MATERIAL COSTS

Materials refer to the tangible inputs into the process of producing useful output. They could be
direct materials or indirect materials (overheads) e.g. to produce tea, tea leaves is the material
(input).
Material cost classification
Material costs may be classified as:
a) Direct Material Cost
Refers to costs of materials that may readily be identified with output units. The cost of timber
used in the manufacture of a chair is an example of a direct material.
b) Indirect Material cost
Refers to items of raw materials for which it would be difficult and/or inefficient to attempt to
charge directly to specific cost units. For example, the glue used to bind the joints in the
assembly of a chair
Other examples of indirect materials include:
- Materials used by service departments e.g. spare parts used by maintenance
department in repairing and servicing plant and machinery
- Materials used by non-production functions e.g. stationary used in accounting
department
Material cost control
Materials form a significant cost of output units and therefore should be controlled. Material
Control is more than simply recording the accounting transactions relating to material cost.
Control should be implemented to ensure that material is available:
a) In appropriate quantities
b) In appropriate quality
c) In appropriate location
d) At an appropriate time
e) At the most economic cost
Control may be exercised at a number of points in the business cycle as follows:
a) When the choice is made as to the type and quality of material to be used;
b) Where the purchase order is being placed with the chosen supplier;
c) On receipt of the material from supplier, check the appropriateness of quality and
quantity of materials received;
d) Where the material is held in store before use: It must be safe from theft and damage;
e) Where the material is issued from the store: it must be issued to the correct department
and

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 f) Where the material is being used for intended purposes e.g. the material must be utilized
to produce the desired output.
The material control system must attempt to ensure that the company does not incur costs in
excess of an agreed efficient level of expenditure. Lack of adequate control routines will result in
the incidence of costs in excess of an acceptable level, reduced profitability of production and
increased operational costs.
Inventory Control and Management
The objectives of inventory management are:
(i) To ensure adequate stocks to allow for continuous operations/production, and
(ii) To minimize the cost of having inventory.
Inventory management is important since in most organizations it represents the largest single
investment. The major types of inventory are:
(i) Raw materials
(ii) Work in progress
(iii) Finished goods
To achieve the above objectives of material cost costing, the manger has to make decisions
regarding the following:
a) What commodities to stock?
 Use Material Requirement Planning
From the Master Production Schedule, the manager has determined the products to be
produced. A Bill of Materials can then be prepared. This lists in descending order the
components required to make the final product. The information required includes part
name or description, part number, next higher-level assembly, required quality per end
item, quantity per end item and quantity required for the next higher-level assembly.
Stores Ledger Account is also used to obtain information on what is currently available.
The file shows balance on hand as well as past data on how much is usually ordered,
lead-time, and safety stock.
From the above the manager can determine what need to be purchased.
b) How much to stock?
1) Use the Economic Order Quantity Model
This is a simple model that helps the manager to determine the optimum quantity of stock
to order so as to keep total costs at a minimum. The main costs of inventory are:
a) Holding or carrying costs;
b) Ordering or set up costs;
c) Shortage costs; and
d) Cost of stock itself

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To determine the economic order quantity, the following formula may be used:

Where D is the annual demand

Co is the cost of making one order
Ch is the holding cost per unit per annum
2) Use Pareto Analysis
Items are classified into three classes as follows:
Class A: These are high cost, fast moving and high usage items. They are few
accounting for only 20 percent of the total number of items yet account for 80
percent of the total inventory budget.
Class B: These are medium moving goods. They account for 15 percent of the total
number of the budget
Class C: These are slow moving low value items. They are very many accounting for
65 percent of the total number of items and only 5 percent of the total inventory
budget.
c) When to stock?
This will be influence by the inventory system in place as follows:
 Periodic order system.
The firm receives a new order of the amount specified by the order quantity at equal
intervals of time. The firm determines the maximum and minimum inventory, the safety
stock and the reorder level.
 Continuous Review System
The firm places orders at regular intervals but the order quantity varies according to how
much a firm requires to bring the level to some predetermined size or value.
 Just In Time (JIT) Inventory System
This is a concept developed by the Japanese and advocates zero inventory and stockless
production. In addition, it calls for 100 per cent quality. Some of the major features of JIT
include:
a) Frequent and reliable deliveries to avoid inventory build-up. Companies are also
setting delivery dates with penalties for not meeting them.
b) Closer location to suppliers and customers
c) Improved communication between companies and suppliers through the use of
computerized purchasing systems that allows for online ordering.
d) Single sourcing and building long-term relations with a few trusted suppliers.
e) Increased supplier involvement in the design aspects of a product to ensure that they
meet the company’s quality requirements.

