CHAPTER 4: ACCOUNTING FOR MATERIAL COSTS AND INVENTORY MANAGEMENT
Inventory classification:
1. 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.
2. Work in progress(WIP) refers to partly made products. They have progressed from the bought in
stage (raw materials) but are not yet complete.
3. Finished goods are complete and are ready for sale.
NB: Movement of materials: raw materials – WIP – finished goods
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. Wood in a table etc.
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, screws, bolts, nails
Question 1
In a factory making chairs, there are four types of material:
1. Wood
2. Glue
3. Polish
4. Fabric for covering the chair
Which would be classified as direct and indirect material?
A Direct: 1 and 2; indirect 3 and 4
B Direct: 1 and 4; indirect 2 and 3
B Direct: 2 and 3; indirect 1 and 4
D Direct: 1 and 3; indirect 2 and 4
Question 2
Which double entry records the movement of raw material to work-in-progress?
A Cr. WIP; Dr. Raw material
B Dr. Purchases; WIP
C Dr. WIP; Cr Raw material
D Cr. Raw material; Dr. Finished goods
NB: The costing department determines the cost or value of the materials using the inventory valuation
techniques/methods to be discussed below.
Question 3
What document shows the amount due to a supplier for goods bought?
A Purchase invoice
B Purchase requisition
C Goods received note
D Purchase order
Question 4
Which of the following sets out the sequence of steps in a purchases transaction?
A Purchase order; purchase requisition; goods received note; purchase invoice
B Purchase order; purchase requisition; purchase invoice; goods received note
C Purchase requisition; purchase order; goods received note; purchase invoice
D Purchase requisition; purchase order; purchase invoice; goods received note
Question 5
When goods are needed for production from stores, what document is used?
A Materials requisition note
B Purchase requisition
C Purchase order
D Materials order
Free Inventory:
This is inventory that is available for sale or booking.
Free inventory = Quantity on hand + units ordered - 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.
Question 6
There are currently 120 units of an item in inventory. There are material requisitions amounting
to 40 units that have not yet been acted on and there are 90 units on order.
What is the free inventory?
A 70
B 170
C 120
D 250
Workings
Free inventory = Quantity on hand + units ordered - units allocated for use.
Free inventory = 120 + 90 – 40 = 170u
Question 7
When goods are received, what is the name given to the document that is raised (created) at that stage.
A Delivery note
B Purchase requisition
C Goods received note
D Purchase invoice
Valuation of Inventory
Different methods/techniques used to price (or value) materials issued or sold from inventory and
to value closing inventory include:
1. FIFO i.e. First in, first out
2. LIFO i.e. Last in, first out
3. Cumulative weighted average (CWA). A new inventory value is calculated after every purchase
4. Periodic weighted average (PWA). Here, a new inventory value is calculated at
the end of a set period. The cost per unit of goods used or sold is given by:
Cost of opening inventory + cost of purchases in the period
Units in opening inventory + units purchased in the period
So, all units used in the period will have the same cost.
