voruganty cost and management accounting: CHAPTER FOUR : MATERIAL COSTING

CHAPTER FOUR : MATERIAL COSTING

Introduction

In this chapter we will learn about the control and valuation of inventory (stock). Stock represents a major investment for many organisations, not only in terms of the capital invested in the stock itself but also in terms of the cost of the space it occupies, the cost of insuring and keeping it safe and so on.

CONTROLLING THE LEVEL OF INVENTORY (STOCK)

The need for inventory (stock)

There are many different forms of stock but essentially stock is either used within an organisation to enable it to operate efficiently or it comprises items for resale.

Irrespective of the use of the item of stock it is important not to run out because this will either result in inefficiency within the organisation or in lost sales or even loss of customers to competing organisations. However, the solution is not to hold huge stocks, except perhaps when a price rise is anticipated. Stockholding is costly in terms of storage space, insurance, security and risk of obsolescence, as well as storekeeper’s wages and salaries. In addition, the holding of stock must be thought of as an investment of money which, therefore, cannot be used to earn further income.

The solution lies in maintaining a level of stock sufficient to meet the needs of the organisation, having regard to the costs both of holding stock and of the procurement process.

A system of control levels

One technique to ensure that stock is held at an optimum level is to use a series of control levels for each stock item. These levels are based on an analysis of past stock usage and delivery (or lead) times. For each of these, minimum, maximum and average values are collected (usually measured in days, but any time period may be used), and from these a number of control levels are calculated.

Before we look at the stock-control formulae and their application, we will need to

consider the concept of the free stock balance. This is a notional, not physical, balance which helps to ensure that stock-outs do not occur.

Free stock balance = Physical stock + Stock on order with suppliers - Outstanding requirements unfulfilled

For example, suppose that the physical stock balance is 1,750 units, 27,500 units are on order with the supplier but have not yet been received, and material requisitions not yet fulfilled amount to 16,250 units. The free stock balance is:

1,750 + 27,500 - 16,250 = 13,000 units

The free stock balance is usually the balance that is monitored to determine when a new order should be placed. Now we will look at the formulae for the various stock control levels.

(a)The reorder level is the level of free stock at which an order should be placed for replacement stock. It is set so that, at least in theory, it is not possible to run out of stock.

Reorder level = Maximum usage x maximum lead time

(b) The minimum level is a warning level which signals to management that stock is falling to unacceptably low levels. Since this level is below the reorder level, an order should already have been placed. Management should progress the order to reduce the possibility of a stockout.

Minimum level = Reorder level - (average usage x average lead time)

( c) The maximum level is a warning level which signals to management that stock is rising to unacceptably high levels. This level should be exceeded only if delivery time or usage is actually less than that used in the original calculations. If this occurs frequently, the data used in the calculations should be reviewed.

Maximum level = Reorder level + reorder quantity - (minimum usage x minimum lead time)

( d) The reorder quantity is the predetermined amount of stock which is ordered when the reorder level is reached. If it represents the order size which minimises the total of ordering ( procurement) costs and stockholding costs, it is referred to as the economic order quantity (EOQ). The EOQ is derived by examining the combined costs of ordering stock and holding stock. The higher the quantity we order each time, the fewer orders we need to place in a year, which means that ordering costs are reduced. On the other hand, holding costs increase if we order large quantities each time. This is because the average stock level is high, leading to an increased need for warehouse space, increased finance charges on the money tied up in stocks, etc. The mathematical technique of differentiation enables us to calculate the optimum order quantity, being the quantity which minimises the total of these two cost elements.

The formula for the EOQ is as follows:

i.e. EOQ = Square root of ( ( 2 x total demand for the period x cost per order ) ÷ (Holding cost per unit) )

= Square Root of [(2 x Total Demand for the period x Cost per order ) ÷ (Holding cost per unit)]

Using the control levels: a worked example

The following example illustrates the calculation of the stock levels.

The data below relate to an item of raw material:

Usage per day 250 units

Minimum lead time 20 days

Maximum lead time 30 days

Cost of ordering material GMD300 per order

Carrying costs GMD1.40 per unit per year

Note: Assume that each year consists of 240 working days.

You are required to calculate:

( i) the reorder level;

(ii) the economic order quantity;

(iii) the maximum level;

(iv) the minimum level.

