Materials

Areas To Be Covered
 Materials
 Purchase Cycle Of Material
 Documents For Buying Material
 Stocktaking
 Free Stock
 Ordering Stock
 Stock Control Levels
 Economic Order Quantity
 Bulk Purchase/ Large Order Discounts
 Economic Batch Quantity
 Accounting For Material Costs
Definition
Material is something with which product is manufactured. For

example, wood is to manufacture chair so wood is material. It can be

divided into the following categories:

• Direct Material

• Indirect Material
Definition
Direct Material: The material, which can be directly or easily associated /

related with a particular unit of product / service. It becomes a major part of

finish good. Examples: wood for a table, papers for a book, etc.

Indirect Material: Materials that are cannot be directly traceable or

identifiable. It will not become a major part of product. Examples: cleaning

materials, lubricants, nails, glue, buttons, etc.

Forms
Raw material: The goods purchased, which are to be used in the

manufacturing of products. For example, plastic is used for the

manufacturing of toys.
Forms
Work in progress: When the product is manufacturing phase that is

known as work in progress. It represents the intermediate stage of

converting the raw material to finished goods.

Forms
Finished goods: When the manufacturing phase is ended, than we

have products which are ready for dispatch are called finished

goods. For example, bike, marker, robot etc.

Documents – Purchase Cycle
The documents involved in buying and selling are prime source of
cost and revenue information.

1. Purchase requisition

• Prepared by storekeeper (when inventory level falls to re-order

level).

• Authorize by the store in charge.

• Send to the purchase department, who will find out the supplier
Documents – Purchase Cycle
2. Letter of Enquiry: The purchase department sends out a letter of
enquiry (in case of new supplier) to various suppliers to find out about
the price, delivery time, delivery charges, discounts, terms of payment
etc. The suppliers will respond to the letter of enquiry with

• A catalogue and price list (for standard goods),

• A quotation (for non-standard goods) or

• An Estimate of cost (for services such as building work and

repair).
Documents – Purchase Cycle
3. Purchase Order: Purchase order is sent to selected or existing supplier. It
specifies the quantity and the price of the goods that are to be bought from
the supplier. It is authorized by head of purchase department. It has four
copies, sent to the following:
o The Purchase department (for record purpose).
o The accounts department (so that the invoice can be matched with the
purchase order for price confirmation).
o The stores department (for making arrangement for the new stock).
o The goods received department (so that they can expect to get the
goods by the date mentioned on the purchase order)
The original purchase order send to the supplier.
Documents – Purchase Cycle
4. Advice Note: An agreement between purchaser and the supplier.
• It decides the terms and conditions of trading to avoid future
disturbance.
• It is also considers as the confirmation of purchase order for the supplier.
Documents – Purchase Cycle
5. Delivery Note: The suppliers sends delivery note with the goods to buyer. The
delivery note has two copies (both are signed by buyer).

• One copy is retained by buyer for documentation.

• The other copy is taken back to the supplier by the driver to confirm the
supplier that the goods have been delivered to the right buyer.

Important:
If the supplier does not use his own transport, the consignment note will
provide the same evidence as the delivery note.
Documents – Purchase Cycle
6. Goods Received Note (GRN) (internal document): When the goods have
been arrived at goods received section, the condition and the quantity of
goods checked and the goods received note is prepared. It has Four copies,
sent to the following so that they know the goods have received.
a. The accounts department (to check against the invoice and purchase
order for quantity confirmation)
b. The stores section (for updating stock records)
c. The purchase department (to confirm that the goods have arrived)
d. The goods received section (will keep a copy in its records)
Documents – Purchase Cycle
7. Invoice: The supplier will send invoice to the buyer’s accounts
department detailing the amount that the company has to pay for
the received goods. The Accounts section should check the
accuracy of the invoice by comparing with the following:

• With Goods Received Note: (To confirm that goods have been
received and the supplier has charged only for the received

• With Purchase Order: To confirm the price charged by the

supplier is same as it was decided)
Documents – Purchase Cycle
• That the calculations on the invoice are correct (including VAT)

• If the invoice is correct, an entry is passed in the purchase ledger.

The purchase is then recorded in the accounts and the invoice is

paid.
Documents – Purchase Cycle
Two types of discounts may be offered by the suppliers:

• Trade discount: usually given for larger orders and is shown as a

deduction in the invoice.

• Cash discount/Settlement discount: usually given for prompt/immediate

payment within a specified period of time. It is NOT shown as a
deduction on the invoice.

