ACCOUNTING FOR MATERIALS

INVENTORY CONTROL SYSTEM

Controls should cover the following functions.

The ordering of inventory

The purchase of inventorys

The receipt of goods into store

Storage

The issue of inventory and maintenance of inventory at the most appropriate level

The ordering, receipt and issue of raw materials

Every movement of a material in a business should be documented using the following as

appropriate:purchase requisition; purchase order; GRN; materials requisition note; materials

transfer note and materials returned note.

Purchase requisition

When Current inventories are run down to the level where a reorder is required., the stores

department issues a purchase requisition which is sent to the purchasing department,

authorizing the department to order further inventory.

Purchase order

The purchasing department draws up a purchase order which is sent to the supplier. (The

supplier may be asked to return an acknowledgement copy as confirmation of their acceptance of

the order.) Copies of the purchase order must be sent to the accounts department and the

storekeeper (or receiving department).

Quotations

The purchasing department may have to obtain a number of quotations if either a new inventory

line is required, the existing supplier's costs are too high or the existing supplier no longer stocks

the goods needed.

Delivery note

The supplier delivers the consignment of materials, and the storekeeper signs a delivery note for

the carrier. The packages must then be checked against the copy of the purchase order to ensure

that the supplier has delivered the types and quantities of materials which were ordered.

(Discrepancies would be referred to the purchasing department.)

Goods received note

If the delivery is acceptable, the storekeeper prepares a goods received note (GRN) to

acknowledge the receipt of the goods by the company.

Materials requisition note

Materials can only be issued against a materials/stores requisition. This document must record

not only the quantity of goods issued but also the cost centre or the job number for which the

requisition is being made.

FREE INVENTORY

Managers need to know the free inventory balance in order to obtain a full picture of the

current inventory position of an item. Free inventory represents what is really available for

future use and is calculated as follows:

Example

Solution

Practice Question

THE INVENTORY COUNT (STOCKTAKE)

The inventory count (stocktake) involves counting the physical inventory on hand at a certain

date, and then checking this against the balance shown in the inventory records. The inventory

count can be carried out on a continuous or periodic basis.

Periodic stocktaking is a process whereby all inventory items are physically counted and valued

at a set point in time, usually at the end of an accounting period.

Continuous stocktaking is counting and valuing selected items at different times on a rotating

basis.

This involves a specialist team counting and checking a number of inventory items each day, so

that each item is checked at least once a year. Valuable items or items with a high turnover could

be checked more frequently.

Inventory discrepancies

There will be occasions when inventory checks disclose discrepancies between the physical

amount of an item in inventory and the amount shown in the inventory records. When this

occurs, the cause of the discrepancy should be investigated, and appropriate action taken to

ensure that it does not happen again.

Other Inventory Concepts

Perpetual inventory refers to an inventory recording system whereby the records are updated

for each receipt and issue of inventory as it occurs.

Obsolete inventories are those items which have become out of date and are no longer required.

Obsolete items are written off and disposed off.

Slow-moving inventories are inventory items which are likely to take a long time to be used up.

INVENTORY CONTROL LEVELS

Inventory costs include

 • Purchase costs,

• Holding costs,

• Ordering costs and

• Costs of running out of inventory.

Reasons for holding inventories

To ensure sufficient goods are available to meet expected demand

To provide a buffer between processes

To meet any future shortages

To take advantage of bulk purchasing discounts

To absorb seasonal fluctuations and any variations in usage and demand

To allow production processes to flow smoothly and efficiently

As a necessary part of the production process (such as when maturing cheese)

As a deliberate investment policy, especially in times of inflation or possible shortages

Holding costs

If inventories are too high, holding costs will be incurred unnecessarily. Such costs occur for a

number of reasons.

(a) Costs of storage and stores operations. Larger inventories require more storage space and

possibly extra staff and equipment to control and handle them.

(b) Interest charges. Holding inventories involves the tying up of capital (cash) on which

interest must be paid.

(c) Insurance costs. The larger the value of inventories held, the greater insurance premiums are

likely to be.

(d) Risk of obsolescence. The longer a inventory item is held, the greater the risk of

obsolescence.

(e) Deterioration. When materials in store deteriorate to the extent that they are unusable, they

must be thrown away with the likelihood that disposal costs would be incurred.

Ordering costs

If inventories are kept low, small quantities of inventory will have to be ordered more frequently,

thereby increasing the following ordering or procurement costs.

(a) Clerical and administrative costs associated with purchasing, accounting for and receiving

goods

(b) Transport costs

(c) Production run costs, for inventory which is manufactured internally rather than purchased

from external sources

Stockout costs (running out of inventory)

An additional type of cost which may arise if inventory is kept too low is the type associated

with running out of inventory. There are a number of causes of stockout costs.

