Professor Vipin 2015
Material Cost Control
Materials
Materials: - The materials are a major part of the total cost of producing a product and are one of the
most important assets in majority of the business enterprises. Hence the total cost of a product can be
controlled and reduced by efficiently using materials.
The materials are of two types, namely:
(i) Direct materials: The materials which can be easily identified and attributable to the individual units
being manufactured are known as direct materials. These materials also form part of finished products.
All costs which are incurred to obtain direct materials are known as direct material costs.
(ii) Indirect materials: Indirect materials, on the other hand, are those materials which are of small value
such as nuts, pins, screws, etc. and do not physically form part of the finished product. Costs associated
with indirect materials are known as indirect material costs.
Purchasing Control and Procedure
Purchasing is an art. Wrong purchases increase the cost of materials, store equipments and the finished
goods. Hence it is imperative that purchases should be effectively, efficiently and economically
performed.
Dr. Walters defines scientific purchasing as the “Procurement by purchase of the proper materials,
machinery, equipment and supplies of stores used in the manufacture of a product, adapted to
marketing in the proper quantity and quality at the proper time and the lowest price consistent with the
quality desired”.
According to Alford and Beatty, “Purchasing is the procuring of materials, supplies, machines tools and
services required for the equipment, maintenance and operation of a manufacturing plant”.
The major objectives of scientific purchasing it to purchase the right quantity at the best price, materials
purchased should suit the objective, production should not be held up, unnecessarily capital
should not be locked up in stores, best quality of materials should be purchased and company’s
competitive position and its reputation for fairness and integrity should be safeguarded.
Only scientific purchasing will help in achieving the above objectives. With proper plans, materials can
be purchased at a lower price than competitors, turnover of investment in inventories can be high,
purchasing department can advise regarding substitute materials, new products, change in trends,
creating goodwill etc.
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Methods of Purchasing
Purchasing can be broadly classified as centralized and localized purchasing.
1. Centralized Purchasing: In a large organization, manufacturing units are many. In such cases
centralized purchasing is beneficial. The advantages of centralized purchasing are:
a) Specialized and expert knowledge is available.
b) Advantages arise due to bulk purchases.
c) The cost of purchasing can be reduced and selling price can be lowered.
d) As there is good knowledge of market conditions, greater control can be exercised.
e) When materials have to be imported, it is advantageous to centralize the buying.
f) Economy and ease in compilation and consultation of results.
g) It can take advantage of market changes.
h) Investment in inventories can be reduced.
i) Other advantages include undivided responsibility, consistent buying policies.
2. Decentralization of Purchases: The advantages of localized purchasing or decentralization of
purchases are:
a) Each plant may have its own particular need. This can be given special attention.
b) Direct contact can be established with suppliers.
c) The time lag between indenting and receiving materials can be reduced.
d) Technical requirements of each plant can be ascertained.
Storekeeping
Store keeping is a service function. The storekeeper is a custodian of all the items kept in the store. The
stores should be maintained properly and cost minimized. The main objectives of store keeping are:a) To protect stores against losses
b) To keep goods ready for delivery/issue
c) To provide maximum service at minimum cost.
The duties and functions of Store-keeper can be summarized as follows:



Materials should be received, unloaded, inspected and then moved to stores. The materials
have to be stored in appropriate places and records the receipts in proper books.
The stores records should be maintained in an efficient and orderly manner so that materials
can be easily located and information can be obtained for various departments.
The stores should provide maximum protection and safety and accessibility and utilize minimum
space. Suitable storage devices should be installed.
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

The materials should be given special covering to prevent damage due to atmospheric
conditions.
All issues should be properly recorded, efficiently, promptly and accurately. All issues should be
duly authorized and procedures laid down should be duly followed.
Inventory Control Techniques
Re-Ordering Level
Re-ordering level is that point of level of stock of a material where the storekeeper starts the process of
initiating purchase requisition for fresh supplies of that materials. This level is fixed somewhere between
the maximum and minimum levels in such a way that the difference of quantity of the material between
the re-ordering level and minimum level will be sufficient to meet the requirements of production until
the fresh supply of the materials is received.
Re-ordering Level= Minimum Level + Consumption during the time required to get the fresh delivery
According to Wheldon,
Re-ordering Level= Maximum Level x Minimum re-order period.
Here, maximum re-order period means the maximum period taken to get the material once the order
for new material is placed. Wheldon has taken the maximum period and maximum consumption during
that period so that factory may not stop production due to shortage of materials.
Illustration: 3. Calculate the ordering level of material A from the following particulars:
Minimum Limit 1,000 units. Maximum Limit 5,000 units.
Daily requirement of material 200 units. Time required for fresh delivery 10 days. Solution
Ordering Level=Minimum limit + Consumption during the time required for fresh delivery
units+ 200 units x 10 days = 3000 units
= 1000
Order for the purchase of material should be placed when the material in stock reaches 3,000 units.