• If VAT is payable, discounts are deducted from the cost of the goods and
THEN VAT is calculated and added to the invoice.(i.e. the amount net of
VAT is coded).
Documents – Purchase Cycle
8. Credit Note

• If the invoice sent by the supplier has any errors in it, the supplier will send a
credit note (which in effect reverses the invoice).

• A credit note may be issued for the whole of the invoice instead of for the
incorrect amount only so this way both the supplier and the company can
remove the incorrect invoice from their books and replace it with the
correct invoice.

• Accounts department of buyer authorized it to make payment against it.

Other Documents
a. Store or material requisition

A material requisition sends by the production department to stores for the

issue of raw materials for production. An authorise officer from production will
sign it and stores will issue the material. It is then used as a source document
for:

• Updating the bin card in stores.

• Updating the stores ledger account in the inventory costing department.

• Charging the job, overhead or department that is using the materials.

Other Documents
b. Goods or material return note
A materials returned note will accompany any unused material back
to stores. In effect this document is reverse of a material requisition
and therefore it must contain all the information that is present on
material requisition and will be used as the source document to
update the same records. This time, though, the material will be a
receipt into stock and a deduction from the job originally charged
with the material issued.
Other Documents
c. Materials transfers note

A material transfer note is usually raised when material issued to one

department is transferred to another department directly. This note

shows the name of both, transferor and transferee departments. This

process enables managers to appropriately allocate the cost

between two departments.

Documents – Recording Material
Material is an important item purchased by manufacturing business.

These are kept in warehouses or in stores. Two types of stock records

that are used:

1. Bin Card

2. Stock Ledger Account

Documents – Recording Material
1. Bin Card

The information on the bin card would be as follows:

• Description of the material (type of material).

• Stock code.

• Stock unit (meters, kgs, boxes, etc).

• Bin number (the location of the items in the store).

Documents – Recording Material
• Issues to production record: date, quantity, material requisition
number against which the material was issued as a reference
number.
• Receipts record: date, quantity, good received note, Materials
Returned Note (MRN) for goods that were returned from the
production department because they were not used in
production (obviously the material will also be sent back to the
store with the materials returned note).
Documents – Recording Material
• Balance of the quantity of stock on hand after each stock

movement (after each time stock is received or issued).

• It can be manual or computerized inventory records that are

maintained and kept in the store department.

BIN CARDS DO NOT HAVE THE AMOUNT/COST OF STOCK

Documents – Recording Material
2. Stock Ledger Account
• It carries all the information that is in bin cards buy they also have
the value/cost of stock units. This means that total cost of each
issue, receipt and that of the balance amount is shown in the store
ledger accounts. It can be manual or computerized and this would
enable the amount of free stock to be monitored.

• BIN cards are kept in the store but the store ledger accounts are
kept in the inventory costing department.
Stocktaking
A stock taking is the counting and recording of the physical quantities

of each item of stock at regular interval (monthly or annually) and the

checking the balance against the stock record.

Stocktaking
There are two methods of stocktaking:
• Periodic Stocktaking: All stocks are counted and updated on specific
date periodically, usually at the end of the accounting period.

• Continuous Stocktaking: All stocks are counted and updated after

each transaction/stock movement (after every issue, return &
receipt). Valuable items are checked more frequently.

Perpetual Inventory System: Recording of each & every stock

movement and update balance after each stock movement.
Stock Valuation Methods
Pricing of Materials Issued

Materials are purchased in large quantities at different prices and

issued to production in smaller lots. It is necessary to price the material

requisitions so that the cost centres (or cost units) can be charged in

a fair and consistent manner.

Stock Valuation Methods
Methods Of Pricing Of Raw Materials:

1. First-In-First Out (FIFO)

2. Last-In-First Out (LIFO)

3. Weighted Average (AVCO)

4. Periodic Weighted Average Method

Stock Valuation Methods
1. First in First Out (FIFO) Method

• The earliest price of materials is used for each issue.

• If prices are rising, issued price will be lower, vice versa.

• Closing stock is valued at most recent prices.

Stock Valuation Methods
Example:

1,000 units of component J, valued at a price of $5.00, were in inventory on 1

May. The following receipts and issues were recorded during May.

3 May Received 700 units @ $6.50 per unit

10 May Issued 1,200 units

13 May Received 900 units @ $8.00 per unit

25 May Issued 800 units

Using the FIFO method, the total inventory value at the end of May?
Stock Valuation Methods
Advantages

• This method is adopted by most of the organisations as this

method is assumes the oldest receipts are issued first.