Question 8
Recent results of a division are:
Calculate the cost of inventory used or sold each time, and the cost of the inventory remaining at the end of the
period using:
(a) FIFO
(b) LIFO
(c) CWA
(d) PWA
Solution
a)
FIFO
Date Details Units Unit price
1 April Opening inventory 1,000 800 5
5 April Purchased 500 100 6
9 April Sold 200 N/A
14 April Purchased 600 5.5
21 April Sold 1,200 N/A
th
Cost of usage on 9 April = 200u * 5 = $1,000
Cost of usage on 21st April = (800u * 5) + (400u * 6) = $6,400
Cost of inventory remaining i.e. closing inventory at the end of period = (100u*6)+(600u*5.5) = $3,900
b)
LIFO
Date Details Units Unit price
1 April Opening inventory 1,000 700 5
5 April Purchased 500 300 6
9 April Sold 200 N/A
14 April Purchased 600 5.5
21 April Sold 1,200 N/A
th
Cost of usage on 9 April = 200u*6 = $1,200
Cost of usage on 21st April = (600u*5.5)+(300u*6)+(300u*5) = $6,600
Cost of inventory remaining i.e. closing inventory at the end of period = 700u*5 = $3,500
c)
CWA
Date Details Units Unit price Total value,
$
1 April Opening inventory 1,000 5 5,000
5 April Purchased 500 6 3,000
Total available 1,500u CWA = 8,000
8,000/1,500 = 5.33
9 April Sold 200 5.33
Remaining 1,300u 5.33 6,929
14 April Purchased 600 5.5 3,300
Total available 1,900u CWA = 10,229
10,229/1,900 = 5.38
21 April Sold 1,200 5.38
Remaining 700u 5.38 3,766
th
Cost of usage on 9 April = 200u*5.33 = $1,066
Cost of usage on 21st April = 1,200u*5.38 = $6,456
Cost of inventory remaining i.e. closing inventory at the end of period = 700u*5.38 = $3,766
d)
PWA
Cost per unit = Cost of opening inventory + cost of purchases in the period
Units in opening inventory + units purchased in the period
Cost per unit = (1,000u*5) + (500u*6) + (600u*5.5)
1,000u + 500u + 600u = $5.38
Cost of usage on 9th April = 200u*5.38 = $1,076
Cost of usage on 21st April = 1,200u*5.38 = $6,456
Cost of inventory remaining i.e. closing inventory at the end of period = (1,000+500+600-200-1,200) @ 5.38 =
$3,766
Managing Inventory:
When inventory is held, there are two main amounts that have to be determined;
1. The reorder level (ROL) - When orders should be placed. How low should inventory be allowed to fall
before an order is placed?
2. The reorder quantity (ROQ) or economic order quantity (EOQ) - How much should be ordered?
Inventory control levels:
Three critical control levels are:
Reorder level
Minimum level
Maximum level (others include reorder quantity)
Reorder level (ROL)
This is inventory quantity that the firm will be having in store when a new order is made. It is the inventory
quantity remaining at hand that will trigger a new order to be placed with the supplier.
Reorder level = maximum usage or consumption * maximum lead time
NB: Lead time is the time taken between placing an order and arrival of the order.
Minimum inventory level
This is the lowest level of inventory that the firm should allow its inventory quantities in store to reach. The
inventory quantities should not go below that particular level. It is a warning level to the management that the
inventory quantities are reaching dangerously low levels and chances of stock-outs are increasing.
Minimum inventory level = reorder level – (average consumption or usage * average lead time)
Maximum inventory level
This is the maximum amount of inventory that the firm should hold at any point in time. It sets the upper limit
of the inventory quantities. It is also a warning signal to the management that the firm is holding too much stock
than necessary and the inventories are reaching wasteful levels.
Maximum inventory level = reorder level + reorder quantity – (minimum usage * minimum lead time)
Reorder quantity (ROQ)
This is the quantities of inventory purchased by the firm for every order the firm places with its suppliers. It is
the inventory quantities that the firm purchases when the inventory levels reach the reorder level.
Reorder quantity = maximum level – reorder level + (minimum usage * minimum lead time)
Average inventory
Is the inventory quantities that the firm has at hand at any point in time during the year.
It is the inventory quantities that the firm will have on average basis, if a stock count was to be carried out on a
random basis.
Average inventory = minimum inventory + reorder quantity
2
NB: Minimum inventory = buffer inventory = safety inventory
Question 9
Inventory statistics are:
Maximum usage/day 20 units
Minimum usage/day 12 units
Average usage per day 15 units
Maximum lead time 11 days
Minimum lead time 4 days
Average lead time 6 days
Reorder quantity 1,000 units (a.k.a EOQ)
Calculate the:
a) Reorder level
b) Minimum stock
c) Maximum stock
d) Average inventory
Solution:
The Economic Order Quantity (EOQ):
The economic order quantity (EOQ) is the order quantity which minimises stockholding costs.
There are two sets of relevant costs:
1. The holding cost (carrying 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.
2. The reorder cost (ordering cost). This is the administration cost of raising requisitions and orders,
receiving the stock (carriage inwards) and processing the invoices.
The precise EOQ can be found using a formula:
EOQ =
√
2 CoD
Ch
Where:
Co = cost of placing an order i.e. ordering cost per order
Ch = cost of holding one unit for one year i.e. the holding cost per unit p.a.
D = annual demand
Question 10
Solution