Example
Calculate the re-ordering level from the following information: Maximum consumption = 500 units per
day; Minimum consumption = 400 units per day; Re-order period = 10 to 12 days
Solution
Re-order Level = Maximum consumption x maximum re-order period = 500 units x 12 days = 6000 units.
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Economic Order Quantity
The quantity of material to be ordered at one time is known as economic ordering quantity. This
quantity is fixed in such a manner as to minimize the cost of ordering and carrying the stock.
The total costs of a material usually consist of:
Total acquisition cost + total ordering cost + total carrying cost.
Since the acquisition cost per unit of material is same whatever is the quantity purchased, it is usually
excluded when deciding the quantity of a material to be ordered at one time. The only costs to be taken
care of are the ordering costs and carrying costs which vary with the quantity ordered.
Carrying Cost: It is the cost of holding the materials in the store and includes:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Cost of storage space which could have been utilized for some other purpose.
Cost of bins and racks
Cost of maintaining the materials to avoid deterioration.
Amount of interest payable on the amount of money locked up in the materials.
Cost of spoilage in stores and handling.
Transportation cost in relation to stock.
Cost of obsolescence of materials due to change in the process or product.
Insurance cost
Clerical cost etc.
Ordering Cost: It is the cost of placing orders for the purchase of materials and includes:
1. Cost of staff posted in the purchasing department, inspection section and stores accounts
department.
2. Cost of stationary postage and telephone charges
√
Q = Quantity to be ordered
C = Consumption of the material concerned in units during a year.
O = Cost of placing one order including the cost of receiving the goods i.e. the cost of getting an item
into the firms inventory
I = Interest payment including variable cost of storing per unit per year i.e holding costs of inventory.
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ABC System
In this technique, the items of inventory are classifi ed according to the value of usage. Materials are
classified as A, B and C according to their value. Items in class ‘A’ constitute the most important class of
inventories so far as the proportion in the total value of inventory is concerned. The ‘A’ items constitute
roughly about 5-10% of the total items while its value may be about 80% of the total value of the
inventory. Items in class ‘B’ constitute intermediate position. These items may be about 20-25% of the
total items while the usage value may be about 15% of the total value. Items in class ‘C’ are the most
negligible in value, about 65-75% of the total quantity but the value may be about 5% of the total usage
value of the inventory.
The numbers given above are just indicative, actual numbers may vary from situation to situation. The
principle to be followed is that the high value items should be controlled more carefully while items
having small value though large in numbers can be controlled periodically.
Just in Time Inventory
This is the latest trend in inventory management. This principle envisages that there should not be any
intermediate stage like storekeeping. Material purchased from supplier should directly go the assembly
line, i.e. to the production department. There should not be any need of storing the material. The
storing cost can be saved to a great extent by using this technique. However the practicality of this
technique in Indian conditions should be verified before practicing the same.
Issue Control
Another important aspect of material control is the issue control. Material is issued to production and
utmost care is to be taken while issuing the material. The fi rst thing is that without authorization
material should not be issued to any department. A Material Requisition Note is prepared by the
department that is in need of the material and sent to the stores department. It is a written request
made to the stores department for sending the material. In the Material Requisition
Note, the details of the material required such as the quantity, quality, date by which it is required etc
It is signed by the authorized signatory of the concerned department. On the receipt of this requisition,
the stores department takes action of supplying the required material to the department. While issuing
material care should be taken that exact quantity as per the requirement should be supplied. If there is
surplus material remaining after satisfying the needs of the concerned department, it should be
returned to the stores department. In such case, Material Return Note should be prepared and sent
along with the material. Similarly if material is transferred from one site to other site without being
returned to the store, it is necessary to prepare Material Transfer Note for recording the same. Proper
documentation is extremely necessary for minimizing the chances of errors and frauds.
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Pricing of Issues
First In First Out:- As per this method, material received fi rst is issued fi rst. Thus the material in stock at
the beginning of a period is issued fi rstly and then the issues are made according to the dates of
purchases made. This method is quite logical as the sequence of issue is as per the dates of purchases.
However the consumption value will be as per the purchases made earlier and hence the latest price
may not be charged to the consumption. In case of rising prices it will result in charging lower prices
while in case of falling price it will result in charging higher prices to the material consumption. The
closing stock will be shown at the latest prices as the material purchased towards the end of the period
will remain the stock.
2. Last In First Out [LIFO]:- The assumption under this method is that the material which is purchased
last is issued first to the production. Therefore the issue should be charged at the latest prices. The main
advantage of this method is that the issues are priced at the latest prices and hence consumption value
is also the latest. This will make the product cost more realistic. However, the inventory valuation will be
at the older price as material in balance will be from the earlier batches of purchases. Valuation of
inventory according to this method is not accepted for inventory valuation in the preparation of
financial statements.
