Accounting for Material Costs And Inventory Management

1 Introduction

This chapter looks at how material costs are accounted for and how inventory can be valued.

2 Material cost classification

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.

Direct materials are those that can be easily identified with or traced to a unit of production. For example, microprocessor chips being incorporated into laptop computers.

Indirect materials are not easy to trace to a unit of production. For example, the solder used to secure electronic components in circuits, or the adhesive used to join components.

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.

4 Material requirements making allowance for sales and product/material inventory changes

Raw materials that have to be 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:

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:

The calculation of the amount of material needed for production can be complicated if there is wastage. For example, to produce 80kg of good output, it might be necessary to input 100kg. The loss of 20kg does not necessarily mean that someone has been careless; a loss might be an inevitable part of the production process (for example, evaporation or removing impurities).

Obtaining 80kg from 100kg can be called a yield of 80%; alternatively, it can be defined as having a wastage rate of 20%. So:

The wastage is 20% of input but 25% (20/80) of output.

If the required output is to be 1,000kg, the input can be worked out using the above model:

Controlling wastage

Knowing how much input a given output needs is only useful if someone then checks that the process actually achieved it. The control measure is the yield: compare the output you actually got with the output the input should have produced, and investigate the difference.

A 70 kg overrun on one batch may be nothing; the same overrun every week is money leaving the business. Practical control measures are to set a standard yield and report the actual yield for every batch, to set a tolerance so that only losses outside it are investigated, to inspect incoming material because poor quality material wastes more, to check machine settings and operator training, and to separate normal loss (unavoidable, expected, built into the standard) from abnormal loss (avoidable, and someone's responsibility).

5 Inventory purchase, use and sale

The purchasing process will normally start with a purchase requisition note that will normally show the following:

• Sequential document number
  

• Date of requisition
  

• Our stock code
  

• Quantity needed
  

• Supplier
  

• Supplier’s product/stock code
  

• Signatures authorising the requisition
  

The purchase requisition notes are passed to the purchasing department where they will be examined and approved or queried. Sometimes, despite the supplier being entered on the purchase requisition, the purchasing department might ask several suppliers for quotations.

A purchase order is then raised (created). This will typically show:

• Our name, address and contact details
  

• Purchase order number
  

• Date
  

• Details of goods required: product codes, description, unit price and total price.
  

• Authorisation
  

The order will have at least two copies: one for the supplier one for the stores to inform them that a delivery is expected.

When goods are received, they will usually be accompanied by a delivery note. This will show the information that is on the purchase order, except for the value of the goods. Goods should not be accepted before checking to a copy of the order that they have, in fact, been ordered. One copy of the delivery note is signed and kept by the supplier. Usually the receiving company will create a standard goods received note from the delivery note. The goods will be stored in the warehouse and stock records on bin cards (see below) will be updated from the goods received note.

A purchase invoice showing the payment due will be received from the supplier, and before this is approved for crediting to the suppliers account and subsequent payment, it should be matched to the order and goods received note to ensure that the correct goods have been received.

When materials are needed for production a materials requisition note should be created requesting the release of material from the stores: part/material code, quantity, job number and so on. This should be signed by the person requesting the goods. Stock records will be updated as goods are issued.

There might be production order setting out goods and labour needed for the production of the goods ordered by customers.

As goods are produced they will be transferred from the production line to the finished goods store. Stock records there should be updated with goods description, quantities and costs.

As goods are sold, customer orders will be received and from those, despatch (or delivery notes) produced. These can be used as the basis for taking goods from stores, updating the bin card (see below) packing and despatching them. There will usually be three copies of the delivery note: two go with the goods and of those one stays with the customer and one is signed by the customer and returned as proof of delivery receipt. One copy will stay in the despatch department in case of later queries.

Central to the material control cycle is the recording of the amount of inventory as this will determine when goods need to be ordered and will also record the receipt and issue of goods.

In manual accounting systems bin cards were used (a bin is where a specific item of inventory is stored). The equivalent records are now usually held in computer systems. A typical bin card would look as follows:

This allows a continuous recording of stock quantities.

A particularly important figure to calculate is free inventory. This is

Free inventory = Quantity on hand plus units ordered less units allocated for use

The calculation of free inventory has the advantage of anticipating stock movements so that receipts and issues that are known about are taken into account when assessing the need to order.

To ensure that the inventory as recorded on the bin cards is accurate, companies should carry out periodic stock counts (sometimes called cycle counts) and correct the amounts on the bin cards. Some companies carry out one only stock count per year.

Minimising discrepancies and losses

Counting the inventory tells you that a discrepancy exists. It does not stop it happening again. Inventory is stolen, damaged, miscounted, issued without paperwork and left on a shelf until it is obsolete, and each of those needs a different control.

• Physical security: a locked, supervised stores area with access limited to stores staff, so that nobody helps themselves and nothing leaves without a signed materials requisition.
  

• Segregation of duties: the person who keeps the stores records should not be the person who counts the inventory, and neither should be the person who authorises a write-off.
  

• Cycle counting: count a few lines every week rather than everything once a year, so errors are found within days and the count is done by people who are not rushed.
  

• Storage conditions: correct racking, temperature and handling reduce damage and deterioration.
  

