CHAPTER 2

MATERIAL COST

LEARNING OUTCOMES
After studying this chapter, you would be able to-
♦ State the meaning, need and importance of materials.
♦ Discuss the procedures and documentations involved in
procuring, storing and issuing material.
♦ Discuss the various inventory control techniques and
determination of various stock levels.
♦ Compute Economic Order Quantity (EOQ) and apply the
EOQ to determine the optimum order quantity.
♦ Discuss the various methods of inventory accounting and
Prepare stock ledger/ account.
♦ Identify and explain normal and abnormal loss and its
accounting treatment.

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 2.2 COST AND MANAGEMENT ACCOUNTING

CHAPTER OVERVIEW

1. INTRODUCTION
We have acquired a basic knowledge about the concepts, objectives, advantages,
methods and elements of cost. We shall now study each element of cost
separately beginning with material cost. The general meaning of material is all
commodities/ physical objects used to make the final product. It may be
direct or indirect.

(i) Direct Materials: Materials, cost of which can be directly attributable to the
end product for which it is being used, in an economically feasible way.

(ii) Indirect Materials: Those materials which are not directly attributable to a
particular final product.
Direct Materials constitute a significant part for manufacturing and production of
goods. Being an input and a significant cost element, it requires adequate

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management attention. Cost control starts from here, and for this purpose it is
necessary that the principle of 3Es (Economy, Efficiency and Effectiveness) i.e.
economy in procurement, efficiency in handling and processing the material and
effectiveness in producing desired output as per the standard, is also applied for
this cost element. Importance of proper recording and control of material are as
follows:
(a) Quality of final product: The quality of output depends on the quality of
inputs.
(b) Price of the final product: Material constitutes a significant part of any
product and the cost of final product is directly related with cost of materials
used to produce the product.
(c) Production continuity: The production firms need to ensure that
production process runs smoothly and should not be paused for the want
of materials. In order to avoid production interruptions, an adequate level
of stock of materials should be maintained.
(d) Cost of Stock holding and stock-out: An entity has to incur stock holding
costs in the form of interest and/or opportunity cost for the fund used, stock
handling losses like evaporation, obsolescence etc. Under-stocking causes in
loss of revenue due to stock-out and breach of commitment.
(e) Wastage and other losses: While handling and processing of materials,
some wastage and loss arise. Based on the nature of material and process,
these are classified as normal and abnormal for efficient utilisation and
control.
(f) Regular information about resources: Regular and updated information
on availability and utilisation of materials are necessary for the entity for
timely and informed decision making.

2. MATERIAL CONTROL
In the previous chapter, we have discussed the term Cost Control, which means all
activities and control mechanism which are necessary to keep the cost in
adherence to the set standards. Material, being one of the total cost elements, are
also required to be controlled so that the overall cost control objective can be
fulfilled.

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2.1 Objectives of System of Material Control

The objectives of a system of material control are as following:
(i) Minimising interruption in production process: Material Control system
ensures that no activity, particularly production, suffers from interruption for
want of materials and stores. It should be noted that this requires constant
availability of every item that may be needed in production process,
howsoever, small its cost may be.
(ii) Optimisation of Material Cost: The overall material costs includes price,
ordering costs and holding costs. Since all the materials and stores are
acquired at the lowest possible price considering the required quality and
other relevant factors like reliability in respect of delivery, etc., holding cost
too needs to be minimized.
(iii) Reduction in Wastages: Material Control System has an objective of
avoidance of unnecessary losses and wastages that may arise from
deterioration in quality due to defective or long storage or from
obsolescence. It may be noted that losses and wastages in the process of
manufacture are a concern of the production department.
(iv) Adequate Information: The system of material control maintains proper
records to ensure that reliable information is available for all items of materials
and stores. This not only helps in detecting losses and pilferages but also
facilitates proper production planning.
(v) Completion of order in time: Proper material management is very
necessary for fulfilling orders of the firm. This adds to the goodwill of the
firm.

2.2 Requirements of Material Control

Material control requirements can be summarised as follows:

1. Proper co-ordination of all departments involved viz., finance, purchasing,

receiving, inspection, storage, accounting and payment.
2. Determining purchase procedure to see that purchases are made, after
making suitable enquiries, at the most favourable terms to the firm.

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3. Use of standard forms for placing the order, noting receipt of goods,
authorising issue of the materials etc.
4. Preparation of budgets concerning materials, supplies and equipment to
ensure economy in purchasing and use of materials.
5. Operation of a system of internal check so that all transactions involving
materials, supplies and equipment purchases are properly approved and
automatically checked.
6. Storage of all materials and supplies in a well designated location with
proper safeguards.
7. Operation of a system of perpetual inventory together with continuous stock
checking so that it is possible to determine, at any time, the amount and the
value of each kind of material in stock.

8. Operation of a system of stores control and issue so that there will be delivery
of materials upon requisition to departments in the right amount at the time
they are needed.
9. Development of system of controlling accounts and subsidiary records which
exhibit summary and detailed material costs at the stage of material receipt
and consumption.
10. Regular reports of materials purchased issue from stock, inventory balances,
obsolete stock, goods returned to vendors, and spoiled or defective units
are required.

2.3 Elements of Material Control

Material control is a systematic control over the procurement, storage and usage
of material so as to maintain an even flow of material.

Material Control

Material
Material Storage Material Usage
Procurement Control Control
Control

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Material control involves efficient functioning of the following operations:

• Purchasing of materials
• Receiving of materials
• Inspection of materials
• Storage of materials
• Issuing materials
• Maintenance of inventory records
• Stock audit

3. MATERIALS PROCUREMENT PROCEDURE

Material procurement procedure can be understood with help of the following
diagram. Documents required and the departments who initiate these documents
are shown sequentially.

Diagram: Material Procurement Procedure

[The name of the departments and documents shown in the diagram are for illustrative purpose only]

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3.1 Bill of Materials

It is also known as Materials Specification List or Materials List. It is a detailed
list specifying the standard quantities and qualities of materials and
components required for producing a product or carrying out of any job. The
materials specification list is prepared by the product development team
commonly known as engineering or planning department in a standard form. This
is shared with other concerned departments like Marketing, Production, Store, and
Cost/ Accounting department.
Format and content of a Bill of Materials vary on the basis of industrial
peculiarities, management information system (MIS) and accounting system in
place.
Uses of Bill of Material

Marketing Production Dept. Stores Dept. Cost/ Accounting

(Purchase) Dept.
Dept.

Materials are Production is planned It is used as a It is used to estimate

procured according to the reference cost and profit. Any
(purchased) on nature, volume of the document while purchase, issue and
the basis of materials required to issuing materials usage are
specifications be used. Accordingly, to the compared/verified
mentioned in it. material requisition requisitioning against this
lists are prepared. department. document.