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 f) Maintenance of strict quality control by all parties.
Material Handling
The objective is to ensure that goods are delivered to the right places at the right time and in
aright manner to avoid delays, congestion and unnecessary handling. A big percentage of
production costs is taken up by material handling activities. A good material handling system
should minimize these costs.
The manager needs to determine the type of equipment to be used to handle the material. The
type of equipment that is most frequently used includes:
 Cranes
 Lifts
 Trucks
 Conveyors
 Towing
The factors that influence the type of equipment used includes:
 Type of materials being moved
 Volume
 Rate or frequency of movement
 Route of movement speed required
 Method of storage employed
 Safety or hazards involved.
Storage and Issue of Material
A number of factors are relevant in control of materials during storage and issue of materials.
They are:
a) Stores location and layout
b) Stock level and its control.
c) Stock control records and issue procedures
d) Stock taking procedures
e) Valuation of inventories (issues and closing stock)
Stores location and layout
The layout of stores should ensure
a) Ease of access for movement of material in and out of stores
b) The issue of perishable materials on a first in first out basis
c) The segregation of toxic and dangerous materials in a separate location
d) Security of materials by restriction of access to authorized personnel only
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The location of stores should ensure:
a) Nearness to point of use to minimize expenditure on handling costs
b) Specialist stores e.g. spare parts for machinery should be located close to the point of use.
Stock Level and its control
Management must make decisions about the control of stock levels with a view to minimizing
the cost of the company while achieving more efficiency in the availability of material to fulfill
planned usage requirements. Consideration should be given to the following control levels:
a) Minimum stock level
b) Maximum stock level
c) Re-order level
d) Re order quantity (Note the re-order quantity is not necessary the EOQ)
a) Minimum stock level
This is the level below which stock should not fall. It is essentially a base (buffer) stock
level. If stock falls below this point, there is a danger of stock-out.
Minimum stock level = Reorder level – (Normal consumption x normal reorder period)
b) Maximum stock level
This is the upper limit above which stock should not be allowed to rise. Each material to be
kept in store must have a maximum level and stock should not be allowed to go beyond this
level
Maximum stock level = Re-order level +re-order Quantity - (Minimum consumption x
minimum re-order period)
c) Re-order level
Is a point that lies between minimum and maximum stock levels at which purchase orders
must be placed to ensure that goods ordered are received before the minimum stock level is
reached? It is the level of stocks at which replenishment must be made to avoid a stock-out.
Re-order level = maximum consumption X maximum re-order period
d) Re-Order quantity
This is the quantity of stock ordered once the re-order point is reached. The quantity is such
as to minimize stock costs taking into consideration the cost of holding stocks and making an
order. This is also regarded as the Economic Order Quantity (EOQ). It is computed as
follows:
Where D is the annual demand (knits)
Co is the cost of making one order
Ch is the holding cost per unit per annum

Economic Order Quantity (EOQ)

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Define the EOQ model and the three methods of computing EOQ.
Assumptions of the model
 Annual demand is known and constant;
 Price per unit is known and constant;
 Ordering constant are known and constant;
 There is instantaneous replenishment;
 Hold cost per unit is known and constant;
 No stock-out costs are allowed;
 The same quantity is ordered every time an order is made since demand as assumed not
to fluctuate significantly.
Illustration
The following information was extracted from the books of Danex Holdings regarding its stocks:
i. Reorder quantity 1,800
ii. Reorder period 4 weeks
iii. Maximum consumption 450 units/week
iv. Normal consumption 300 units/week
v. Minimum consumption 150 units/week
Vi Maximum reorder period 5 weeks
Vii Minimum reorder period 3 weeks
Required
Determine the following stock levels for Danex Holdings:
i. Re-order level
ii. Maximum stock level
iii. Minimum stock level
Solution
i) Re-order level = Maximum consumption X maximum reorder period
= 450 units X 5 weeks= 2,250 units
ii) Maximum stock level = reorder level + reorder quantity-
(Minimum consumption X minimum reorder period)
= 2250 + 1800 – (150 X3) = 4050 – 450 = 3600 units
iii) Minimum stock level = Reorder level – (Normal consumption X
normal reorder period)
= 2,250 – (300 X 4) = 2250 – 1200 = 1050 units
Economic Order Quantity (EOQ)
It constitutes the quantity purchased of either stocks or raw materials that is considered most
optimum. This is the quantity that minimizes both holding costs and ordering costs, As the
quantity of purchase increases there is a reduction in ordering costs, but an increase in holding
costs as illustrated in the graph below:

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Total cost
Ordering costs Total cost

