Material Costing

Material Accounting
Operations Management notes by Rahul Sir’s MBA/BBA Classes
The substance from which the product is made is termed as material. It may be in a raw or a
manufactured state. It forms an integral part of finished product. Materials are used for
manufacturing goods. In most cases material is an important constituent of total cost. Hence,
material cost is the main component of the cost of production. Materials may be direct or
indirect:
Direct materials
Direct material means cost of raw material used or consumed in production. It is not necessary
that all materials purchased in a particular period is used in production (in that period itself).
Indirect materials
Indirect Material is that material which cannot be easily identified and related with a particular
product, job, and process. Stores and material are used interchangeably. However, both the terms
differ. A store has a wider meaning than materials. Store is a place in which the materials are
stored. Different types of materials are kept in the stores. It includes raw material, tools,
equipment’s, repair, and maintenance of parts factory supplies, components, Fixtures, Jigs etc.
Sometimes, it also includes finished goods, and semi-finished goods within the scope of this
term. Thus, items kept in the store are called stores.
Classification and codification
The storekeeper keeps the material in the store. The duties of storekeeper include accepting, identifying,
classifying, and placing of materials. Efficient storage requires the consideration of the following:
Checking of material
He should verify the materials received with consignment note, inspection report and materials
received report. Therefore, he should send the copy of materials received report received by him,
after due verification to the Accounts Department for payment purposes.
Classification and codification

Classification and codification of materials is necessary for keeping the material in store. All
items in the stores department are properly classified and codified to prevent mixing of one type
of materials with the other and minimize the cost of retrieval. Materials are classified according
to nature in appropriate categories, e.g., Materials related with engineering are classified as
bronze, copper, steel, and mild steel etc., and each category is further classified suitably. To save
Rahul Sir’s MBA/BBA Classes Page 1

Material Accounting
time in handling of materials, a written document known as material manual, is prepared in

which description and code number to each store item is given. Following are the methods of
coding of materials:
 Alphabetical method
 Numerical method.
 Alphabetical-cum-Numerical method
Alphabetical method
In this method first alphabet letters are used for codification of each category of materials. For
example, steel wire is coded as SW or steam coal is coded as SC etc.
Numerical method
This method is used where materials accounting is to be mechanized by use of punched cards or
computers. For numerical coding a list is prepared for various departments and allotting to each
of them a suitable number. The first two digits of the code number represent the department for
which the materials are meant and other two digits state the name of material as mentioned in the
standard list or materials manual. For example, if code is 2341 it means Material No.41 [copper
wire] is to be used in Department No.23.
Alphabetical-cum-Numerical method
In this method, a combination of these two methods is used for coding of materials. For example,
a steel wire of gauge 4mm quality A stored in rack/ bin No.22, is given the code number
SW4A/22. Such a method gives exact information than any of the above two methods.
Codification of materials helps in two ways:
(i) In absence of coding the title of an account may have to be written a number of times. This
results in avoidable clerical work, particularly in case of lengthy account titles.
(ii) Secrecy about the exact nature of the transaction from the office employees is maintained.
STOCK LEVELS
The store is divided into different sections, each is meant for one particular type of material.

Material Accounting
Each section has some containers for keeping different varieties of that particular type of
material. These containers are termed as Bins or Racks, each bin/rack should be appropriately
numbered and indexed for easy identification. For example, the store has a separate section for
bolts. The different sizes of bolts are kept in the different bins. To facilitate the location of
section and various materials, it is better if location plans are exhibited at the entrance of the
storeroom.
Stocks levels
Maximum and minimum stock Level
To avoid over and under investment in materials, the management decides the maximum
quantity of materials to be kept in the store. The limits of minimum/maximum quantity set by the
management should be strictly observed by the storekeeper.
Maximum stock Level

The maximum level is the largest quantity of a certain material which should
be kept in the store at any point of time. Maximum stock level is computed
as follows:
Maximum stock level = Reorder level + Reorder quantity – [Minimum consumption x
minimum reorder period]
Or
Maximum stock level = Economic order quantity + Minimum stock
Minimum stock Level
The minimum stock level is the lowest quantitative balance of material which must be kept at all
times so that the assembly line may not be stopped on account of non-availability of materials. It
is decided by taking into account the followings:
 Re-order level
 Average stock level

Material Accounting
Minimum stock level is computed as follows:

Minimum stock level = Re-order level – [Normal consumption × average Reorder period]
Re-order level
It is the point at which if material in store is reached, the order of further supply of material must
be placed. This point is fixed between maximum level and minimum level. This point
automatically initiates the process of placing a fresh order. Re-order level depends on the
following factors:
 Maximum usage
 Time interval i.e. the anticipated time lag between the date of issuing orders and the
receipt of materials.
Re-order level = Maximum re-order period × Maximum usage
Average stock level

This level indicates the average stock held by the firm. It is calculated with the help of following:
Average stock level = 1/2 [Maximum stock level + Minimum stock level]
Or
Average stock level = Minimum stock level + 1/2 Re-order Quantity
Economic order quantity

The economic order quantity (EOQ) is the size of the purchase order which gives maximum
economy in purchasing material. It is also termed as standard order quantity. It is fixed after
taking into consideration the following points:
(i) Ordering cost

Cost of placing a order refers to the cost incurred for acquiring materials. It depends upon
number of orders placed and the number of items ordered. If the order size is larger in quantity,
orders placing cost per unit is lower and if order size is smaller in quantity, order placing cost per
unit is higher: It includes cost of preparing and placing an order, cost of transportation, cost of
receiving

Material Accounting
and inspecting the materials.

(ii) Carrying cost
It is the cost that is incurred in maintaining a given level of stock. It includes cost of handling materials,
insurance premium, cost of storage space, obsolescence losses etc., larger size of stock, higher the stock
carrying cost per unit per annum and vice versa.
EOQ is calculated as follows:
Assumptions of EOQ Model
The model is based on the following assumption:
 Demand is known with certainty and is constant over time.
 There is no time gap between placing an order and receiving its supply i.e. lead time for
the receipt of order is constant.
 Ordering cost vary directly with the number of orders.
 Carrying cost vary directly with the average inventory.
 There is no quantity discount.
METHODS OF PRICING OF THE ISSUE OF MATERIALS

Different methods are in use concerning the pricing of materials issued from the store. They are
as follows:
First-in, First-out [FIFO]
Last-in, First out [LIFO
First-in, First-out [FIFO]

Material Accounting
It is based on the assumption that the materials purchased and received first are issued first to the job.
After the first lot of material is used for production, the next lot is taken for the supply. This assumption is
made for the purpose of assigning cost of material to a job/process/product. The price of first purchase for
all the issues is same until the material of first purchase is entirely issued to various jobs, cost of materials
issued represents the cost of earlier purchases. Cost of closing stock shows the cost of latest purchases.
It is not necessary that the physical movement of the stock be in the order of first in and first out.
Advantages of FIFO Method
Advantages of FIFO method are as follow:
1. Materials are issued on the basis of purchases.
2. It is very simple and easily understandable.
3. The closing inventory is valued at the current level prices.
4. Mostly used in case of perishable goods.
5. Better to follow in case of deflation than inflation to reduce the tax liability.
Disadvantages of FIFO Method

Disadvantages of FIFO method are as follows :
1. It is difficult to record the returns and rejected items.
2. Regular purchases and issues can make this cumbersome.
3. As in the warehouse, all the materials are kept together, there is no sure that the one which was
purchased earlier is issued first.
4. Due to frequent price changes comparison between similar job become difficult.
5. If followed during inflationary situation, the value of the closing stock will be higher, there by
tax liability will increase.
The FIFO method is suitable, where the size and cost of raw material units are large, materials
are identified and belonging to a particular lot and not more than two or three different prices of
material are on hand at one time.
Last-in, First out [LIFO]

It is based on the assumption that the material purchased and received last are issued first to the
job. The cost of last lot of materials received is used to price the materials issued until the stock

Material Accounting
of that lot is exhausted. Thereafter the next lot for pricing is used, and so on through successive
lots. The stock is priced at the oldest cost.
Advantages of LIFO Method
Advantages of LIFO method are as follow:
1. This method is suitable for the time period when price is rising.
2. Since material is charged at the latest price level the cost of production is realistic.
3. It is easy to understand.
4. This leads to minimal unrealised gain.
Disadvantages of LIFO Method
Disadvantages of LIFO method is as follows :