3.2 Material Requisition Note

It is also known as material requisition slip. It is a voucher of authority used to
get materials issued from store. Generally, it is prepared by the production
department and materials are withdrawn on the basis of material requisition list or
bill of materials. If no material list has been prepared, it is desirable that the task
of the preparation of material requisition notes be left to the planning department
or by the department requires the materials. The note is shared with Store and
Cost/ Accounting department.

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Format of a Material requisition note may vary on the basis of Industrial

Peculiarities, Management Information System (MIS) and Accounting System in
place.

Difference between Bill of Materials and Material Requisition Note

Bill of Materials Material Requisition Note

1. It is the document prepared by the 1. It is prepared by the production

engineering or planning dept. or other consuming department.

2. It is a complete schedule of 2. It is a document asking

component parts and raw materials Store-keeper to issue materials
required for a particular job or work to the consuming department.
order.

3. It often serves the purpose of a 3. It cannot replace a bill of

material requisition as it shows the materials.
complete schedule of materials
required for a particular job i.e. it can
replace material requisition.

4. It can be used for the purpose of 4. It is useful in arriving historical

quotations. cost only.

5. It helps in keeping a quantitative 5. It shows the material actually

control on materials drawn through drawn from stores.
material requisition.

3.3 Purchase Requisition

This document authorises the purchase department to order for the materials
specified in the note. Since the materials purchased will be used by the production
departments, there should be constant co-ordination between the purchase and
production departments. A purchase requisition is a form used for making a
formal request to the purchasing department to purchase materials. This
form is usually filled up by the store keeper for regular materials and by the
departmental head for special materials (not stocked as regular items).

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At the beginning a complete list of materials and stores required should be drawn
up, which should be reviewed periodically for any addition or deletion. On the
basis of standing order, once an item is included in the standard list, it becomes
the duty of the purchase department to arrange for fresh supplies before existing
stocks are exhausted. Any change in the consumption pattern should be informed
to the purchase department for necessary action from their end.
For control over buying of regular store materials, Inventory control system is to
determine stock levels to be maintained and the number of quantities to be
ordered. In respect of special materials, required for a special order or purpose, it
is desirable that the concerned technical department should prepare materials
specifications list specifying the quantity, size and order for the materials.
Purchase requisition note may either be originated by the stores department in
connection with regular materials or by the production planning or other technical
departments in respect of special materials.
Format of a purchase requisition note may vary on the basis of Industrial
Peculiarities, Management Information System (MIS) and Accounting System in
place.

3.4 Inviting Quotation/ Request for Proposal (RFP)/

Notification Inviting Tender (NIT)
Materials purchase department has to answer the following question before
initiating purchasing of materials:
(i) What to purchase?
(ii) When to purchase?
(iii) How much to purchase?
(iv) From where to purchase?
(v) At what price to purchase?
The following are the few suggestive steps to answer to the questions:
(i) What to purchase?
Materials are purchased as per the requisition received from the stores or
user departments. In case of materials used regularly, the materials are
purchased as per the standard operating procedures (SOP).

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(ii) When to purchase?

Materials are purchased considering the need for the materials for
production and safety, however, the timing of placing the order is very
important to get the materials replenished before the requirement arise and
without affecting the production schedule. Supply of materials i.e., how
easily the materials are available in the market, Lead time i.e., time required
to get the order from supplier’s place to production place, consumption
pattern of materials are the important factors which affects the timing of
purchase. Related to the question, later in this chapter Re-order Stock Level
will be learnt. Further the concept of just-in-time (JIT), which is briefly
discussed in this chapter is also associated with the question ‘when’ to
purchase.

(iii) How much to purchase?

The quantity of materials to be ordered depends on the factors like material

consumption pattern, minimum order size as offered by the supplier,
quantity discount, storage cost and capacity and working capital
requirement etc. The concept of Economic Order Quantity (EOQ) will be
discussed later in this chapter.

(iv) Where to purchase?

This is the process of selecting supplier of materials to be purchased. This is

a very sensitive and crucial process, though for every organization but
specifically for the organizations where public money is involved i.e., public
sector undertakings (PSUs). Selection process of supplier could be a grey area
which attracts special attention of regulators like CVC (Central Vigilance
Commission), CAG (Comptroller and Auditor General of India), Auditors and
others. The question is why this is so sensitive to attract attention of
watchdogs. The answer to this question is in a line from Preamble of the
Constitution of India, which reads as to secure to all its citizens: “Equality of
status and of opportunity”. This means the supplier selection process be such
transparent and fair that all suppliers are treated equal to get opportunity in
participation in Tender process.

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The selection process starts with Enquiry/Request for Proposals (RFP)/

Notification Inviting Tender (NIT). The geographical area for an enquiry/ RFP
or NIT can be local or global depending on the propriety, availability and
government guidelines for materials to be purchased. The RFP or NIT can be
floated offline i.e., manual process or online by publishing on website or
designated electronic market places. One of the examples of electronic
market place is GeM (Government e Marketplace).
Government e Marketplace (GeM): A dedicated e-market for different
goods & services procured by Government Organisations / Departments /
PSUs. It aims to enhance transparency, efficiency and speed in public
procurement. It provides the tools of e-bidding, reverse e-auction and
demand aggregation to facilitate the government users, achieve the best
value for their money. The purchases through GeM by Government users
have been authorised and made mandatory by Ministry of Finance.
(v) At what price to purchase?
The answer to the question is discussed in the following paragraph where
the Lowest bidder (also called L1 bidder) for the material is selected.

3.5 Selection of Quotation/ Proposal

After invitation of tender from the vendors, interested vendors who are fulfilling
all the criteria mentioned in the tender notice send their price quotations/
proposals to the purchase department. On the receipt of quotations, a
comparative statement is prepared. For selecting material suppliers, the factors
which the purchase department keeps in its mind are—price, quantity, quality
offered, time of delivery, mode of transportation, terms of payment, reputation of
supplier etc. In addition to the above listed factors purchase manager obtains
other necessary information for final selection of material suppliers.

3.6 Preparation and Execution of Purchase Orders

Having decided on the best quotation that should be accepted, the purchase
manager or concerned officer proceeds to issue the formal purchase order. It is a
written request to the supplier to supply specified materials at specified rates and
within a specified period. Generally, copies of purchase order are given to Store or

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order indenting department, receiving department and cost accounting

department. A copy of the purchase order with relevant purchase requisitions, is
held in the file of the department to facilitate the follow-up of the delivery and
also for approval of the invoice for payment.

3.7 Receipt and Inspection of Materials

After execution of purchase order and advance payment (if terms of quotation so
specify), necessary arrangement is made to receive the delivery of materials After
receipt of materials along with relevant documents or/ and invoice, receiving
department (store dept.) arrange to inspect the materials for its conformity with
purchase order. After satisfactory inspection, materials are received and Goods
Received Note is issued. If some materials are not found in good condition or are
not in conformity with the purchase order are returned back to the vendor along
with a Material Returned Note.