• Issued prices are based on the prices actually paid for the stock.

• Closing stock values are based on the most recent prices.

• It is an acceptable method for companies act 1985, IAS 2, and for

taxation purposes.
Stock Valuation Methods
Disadvantages

• It uses the older prices and this can affect the costing of worked

done.

• In time of rising prices FIFO value stock at out of date prices which

lower the cost of sales figure thus increases the profit figure which

is not prudent.
Stock Valuation Methods
2. Last In First Out (LIFO) Method

• The most recent price of materials is used for each issue.

• If prices are rising, issued price will be higher, vice versa.

• Closing stock is valued at the earliest prices.

Stock Valuation Methods
Example:

1,000 units of component J, valued at a price of $5.00, were in inventory on 1

May. The following receipts and issues were recorded during May.

3 May Received 700 units @ $6.50 per unit

10 May Issued 1,200 units

13 May Received 900 units @ $8.00 per unit

25 May Issued 800 units

Using the LIFO method, the total inventory value at the end of May?
Stock Valuation Methods
Advantages

• The value of closing stock is based on prices actually paid for the

stock.

• Issues are valued at the most recent prices so it incorporates the

prudence concept.
Stock Valuation Methods
Disadvantages

• It is less realistic than FIFO since it assumes that the most recent

purchases will be issued before the older stock.

• LIFO is unacceptable for the purpose of taxation and IAS 2.

Stock Valuation Methods
3. Weighted Average Price Method

• Weighted average rate is calculated before every issue by

dividing Total Cost of receipts by the Total Units.

• Issue price will be between FIFO & LIFO methods.

• Closing stock valued at weighted average price.

Stock Valuation Methods
Example:

1,000 units of component J, valued at a price of $5.00, were in inventory on 1

May. The following receipts and issues were recorded during May.

3 May Received 700 units @ $6.50 per unit

10 May Issued 1,200 units

13 May Received 900 units @ $8.00 per unit

25 May Issued 800 units

Using the AVCO method, the total inventory value at the end of May?
Solution:

Date Receipts Issues Balance

Units $ Rate $ Amount Units $ Rate $ Amount Units $ Rate $ Amount
Stock Valuation Methods
Advantages
• Since prices are averages, it recognises that issues from stock
have equal value to the business and variation in these values are
minimised.
• The value of closing stock will be fairly close to latest price paid for
purchases.
• AVCO is an acceptable method for purpose IAS 2 and
companies act 1985.
Stock Valuation Methods
Disadvantages

• Time consuming and it involves complex calculations.

• The prices charged to the issues of stock will not agree to the

price paid to purchase the stock.

Stock Valuation Methods
Example:

1,000 units of component J, valued at a price of $5.00, were in inventory on 1

May. The following receipts and issues were recorded during May.

3 May Received 700 units @ $6.50 per unit

10 May Issued 1,200 units

13 May Received 900 units @ $8.00 per unit

25 May Issued 800 units

Using the Periodic Weighted Average Method, the total inventory value at the
end of May?
Solution:
Example 4: Homework
Example 4: Home Assignment
Free Stock
Free stock means the stock which is free from restrictions and
available for use. It means that only that stock is issued for use that
has not been already scheduled or allocated to a job or a
department. Free stock helps in ordering further quantities. Free stock
is calculated as follows:

= Stock in hand + stock on order with supplier – Reserved/Scheduled

stock.
Free Stock
Example 4: A business has 8,400 units outstanding for Material X on

existing customer's orders. There are 4,000 units in stock and

calculated free stock is 5,650 units. How many units does the

wholesaler have on order with his supplier?

Solution:
Ordering Stock
• In some organizations, a present quantity of stock is ordered each

time an order is placed.

• In other organizations, orders will be placed according to plans of

future production or sales.

