200 | N/a | |
14 April | Purchased | 600 | 5.50 | |
21 April | Sold | 1,200 | N/a |
Calculate the cost of inventory used each time and the cost of the inventory remaining at the end of the period using:
(a) FIFO
(b) LIFO
(c) Average cumulative cost
(d) Periodic average cost
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6 Advantages and disadvantages of the methods:
Advantages | Disadvantages | |
FIFO | Permitted by accounting standards as an acceptable approach to inventory valuation | Requires care to get it right |
LIFO | Inventory is issued at close to its current cost (significant if there is high inflation of volatile inventory prices) | Not permitted as an inventory valuation method under financial reporting standards |
Average inventory values | Averages out inventory price fluctuations |
Accounting for Materials Costs
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