3.7.1 Goods Received Note

If everything is in order and the supply is considered suitable for acceptance, the
Receiving department prepares a Receiving Report or Material Inward Note or
Goods Received Note. Generally, it is prepared in quadruplicate, the copies being
distributed to purchase department, store or order indenting department,
receiving department and accounting department.
3.7.2 Material Returned Note
Sometimes materials have to be returned to suppliers after these have been
received in the factory. Such returns may occur before or after the preparation of
the receiving report. If the return takes place before the preparation of the
receiving report, such material obviously would not be included in the report and
hence not shown in the stores ledgers. In that case, no adjustment in the account
books would be necessary. But if the material is returned after its entry in the
receiving report, a suitable document must be drawn up in support of the issue so
as to exclude from the Stores of Material Account the value of the materials
returned back. This document usually takes the form of a Material Returned Note
or Material outward return note.

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3.8 Checking and Passing of Bills for Payment

The invoice received from the supplier is sent to the accounts section to check
authenticity and mathematical accuracy. The quantity and price are also checked
with reference to goods received note and the purchase order respectively. The
accounts section after checking its accuracy finally certifies and passes the invoice
for payment.

4. VALUATION OF MATERIAL RECEIPTS

After the procurement of materials from the supplier actual material cost is
calculated. Ascertainment of cost of material purchased is called valuation of
materials receipts. Cost of material includes cost of purchase net of trade
discounts, rebates, duty draw-back, input credit availed, etc. and other costs
incurred in bringing the inventories to their present location and condition.
Invoice of material purchased from the market sometime contain items such as
trade discount, quantity discount, freight, duty, insurance, cost of containers,
taxes, cash discount etc.
Treatment of items associated with purchase of materials is tabulated as below

Sl No. Items Treatment

Discounts and Subsidy

(i) Trade Trade discount is deducted from the purchase

Discount price if it is not shown as deduction in the invoice.

(ii) Quantity Like trade discount quantity discount is also shown

Discount as deduction from the invoice. It is deducted from
the purchase price if not shown as deduction.

(iii) Cash Discount Cash discount is not deducted from the purchase
price. It is treated as interest and finance item. It is
ignored.

(iv) Subsidy/ Any subsidy/ grant/ incentive received from the

Grant/ Government or from other sources deducted from
Incentives the cost of purchase.

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Duties and Taxes

(v) Road Tax/ Toll Road tax/ Toll tax, if paid by the buyer, is included
Tax with the cost of purchase.

(vi) Goods and Goods and Service Tax (GST) is paid on supply of
Service Tax goods and provision of services and collected from
(GST) the buyers. It is excluded from the cost of
purchase if credit for the same is available. Unless
mentioned specifically it should not form part of
cost of purchase.

(vii) Custom Duty Custom duty is paid on import of goods from

outside India. It is added with the purchase cost.

Penalty and Charges

(viii) Demurrage Demurrage is a penalty imposed by the transporter

for delay in uploading or offloading of materials. It
is an abnormal cost and not included with cost of
purchase

(ix) Detention Detention charges/ fines imposed for

charges/ Fine non-compliance of rule or law by any statutory
authority. It is an abnormal cost and not included
with cost of purchase

(x) Penalty Penalty of any type is not included with the cost of
purchase

Other expenditures

(xi) Insurance Insurance charges are paid for protecting goods

charges during transit. It is added with the cost of purchase.

(xii) Commission or Commission or brokerage paid is added with the

brokerage paid. cost of purchase.

(xiii) Freight inwards It is added with the cost of purchase as it is directly

attributable to procurement of material.

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(xiv) Cost of Treatment of cost of containers are as follows:

containers • Non-returnable containers: The cost of
containers is added with the cost of purchase
of materials.
• Returnable Containers: If the containers are
returned and their costs are refunded, then
cost of containers should not be considered in
the cost of purchase.
• If the amount of refund on returning the
container is less than the amount paid, then,
only the short fall is added with the cost of
purchase.
(xv) Shortage Shortage in materials is treated as follows:
Shortage due to normal reasons: Good units
absorb the cost of shortage due to normal reasons.
Losses due to breaking of bulk, evaporation, or due
to any unavoidable conditions etc. are the reasons
of normal loss.
Shortage due to abnormal reasons: Shortage
arises due to abnormal reasons such as material
mishandling, pilferage, or due to any avoidable
reasons are not absorbed by the good units. Losses
due to abnormal reasons are debited to costing
profit and loss account.

ILLUSTRATION 1
An invoice in respect of a consignment of chemicals A and B provides the following
information:

(`)
Chemical A: 10,000 kgs. at ` 10 per kg. 1,00,000
Chemical B: 8,000 kgs. at ` 13 per kg. 1,04,000
Basic custom duty @ 10% (Credit is not allowed) 20,400
Railway freight 3,840
Total cost 2,28,240

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A shortage of 500 kgs. in chemical A and 320 kgs. in chemical B is noticed due to
normal breakages. You are required to COMPUTE the rate per kg. of each chemical,
assuming a provision of 2% for further deterioration.
SOLUTION
Working:

Computation of effective quantity of each chemical available for use

Chemical A (kg.) Chemical B (kg.)

Quantity purchased 10,000 8,000

Less: Shortage due to normal breakages 500 320

9,500 7,680

Less: Provision for deterioration 2% 190 153.6

Quantity available 9,310 7,526.4

Statement showing the computation of rate per kg. of each chemical

Chemical A (`) Chemical B (`)

Purchase price 10,000@ `10 per kg, 1,00,000 1,04,000

8,000@`13 per kg

Add: Basic Custom Duty @10% 10,000 10,400

Add: Railway freight

(in the ratio of quantity purchased i.e., 5:4) 2,133 1,707

Total cost (A) 1,12,133 1,16,107

Effective Quantity (see working) (B) 9,310 kg. 7,526.4 kg.

Rate per kg. (A ÷ B) 12.04 15.43

ILLUSTRATION 2
At WHAT price per unit would Part No. A 32 be entered in the Stores Ledger, if the
following invoice was received from a supplier:

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Invoice (` )

200 units Part No. A 32 @ ` 5 1,000.00

Less: 20% discount (200.00)

800.00

Add: GST @ 12% 96.00

896.00

Add: Packing charges (5 non-returnable boxes) 50.00

946.00

(i) A 2 per cent cash discount will be given if payment is made in 30 days.
(ii) Documents substantiating payment of GST are enclosed for claiming Input
credit.
SOLUTION
Computation of cost per unit
(`)

Net purchase Price 800.00

Add: Packing charges (5 non-returnable boxes) 50.00

850.00

No. of units purchased 200 units

Cost per unit 4.25

Note: (i) Cash discount is treated as interest and finance charges, hence, it is not
considered for valuation of material.

