Chapter 3

Accounting for material

Concept of Material / Inventory
Material is the first and most important element of cost.
Material means any commodity or substance which is processed in
a factory in order to be converted into finished product. Materials
may be raw material, components, tools, spare parts, consumable
stores etc. Materials include both DIRECT AND INDIRECT
materials. Direct and indirect materials purchased for stock
purposes, to be issued to different jobs, work orders or
departments as when required are known as sock or inventory .
 Types of inventory
1. Raw material:-Raw material is a very important factor of
production .it includes physical commodities used to manufacture
the final product.

2. work in progress:-Work in progress inventories are those

material or goods which are partially worked but not fully
completed as goods.

3. Finished goods:-Stock of goods which are ready for sell are

called finished stock or finished goods.
 Reason of Holding material
1.Transaction motive

2. Precautionary motive

3. Speculative motive
 Meaning of inventory control
A manufacturing company requires many types of material to
produce any goods or render services. If a company does not get
the required material as needed then the production system will get
disturbed and fail to produce and sale required quantity of products
on time. The over stock of inventory is unsuitable due to large
amount of investment on it as well as other cost associated with it.
On the other hand, lower stock of inventory might create the
problems of shortage resulting in the disturbance on production.
 Importance or objectives of inventory control
1) AVAILABILITY OF MATERIALS : There should be availability of all
types of materials in the factory so that the production may not held up for
the want of materials.
2) NO EXCESSIVE INVESTMENT IN MATERIALS : There should not be
excessive investment in materials. Overstocking must be avoided. Investment
must not tied up funds ,that could be better used in other activities.
3) REASONABLE PRICE : while purchasing it is seen that it is purchased at
low prices. But quality should not be sacrificed at the cost of lower price.
4) MINIMUM WASTAGE : There should be minimum possible wastage of
materials while these are being stored in godowns or used in factory. It
should be allowed upto certain level known as normal wastage.
 Cont..
5) NO RISK OF SPOILAGE OR OBSOLESCENCE : In order to avoid spoilage or
obsolescence , maximum quantity of each material is determined and proper
method of issue of materials is followed.
6) READY INFORMATION ABOUT AVAILABILITY OF MATERIAL : The
shopkeeper can supply the information because he keeps an up to date record of
every item of stocks under a proper system of material control.
7) RMIDUCE MISAPPROPRIATION OF MATERIAL : Material can easily be
misappropriated by employees. Therefore, this requires an internal check on
materials which is a part of material control.
8) RIGHT AMOUNT OF PAYMENT TO SUPPLIERS : Invoices received from
supplies should be approved for payment only if items of materials ordered have
been received and properly checked to avoid excess payment to supplies.
 Essential for material control
There should be proper coordination and cooperation among
departments involved in purchasing, receiving and inspection, storage
, sales, production and accounting department.
1. Purchases of materials should be centralized.
2 There should be proper scheduling of materials.
3 A good method of classification of materials should be followed.
4 there should be proper inspection of materials when they are
received by the receiving department.
Technique of inventory control
A) Economic order quantity
B) stock level
Reorder level
Maximum stock level
Minimum stock level
Average stock level.
Safety Stock level.
Danger stock level
.

 C) Just in time purchase

 D) Perpetual inventory System
 E) ABC analysis
 Types of inventory cost
1.Cost of purchase or material purchase price.
2. Holding costs /carrying cost
3. Ordering costs
 Cost of purchase / acquisition cost
The cost price of material is the cost at which materials are
purchased from the supplier or seller for annual requirement. In
case of discounts, received from suppliers total acquisition cost will be
calculated after deducting discount .
Which is calculated as ;
Total purchase price of inventory = Annual requirement X purchase price per unit

For example :- if total annual requirement of material is 10000 units at Rs. 10 per unit.
So total acquisition cost will be ( 10000units * 10 per unit )
Rs. 100000
 Holding Cost
Holding costs are also known as carrying costs as it is incurred while holding the inventory in a
warehouse or a store.
For example.
1. rent of storage
2. loss in store , damage
3. deterioration,
4. obsolescence,
5. Insurance of store
6. property tax etc.
7. Interest on investment in inventory / opportunity cost
The total holding cost usually depends upon the size of the order placed for inventory. Mostly,
the larger the order size, the higher the annual holding cost and vice versa.
 Ordering costs
Whenever a company places an inventory order with the supplier the cost which incurs is
known as ordering costs. The total cost will vary as it is dependent upon the frequency of placing
orders. For example
 Telephone expenses ,fax , email charge for order of material
 Set up cost
 Transportation and Shipping charge or delivery charges,
 Clerical and administration cost for purchasing dept.
 Cost of inspection for material control
 payment processing charges,
The total ordering cost usually varies according to the frequency of placing orders. If the
number of orders placed during the year increases, the annual ordering cost will also increase and
if, the number of orders placed during the year decreases, the annual ordering cost will also
decrease.
 Economic order quantity (EOQ)

Economic order quantity (EOQ) is that order size which

minimizes the sum of ordering cost and holding(storage) costs
related to raw materials or merchandise inventories. In other words,
it is the optimal inventory size that should be ordered with the
supplier to minimize the total annual inventory cost of the business.
It also called optimal order quantity and optimal order size.
Assumptions for economic order quantity
Annual requirement of material should be certain.
The ordering cost per order should b fixed and known.
The carrying cost per unit should be fixed and known
Carrying cost always calculated on average inventory
The Purchase price of material should be constant throughout the

year and known

Demand of the inventory should be uniform throughout the year
 it is not used for seasonable goods that means material should be

available in market throughout the year or there is no any shortage

of material
Determination of Economic Order Quantity
 Formula method
 Trial and error method or Tabular method
 Graphic method
Formulas
Illustrations
 The following information is provided by a company
 Yearly Requirements (A) 32000 units
 Cost price per unit (PP) Rs 20
 Ordering cost per order (O) Rs 500
 Carrying cost (C) 10% of average inventory value
20*10% =2 % of
carrying should be calculated from cost per unit. But if cost per unit is
unknown at that time it should be assumed Re 1.