Solution

( i) The reorder level is given by:

Maximum usage per day x maximum number of days’ delivery time

= 250 x 30 = 7;500 units

(ii) The economic order quantity is given by:

EOQ = Square root of ( (

2 x 300 x (240 x 250) ÷1.4) ) = 5,070 units

*Annual demand = 250 units x 240 working days

(iii) The maximum level is given by:

Reorder level + reorder quantity (minimum usage per day x minimum lead time

= 7,500 + 5,070 - 5,000 = 7,570 units

(iv) The minimum level is given by:

Reorder level _ (average usage _ average lead time)

= 7,500 - (250 x 25*)= 1,250 units

*Average lead time = (20 + 30) ÷ 2

The disadvantage of the control level system is that it requires control levels to be set and then monitored for each item of stock to ensure that there has not been a significant change in the factors determining the stock levels. This is a time-consuming exercise but the task is made easier with the assistance of computers.

Pareto’s law

Pareto’s law is also referred to as the 80/20 rule. It represents an analysis of a frequency distribution comparing value and number of items. It can be applied to stock control because in many organisations 80 per cent of the value of stock will be represented by just 20 per cent of the items.

VALUATION OF INVENTORY (STOCK) AND MATERIALS ISSUED

The basic principle

The valuation of stock, although a cost accounting function, is required for financial accounting too, and you should be aware that the regulations concerning the valuation of stock which apply to financial accounting may be a significant influence in determining the valuation method used. The general principle is that stock should be valued at cost. The definition of cost can be fairly complex, particularly in the case of internally manufactured items.

For bought-in items, cost is defined as the cost of purchase together with any additional costs necessary to the acquisition. Some items that can cause complications are detailed below:

- Carriage and storage costs. If the purchaser is required to pay these costs, then they can be included as a part of the cost of the goods.

- Value added tax (VAT ). This is an amount added to the purchase price of goods. It can usually be reclaimed. If this is the case then the VAT does not represent a cost and it must be excluded from the purchase price.

- Cash discount. This is a discount which may be given for early payment of an invoice. Cash discounts are not usually included in the cost accounts. They are regarded as a financial accounting item.

- Trade discount. This is a reduction in the unit price which is given to some customers. It is often given as a ‘reward’ for ordering large quantities. For example, the unit price of an item may be GMD10 but a 5 per cent discount is offered for purchases of more than 50 units. For orders of 50 units or less the unit price would be GMD10 but for orders of more than 50 units the unit price shown in the stock records would be GMD9.50.

First in, first out (FIFO)

This method assumes for valuation purposes that the items received earliest are those which are issued first. This does not necessarily mean that these are the items which have physically been issued first.

Last in, first out (LIFO)

This method assumes for valuation purposes that the latest price paid for items received is the one to be used to price issues.

Cumulative weighted average (AVCO)

This method calculates a weighted average price each time there is a receipt.

Examples:
1. Transactions during May 2009

	Units	Unit Cost (GMD)	Total Cost (GMD)	Market Value per unit on date of transaction
Opening balance 1 May	100	2.00	200
Receipts 3 May	400	2.10	840	2.11
Issues 4 May	200			2.11
Receipts 9 May	300	2.12	636	2.15
Issues 11 May	400			2.20
Receipts 18 May	100	2.40	240	2.35
Issues 20 May	100			2.35
Closing balance 31 May	200			2.38

Required:
How would issues and closing stock be valued using:

(a) FIFO

(b) LIFO

Answer:
FIFO Method

Date of Issue	Quantity Units	Value Issued GMD	Cost of Issues
Date of Issue	Quantity Units	Value Issued GMD	GMD	GMD
4 May	200	100 o/s @GMD2 100 o/s @GMD2.10	200 210	410
11 May	400	300@GMD2.10 100 @ GMD2.12	630 212	842
20 May	100	100 @ GMD2.12		212
Value of Stock Issue				1,464
Closing stock value	200	100 @ GMD2.12 100 @ GMD2.40	212 240	452
				1,916

LIFO Method

Date of Issue	Quantity Units	Value Issued GMD	Cost of Issues
Date of Issue	Quantity Units	Value Issued GMD	GMD	GMD
4 May	200	200 o/s @GMD2.10		420
11 May	400	300@GMD2.12 100 @ GMD2.10	636 210	846
20 May	100	100 @ GMD2.40		240
Value of Stock Issue				1,506
Closing stock value	200	100 @ GMD2.00 100 @ GMD2.10	200 210	410

Average Cost Method

	Units	Unit Cost (GMD)	Total Cost (GMD)	Average Unit Cost (GMD)	Value of Issue (GMD)
Opening balance 1 May	100	2.00	200	2.00
Receipts 3 May	400	2.10	840	(200+840) / 500 = 2.08
Issues 4 May	200			2.08	200 x GMD2.08 = 416
Receipts 9 May	300	2.12	636	((300 x 2.08) + 636) / 600 = 2.10
Issues 11 May	400			2.10	400 x 2.1 = 840
Receipts 18 May	100	2.40	240	((200 x 2.1) + 240) / 300 = 2.20
Issues 20 May	100			2.20	100 x 2.2 = 220
Closing balance 31 May	200			2.20	440

Value of Stock Issued = GMD (416 + 840+ 220) = GMD1,476

Closing Stock Value = GMD440

Points to note about the different inventory (stock) valuation methods include the

following.