Ordering Stock
Calculated as:
For Retail Businesses
Order quantity = Sales requirements + closing stock– opening stock

For Manufacturing Businesses

Order quantity = Production requirements + closing stock– opening
stock

Here production units = sales units + closing stock – opening stock

Retailing Business
Example 5: A company buys and sells Deltas. At the beginning of June the
store’s manager realizes that there is only 35 Deltas in stock and decides to
order more. He determines from the sales department that the planned sales
for the next 3 months are as follows;
June July August
Planned sales 120 150 130
The store’s manager feels that there will be 50 Deltas in stock at the end of
August. How many Deltas must be ordered?
Manufacturing Business
Example 6: A business makes a product, the Eel, each unit of which
requires 4kgs of material X. At the end of July, the store’s manager
decides to place more order for material X as there are only 220 kgs
in stock at that date. The production plans for the next 2 months are
400 Eels in August and 500 Eels in September. At the end of
September it is planned to have 300 kgs of material X in stock. How
much of material X should be ordered?
Stock Control Levels
The main purpose to maintain stock control levels is to ensure only the

right quantity of stock is held, not over or under stocking. These are

maintained to avoid stock out situation. There are three stock control

levels.
Stock Control Levels
Reorder Level
It is also called replenishment order level. When stock reaches this
level, it indicates that ordering of stock is necessary. At this level, even
if usage is at maximum level and the lead-time is the longest, there
will still be no stock-out situation. It is calculated as:

Reorder level = Maximum Usage x Maximum lead time

Stock Control Levels
Lead time

Lead time is the time between placing the order and receiving the goods.

Maximum Level

This identifies the maximum quantity of stock to keep. It avoids cost of over-

stocking.

Maximum level = Reorder level + Reorder quantity – (Minimum

usage x Minimum lead time)
Stock Control Levels
Reorder quantity

Reorder quantity is the number of units of stock ordered each time

when re-order level is reached. If it is set so as to minimize the total

costs associated with holding and ordering stock, then it is known as

EOQ.
Stock Control Levels
Minimum Level

This is the lowest quantity of stock that should be kept. This level warns

the danger of stock-out. When stock reaches this level, emergency

action will have to be taken to avoid stock-out.

Minimum level = Reorder level – (Average usage x Average lead time)

Note: Buffer Stock/Safety Stock will also be calculated using Minimum Level

Formula.
Stock Control Levels
Example 7: Mike Ltd has the following information:
Reorder quantity: 2,500 units
Usage per month: Max: 1,000 units
Min: 700 units
Expected Lead time: Max: 8 weeks
Min: 4 weeks
Required: Calculate Reorder level, Maximum level and Minimum
level?
Stock Control Levels
Solution:
Stock Control Levels
Average Stock

Average stock is the average between the minimum stock level and

the highest possible stock level.

Average stock = Safety stock + ½ reorder quantity

Safety stocks (or buffer stocks) are level of units maintained in case

there is unexpected demand.

Stock Control Levels
Example 8: A component has a safety stock of 600 units and the

reorder quantity is 4,000 units and at a rate of demand which varies

between 200 and 650 units per week.

Required: What is the average stock?

Solution:
Stock Out Cost
If stock is kept too low, there is a risk of stock-out, for example

production stoppage, loss of customer goodwill, loss of sales, labour

idle time and extra cost for urgent re-orders.

The cost should be considered when determining optimum stock

level consists of holding costs and ordering costs.

Stock Out Cost
To maintain stock at optimum level and to minimise cost, the total

costs of holding and ordering stock a company can

• Order in large quantity by placing a few orders.

• Order in small quantity and placing many orders.

• The aim of stock control is to minimize stock costs.

Economic Order Quantity (EOQ)
1. Purchase cost: The cost of buying the material. This is the largest

cost faced by an organization and once purchased, stock has to be

carefully controlled and checked. It can be reduced through

availability of bulk purchase discounts.

Economic Order Quantity (EOQ)
2. Ordering cost: The costs involved in ordering, receiving and paying

for stock for example administrative costs for contacting supplier to

place an order, transport/shipment costs, filing paper works, receiving

goods, checking quantities and paying invoices. It can be reduced

through ordering more quantity per order.

Economic Order Quantity (EOQ)
3. Holding cost: The costs incurred in keeping and storing stock, for

example interest charges, insurances, electricity and water,

storekeeper's wages and risk of obsolescence, pilferage and

deterioration. A company has to make a balance between keeping

the stock for production and having an amount of working capital

tied up in stock. It can be reduced through ordering less quantity in

an order.
Economic Order Quantity (EOQ)
Reasons of holding stock are:

• To ensure sufficient quantity is available to meet future demand.

• To meet future shortage of required material.

• To avail bulk purchase discounts.

• To avoid blockage in production process.

• To avoid stock-out costs.

Economic Order Quantity (EOQ)

Total annual inventory costs = Total annual purchase cost + Total

annual ordering cost + Total annual holding cost

Economic Order Quantity (EOQ)
The Economic Order Quantity (EOQ) is the optimized order size/

quantity that will result in total amount of the ordering and holding

costs being minimised. In other words, it is the most economic stock

replenishment order size which minimizes stock costs. It splits cost in

three, Purchase cost, ordering cost and holding cost.

