Chanderprabhu Jain College of Higher Studies

&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

E-Notes
Class : B.COM (H) III Semester
Paper Code : B.COM 201
Subject : Cost Accounting
Faculty Name : Ms. Saumya Goel

Unit-I

Cost
Introduction
In accounting, the term cost refers to the monetary value of expenditures for raw
materials, equipment, supplies, services, labor, products, etc. It is an amount
that is recorded as an expense in bookkeeping records.
Meaning of Cost
Cost is the amount of resources given up in exchange for some goods and
services. CIMA defines the term cost as “the amount of expenditure (actual or
notional) incurred on or attributable to a given thing”. The given thing may be
considered as a product, service, or any other activity.
Cost Accounting
Introduction
Cost accounting is the application of accounting and costing principles,
methods, and techniques in the ascertainment of costs and the analysis of saving
or excess cost incurred as compared with previous experience or with standards.

Meaning
It is the recording of all the costs incurred in a business in a way that can be
used to improve its management.
Definition of Cost Accounting
“Cost accounting is a form of managerial accounting that aims to capture a
company's total cost of production by assessing the variable costs of each step
of production as well as fixed costs, such as a lease expense.”
Objectives of Costing
Costing aims to serve the informational needs of the management for planning,
controlling, and decision making.
(i) It helps to determine the product cost. It is important in valuating inventory
and taking decisions regarding pricing of the product.

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 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

(ii) It facilitates planning and controlling of operating activities.

(iii) It supplies information for short-term and long-term decisions.
Scope of Cost Accounting
The scope of cost accounting is actually quite wide. It mainly consists of three
main aspects. Let us take a brief look at them.
(i) Cost Ascertainment
This is one of the main criteria for cost accounting. Cost ascertainment is the
process of collection of expenses and by analysis of these expenses. It links up
the production of various products at their different stages of production with
such expenses. Over time we have seen the development of a variety of
production processes, and so different systems of costing were also developed.
Examples include historical cost, actual costs, standard costs etc. and linking of
these
expenses with the manufacturing process occurs via many techniques such as
marginal cost technique, direct cost technique etc.
(ii) Cost Accounting
This is the process of accounting for the costs of a firm. Classifying and
recording of costs is the first step in the process. The end result is the
preparation and presentation of this statistical data in an acceptable format.
Cost accounting is almost as crucial to management as financial accounting. It
allows them to make decisions. And if the cost accounting and financial
recording statements are separate, they must be reconciled at year-end.
(iii) Cost Control
Cost control is the process by which action is taken to reduce the costs and
expenses to boost profitability and efficiency. The idea is to bring the actual
figures as close to the target or budgeted figures as possible. This involves the
regulation of any costs that deviate from the target.
Cost centre and Cost units
Cost Centre
Cost centre definition relates to the cost incurring subdivision or part of the firm,
that doesn't contribute directly to the organization's revenue.
Cost centre is the important concept to be known in costing. Cost centre refers to a
section of the business to which costs can be charged. It may be a location (a
department, sales area), an item of equipment (a machine, a delivery van), a
person (salesman, machine operator), or a group of these.
Cost Unit
The cost unit is defined as the measurable unit of the products and services with
which the cost is associated.
Cost unit is a unit of quantity of product, service, or time (or a combination of

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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

these), in relation to which the cost can be ascertained or expressed.

Difference between Cost Centre and Cost Unit

BASIS FOR
COST CENTRE COST UNIT
COMPARISON

Meaning Cost centre refers to a Cost unit implies any

subdivision or any part measurable unit of product
of the organization, to or service, with respect to
which costs are incurred, which costs are assessed.
but does not contribute
to the company's
revenues directly.

Use It is used as a basis for It is used as a standard for

classifying costs. making a comparison.

Cost Costs are collected and Measured and Expressed

absorbed by cost units. in terms of cost units.

Ascertainment Ascertained as per the Ascertained as per the

nature and technique of nature of the final output
production process, and the existing trade
organization size and practices.
structure.

Sequence First Second

How many? Several cost centres are Different cost units for
there, even if there is different products or
just one product or services.
service offered.