1. It does not conform to the physical flow of the goods.
2. Inventory is not priced at current market price.
3. Price comparison is different, if similar jobs are carried out using material from different lots.
4. This method is not supported by Income Tax Act or Accounting Conventions.
5. This method leads to inflated profit and tax liability in the time of downward prices and vice
versa.
6. It can be difficult to calculate if there are frequent price changes.
Simple Average Price Method
When the material are kept in store and they are homogeneous in nature, they tend to get mixed
up with each other in a way that they lost their identity. This makes it rather difficult or almost
impossible at times to identify the lot to which the material belongs and when the above was
procured. So, for pricing purpose the average price is considered till the time the existing lot is
totally consumed. Further, when a new lot is purchased, the price is re-computed again.
The formula for calculation of average price is as follows:
Total unit prices of
All lots in stores
Average price = -----------------------------------
Total no. of unit prices

Material Accounting
Advantages of Simple Average Price Method -

Following are the advantages of simple average price method :
1. The end result are often accurate when identical purchases are made at a similar rate.
2. Even through the purchases are being made at an inflated or deflected rate, the prices are not
affected much.
3. Simplicity of the method makes it easily operational.
Disadvantages of Simple Average Price Method -
Disadvantages of simple average price method are as follows :
1. Closing inventory is not easily identifiable.
2. As the material issued carries a different price then the price at which it was procured. There
will arise certain profit or loss in this case.
3. The end results may not be accurate where the purchasers are not similar and when there is
fluctuation in prices.
4. Number of units at level of price is ignored. Weighted is only given to the prices and not be
quantity. This makes this method impractical.
5. Closing inventory may appear to be negative in inflationary situation.
Suitability -
Simple average price method is suitable in the following cases :
1. When prices at which the purchases are made do not very much.
2. It will give accurate outcome only when the material is procured in uniform numbers.
Weighted Average Price Method -

Weighted average price of the materials procured is considered and the quantity is duly taken
into account. This method follows a practical approach as compared with the other methods. The
issue price calculated is a realistic one and in ratio of the material procured. Every time a new lot
is procured. Weighted average price is recomputed.
The formula for calculating weighted average price is as follows :
Total cost of materials in stock
WAP = ---------------------------------------------------
Total quantity of material in stock

Material Accounting
This method is not suitable when the quantity in each lot varies.
Advantages of Weighted Average Price Method -

Following are the advantages of weighted average price method :
1. There is not much of critical work as the price of issue is constant till the expiry of the current
lot.
2. Which method is simple and easy.
3. The value of closing inventory calculated is quite accurate and can be taken into consideration
while preparation the financial statements.
4. When prices fluctuate the debits are set off as against the credits, thus no profit and loss exist
on account of issues.
Disadvantages of Weighted Average Price Method -

Following are the disadvantages of weighted average price :
1. In order to minimize clerical error, calculations are made to 4/5 decimal places, which makes
the job tedious.
2. Closing inventory is valued at per the calculations and not the current cost.
3. The issues continue to be made at a fixed price even after the previous lot of stock has been
totally consumed till the new stock comes in.

Material Costing

Uploaded by

Copyright:

Available Formats

Material Costing

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Material Costing

Uploaded by

Copyright:

Available Formats

Material Accounting

Operations Management notes by Rahul Sir’s MBA/BBA Classes

Classification and codification

Rahul Sir’s MBA/BBA Classes Page 1

time in handling of materials, a written document known as material manual, is prepared in

Rahul Sir’s MBA/BBA Classes Page 2

Maximum stock Level

Minimum stock Level

 Average stock level

Rahul Sir’s MBA/BBA Classes Page 3

Minimum stock level is computed as follows:

Average stock level

Economic order quantity

(i) Ordering cost

Rahul Sir’s MBA/BBA Classes Page 4

and inspecting the materials.

Assumptions of EOQ Model

The model is based on the following assumption:

 Demand is known with certainty and is constant over time.

 Ordering cost vary directly with the number of orders.

 Carrying cost vary directly with the average inventory.

 There is no quantity discount.

METHODS OF PRICING OF THE ISSUE OF MATERIALS

Rahul Sir’s MBA/BBA Classes Page 5

Disadvantages of FIFO Method

Last-in, First out [LIFO]

Rahul Sir’s MBA/BBA Classes Page 6

Disadvantages of LIFO Method

Disadvantages of LIFO method is as follows :

Rahul Sir’s MBA/BBA Classes Page 7

Advantages of Simple Average Price Method -

Weighted Average Price Method -

Rahul Sir’s MBA/BBA Classes Page 8

Advantages of Weighted Average Price Method -

Disadvantages of Weighted Average Price Method -

Rahul Sir’s MBA/BBA Classes Page 9

You might also like