EOQ Assumptions / Limitations:
 Demand/usage is constant throughout the year
 Lead time is zero or fix (for example suppliers
are reliable)
 Purchase costs per unit are constant (for
example no bulk discounts & no inflation)
 Holding cost per unit per annum will be
constant
 Ordering cost per order will be constant
regardless of quantity ordered
 There is no safety stock
 Average stock concept
Economic Order Quantity (EOQ)
EOQ Graph

The total costs are at a minimum for an order quantity at point Q,

which is EOQ. It is also a point where the holding cost curve intersects
with the ordering cost curve.
Economic Order Quantity (EOQ)
EOQ formula is

Where,

• D = Annual demand / usage

• Ch = Annual holding cost of one unit

• Co = Cost of placing an order

• Pc = Purchase cost per unit

Economic Order Quantity (EOQ)
Formulas:
• Number of orders: D / EOQ
• Frequency of orders: EOQ/D x 365 days OR 365 days/No. of orders
• Annual ordering cost: D / EOQ x Co OR No of orders x Co
• Annual holding cost: [EOQ / 2 + Safety stock] x Ch
• Annual Purchase cost: D x purchase price per unit
• Annual total inventory cost = Annual Ordering cost + Annual
Holding cost + Annual Purchase cost
Economic Order Quantity (EOQ)
Example 9: The demand of a company’s particular stock item is 1,000

units per year. The cost of ordering that stock item is $10 per order

and it costs 10% to store for a year. The purchase price is $20 per stock

item.

a. What is this item’s EOQ?

b. What are the total costs?

Solution:
Bulk Purchase
Frequently, discount will be offered for ordering large quantities.
When bulk discounts are available we have two options; take
advantage of discount by ordering a larger quantity or ignore the
discount offer and go for economic order quantity. We take decision
based on mathematical calculation.
If it results in savings than we avail the discount offer and if it results in
additional cost than we go with economic order quantity.
Bulk Purchase
Solution:
Bulk Purchase
Example 10:

Using the data from the example 9, consider the following additional

data: The supplier offers the following discounts:

250 units 2.5% discount

You are required to determine whether the discount is worth taking?

Economic Batch Quantity (EBQ)
Economic Batch Quantity (EBQ), also called Optimal Batch Quantity

or Economic Production Quantity.

This model is primarily concerned with determining the number of

items that should be produced in a batch. By EBQ model we can

calculate the optimum batch size.

Economic Batch Quantity (EBQ)
2CoD
EBQ =
CH(1-D/R)
Where:

D = Annual Demand / usage

R = Annual production replacement rate/production rate per period

CH = Annual holding cost per unit per period

Co = cost of setting up a batch

Economic Batch Quantity (EBQ)
Example 11: A company manufactures a component for use in its

production of main product. The company can manufacture this

component at the rate of 2,000 items per month and demand for this

component is 800 items per month. Cost incurred each time

production run is set up is $150. Holding cost of this item is 50 cents per

item per month. Calculate Economic Batch quantity (EBQ)?

Economic Batch Quantity (EBQ)
Solution:
Economic Batch Quantity (EBQ)
Example 12: Which of the following statement is true about economic batch
quantity (EBQ)?

a. EBQ gives even better result for reorder quantity compared to EOQ

b. EBQ means ordering quantities in large batches for each inventory

component

c. EBQ means that once our stock level reaches to half of optimal level, new
order should be placed

d. EBQ concept is used to determine optimal quantity that should be

produced
Accounting For Material Cost
The opening balance of materials is a debit balance because it is a current
asset (i.e. it will come on the debit side of the materials control account.)

Entries
Purchase of material (in an integrated system of accounts)
Debit Material control account
Credit Creditors account
Purchase of materials (in an interlocking system of accounts)
Debit Material control account
Credit Cost ledger control account
Accounting For Material Cost
Direct material issued to production

Debit Work in progress control account

Credit Material control account

Indirect material issued to production

Debit Production overhead control account

Credit Material control account

Accounting For Material Cost
Direct material returned to stores.

Debit Material control account

Credit Work in progress control account

Indirect material returned to stores.

Debit Material Control account

Credit Production overhead control account

Accounting For Material Cost
Material Ledger Control Account
Opening Balance X Issues X
Purchases X Return to supplier X
Return to stores X Written off X
Theft X
Closing Balance X
XX XX