Difference between Financial Accounting, Cost Accounting and

Management Accounting
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An ISO 9001:2015 Certified Quality Institute
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Financial Accounting gives out information about the enterprise’s financial

activities and situation. It makes use of the past or historical data. All the
transactions and statements are recorded and presented in terms of money
mostly. Persons who make use of these financial statements are outsiders like
banks, shareholders, creditors, government authorities etc. Financial
statements are usually presented once in a year and there is a certain format for
their presentation. It is mandatory for the companies to follow the rules and
policies framed under GAAP (Generally Accepted Accounting Principles). It
indicates whether the company is running in loss or profit.
Cost Accounting helps in the determination of the cost of the product, how to
control it and in making decisions. It makes use of both past and present data for
ascertainment of product cost. There is no specific format for the preparation of
cost accounting statements. It is used by the internal management of the
company and usually the cost accountant prepares this to ascertain the cost of a
particular product taking into account the cost of materials, labor and different
overheads. No certain periodicity is needed for the preparation of these
statements and they are needed as and when required by the management. This
makes use of certain rules and regulations while computing the cost of different
products in different industries.
Unlike the above two accounting, Management Accounting deals with both
quantitative and qualitative aspects. This involves the preparation of budgets,
forecasts to make viable and valuable future decisions by the management.
Many decisions are taken based on the projected figures of the future. There is
no question of rules and regulations to be followed while preparing these
statements but the management can set their own principles. Like cost
accounting, in management accounting also there is no specific time span for its
statement and report preparation. It makes use of both cost and financial
statements as well to analyze the data.

Difference between Cost accounting and Financial Accounting

BASIS FOR FINANCIAL

COST ACCOUNTING
COMPARISON ACCOUNTING

Meaning Cost Accounting is an accounting Financial Accounting is an

system, through which an accounting system that
organization keeps the track of captures the records of
various costs incurred in the financial information about

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 Chanderprabhu Jain College of Higher Studies
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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

BASIS FOR FINANCIAL

COST ACCOUNTING
COMPARISON ACCOUNTING

business in production activities. the business to show the

correct financial position of
the company at a particular
date.

Information type Records the information related to Records the information

material, labor and overhead, which which are in monetary
are used in the production process. terms.

Which type of Both historical and pre-determined Only historical cost.

cost is used for cost
recording?

Users Information provided by the cost Users of information

accounting is used only by the provided by the financial
internal management of the accounting are internal and
organization like employees, external parties like
directors, managers, supervisors etc. creditors, shareholders,
customers etc.

Valuation of At cost Cost or Net Realizable

Stock Value, whichever is less.

Mandatory No, except for manufacturing firms Yes for all firms.
it is mandatory.

Time of Details provided by cost accounting Financial statements are

Reporting are frequently prepared and reported reported at the end of the
to the management. accounting period, which is
normally 1 year.

Profit Analysis Generally, the profit is analyzed for Income, expenditure and
a particular product, job, batch or profit are analyzed together

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 Chanderprabhu Jain College of Higher Studies
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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

BASIS FOR FINANCIAL

COST ACCOUNTING
COMPARISON ACCOUNTING

process. for a particular period of

the whole entity.

Purpose Reducing and controlling costs. Keeping complete record

of the financial
transactions.

Forecasting Forecasting is possible through Forecasting is not at all

budgeting techniques. possible.

Elements of Costing
The elements that constitute the cost of manufacture are known as the elements
of cost. Such element of cost is divided into three categories. In a manufacturing
concern, raw materials are converted into a finished product with the help of
labour and other service units. They are Material, Labour and Expenses.