• Obsolescence reporting: a regular report of slow-moving lines lets management sell or scrap them while they are still worth something.
  

• Write-offs authorised in writing, so that a difference cannot simply be adjusted away by the person who caused it.
  

When a count does disagree with the records, the difference is not just corrected. It should be recounted to rule out a counting error, then traced back through the receipts and issues for that line, then written off only on proper authority, and the reason recorded so that a pattern in one storeman, one supplier or one item can be spotted.

6 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
  

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.

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.

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.

Note:

Sales do not alter the average cost.

Receipts and sales are handled on a strict time basis.

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:

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.

Advantages and disadvantages of the methods:

How the two systems fit together

These are not two separate records. The inventory control system records the quantities — what came in, what went out, what is left, and therefore when to reorder. The materials costing system puts a price on exactly those same movements, so that the cost of material can be charged into production and the inventory that remains can be valued.

That is why the pricing method matters to both. FIFO, LIFO or a weighted average is a rule applied to the inventory record: each receipt is entered with its quantity and its cost, and each issue takes its quantity out and takes a cost with it. Change the rule and you change the charge to production, the profit for the period and the value of the closing inventory — but not a single physical item moves.

The link runs both ways. A goods received note updates the quantity on hand (control) and, once matched to the purchase invoice, fixes the cost of that receipt (costing). A materials requisition releases stock (control) and charges a job or a process (costing). If the quantity records are wrong, the costs will be wrong too, which is why the stores controls described earlier protect the management accounts as well as the inventory.

7 The need for inventory

Inventory is held for the following reasons:

• To cope with erratic demand
  

• To deal with unreliable supplies
  

• Because raw material is seasonal and must be bought when available.
  

• Because demand is seasonal. Manufacturing at a constant rate and storing in inventory might be cheaper than paying employees overtime during busy periods.
  

• To qualify for bulk discounts, large volumes must be purchased
  

• Because prices are volatile and large quantities are bought when prices seem low.
  

• The production process requires time. For example, Scotch whisky matures for many years.
  

• To provide flexibility in case of machine breakdown
  

Some businesses attempt just-in-time inventory management (JIT), where the aim is to have no inventory at all. When a customer order is received, material is ordered for production and the goods produced and despatched.

JIT requires very good management information systems and integrated systems to ensure that everything works like clockwork. Suppliers must be very reliable and need to be physically close if goods have to be transferred by road or sea. You cannot really organise JIT if it takes goods two months to arrive from suppliers.

Although costs are saved because no inventory has to be held, JIT has dangers. If a supplier doesn’t supply on time or a machine breaks down then production will soon stop, wasting huge amounts of money (as employees will usually still have to be paid) and damaging the company’s reputation with its customers.

8 The managing inventory

When inventory is held, there are two main amounts that have to be determined;

• The reorder level     When orders should be placed. How low should inventory be allowed to fall before an order is placed?
  

• The reorder quantity     How much should be ordered?
  

These are independent quantities.

If the usage rate of inventory and the lead time (the delay between placing the order and receiving the goods) were constant, the reorder level would be easy to work out.

Reorder level = Daily usage rate x lead time (days)

So, if 120 units were used per day, and the lead time is 4 days, reorder level (ROL) = 4 x 120 = 480 units.

However, both usage and lead times can vary. It is usually very important to businesses not to run out of stock (a ‘stock out’) because that will be expensive and cause ill-will with customers. Therefore, when usage and lead times vary the reorder level is set to;

Reorder level = maximum usage rate x maximum lead time

This should prevent stock outs.

The minimum stock level will be:

Minimum stock level = Reorder level – average usage x average lead time

This is not the absolute minimum to which inventory can fall; it is the average minimum stock level.

The maximum stock level will be

9 The economic order quantity

The economic order quantity (EOQ) is the order quantity which minimises stockholding costs. There are two sets of costs relevant;

The holding cost. This is made up of costs such as financing the inventory, storing it, and the risks of the stock being damaged, deteriorating or becoming out-of-date.

The reorder cost. This is the administration cost of raising requisitions and orders, receiving the stock and processing the invoices.

For example:

Annual demand for inventory 20,000 units

Order quantity is 1,000 units per order

Ordering costs = $50/order

Holding cost = $5 per unit per year.

Holding costs: the maximum inventory is assumed to be 1,000 units ie the reorder quantity. That is then used up steadily and just as the last unit is used, another 1,000 units will be received.

The average stock level will be 500 (order quantity/2)

So the annual holding cost will be 500 x $5 = $2,500.

Ordering costs: if annual demand = 20,000 units and order quantity = 1,000 units, there will be 20 orders per year. Each costs $50, so the annual cost of ordering is $50 x 20 = $1,000.

The total cost of holding and ordering is therefore $2,500 + $1,000 = $3,500

As the reorder quantity increases, the holding costs increase and the ordering costs decrease. The total costs fall to a minimum, then rise. The minimum costs are at the economic order quantity (EOQ). Here, EOQ is probably a little above 500.

The precise EOQ can be found using a formula

EOQ = √( 2 × Cₒ × D ÷ Cₕ )

C_O = cost of placing an order

C_H = cost of holding one unit for one year

D = annual demand

So for this example:

EOQ = √( 2 × 50 × 20,000 ÷ 5 ) = 632 units