(ii) Input credit is available for GST paid; hence it will not be added to
purchase cost.

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5. MATERIAL STORAGE & RECORDS

Proper storing of materials is of primary importance. It is not enough only to
purchase material of the required quality. If the purchased material subsequently
deteriorates in quality because of bad storage, the loss is even more than what
might arise from purchase of bad quality of materials. Apart from preservation of
quality, the store-keeper also ensures safe custody of the material. It should be
the function of store-keeper that the right quantity of materials always should be
available in stock.

5.1 Duties of Store Keeper

These can be briefly set out as follows:
(i) General control over store: Store keeper should keep control over all
activities in Stores department. He should check the quantities as mentioned
in Goods received note and with the purchased materials forwarded by the
receiving department and to arrange for the storage in appropriate places.
(ii) Safe custody of materials: Store keeper should ensure that all the materials
are stored in a safe condition and environment required to preserve the
quality of the materials.
(iii) Maintaining records: Store keeper should maintain proper record of
quantity received, issued, balance in hand and transferred to/ from other
stores.
(iv) Initiate purchase requisition: Store keeper should initiate purchase
requisitions for the replacement of stock of all regular stores items whenever
the stock level of any item of store approaches the re-order level fixed.
(v) Maintaining adequate level of stock: Store keeper should maintain
adequate level of stock at all time. He/ she should take all the necessary
action so that production could not be interrupted due to lack of stock.
Further he/ she should take immediate action for stoppage of further
purchasing when the stock level approaches the maximum limit. He also
needs to reserve a particular material for a specific job when so required.

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(vi) Issue of materials: Store keeper should issue materials only against the
material requisition slip approved by the appropriate authority. He/ she
should also refer to bill of materials while issuing materials to requisitioning
department.
(vii) Stock verification and reconciliation: Store keeper should verify the book
balances with the actual physical stock at frequent intervals by way of
internal control and check the any irregular or abnormal issues, pilferage,
etc.

5.2 Store Records

The record of stores may be maintained in three forms:
 Bin Cards
 Stock Control Cards
 Store Ledger
Bin Cards: It is a quantitative record of inventory which shows the quantity of
inventory available in a particular bin. Bin refers to a box/ container/ space where
materials are kept. Card is placed with each of the bin (space) to record the details
of material like receipt, issue and return. It is maintained by store department.
Stock Control Cards: It is also a quantitative record of inventory maintained by
stores department for every item of material. In other words, it is a record which
shows the overall inventory position in store. Recording includes receipt, issue,
return, in hand and order given.

Advantages and Disadvantages of Bin Cards

Advantages:
(i) There would be fewer chances of mistakes being made as entries are made
at the same time as goods received or issued by the person actually
handling the materials.
(ii) Control over stock can be more effective, as comparison of the actual
quantity in hand at any time with the book balance is possible.
(iii) Identification of the different items of materials is facilitated by reference to
the Bin Card, the bin or storage receptacle.

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Disadvantages
(i) Store records are dispersed over a wide area.
(ii) The cards are liable to be smeared with dirt and grease because of proximity
to material and also because of handling materials.
(iii) People handling materials are not ordinarily suitable for the clerical work
involved in writing Bin Cards.
Advantages and Disadvantages of Stock Control Cards
Advantages:
(i) Records are kept in a more compact manner so that reference to them is
facilitated.
(ii) Records can be kept in a neat and clean way by men solely engaged in
clerical work so that a division of workers between record keeping and
actual material handling is possible.
(iii) As the records are at one place, it is possible to get an overall idea of the
stock position without the necessity of going round the stores.
Disadvantages:
(i) On the spot comparison of the physical stock of an item with its book
balance is not facilitated.
(ii) Physical identification of materials in stock may not be as easy as in the case
of bin cards, as the Stock Control Cards are housed in cabinets or trays.
Stores Ledger: A Stores Ledger is maintained to record both quantity and cost
of materials received, issued and those in stock. It is a subsidiary ledger to the
main cost ledger; it is maintained by the Cost/ Accounts Department. The source
documents for posting the ledger are Goods received notes, Materials requisition
notes etc.
The first two forms are records of quantities received, issued and those in balance,
but in the third record i.e. store ledger, value of receipts, issues and closing
balance is also maintained. Usually, records of quantities i.e. Bin cards and Store
Control Cards are kept by the store keeper in store department while record of both
quantity and value is maintained by cost accounting department.

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Difference between Bin Card & Stores Ledger

Bin Card Stores Ledger

It is maintained by the storekeeper in It is maintained in cost accounting

the store. department.

It contains only quantitative details of It contains information both in

material received, issued and quantity and value.
returned to stores.

Entries are made when transaction It is always posted after the

takes place. transaction.

Each transaction is individually Transactions may be summarized and

posted. then posted.

Inter-department transfers do not Material transfers from one job to

appear in Bin Card. another job are recorded for costing
purposes.

6. INVENTORY CONTROL
The Chartered Institute of Management Accountants (CIMA) defines Inventory
Control as “The function of ensuring that sufficient goods are retained in stock to
meet all requirements without carrying unnecessarily large stocks.”
The objective of inventory control is to make a balance between sufficient stock
and over-stock. The stock maintained should be sufficient to meet the production
requirements so that uninterrupted production flow can be maintained.
Insufficient stock not only pause the production but also cause a loss of revenue
and goodwill. On the other hand, inventory requires some funds for purchase,
storage, maintenance of materials with a risk of obsolescence, pilferage etc. The
main objective of inventory control is to maintain a trade-off between stock-out
and over-stocking. The management may employ various methods of inventory
control to have a balance. Management may adopt the following basis for
inventory control:

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 2.22 COST AND MANAGEMENT ACCOUNTING

Inventory Control

By Setting On the basis of

Using Ratio
Quantitative Relative Physical Control
Analysis
Levels Classification

6.1 Inventory Control- By Setting Quantitative Levels

Re-order Stock Level •When to Order

Re-order Quantity/ EOQ •How Much to Order

Maximum Stock Level •Upto How much to stock

Minimum Stock Level •Atleast How much to stock

Average Stock Level •Stock normally kept

Danger Stock Level •Kept for emergency requirement

Buffer Stock •To meet sudden demand

(i) Re-order Stock Level (ROL): This level lies between minimum and the
maximum levels in such a way that before the material ordered is received
into the stores, there is sufficient quantity in hand to cover both normal and
abnormal consumption situations. In other words, it is the level at which
fresh order should be placed for replenishment of stock.
It is calculated as:
ROL = Maximum Consumption × Maximum Re-order Period

Maximum Consumption = The maximum rate of material

consumption in production activity
Maximum Re-order period = The maximum time to get order from
supplier to the stores

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 MATERIAL COST 2.23
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This can also be calculated alternatively as below:

ROL = Minimum Stock Level + (Average Rate of Consumption × Average
Re-order period)
Minimum Stock Level = Minimum Stock level that must be
maintained all the time.
Average Rate of Consumption = Average rate of material consumption in
production activity. It is also known as
normal consumption/ usage
Average Re-order period = Average time to get an order from
supplier to the stores. It is also known as
normal period.