Again, these elements of cost are divided into two categories such as Direct
Material and Indirect Material, Direct Labour and Indirect Labour, Direct
Expenses and Indirect Expenses.
All direct material, direct labour and direct expenses are added to get prime
cost. Likewise all indirect material, indirect labour and indirect expenses are
added to get overhead. Again, overhead is divided into four categories. They are
factory overhead, administration overhead, selling overhead and distribution
overhead.
(1) Material
(i) Direct Material
It refers to material out of which a product is to be produced or manufactured.
The cost of direct material is varying according to the level of output. For
example: Milk is the direct material of butter.
(ii) Indirect Material
It refers to material required to produce a product but not directly and does not
form a part of a finished product. For example: Nails are used in furniture. The
cost of indirect material is not varying in direct proportion of product.
(2) Labour
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An ISO 9001:2015 Certified Quality Institute
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(i) Direct Labour

It refers to the amount paid to the workers who are directly engaged in the
production of goods. It varies directly with the output.
(ii) Indirect Labour
It refers to the amount paid to the workers who are indirectly engaged in the
production of goods. It does not vary directly with the output.
(3) Expenses
(i) Direct Expenses
It refers to the expenses that are specifically incurred by the company to
produce a product. A product cannot be produced without incurring such
expenses. It varies directly with the level of output.
(ii) Indirect Expenses
It refers to the expenses that are incurred by the organization to produce a
product. But, these expenses cannot be easily found out accurately. For
example: Power used for production.
Overheads
It is the combination of all indirect materials, indirect labour and indirect
expenses.
(i) Factory Overhead
It is otherwise called Production Overhead or Works Overhead. It refers to the
expenses that are incurred in the production place or within factory premises.
For example: Indirect material, rent, rates and taxes of factory, canteen
expenses etc.
(ii) Administration Overhead
It is otherwise called Office Overhead. It refers to the expenses that are incurred
in connection with the general administration of the company. For example:
Salary of administrative staff, postage, telegram and telephone, stationery etc.
(iii) Selling Overhead
It refers to all expenses incurred in connection with sales. For example: Salary
of sales
department staff, travelers’ commission, advertisement etc.
(iv) Distribution Overhead
It refers to all expenses incurred in connection with the delivery or distribution
of goods and services from the producer to the consumer. For example:
Delivery van expenses, loading and unloading, customs duty, salary of
deliverymen etc.
Classification of Cost (Elements of Costs)
The elements of costs are classified as materials, labour, and expenses. These
three elements of cost would be grouped into direct and indirect categories.

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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Following are the three broad elements of cost.

(1) Material – direct (chargeable) and indirect
(2) Labour – direct and indirect
(3) Expense - direct and indirect
These elements in detail are as follows:
(1) Direct Material
It refers to the cost of materials that are conveniently and economically
traceable to specific units of output. E.g., raw cotton in textiles, crude oil to
make diesel, steel to make automobiles, components or parts, primary packing
materials, import duties, dock charges, and transport of raw materials.
(2) Direct Labour
It is defined as the labour of those workers who are engaged in the production
process. It is the labour expended directly upon the materials comprising the
finished goods.
(3) Direct Expense
It includes any expenditure other than direct material and direct labour directly
incurred on a specific product or job. E.g., cost of hiring special machinery or
plant, cost of special moulds, designs and patterns, experimental cost on models
and pilot schemes, fee paid to architects, surveyors, inward carriage and freight
on special materials, cost of patent, etc.
(4) Factory Overhead
Factory overheads are defined as the cost of indirect materials, indirect labour,
and indirect expenses.
(i) Indirect Material
It refers to materials that are needed for the completion of the product but whose
consumption with regard to the product is either so small or so complex that it
would not be appropriate to treat it as a direct material item. These materials
cannot be

conveniently assigned to specific physical units. E.g., lubricants, cotton waste,

hand tools, works stationery.
(ii) Indirect Labour
It includes foremen, shop clerks, general helpers, cleaners, material handlers,
plant guards, and maintenance men.
(iii) Indirect Expense
It covers all indirect expenditures incurred from the time production has started
to its completion and its transfer to the finished goods store. E.g., heat, light,
maintenance, factory and manager’s salary.
(5) Selling, Distribution and Administration Overhead Cost

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School of Law
An ISO 9001:2015 Certified Quality Institute
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Such expenses are generally incurred when the product is in saleable condition.
It includes advertising, salesmen salaries, commission, packing, storage,
transportation, and sales administrative costs.
(6) Fixed Cost
It is a cost that does not change in total for a given time period despite wide
fluctuations in the output or volume of activity. These costs are also known as
standby costs, capacity costs, or period costs. E.g., rent, property taxes,
supervising salaries, depreciation of office facilities, advertising, and insurance.
Classification of Fixed Cost
There are various classifications under fixed cost.
(i) Committed Cost
Such costs are primarily incurred to maintain the company’s facilities and
physical existence and over which management has little or no discretion. E.g.,
depreciation on
Plant & Machinery, taxes, insurance, rent etc.