- The values for AVCO in the table lie between those for LIFO and FIFO. This should always occur because AVCO is an averaging method.

- Both LIFO and FIFO require records to be kept of each batch of purchases so that the appropriate price may be attached to each issue.

- Price fluctuations are smoothed out with the AVCO method which makes the data easier to use for decision making, although the rounding of the unit value might cause some difficulties.

- Many management accountants would argue that LIFO provides more relevant

information for decision making because it uses the most up-to-date price.

- However LIFO may sometimes confuse managers, since the pricing method represents the opposite to what is happening in reality, that is, the stock will probably be physically issued on a FIFO basis.

The overriding consideration for the internal cost accounting system is that the

information should be useful for management purposes.

Stock valuation and the effect on profit

An important point to realize is that, since each of the stock valuation methods produces a different stock valuation, the profit reported under each of the methods will be different. An example will help you to see the difference.

Example

Continuing with the above example, suppose that the units issued from stock are sold direct to the customer for GMD3 per unit. The gross profit recorded under each of the stock valuation methods would be as follows.

	FIFO (GMD)	LIFO (GMD)	Average Cost (GMD)
Sales (700 units@GMD3)	2,100	2,100	2,100
Less COS
Opening Stock	200	200	200
Purchases (GMD840+636+240)	1,716	1,716	1,716
Less Closing Stock	(452)	(410)	(440)
	(1,456)	(1,506)	(1,476)
Gross Profit	644	594	624

The prices of receipts are rising during the month. Therefore the FIFO method, which prices issues at the older, lower prices, results in the highest value of closing stock and the highest profit figure. The AVCO method produces results that lie between those for FIFO and LIFO.

Summary

The main points that you should understand are as follows.

1. The free stock balance is usually the balance that is monitored to determine when a new order should be placed. It takes account of the stock on order from suppliers and the outstanding requirements not yet fulfilled.

2. The economic order quantity is the order quantity which minimises the total costs associated with ordering and storing stock.

3. Continuous stocktaking involves counting the stock of a number of items on a

random basis throughout the year so that each item is counted and checked against stock records at least once each year.

4. A perpetual inventory system records each receipt and issue of stock as it occurs.

5. The pricing of issues from stock has a direct effect on cost of sales, stock valuations and reported profits.

6. The FIFO method prices issues at the price of the oldest items remaining in stock.

7. The LIFO method prices issues at the price of the items in stock that were received most recently.

8. The weighted average method uses an average price that can be calculated using two different bases: the cumulative weighted average and the periodic weighted average.

PRACTICE QUESTIONS

1. ABC Ltd is a small importing company. On 1 November, it had an opening balance of 50 units of commodity X, valued at GMD900. On 12 November, it purchased in bulk a further 250 units of commodity X for a gross price of GMD5,000.

It received a bulk purchase discount of 5 per cent and a further discount of 3 per cent on the gross price for making an early cash payment. On 29 November, it sold 200 units of commodity X for a sales value of GMD6,600. Using the FIFO method of valuation, the gross profit in the company’s trading account for November for the sale of commodity X was:

(A) GMD2,700

(B) GMD2,790

(D) GMD2,940

2 P Ltd had an opening stock value of GMD2,640 (300 units valued at GMD8.80 each) on 1 April. The following receipts and issues were recorded during April:

10 April Receipt 1,000 units GMD8.60 per unit

23 April Receipt 600 units GMD9.00 per unit

29 April Issues 1,700 units

Using the LIFO method, what was the total value of the issues on 29 April?

(A) GMD14,840

(B) GMD14,880

(D) GMD15,300

3 A firm has a high level of stock turnover and uses the FIFO issue pricing system. In a period of rising purchase prices, the closing stock valuation is:

(A) close to current purchase prices.

(B) based on the prices of the first items received.

(D) the average of all goods purchased in the period.

4 Using the FIFO system for pricing stock issues means that, when prices are rising:

(A) product costs are overstated and profits understated.

(B) product costs are kept in line with price changes.

(D) product costs are understated and profits overstated.

5 During a period of rising prices, which one of the following statements is correct?

(A) The LIFO method will produce lower profits than the FIFO method, and lower

closing stock values.