Holding Costs Holding costs

Ordering costs

0 Qx Quantity of Inventory

Qx represents the EOQ where the aggregate stock cost is lowest

Total cost = Total ordering costs + Total holding costs
Total ordering costs = cost per order X no of orders in a period
Total holding cost = average stock quantity X holding cost per unit
The EOQ can also be delivered mathematically as explained below:
Mathematical Derivation of EOQ
Let cost per order be represented by C o. This is the cost incurred every time one order is
placed.
Let the economic quantity purchase every time be represented by Q
Let holding cost per unit be represented by Ch
Let total demand be represented by D
The total holding cost = ½ QCh

The total Ordering cost = CO: Note that gives you the number of order in the period

Then total cost = ½ Qch + D/Q C O (or simply the total holding up cost plus the
total ordering costs)

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 EOQ is at the point where holding cost is equal to ordering costs
i.e. ½ Ch = D/Q CO
½ Q2Ch = D CO Q2=
Q2Ch = 2D CO
Q2 = Therefore Q Therefore EOQ=
The EOQ model assumes:
 Annual demand is known
 Hold costs are constant and known
 Ordering costs are known and constant
Example
ABC Ltd has an aggregate demand of 1.2 Million units. Each time they place an order there is an
ordering cost of shs 1,000, holding cost is shs 100 per unit. Determine:
i. EOQ
ii. No. of order to be made based EOQ
iii. Total cost of stocks based on the EOQ
Solution

EOQ =

i) No of order = 1200000 = 244.9 ≈ 245 Orders

4899
ii) Total cost = DCo + ½ QCh = 1200000(1000) + ½ (4899)100 = 489,900
Q 4899
Valuation of inventory (Issues and closing stocks)
Valuation of inventory aims at attaching a monetary value in the stores or issued for production.
This is useful in producing. State costing the output and pricing production, as well as decision
making.
Methods used in valuing inventory:
a) First In First Out
b) Last In Last Out
c) Weighted Average method

First in First out (FIFO)

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This method is based on the assumption that stock purchased first is issued first. Prices of stock
purchased first are used to determine the cost or value of inventory issued. Closing stocks are
carried at the latest costs.
Advantages
1. It is a realistic system: oldest items are usually issued first out.
2. Unrealized profits or losses do not arise
3. It is easy to calculate if prices of materials don’t fluctuate
4. Closing stocks values reflect the latest costs thus tend to reflect the current market values.
5. It is acceptable to many tax authorities and is also consistent with accounting practices e.g.
IAS/IFRS.
Disadvantages
1. It involves tedious calculations if the price of materials fluctuates from time to time
2. Product costs, based on the oldest material prices, lag behind current conditions especially in
inflationary markets.
3. Comparison of one job with another may be difficult if materials are issued at different
prices.
Last in first out (LIFO)
Is based on the assumption that the stock purchased last is issued first. Stock valuation should
therefore be based on the prices ruling on the acquisition of the last stocks.
Advantages
1. Product costs tend to be based on current market prices and is therefore realistic.
2. A charge to production is as closely related to current price levels as possible
Disadvantages
1. Stocks are valued at the oldest prices.
2. It involves tedious calculations if the price of materials fluctuates from time to time.
3. Comparison of one job with another may be unfair and difficult
Weighted average method
i. This method is a perpetual weighted average system where the issue price is recalculated
after each receipt of stocks taking into account both quantities and money value of the stocks
received.
In this case stock used or unused is based on the average price per unit where the average
price per unit is calculated as follows:
= Total value of stocks = Average Price Per Unit
No. of units of stock

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 = (Money value of old stocks + Money Value of New Stocks)
(Quantity of old stocks + Quantity of New Stocks)

Illustration
Assume the following purchases were made in ABC Ltd
Date of purchase Units purchased Price/unit
1st January 500 100
2nd January 600 200
3rd January 800 400
Units used on 4th January are 900. Determine the value/cost of units used by using FIFO, LIFO
and weighted average.
Required:
Determine the cost of units used and the value of the closing stocks using FIFO, LIFO and
Weighted Average.
Solution
1. FIFO
Cost of units used
Date Units Unit price Total cost
Jan 1 500 100 50,000
Jan 2 400 200 80,000
900 Cost of units used 130,000

Closing stock is valued as

Jan 2 200 units x 200 shillings = 40,000
Jan 3 800 units x 400 shillings = 320,000
1,000 360,000
2. LIFO
Cost of units used
Date Units Unit price Total cost
Jan 3 800 400 320,000
Jan 2 100 200 20,000
900 Cost of units used 340,000

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Closing stock is valued as
Date Units Unit price Total cost
Jan 2 500 200 100,000
Jan 1 500 100 50,000
1,000 Value of closing stocks 150,000

3. Weighted average
Date Units Unit Price Total Cost of Issues

0–0 900 257.8 232,105.20

Closing Stock Valuation = (Goods Available – Goods Issued) x Unit Price =

Unit Price =

Other methods include

 Standard cost
 Replacement cost
 Next in first out
 Highest in first out.

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