(ii) Managed Cost

Such costs relate to the current operations which must continue to be paid to
ensure the continued operating existence of the company. E.g., staff and
management salaries.
(iii) Discretionary Cost
Such costs are also known as programmed cost. They are incurred due to special
policy decision, management programme, new research, or new system
development.
(iv) Step Cost
Such costs are constant for a given amount of output and then increase by a
fixed amount at a higher output level. E.g., one supervisor is required for a
salary of Rs.10000 per month for every 50 workers. The cost of supervisor
salary increases to Rs.20000 per month on employing the 51st worker.
(7) Variable Cost
Variable Cost varies directly and proportionately with the output. There is a
constant ratio between the change in the cost and the change in the level of
output. E.g., direct material, direct labour, and variable overheads (factory
supplies, indirect materials, sales commission, office supplies). If the factory is
shut down, variable costs are eliminated.
(8) Mixed Cost
Mixed Cost is made up of fixed and variable element. This cost is a
combination of semi-variable cost and semi-fixed costs. It fluctuates with
volume due to the variable component. However, due to the fixed component it

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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

does not change in direct proportion to output.

Semi-fixed cost is the cost which remains constant up to a certain level of
output after which it becomes variable.
Semi-variable cost is the cost which is basically variable but whose slope may
change abruptly when a certain output level is reached.
(9) Product Cost
Product cost is identified with the product and included in inventory values. In
other words, it is the cost included in the cost of manufacturing a product. It is
composed of four elements- direct materials, direct labour, direct expenses, and
manufacturing overhead.
(10) Period Cost
Period cost is not identified with the product or job and is deducted as expenses
during the period in which it is incurred. It is not carried forward as a part of
value of inventory to the next accounting period.
(11) Opportunity Cost
Opportunity cost is a cost of the opportunity lost. It is the cost of selecting one
course of action in terms of the opportunities that are given up to carry out that
course of action. It is the benefit lost by rejecting the best competing alternative
to the one chosen.
(12) Sunk Cost
Sunk cost is the cost that has already been incurred. It is generally unavoidable
because this cost cannot be changed once incurred. If the plant has a book value
of Rs.10 lakh and a scrap value of Rs.50000, then the sunk cost is Rs.9.5 lakh.
(13) Relevant Cost
Relevant cost is the future cost that differs between alternatives. It may also be
defined
as the cost which is affected and changed by a decision. It is not historic (sunk)
cost and is only incremental (additional) or avoidable cost.
(14) Differential Cost
Differential cost is the difference in total costs between any two alternatives. It
is equal to the additional variable expenses incurred with respect to the
additional output, plus the increase in the fixed costs, if any.

(15) Imputed Cost

It is the cost that is not actually incurred in some transaction but is relevant to
the decision as it pertains to a particular situation. E.g., interest on internally
generated funds, rental value of company owned property, and salaries of
owners.
(16) Out-of-Pocket Cost