3. Highest In First Out [HIFO]:- Under this method, the materials with highest prices are issued first,
irrespective of the date upon which they are purchased. The basic assumption is that in fluctuating and
inflationary market, the cost of material are quickly absorbed into product cost to hedge against risk of
inflation. As the issues are shown at highest prices, the product costs tend to be on the higher side and
hence this method is not suitable in competitive environment.
4. Simple Average Cost Method:- Under this method, the issues are charged at the average price of the
material purchased without taking into consideration the quantities involved in the same. For example,
if materials are purchased in three batches at prices of Rs.18, Rs.19 and Rs.23, the issue will be charged
at the average price of the three prices, i.e. Rs.18 + Rs.19 + Rs.23 = Rs.60/3 = Rs.20. This method is not
very popular because it takes into consideration the prices of different batches but not the quantities
purchased in different batches. In the periods of price fluctuations this method is useful but if
fluctuations are too wide, the method may not be useful.
5. Weighted Average Method:- This method takes into consideration the prices as well as the quantities
of materials purchased. Thus weighted average is computed after each receipt by dividing the total
amount by the total quantity. The issue is charged at prices arrived at according to this calculation.
6. Periodic Average Cost Method:- Under this method, instead of recalculating the simple or weighted
average cost every time there is a receipt, periodic average is computed. The average may be calculated
for the entire period. The price may be calculated as given below. Cost of Opening Stock + Total Cost of
all receipts / Units in Opening Stock + Total Units received during the period.
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7. Standard Cost Method:- Under this method, material issues are priced at a predetermined standard
issue price. Any difference between the actual purchase price and the standard price is written off to the
Costing Profit and Loss Account. Standard Cost is a predetermined cost and if it is set accurately, it can
be very effective. However revision of standard cost at regular intervals is required.
8. Replacement Cost [Market Price]:- The replacement cost is the cost at which material identical to that
is to be replaced could be purchased at the date of pricing of the issues as distinct from the actual cost
price at the date of purchase. The replacement price is the price of replacing the material at the time of
the issue of materials or on the date of valuation of closing stock. This method is not acceptable for
standard accounting practices as it reflects the price, which has not been paid actually.
9. Next In First Method:- Under this method, the price quoted on the latest purchase order or contract is
used for all issues until a new order is placed. Thus this method is a variation of the Replacement Cost
Method.
10. Base Stock Method:- Under this method, a certain quantity of materials is always held in stock and
any material over and above this quantity is priced according to any other pricing method like First In
First Out or Last In First Out or any other method. For example, it may be decided that 500 units will be
held in stock and for materials over and above this FIFO method may be followed. However, this method
is not popular and also not accepted under standard accounting practices as it would result in stock
valuation totally unrealistic.
Example
From the following figures relating to two components X and Y, compute Reorder Level, Minimum Level,
Maximum Level and Average Stock Level.
Particulars
Maximum consumption per
week
Average consumption per
week
Minimum consumption per
week
Reorder period
Reorder quantity
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Component
X
Component
Y
75
75
50
50
25
25
4 to 6 weeks 2 to 4 weeks
400
600
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Solution
The computation of various levels is shown below.
A] Reorder Level = Maximum Consumption Maximum Reorder Period
Component X = 75 units 6 weeks = 450 units
Component Y = 75 units 4 weeks = 300 units.
B] Minimum Level = Reorder Level – Average Consumption Average Reorder Period
Component X = 450 units – [50 units 5 weeks] = 200 units
Component Y = 300 units – [50 units 3 weeks] = 150 units
C] Maximum Level = Reorder Level + Reorder Quantity – [Minimum Consumption Minimum
Reorder Period]
Component X = 450 units + 400 units – [25 units 4 weeks] = 750 units
Component Y = 300 units + 600 units – [25 units 2 weeks] = 850 units
D] Average Level = ½ [Maximum Level + Minimum Level]
Component X = ½ [750 units + 200 units] = 475 units
Component Y = ½ [150 units + 850 units] = 500 units 2. From the following particulars, compute
Economic Order Quantity Annual consumption = 8, 10, 000 units
Order placing and receiving costs: Rs.10 per order
Annual stock holding stock: 20% of consumption
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Example
From the following information, prepare Store Ledger using First In First Out [FIFO], Last In First Out
[LIFO] and Weighted Average Method of pricing the issues
December 1st: Balance in hand 1000 units @ Rs.1 each.
December 15th: Received 3000 units costing Rs.3, 300
January 12th: Received 2000 units costing Rs.2400
January 30th: Issued 2000 units
February 17th: Issued 3400 units.