(B) The LIFO method will produce lower profits than the FIFO method, and

higher closing stock values.

closing stock values.

(D) The FIFO method will produce lower profits than the LIFO method, and

higher closing stock values.

6 There are 27,500 units of Part Number X53 on order with the suppliers and 16,250 units outstanding on existing customers’ orders. If the free stock is 13,000 units, what is the physical stock?

(A) 1,750 units.

(B) 3,250 units.

(D) 29,250 units.

7. A component has a safety stock of 500, a reorder quantity of 3,000 and a rate of demand which varies between 200 and 700 per week. The average stock is approximately:

(A) 2,000 units.

(B) 2,300 units.

(D) 3,500 units.

8. The economic order quantity is:

(A) the order quantity which minimises the total of stock ordering and holding

costs.

(B) the order quantity used for special ordering purposes.

(D) the order quantity used to avoid stock-outs.

9. Is the following statement true or false?

The minimum level is the level of free stock at which an order should be placed for replacement stock. True OR False

10. Opening stock for a particular component at the beginning of April was zero. The following receipts and issues were recorded during April.

April 1 Received 100 components at a price of GMD6.00 each

April 2 Issued 30 components

April 8 Received 30 components at a price of GMD6.50 each

April 10 Issued 60 components

April 15 Received 100 components at a price of GMD6.50 each

April 16 Issued 40 components

The weighted average pricing method is used.

Complete the following.

The total value of the components issued on April 10 was GMD .

The cost per component issued on April 16 was GMD .

11. In a period of rising prices, which of the following statements are true?

(a) Reported profits will be higher with FIFO than with LIFO.

(b) The value of closing stock will be higher with FIFO than with LIFO.

12. BB imports product U and sells the product to retail customers at a price of GMD14 per case. BB had no stock at the beginning of February and during February the following receipts and sales were recorded.

6 February Received 1,400 cases @ GMD8.20 per case

15 February Received 900 cases @ GMD9.10 per case

20 February Sold 780 cases

22 February Received 330 cases @ GMD9.90 per case

28 February Sold 860 cases

(a) Using the FIFO method of stock valuation, the gross profit reported for February would be GMD .

(b) Using the LIFO method of stock valuation, the gross profit reported for February would be GMD .

13. The following are the stock movements of a new stock item RK21:

Receipts Issues

(units) (units)

01 April 2,000 at GMD6 each

06 April 3,000 at GMD7 each

12 April 3,000 at GMD7.50 each

17 April 5,000

24 April 4,000 at GMD8.00 each

27 April 5,000

There was no opening stock.

REQUIRED

a) Prepare stock cards for stock item RK21 showing the value of each of the two issues and the value of closing stock using EACH of the following stock pricing methods:

i FIFO

ii LIFO

iii AVCO [15]

b) Explain the term perpetual inventory. [5]

14. The following are the stock movements of stock item A1:

Receipts Issues

(units) (units)

01 May 2,000 at GMD10 each

05 May 3,000 at GMD11 each

12 May 3,000 at GMD11.50 each

15 May 2,500

24 May 2,000 at GMD12 each

27 May 6,500

There was no opening stock.

REQUIRED

a) Prepare stock cards for stock item A1, showing the value of each of the two issues and the value of closing stock using EACH of the following stock pricing methods:

i FIFO ii LIFO

iii AVCO [15]

b) Outline the principal benefits of perpetual inventory. [5]

15. The following are the stock movements for stock item J5:

Receipts Issues

01 Jan. 1,500 at GMD5.00 each

07 Jan. 2,000 at GMD5.50 each

10 Jan. 2,500

28 Jan. 2,000 at GMD6.00 each

02 Feb. 2,500

There was no opening stock.

REQUIRED

a) Prepare stock cards for item J5, showing the value of each of the issues, and the value of closing stock using EACH of the following stock pricing methods:

i FIFO

ii LIFO

iii AVCO [15]

b) Explain the importance of setting the appropriate stock levels.[5]

16. The following are the stock movements of stock item R2:

Receipts Issues

(units) (units)

01 April 1,000 at GMD12 each

04 April 2,000 at GMD14 each

11 April 3,000 at GMD15 each

13 April 2,000

22 April 2,000 at GMD15 each

26 April 5,500

There was no opening stock.

REQUIRED

a) Prepare stock cards for stock item R2, showing the value of each of the two issues and the value of closing stock using EACH of the following stock pricing methods:

i FIFO ii LIFO

iii AVCO [15]

b) Explain the benefits of using a computerised stock control system.[5]

voruganty cost and management accounting

Saturday, 12 October 2013

CHAPTER FOUR : MATERIAL COSTING

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