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An ISO 9001:2015 Certified Quality Institute
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While imputed cost does not involve cash outlays, out-of-pocket cost signifies
the cash cost incurred on an activity. This cost concept is significant for the
management in deciding whether a particular project will at least return the cash
expenditure associated with the project or not.
(17) Shut Down Cost
It is a cost that has to be incurred under all situations, in case the manufacturing
of a product is stopped or a department or a division is closed down. It is a fixed
cost. It also refers to a minimum fixed cost that is incurred in the event of
closure.
Importance of Cost Accounting
Cost accounting has the following importance. Specially, the following parties
are benefitted from it.
(i) Importance to Management
Management is highly benefitted with the introduction of cost accounting. It
helps to ascertain the cost and selling price of the product. Cost data help
management to formulate the business policies. The introduction of budgetary
control and standard cost would be an aid to analyze cost.
It also helps to find out reasons for profit or loss. It provides data to submit
tender as well. Thus, cost accounting is an aid to management.
(ii) Importance to Investors
Investors want to know the financial conditions and earning capacity of the
business. An investor must gather information about organization before
making investment decision and investor can gather such information from cost
accounting.
(iii) Importance of Consumers
The ultimate aim of costing is to reduce the cost of production to minimize the
profit of business. Reduction in the cost is usually passed on the consumers in
the form of lower price. Consumers get quality goods at a lower price.
(iv) Importance to Employees
Cost accounting helps to fix the wages of the workers. Efficient workers are
rewarded for their efficiency. It helps to induce incentive wage plan in business.
(v) Importance to Government
Cost accounting is one of the prime sources to provide reliable data to internal
as well as external parties. It helps government agencies to determine excise
duty and income tax. Government formulates tax policy, industrial policy,
export and import policy based on the information provided by the cost
accounting.

Material Control

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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Meaning of Material Control

Material control is a systematic control over purchasing, storing and
consumption of materials, so as to maintain a regular and timely supply of
materials, at the same time avoiding overstocking.
Objectives of material control
Material control is basically aims at efficient purchase, storage and consumption
of materials.
The following are the major objectives of materials control.
(i) Efficient and uninterrupted production
To ensure better quality of materials at right quantity at right time for efficient
and uninterrupted production of output.
(ii) Cost of material at minimum level
To maintain the cost of materials at the minimum level.
(iii) Reasonable price
To purchase materials at a reasonable price.
(iv) Minimize handling cost
To minimize the handling cost and time in storing and using the materials.
(v) Update information of raw material
To provide information to the management about raw materials, their cost and
availability.
(vi) Protection of material
To protect materials against loss by fire, theft or leakage.
(vii) Avoid obsolescence
To avoid obsolescence of materials by adopting an appropriate method of
materials issue.
Steps in Material Control
The material control is guaranteed through laying down proper methods for
Storing, Purchasing, Issuing and minimizing material losses through identifying
slow moving, obsolete, dormant material and also through minimizing scrap,
wastages, spoilages and defectives. These steps are discussed below.
(i) Purchasing and Receiving
Purchase procedure different from business to business, but all of them follow a
usual pattern or technique. There should be an appropriate Purchase Procedure
to make sure that at right time right type of material is purchased, and that
should be in right quantity, at right place and at right prices.

(ii) Storing of Materials

Through the purchase department, the material purchased is sent to stores before

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 Chanderprabhu Jain College of Higher Studies
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School of Law
An ISO 9001:2015 Certified Quality Institute
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it is issued for production. So storing of material can be termed as an

intermediate step in the material control. there is no requirement for storing the
materials, If an organization practices Just in Time inventory system, if not
there is a requirement that there is a well-organized stores department in the
company which will take care of the storing material.
(iii) Issue Control
Other significant aspect of material control is the issue control. Material is
issued to production and greatest care is to be taken when issuing the material.
The first thing is that material should not be issued to any department with no
authorization. A Material
Requisition Note is prepared through the department that is in requirement of
the material and sent to the stores department. It is a written request created to
the stores department for sending the material. The details of the material
required like the quantity, quality, date through which it is needed etc, in the
Material Requisition Note.
(iv) Material Losses
One of the major reasons of increasing material costs is the loss of material
within the production process. It is of paramount significance that there should
be fixed control over the material losses failing that it will be very hard to keep
the material costs in check.
(v) Inventory Turnover Ratio
There are various items in the store that are slow moving the meaning of that is
they are issued to the production after a long time gap. A few items are like that
they are never issued to the production because they have become obsolete or
outdated and require to be disposed off. For make out these items, it is essential
to calculate the inventory turnover ratio. Inventory turnover ratio allows the
management to prevent the capital being locked in such types of items. This
ratio points out the inefficiency or efficiency by which inventories are
maintained.
Materials and Inventory
The primary difference is that raw materials inventory is used in the production
of goods and finished goods inventory is what the company produces and
eventually sells to a product reseller.
Fixation of inventory levels/Inventory management techniques
Fixation of inventory levels facilitates easy maintenance and control of various
materials in a proper way. However, following points should be remembered:
only fixation of inventory levels does not facilitate inventory control. A constant
watch on the actual stock level of materials should be kept so that proper action
can be taken in time. The levels which are fixed are not for permanent basis and

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 Chanderprabhu Jain College of Higher Studies
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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

are subject to regular revision.