(Re-order period is also known as Lead time)

(ii) Re-Order Quantity: Re-order quantity is the quantity of materials for which
purchase requisition is made by the store department. While setting the
quantity to be re-ordered, consideration is given to the maintenance of
minimum level of stock, re-order level, minimum delivery time and the most
important the cost. Hence, the quantity should be where, the total of
carrying cost and ordering cost is at minimum. For this purpose, an
economic order quantity should be calculated.
Economic Order Quantity (EOQ): The size of an order for which total of
ordering and carrying cost are minimum.
Ordering Cost: Ordering costs are the costs which are associated with the
purchase or order of materials such as cost to invite quotations,
documentation works like preparation of purchase orders, employee cost
directly attributable to the procurement of material, transportation and
inspection cost etc.
Carrying Cost: Carrying costs are the costs for holding/ carrying of
inventories in store such as the cost of fund invested in inventories, cost of
storage, insurance cost, obsolescence etc.

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 2.24 COST AND MANAGEMENT ACCOUNTING

The Economic Order Quantity (EOQ) is calculated as below:

2 × Annual Requirement (A) ×Cost per order (O)

EOQ =
Carrying Costperunitper annum (C)

Annual Requirement (A)- It represents demand for raw material or Input for a
year.
Cost per Order (O) - It represents cost of placing an order for purchase.
Carrying Cost (C) – It represents cost of carrying average inventory on annual
basis.
Assumptions underlying E.O.Q. : The calculation of economic order of
material to be purchased is subject to the following assumptions:
(i) Ordering cost per order and carrying cost per unit per annum are
known and they are fixed.

(ii) Anticipated usage of material in units is known.

(iii) Cost per unit of the material is constant and is known as well.
(iv) The quantity of material ordered is received immediately i.e. the lead
time is zero.

ILLUSTRATION 3
CALCULATE the Economic Order Quantity from the following information. Also
state the number of orders to be placed in a year.
Consumption of materials per annum : 10,000 kg.

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 MATERIAL COST 2.25
2.25

Order placing cost per order : ` 50

Cost per kg. of raw materials : `2
Storage costs : 8% on average inventory
SOLUTION

2× A ×O
EOQ =
C
A = Units consumed during year = 10,000
O = Ordering cost per order = 50
C = Inventory carrying cost per unit per annum. = 8% of ` 2

2 ´ 10,000 ´ 50 2×10,000×50×25
EOQ = = = 2,500 kg
2´ 8 4
100

No. of orders to be placed in a year

= Total consumption of materials per annum

EOQ

= 10,000 kg. = 4 Orders per year

2,500 kg.

ILLUSTRATION 4
(i) COMPUTE E.O.Q. and the total variable cost for the following:
Annual Demand = 5,000 units
Unit price = ` 20.00
Order cost = ` 16.00
Storage rate = 2% per annum

Interest rate = 12% per annum

Obsolescence rate = 6% per annum
(ii) DETERMINE the total cost that would result for the items if a new price
of ` 12.80 is used.

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 2.26 COST AND MANAGEMENT ACCOUNTING

SOLUTION
(i) Carrying cost (C) = Storage rate = 2%
Interest Rate = 12%
Obsolescence Rate = 6%
Total = 20% per annum
C= 20% of `Rs 20 = `Rs 4 per unit per annum.

2AO 2×5000×16
E.O.Q = = = 40,000 = 200 units
C 4

Total cost:
Purchase price of 5,000 units @ ` 20.00 per unit = ` 1,00,000
5000
Ordering cost = =25 orders @ ` 16 = ` 400
200

Carrying cost of average Inventory

200
= =100 units @ ` 4 = ` 400
2

Total cost ` 1,00,800

(ii) If the new price of ` 12.80 is used:

C = 20% of 12.80 = ` 2.56 per unit per annum.

2×5,000×16
E.O.Q. = = 250 units
2.56

Total cost:
Purchase price of 5,000 units @ ` 12.80 per unit = ` 64,000
5,000
Ordering cost = = 20 orders @ ` 16 = ` 320
250

Carrying cost (of average inventory) = 250 =125 units @ ` 2.56= ` 320
2

Total variable cost ` 64,640

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 MATERIAL COST 2.27
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(iii) Minimum Stock Level: It is lowest level of material stock, which must be
maintained in hand at all times, so that there is no stoppage of production
due to non-availability of inventory.
It is calculated as below:
Minimum Stock Level = Re-order Stock Level - (Average Consumption Rate
× Average Re-order Period)

(iv) Maximum Stock Level: It is the highest level of quantity for any material
which can be held in stock at any time. Any quantity beyond this level cause
extra amount of expenditure due to engagement of fund, cost of storage,
obsolescence etc.
It can be calculated as below:
Maximum Stock Level = Re-order Level + Re-order Quantity - (Minimum
Consumption Rate × Minimum Re-order Period)
Here, Re-order Quantity may be EOQ
(v) Average Inventory Level: This is the quantity of material that is normally
held in stock over a period. It is also known as normal stock level.
It can be calculated as below:
Average Stock Level = Minimum Stock Level + 1/2 Re-order Quantity
Alternatively, it can be calculated as below:
Maximum Stock Level + Minimum StockLevel
Average Stock Level =
2
(vi) Danger level: It is the level at which normal issues of the raw material
inventory are stopped and emergency issues are only made.
It can be calculated as below:
Danger Level = Average Consumption* × Lead time for emergency purchase
*Some time minimum consumption is also used.
(vii) Buffer Stock: Some quantity of stock may be kept for contingency to be
used in case of sudden order, such stock is known as buffer stock.

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 2.28 COST AND MANAGEMENT ACCOUNTING

All the above stock levels can be understood with the help of the following
diagram:
Stock Control Chart

When the materials are purchased, the level keeps rising. It may reach maximum
level if the rate of issuance is less. As the materials are consumed, the stock level
starts declining. At re-order level, reorder quantity is ordered and fresh supplies
are normally received when stocks reach minimum level. The time interval
between re-order level, when the fresh order is placed, and the time of actual
receipt of materials is known as lead time.
ILLUSTRATION 5
Two components, A and B are used as follows:

Normal usage 50 per week each

Maximum usage 75 per week each
Minimum usage 25 per week each

Re-order quantity A: 300; B: 500

Re-order period A: 4 to 6 weeks
B: 2 to 4 weeks

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CALCULATE for each component (a) Re-ordering level, (b) Minimum level, (c)
Maximum level, (d) Average stock level.
SOLUTION
(a) Re-ordering level:
Maximum usage per week × Maximum delivery period.