 Required a) Economic order quantity(EOQ)

b) No. of order
c) Length of inventory cycle (assume 360 days in a year)
d)Total cost at EOQ
Solution:-
Trial and error method or Tabular method
 Under this approach the total cost is calculated under different
order size. the economic order quantity is that inventory level
that minimize the total of ordering and carrying cost . under
this approach we prepare a table and try to find out the total
cost at different order size.
 Graphic method
Under this method ,the carrying cost ,ordering cost and total
cost are shown in graph. Cost data are plotted on y –axis and
quantity on X-axis. It is based on the principle that the total
carrying cost increase as the order size increase. However, the
ordering cost decrease as the order size increase. The ordering cost
curve slopes down from the left to the right but the carrying cost
curb slopes upward from left to right as the carrying cost increases
with the no of order. The point where ordering and carrying cost
curve intersect each other. Total cost is minimum the point is
called economic order point.
 Carrying cost

c
o
s
t

Ordering cost

Order quantity
E.O.Q.
In the above graph where the ordering and carrying cost are equal at point ‘M’ so that
order quantity under that is regarded as economic order quantity
Stock level
 RE-ORDER LEVEL
It is the point at which if stock of a particular material in store approaches, the
storekeeper should initiate the purchase requisition for fresh supplies of that material.
it is fixed by taking into account as abnormal use of material, unexpected delay in
purchasing the material etc. In such a way that difference in quantity of the material
between re ordering level and the minimum level will be sufficient to meet the
requirements of production up to the time of fresh supply of material is received.
Formula
Re order level = Daily consumption x Lead time
or
Re order level = Daily consumption x Lead time +Safety Stock
or
Re order level = Maximum consumption x Maximum Lead time
 MAXIMUM STOCK LEVEL
it is peak level the material in the stock . it represents the maximum
quantity of an item of a material which can be held in stock at any time. Stock
should not exceed this quantity. This level is fixed so that there be no
overstocking. Overstocking unnecessarily blocks working capital . also increase
the cost due to the requirement of more space in godown . There may be more
chance of having obsolescence and deterioration of material.
Formula
Maximum stock level = re-ordering level + re-ordering quantity - ( minimum consumption x minimum re-order period )
 MINIMUM(SAFETY) STOCK LEVEL
This represents the minimum quantity of the material
which must be maintained in hand all the times. It is fixed so that
production may not up due to shortage of the material. It is also
called buffer stock or safety stock level.
Formula

Minimum stock level = Re-ordering level – (normal consumption x normal reorder period )

Normal consumption = Maximum consumption + Minimum consumption

2

Normal Lead time = Maximum lead time + Minimum lead time

2
 Average stock level
Average stock level refer the normal or moderate stock level.
Average stock level is equal to stock at the beginning of the period
plus stock at the ending of the period divided by two. It represents the
investment a business has made in inventory.

Average stock level = minimum stock level + maximum stock level

2
OR
Average stock level = Minimum stock level + ½ of re-order quantity
 Safety stock level
Safety stock is the additional inventory that is held by a
company to mitigate risk of stock outs, caused by fluctuations
in supply and demand.

Safety stock = daily consumption x Required time

 DANGER LEVEL
This means a level at which a normal issue of the material are stopped
and issues are made only under specific instructions. The purchase officer will
make special arrangements to get the materials which reach at their danger levels
so that production may not stop due to shortage of material.
Formula

Danger stock level = Average consumption x maximum re-order period for emergency situations
Illustration

(g) Maximum for emergency period 4 days

= 2700 units
(v)Danger stock level = Normal consumption X Maximum emergency period
=300 x 4
=1200 units
 JUST IN TIME PURCHASING
Just in time purchasing is the purchase of material or goods in
such a way that delivery of purchased items is assured before their
use or demand. Just in time purchasing recognizes too much
carrying cost associated with holding high inventory levels.
Therefore, it advocates good relations with suppliers and making
timely purchases from proven suppliers who can make ready
delivery of goods available as and when required. It advocates a
different quantity for each order if demand fluctuates.
 ABC ANALYSIS
An organization found it useful to divide materials into three categories for the purpose of
exercising selective control on materials. An analysis of material cost will show that a smaller
percentage of items of material in the store may contribute to the large percentage of value of
consumption and vice versa. It exercises discriminating control over different items of stores
classified on the basis of investment involved. Usually they are divided into three categories
according to their value and frequency of replenishment. It is also known as VALUE METHOD or
ALWAYS BETTER CONTROL METHOD or PROPORTIONAL OARTS VALUE ANALYSIS
METHOD. “ A ’’ category of items consists of small percentage i.e. about 10% of total items
handles by the stores but requires heavy investment about 70% of inventory value because of their
high price or heavy requirement or both. “ B ’’ category of items are relatively less important20% of
the total items of material handled by the store and % of investment required is about 20% of total
investment in inventories. “ C ’’ category include- 70% of total items handled and 10% of value
 Perpetual inventory System
It is a system of records maintained by the controlling
department which reflects the physical movement of stocks and
their current balance. Bin cards and store ledger helps the
management in maintaining this system as they make record of
physical movements of stocks. It is a system of ascertaining
balance after every receipt and issue of materials through stock
records to facilitate regular checking. To ensure the accuracy of
perpetual inventory records, physical verification of stores is made
by the program of continuous stocking.