The importance of effective inventory management is directly influenced by the
size of
investment in inventory. While the total ordering costs can be decreased by
increasing the order size. The carrying cost increases with the increase in order
size indicating the need for proper balancing of these two types of costs
behaving in opposite directions with changes in size of order. There are many
techniques of management of inventory. Some of them are as follows:
Re-order level/Re-order point
“When to order” is another aspect of inventory management. This is answered
by re-order point/re-order level. The re-order point/re-order level is that
inventory level at which an order should be placed to replenish the inventory.

To arrive at the re-order point/re-order level under certainty, details of the two
keys required are:
(a) Lead time
(b) Average usage
Lead time refers to the average time required to replenish the inventory after
placing orders for inventory.
Average usage is the average of the maximum usage and minimum usage in a
particular time period.
Re-order point/Re-order level = Lead time x Average usage
Under certainty, re-order point refers to that inventory level which will meet the
consumption needs during the lead time.
Economic Order Quantity (EOQ)
Economic Order Quantity (EOQ) refers to the optimal order size that will result
in the lowest ordering and carrying costs for an item of inventory based on its
expected usage, carrying costs and ordering cost.
EOQ model answers the following key quantum of inventory management.
(a) What should be the quantity ordered for each replenishment of stock?
(b) How many orders are to be placed in a year to ensure effective inventory
management?
(c) What order size will minimise the total inventory costs?
EOQ is defined as the order quantity that minimises the total cost associated
with inventory management.
EOQ is based on the following assumptions, as shown in figure below:
(i) Constant or uniform demand
The demand or usage is even throughout the period.
(ii) Known demand or usage

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 Chanderprabhu Jain College of Higher Studies
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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Demand or usage for a given period is known i.e. deterministic.

(iii) Constant unit price
Per unit price of material does not change and is constant irrespective of the
order size.
(iv) Constant carrying costs
The cost of carrying is a fixed percentage of the average value of inventory.
(v) Constant ordering cost
Cost per order is constant and is not affected by the size of the order.
Inventories can be replenished immediately as the stock level reaches exactly
equal to zero.
Constantly there is no shortage of inventory.
Following calculation are necessary before calculating the EOQ.
Total Inventory Cost = Ordering cost + Carrying cost
Total Ordering Cost = Number of orders X Cost per order =
Annual usage X Fixed cost per order / Quantity ordered
Total Carrying Cost = Average level of inventory X Price per unit X Carrying
cost (as a percentage)
Economic Order Quantity is represented using the following formula:
EOQ = √2AO/C
Where,
EOQ = Economic Order Quantity
A = Annual usage or demand of raw material
O = Ordering cost per order
C = Carrying cost per unit per annum
Minimum Level
Minimum level is that level below which stock of inventory should not
normally fall. In other words it is the level below which inventory should never
drop. This number is 0 only if backorders are not permitted. It is determined by
calculating the estimated amount of time from the beginning of production,
through the time of transit, to the
point at which the product is either “on the shelf” or in the hands of the
customer who ordered it. It is also called the minimum stock level.
Minimum level = OL – (NRC x NLT)
Where, OL = Ordering level
NRC = Normal rate of consumption (Maximum consumption-Minimum
consumption)
NLT = Normal lead time (Maximum lead time-Minimum lead time)
Maximum Level
Maximum level is that level above which stock of inventory should never rise.