Re-ordering level for component A = 75 units × 6 weeks = 450 units

Re-ordering level for component B = 75 units × 4 weeks = 300 units
(b) Minimum level:
Re-order level – (Normal usage × Average period)
Minimum level for component A = 450 units – (50 units × 5 weeks) = 200 units
Minimum level for component B = 300 units – (50 units × 3 weeks) = 150 units
(c) Maximum level:
Re-order level + Re-order quantity – (Min. usage × Minimum period)
Maximum level for component A = (450 units + 300 units) – (25 units × 4
weeks) = 650 units
Maximum level for component B = (300 units + 500 units) – (25 units × 2
weeks) = 750 units
(d) Average stock level:
½ (Minimum + Maximum) stock level
Average stock level for component A = ½ (200 units + 650 units) =425 units.

Average stock level for component B = ½ (150 units + 750 units) =450 units.
ILLUSTRATION 6
From the details given below, CALCULATE:
(i) Re-ordering level
(ii) Maximum level

(iii) Minimum level

(iv) Danger level.

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 2.30 COST AND MANAGEMENT ACCOUNTING

Re-ordering quantity is to be calculated on the basis of following information:

Cost of placing a purchase order is ` 20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is ` 50
Annual cost of storage per units is ` 5.
Details of lead time : Average- 10 days, Maximum- 15 days, Minimum- 5 days.

For emergency purchases- 4 days.

Rate of consumption : Average: 15 units per day,
Maximum: 20 units per day.
SOLUTION
Basic Data:
A (Number of units to be purchased annually) = 5,000 units
O (Ordering cost per order) = ` 20
C (Annual cost of storage per unit) = `5
Purchase price per unit inclusive of transportation cost = ` 50.
Computations:
(i) Re-ordering level = Maximum usage per period × Maximum lead time
(ROL) = 20 units per day × 15 days
= 300 units
(ii) Maximum level = ROL + ROQ – [Min. rate of consumption × Min.
(Refer to working notes1 and 2) lead time]
= 300 units + 200 units – [10 units per day × 5 days]
= 450 units
(iii) Minimum level = ROL – Average rate of consumption × Average re-
order-period
= 300 units – (15 units per day × 10 days)
=150 units

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(iv) Danger level = Average consumption × Lead time for emergency

purchases
= 15 units per day × 4 days
= 60 units
Working Notes:
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2
X units/day + 20 units per day
15 units per day = or X = 10 units per day.
2

2. Re-order Quantity (ROQ) or Economic Order Quantity (EOQ) =

2×5,000 units×` 20
= 200 units
5

6.2 Inventory Stock-Out

Stock out is said to be occurred when an inventory item could not be supplied
due to insufficient stock in the store. The stock- out situation costs to the entity
not only in financial terms but in non-financial terms also. Due to stock out an
entity not only loses overheads costs and profit but reputation (goodwill) also due
to non-fulfilment of commitment. Though it may not be a monetary loss in short
term but in long term it could be a reason for financial loss.

While deciding on the level of inventory, a trade-off between the stock out cost
and carrying cost is made so that overall inventory cost can be minimized.
ILLUSTRATION 7
M/s Tyrotubes trades in four-wheeler tyres and tubes. It stocks sufficient quantity of
tyres of almost every vehicle. In year end 2022-23, the report of sales manager
revealed that M/s Tyrotubes experienced stock-out of tyres.

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 2.32 COST AND MANAGEMENT ACCOUNTING

The stock-out data is as follows:

Stock-out of Tyres No. of times of Stock Out

100 2
80 5
50 10
20 20
10 30
0 33

M/s Tyrotubes loses ` 150 per unit due to stock-out and spends ` 50 per unit on
carrying of inventory.
DETERMINE optimum safest stock level.
SOLUTION
Computation of Stock-out and Inventory carrying cost

Safety Stock- Probability Stock- Expected Inventory Total

Stock out (3) out cost stock-out carrying cost cost (`)
Level (units) (`) cost (`) (`) (7) =
(units) (2) (4) = (2) (5)=(3)x(4) (6) =(1)x` 50 (5)+(6)
(1) x ` 150
100 0 0.33 0 0 5,000 5,000
80 20 0.02 3,000 60 4,000 4,060
50 50 0.02 7,500 150
30 0.05 4,500 225
12,000 375 2,500 2,875
20 80 0.02 12,000 240
60 0.05 9,000 450
30 0.10 4,500 450
25,500 1,140 1,000 2,140
10 90 0.02 13,500 270
70 0.05 10,500 525

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 MATERIAL COST 2.33
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40 0.10 6,000 600

10 0.20 1,500 300
31,500 1,695 500 2,195
0 100 0.02 15,000 300 2,700
80 0.05 12,000 600
50 0.10 7,500 750
20 0.20 3,000 600
10 0.30 1,500 450
39,000 2,700 0 2,700

At safety stock level of 20 units, total cost is least i.e., ` 2,140.

Working Note:
Computation of Probability of Stock-out

Stock-out (units) 100 80 50 20 10 0 Total

Nos. of times 2 5 10 20 30 33 100
Probability 0.02 0.05 0.10 0.20 0.30 0.33 1.00

Explanation:
Stock-out means the demand of an item that could not be fulfilled because of
insufficient stock level.
Safety stock is the level of stock of any item which is maintained in excess of
lead time consumption. It is kept as cushion against any unexpected demand
for that item.

Safety stock Impact

level
100 units Any unexpected demand up-to 100 units can be met.
80 units Stock out will only arise if unexpected demand will be for 100
units. In this case 20 units will remain unsatisfied. The
probability of any unexpected demand for 100 units is 0.02.

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 2.34 COST AND MANAGEMENT ACCOUNTING

50 units Any unexpected demand beyond 50 units will be remain

unsatisfied. If unexpected demand for 100 units arises
(probability is 0.02) 50 units will be unsatisfied. Similarly, if
unexpected demand for 80 units arises (probability is 0.05), 30
units will be unsatisfied.

20 units Any unexpected demand beyond 20 units will be remain

unsatisfied. If unexpected demand for 100 units arises
(probability is 0.02), 80 units will remain unsatisfied. If
unexpected demand for 80 units arises (probability is 0.05), 60
units will remain unsatisfied. Similarly, when unexpected
demand for 50 units arises (probability is 0.10), 30 units will
remain unsatisfied.

10 units Any unexpected demand beyond 10 units will be remain

unsatisfied. If unexpected demand for 100 units arises
(probability is 0.02), 90 units will remain unsatisfied. If
unexpected demand for 80 units arises (probability is 0.05), 70
units will remain unsatisfied. If unexpected demand for 50 units
arises (probability is 0.10), 40 units will remain unsatisfied.
Similarly, when unexpected demand for 20 units arises
(probability is 0.20), 10 units will remain unsatisfied.