Lost contribution from lost sales

Loss of future sales due to disgruntled customers

Loss of customer goodwill

Cost of production stoppages

 Labour frustration over stoppages

Extra costs of urgent, small quantity, replenishment orders

Objective of Inventory Control

The overall objective of inventory control is, therefore, to maintain inventory levels so that the

total of the following costs is minimised.

Holding costs

Stockout costs

Ordering costs

Inventory control levels

Inventory control levels can be calculated in order to maintain inventories at the optimum level.

The three critical control levels are

• reorder level,

• minimum level and

• maximum level.

Reorder level

When inventories reach this level, an order should be placed to replenish inventories. The reorder

level is determined by consideration of the following:

The maximum rate of consumption The maximum lead time

Minimum level

This is a warning level to draw management attention to the fact that inventories are approaching

a dangerously low level and that stockouts are possible.

Maximum level

This also acts as a warning level to signal to management that inventories are reaching a

potentially wasteful level.

Illustration

Solution
Reorder quantity

This is the quantity of inventory which is to be ordered when inventory reaches the reorder

level.

If it is set so as to minimise the total costs associated with holding and ordering inventory,

then it is known as the economic order quantity (EOQ).

Average inventory

The formula for the average inventory level assumes that inventory levels fluctuate evenly

between the minimum (or safety) inventory level and the highest possible inventory level (the

amount of inventory immediately after an order is received, ie safety inventory + reorder

quantity).

Illustration
ECONOMIC ORDER QUANTITY (EOQ)

The economic order quantity (EOQ) is the order quantity which minimises inventory costs.

The EOQ can be calculated using a table, graph or formula.

Example

Suppose a company purchases raw material at a cost of $16 per unit. The annual demand for the

raw material is 25,000 units. The holding cost per unit is $6.40 and the cost of placing an order is

$32.

Solution
Practice Question

Practice Question
Solution

The EOQ GRAPH

Note that the total cost line is at a minimum for an order quantity of 500 units and occurs at the

point where the ordering cost curve and holding cost curve intersect. The EOQ is therefore

found at the point where holding costs equal ordering costs.

ECONOMIC BATCH QUANTITY (EBQ)

The economic batch quantity (EBQ) is a modification of the EOQ and is used when resupply is

gradual instead of instantaneous.

Illustration
BULK DISCOUNTS

The solution obtained from using the simple EOQ formula may need to be modified if bulk

discounts (also called quantity discounts) are available.

To decide mathematically whether it would be worthwhile taking a discount and ordering larger

quantities, it is necessary to minimise the total of the following.

Total material costs

Inventory holding costs

Ordering costs

The total cost will be minimized at one of the following.

At the pre-discount EOQ level, so that a discount is not worthwhile

At the minimum order size necessary to earn the discount

Example: Bulk discounts

The annual demand for an item of inventory is 45 units. The item costs $200 a unit to purchase,

the holding cost for 1 unit for 1 year is 15% of the unit cost and ordering costs are $300 an order.

The supplier offers a 3% discount for orders of 60 units or more, and a discount of 5% for orders

of 90 units or more.

Required

Calculate the cost-minimising order size.

Solution
Practice Question
ACCOUNTING FOR MATERIAL COSTS

Notes on transactions:

(1) All raw material purchases are entered into the material control account as a debit entry –

the corresponding credit goes to the payables control account.

(2) Any returns of material are treated in the opposite way to purchases of material.

(3) Direct material is directly related to production. The material control account will be

reduced (credited) by the amount of material being issued. Ongoing production is represented by

a Work in Progress account in the ledger system.

(4) Indirect materials are not directly related to production so will not affect the Work in

Progress account. Such materials are classed as factory overheads and will therefore be entered

into a Factory Overheads account.

(5) The unused material returned to stores (inventory) will increase materials inventory and

will therefore be a debit entry in the material control account. As it is being returned from

production, the corresponding credit entry will be in the Work in Progress account.

Example – material control account

Bossy Co manufactures a single product and has the following transactions for material during a

particular period.

(1) Raw materials of $500,000 were purchased on credit from a supplier (Timid Co).

(2) Raw materials costing $10,000 were returned to the same supplier due to defects.

(3) The total stores requisitions for direct material for the period were $400,000.

(4) Total issues for indirect materials during the period were $15,000.
(5) $5,000 of unused material was returned to stores from production.

Required

Prepare the material control account for the period, showing clearly how each transaction is

treated.

Practice Question

Assignment

Revision Kit Questions