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 Chanderprabhu Jain College of Higher Studies
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School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Maximum level is fixed after taking into account the following factors.
(a) Requirement and availability of capital
(b) Availability of storage space and cost of storing
(c) Keeping the quality of inventory intact
(d) Price fluctuations
(e) Risk of obsolescence
(f) Restrictions, if any, imposed by the government
Maximum Level = Ordering level – (MRC x MDP) + standard ordering
quantity
Where, MRC = minimum rate of consumption
MDP = minimum lead time.
Danger Level
Danger level is a level of fixed usually below the minimum level. When the
stock reaches danger level, an urgent action for purchase is initiated.
Danger Level = Normal consumption x Maximum re-order period for
emergency purchase

Illustration: Daily consumption = 100 to 200 units

Maximum re-order period for emergency purchase = 5 days
Calculate Danger level.
Solution: Danger Level = Normal consumption x Maximum re-order period for
emergency purchase
= 150x5 = 750 units.
Techniques of Material/Inventory Control
(i) Economic order quantity
Economic order quantity, or EOQ, is a formula for the ideal order quantity a
company needs to purchase for its inventory with a set of variables like total
costs of production, demand rate, and other factors.
The overall goal of EOQ is to minimize related costs. The formula is used to
identify the greatest number of product units to order to minimize buying. The
formula also takes the number of units in the delivery of and storing of
inventory unit costs. This helps free up tied cash in inventory for most
companies.
(ii) Minimum Order Quantity
On the supplier side, minimum order quantity (MOQ) is the smallest amount of
set stock a supplier is willing to sell. If retailers are unable to purchase the MOQ
of a product, the supplier won’t sell it to you.
For example, inventory items that cost more to produce typically have a
smaller MOQ as opposed to cheaper items that are easier and more cost

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 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

effective to make.
(iii) ABC Analysis
This inventory categorization technique splits subjects into three categories to
identify
items that have a heavy impact on overall inventory cost.

Category A serves as your most valuable products that contribute the most to
overall profit.
Category B is the products that fall somewhere in between the most and least
valuable.
Category C is for the small transactions that are vital for overall profit but don’t
matter much individually to the company altogether.
(iv) VED Analysis
VED Analysis is an inventory management technique that classifies inventory
based on its functional importance. It categorizes stock under three heads based
on its importance and necessity for an organization for production or any of its
other activities. VED analysis stands for Vital, Essential, and Desirable.
(v) FSN
FSN stands for fast-moving, slow-moving and non-moving items. Essentially,
this segments inventory into three classifications. It looks at quantity,
consumption rate and how often the item is issued and used.
(vi) Just-in-Time Inventory Management
Just-in-time (JIT) inventory management is a technique that arranges raw
material orders from suppliers in direct connection with production schedules.
JIT is a great way to reduce inventory costs. Companies receive inventory on an
as-needed basis instead of ordering too much and risking dead stock. Dead
stock is inventory that was never sold or used by customers before being
removed from sale status.
(vii) Safety Stock Inventory
Safety stock inventory management is extra inventory being ordered beyond
expected demand. This technique is used to prevent stockouts typically caused
by incorrect forecasting or unforeseen changes in customer demand.

(viii) FIFO and LIFO

LIFO and FIFO are methods to determine the cost of inventory. FIFO, or First
in, First out, assumes the older inventory is sold first. FIFO is a great way to
keep inventory fresh.
LIFO, or Last-in, First-out, assumes the newer inventory is typically sold first.
LIFO helps prevent inventory from going bad.

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 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Methods of valuing material issues

In management accounting, there are various methods to value closing
inventory and issues from stores.
The three main inventory valuation methods are
(i) FIFO (First-in, First-out)
Materials are issued out of stock in the order in which they were delivered into
inventory, i.e. issues are priced at the cost of the earliest delivery remaining in
inventory.
This is a logical pricing method but can be cumbersome to operate since each
batch of material has to be identified separately
(ii) LIFO (Last-in, First-out)
The last items of material received are the first items to be issued. LIFO is not
accepted for financial accounting purposes (IAS 2).
The items remaining in inventory are the first which were produced or
purchased.
(iii) Cumulative Weighted Average Cost
AVCO (Average cost) calculates a weighted average price for all units in
inventory. Issues are priced at this average cost, and the balance of inventory
remaining would have the same unit valuation. A new weighted average price is
calculated whenever a new delivery of materials into store is received.
Hence, fluctuations in prices are smoothed out, making it easier to use the data
for decision making

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