0 unit When no safety stock level is maintained, any unexpected

demand cannot be satisfied. If unexpected demand for 100
units arises (probability is 0.02), 100 units will remain
unsatisfied. If unexpected demand for 80 units arises
(probability is 0.05), 80 units will remain unsatisfied. If
unexpected demand for 50 units arises (probability is 0.10), 50
units will remain unsatisfied. If unexpected demand for 20 units
arises (probability is 0.20), 20 units will remain unsatisfied.
Similarly, unexpected demand for 10 units (probability is 0.30),
10 units will remain unsatisfied.

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6.3 Just In Time (JIT) Inventory Management

JIT is a system of inventory management with an approach to have zero
inventories in stores. According to this approach material should only be
purchased when it is actually required for production.
JIT is based on two principles
(i) Produce goods only when it is required and

(ii) the products should be delivered to customers at the time only when they want.
It is also known as ‘Demand pull’ or ‘Pull through’ system of production. In
this system, production process actually starts after the order for the products is
received. Based on the demand, production process starts and the requirement for
raw materials is sent to the purchase department for purchase. This can be
understood with the help of the following diagram:

Production Material Order for

Supplier
Demand starts to requirement is raw
sends the
for final process the sent to the materials
material for
product demand for Purchase sent to
production
product department supplier

6.4 Inventory Control- On the basis of Relative

Classification

ABC Analysis •On the basis of value and frequency of inventory

•On the basis of inventory turnover

Fast, Slow and Non Moving (FSN)

Vital, Essential and Desirable (VED) •On the basis of importance of inventory

High, Medium and Low (HML) •On the basis of price of an item of inventory

(1) ABC Analysis: This system exercises discriminating control over different
items of inventory on the basis of the investment involved. Usually the items are
classified into three categories according to their relative importance, namely,
their value and frequency of replenishment during a period.

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(i) ‘A’ Category: This category of items consists of only a small percentage i.e.,
about 10% of the total items handled by the stores but require heavy
investment about 70% of inventory value, because of their high prices or
heavy requirement or both. Items under this category can be controlled
effectively by using a regular system which ensures neither over-stocking
nor shortage of materials for production. Such a system plans its total
material requirements by making budgets. The stocks of materials are
controlled by fixing certain levels like maximum level, minimum level and
re-order level.
(ii) ‘B’ Category: This category of items is relatively less important; they may be
20% of the total items of material handled by stores. The percentage of
investment required is about 20% of the total investment in inventories. In the
case of these items, as the sum involved is moderate, the same degree of
control as applied in ‘A’ category of items is not warranted. The orders for
the items, belonging to this category may be placed after reviewing their
situation periodically.
(iii) ‘C’ Category: This category of items does not require much investment; it
may be about 10% of total inventory value but they are nearly 70% of the
total items handled by store. For these categories of items, there is no need
of exercising constant control. Orders for items in this group may be placed
either after six months or once in a year, after ascertaining consumption
requirements. In this case the objective is to economies on ordering and
handling costs.

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ILLUSTRATION 8
From the following details, DRAW a plan of ABC selective control:

Item Units Unit cost (`)

1 7,000 5.00

2 24,000 3.00

3 1,500 10.00

4 600 22.00

5 38,000 1.50

6 40,000 0.50

7 60,000 0.20

8 3,000 3.50

9 300 8.00

10 29,000 0.40

11 11,500 7.10

12 4,100 6.20

SOLUTION
Statement of Total Cost and Ranking

Item Units % of Total Unit cost Total % of Total Ranking

units (`) cost (`) cost

1 7,000 3.1963 5.00 35,000 9.8378 4

2 24,000 10.9589 3.00 72,000 20.2378 2

3 1,500 0.6849 10.00 15,000 4.2162 7

4 600 0.2740 22.00 13,200 3.7103 8

5 38,000 17.3516 1.50 57,000 16.0216 3

6 40,000 18.2648 0.50 20,000 5.6216 6

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 2.38 COST AND MANAGEMENT ACCOUNTING

7 60,000 27.3973 0.20 12,000 3.3730 9

8 3,000 1.3699 3.50 10,500 2.9513 11

9 300 0.1370 8.00 2,400 0.6746 12

10 29,000 13.2420 0.40 11,600 3.2605 10

11 11,500 5.2512 7.10 81,650 22.9502 1

12 4,100 1.8721 6.20 25,420 7.1451 5

2,19,000 100 3,55,770 100

Basis for selective control (Assumed)

` 50,000 & above -- ‘A’ items
` 15,000 to 50000 -- ‘B’ items
Below ` 15,000 -- ‘C’ items
On this basis, a plan of A B C selective control is given below:

Ranking Item % of Total Cost (`) % of Total Category

Nos. units Cost
1 11 5.2512 81,650 22.9502
2 2 10.9589 72,000 20.2378
3 5 17.3516 57,000 16.0216
Total 3 33.5617 2,10,650 59.2096 A
4 1 3.1963 35,000 9.8378

5 12 1.8721 25,420 7.1451

6 6 18.2648 20,000 5.6216

7 3 0.6849 15,000 4.2162

Total 4 24.0181 95,420 26.8207 B

8 4 0.2740 13,200 3.7103

9 7 27.3973 12,000 3.3730

10 10 13.2420 11,600 3.2605

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11 8 1.3699 10,500 2.9513

12 9 0.1370 2,400 0.6746

Total 5 42.4202 49,700 13.9697 C

Grand Total 12 100 3,55,770 100

Advantages of ABC analysis: The advantages of ABC analysis are the following:
(i) Continuity in production: It ensures that, without there being any danger of
interruption of production for want of materials or stores, minimum
investment will be made in inventories of stocks of materials or stocks to be
carried.
(ii) Lower cost: The cost of placing orders, receiving goods and maintaining
stocks is minimised specially if the system is coupled with the determination
of proper economic order quantities.
(iii) Less attention required: Management time is saved since attention need to
be paid only to some of the items rather than all the items, as would be the
case if the ABC system was not in operation.
(iv) Systematic working: With the introduction of the ABC system, much of the
work connected with purchases can be systematized on a routine basis, to
be handled by subordinate staff.
ILLUSTRATION 9
A factory uses 4,000 varieties of inventory. In terms of inventory holding and
inventory usage, the following information is compiled:

No. of varieties of % % value of % of inventory

inventory inventory holding usage (in
(average) end-product)
3,875 96.875 20 5
110 2.750 30 10
15 0.375 50 85
4,000 100.00 100 100

CLASSIFY the items of inventory as per ABC analysis with reasons.