Solution
FIFO
Date
Particulars
Receipts
Issue
3000 units
Rs. 3300
1000 units
@ Re.1 =
Rs.1000
4000 units
Rs.4300
2000 units
Rs. 2400
6000 units
Rs.6700
Dec-01 Opening Balance
Dec-15 Receipts
Jan
12th
Jan
30th
Receipts
Issue
Feb-17 Issue
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Balance
2000 units 1000 units
@ Re.1 per unit =
Rs.1000 1000 units @
Rs.1.10 = Rs.1100
4000 units
Rs.4600
3400 units 2000 units
@ Rs.1.10 = Rs.2200
1400 units @ Rs.1.20 = 600 units
Rs.1680
Rs.720
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LIFO
Date
Particulars
Receipts
Dec-01 Opening Balance
Dec-15 Receipts
Jan
12th
Receipts
Jan
30th
Issue
3000 units
Rs. 3300
2000 units
Rs. 2400
Issue
Balance
1000 units
@ Re.1 =
Rs.1000
4000 units
Rs.4300
6000 units
Rs.6700
2000 units @ Rs.1.10 = 4000 units
Rs.2200
Rs.4500
3400 units 2000 units
@ Rs.1.20 = Rs.2400
1000 units @ Rs.1.10 =
Rs.1100 400 units @
600 units
Re.1 = Rs.400
Rs.600
Feb-17 Issue
Weighted Average Method
Date
Particulars
Receipts
Issue
Balance
Dec-01 Opening Balance
1000 units @
Re.1 =
Rs.1000
Dec-15 Receipts
3000 units
Rs. 3300
4000 units
Rs.4300 Rate
per unit =
Rs.4300/4000
= Re.1.075
2000 units
Rs. 2400
6000 units
Rs.6700 Rate
per unit =
Rs.6700/6000
= Re.1.11
Jan
12th
Receipts
Issue
2000 units @ Rs.1.10
= Rs.2200
4000 units
Rs.4480 Rate
per unit =
Rs.4480/4000
= Re.1.11
Feb-17 Issue
3400 units @ Rs.1.11
= Rs.3774
600 units
Rs.706
Jan
30th
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Example
ABC Ltd. provides you the following information. Calculate the cost of goods sold and ending inventory
applying the Last In First Out method of pricing raw materials under the Perpetual Inventory and
Periodic Inventory Control System.
Date
Jan-01
Jan-10
Jan-12
Jan-16
Jan-19
Jan-30
Particulars
Opening Stock
Purchases
Withdrawals
Purchases
Issues
Receipts
Units
Receipts
200
10
400
12
500
300
11
200
100
15
Also explain the difference in profits if any.
Solution
Particulars
Perpetual Inventory
Method Units X Rate =
amount
Periodic Inventory
Method Units X Rate =
amount
Cost of goods sold/
withdrawn or issued –
12th January
400 x 12 = 4, 800
100 x 15 = 1, 500
100 x 10 = 1, 000
5, 800
300 x 11 = 3, 300
300 x 12 = 3, 600
200 x 11 = 2, 200
Total Rs.8, 000
100 x 10 = 1, 000
100 x 10 = 1, 000
100 x 15 = 1, 500
300 units = 3, 500
700 units = 8, 400
On 19th January
Ending Inventory
100 x 12 = 1, 200
200 x 10 = 2, 000
300 units = 3, 200
Reasons for the difference: The cost of goods sold/ issued/withdrawn is more under Periodic Inventory
System as compared to Perpetual Inventory System. Hence the profit under the former will be less as
compared to the latter. It can also be said that the lesser is the amount of ending inventory lesser will be
the profits.
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Example
From the following details, prepare Store Ledger under Simple Average Method of pricing the issues.
January 2007
1st: Received 500 units @ Rs.20 per unit
10th: Received 300 units @ Rs.24 per unit
15th: Issued 700 units
20th: Received 400 units @ Rs.28 per unit
25th: Issue 300 units
27th: Received 500 units @ Rs.22 per unit
31st: Issued 200 units.
Solution
Date
Jan-01
Jan-10
Jan-15
Jan-20
Jan-25
Jan-27
Jan-31
Particulars
Receipts
Receipts
Issue
Receipts
Issue
Receipts
Issue
Receipts
Issue
Balance
Qty
Rate
Amount
Qty
Rate
Amount
Qty Amount
500
20
10000
500
10000
300
24
7200
800
17200
700
22
15400 100
1800
400
28
11200
500
13000
300
26
7800 200
5200
500
22
11000
700
16200
200
25
5000 500
11200
The rate of issue is computed by taking the simple average of the rates of Rs.20 and Rs.24, i.e. Rs.22
The rate is computed by taking the simple average of the rates of Rs.24 and Rs.28, i.e. Rs.26. The earlier
rate of Rs.20 is not taken into consideration as the material quantity has been issued and is not there in
the stock on 15th January.
The rate is computed by taking the simple average of the rates of Rs.28 and Rs.22, i.e. Rs.25.
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