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 2.40 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Classification of the items of inventory as per ABC analysis
1. 15 number of varieties of inventory items should be classified as ‘A’ category
items because of the following reasons:
(i) Constitute 0.375% of total number of varieties of inventory handled by
stores of factory, which is minimum as per given classification in the
table.
(ii) 50% of total use value of inventory holding (average), which is
maximum, according to the given table.
(iii) Highest in consumption, about 85% of inventory usage (in
end-product).
2. 110 number of varieties of inventory items should be classified as ‘B’
category items because of the following reasons:
(i) Constitute 2.750% of the total number of varieties of inventory items
handled by stores of factory.
(ii) Requires moderate investment of about 30% of total use value of
inventory holding (average).
(iii) Moderate in consumption, about 10% of inventory usage (in end–
product).
3. 3,875 number of varieties of inventory items should be classified as ‘C’
category items because of the following reasons:

(i) Constitute 96.875% of total varieties of inventory items handled by

stores of factory.
(ii) Requires about 20% of total use value of inventory holding (average).

(iii) Minimum inventory consumption, i.e., about 5% of inventory usage (in

end-product).
(2) Fast Moving, Slow Moving and Non-Moving (FSN) Inventory: It is also
known as FNS (Fast, Normal and Slow moving) classification of inventory analysis.
Under this system, inventories are controlled by classifying them on the basis of
frequency of usage. The classification of items into these three categories

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depends on the nature and managerial discretion. A threshold range on the basis
of inventory turnover is decided and classified accordingly.
(i) Fast Moving- This category of items is placed nearer to store issue point
and the stock is reviewed frequently for making of fresh orders.
(ii) Slow Moving- This category of items is stored little far and stock is
reviewed periodically for any obsolescence, and may be shifted to
Non-moving category.
(iii) Non-Moving- This category of items is kept for disposal. This category of
items is reported to the management and an appropriate provision for loss
may be created.
Some of the reasons for slow moving and non-moving inventories are stated
below:
(i) Failure of production management to communicate the updated
requirement to the stores management
(ii) Technological upgradation in terms of new machine requiring new kind of
material or existing material becoming obsolete.
(iii) Lack of periodic review of inventories.
By careful observation, timely identification and adoption of inventory
management techniques such as maintenance of minimum level or just in time
approach, one can manage slow moving and non-moving inventories. We may
calculate inventory turnover ratio and present the reports of comparison of actual
and standards with variations, if any to the management.
(3) Vital, Essential and Desirable (VED): Under this system of inventory
analysis, inventories are classified on the basis of its criticality for the
production function and final product. Generally, this classification is done for
spare parts which are used for production.
(i) Vital- Items are classified as vital when its unavailability can interrupt the
production process and cause a production loss. Items under this category
are strictly controlled by setting re-order level.
(ii) Essential- Items under this category are essential but not vital. The
unavailability may cause sub standardisation and loss of efficiency in
production process. Items under this category are reviewed periodically and
get the second priority.

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 2.42 COST AND MANAGEMENT ACCOUNTING

(iii) Desirable- Items under this category are optional in nature, unavailability
does not cause any production or efficiency loss.
For instance, in hospital administration, stock of medicines and essential chemicals
are categorized as VED or FSN inventory. In case of life saving, rare and critical
drugs, they are being categorized as vital inventory. They are the ones whose
unavailability can interrupt smooth service. Those inventories which are optional
or substitutes, not leading to loss in efficiency would be categorized as desirable
inventories. FNS categorization helps the store keepers in hospitals to keep a
check on medicines whose expiry date is close and needs to be disposed off at the
earliest. The quantity of slow-moving drugs are maintained accordingly.
(4) High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system,
inventory is classified on the basis of the cost of an individual item, unlike ABC
analysis where inventories are classified on the basis of overall value of inventory.
A range of cost is used to classify the inventory items into the three categories.
High-Cost inventories are given more priority for control, whereas Medium-cost
and Low-cost items are comparatively given lesser priority.

6.5 Using Ratio Analysis

(i) Input-Output Ratio: Inventory control can also be exercised by the use of
input- output ratio analysis. Input-output ratio is the ratio of the
quantity of input of material to production and the standard material
content of the actual output.

This type of ratio analysis enables comparison of actual consumption and

standard consumption, thus indicating whether the usage of material is
favourable or adverse.

(ii) Inventory Turnover Ratio: Computation of inventory turnover ratios for

different items of material and comparison of the turnover rates provides a
useful guidance for measuring inventory performance. High inventory
turnover ratio indicates that the material in the question is a fast moving one.
A low turnover ratio indicates over-investment and locking up of the working
capital in inventories. Inventory turnover ratio may be calculated by using
the following formulae: -

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Inventory Turnover Ratio = Cost of materials consumed during the period

Cost of average stock held duirng the period

Average stock = 1/2 (opening stock + closing stock)

365 days /12months
Average no. of days of Inventory holding =
Inventory Turnover Ratio
By comparing the number of days in the case of two different materials, it is
possible to know which is fast moving and which is slow moving. On this basis,
attempt should be made to reduce the amount of capital locked up, and prevent
over-stocking of the slow-moving items.
ILLUSTRATION 10
The following data are available in respect of material X for the year ended 31st
March, 2023.
(`)
Opening stock 90,000
Purchases during the year 2,70,000
Closing stock 1,10,000
CALCULATE:
(i) Inventory turnover ratio, and
(ii) The number of days for which the average inventory is held.
SOLUTION
Inventory turnover ratio
(Refer to working note) = Cost of stock of raw material consumed
Average stock of raw material

`2,50,000
= = 2.5
`1,00,000

Average number of days for which the average inventory is held

365 365 days
= = = 146 days
Inventory turnover ratio 2.5

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Working Note:
(`)
Opening stock of raw material 90,000
Add: Material purchases during the year 2,70,000
Less: Closing stock of raw material 1,10,000
Cost of stock of raw material consumed 2,50,000
ILLUSTRATION 11
From the following data for the year ended 31st March, 2023, CALCULATE the
inventory turnover ratio of the two items and put forward your comments on them.

Material A (`) Material B (`)

Opening stock 1.04.2022 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.03.2023 6,000 11,000

SOLUTION
First of all, it is necessary to find out the material consumed:

Cost of materials consumed Material A Material B

(`) (`)
Opening stock 10,000 9,000
Add: Purchases 52,000 27,000
62,000 36,000
Less: Closing stock 6,000 11,000
Materials consumed 56,000 25,000
Average inventory: (Opening Stock + Closing Stock) ÷ 2 8,000 10,000
Inventory Turnover ratio: (Consumption ÷ Average 7 times 2.5 times
inventory)
Inventory Turnover (Number of Days in a year/IT ratio) 52 days 146 days
Comments: Material A is moving faster than Material B.

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6.6 Physical Control

(i) Two Bin System: Under this system, each bin is divided into two parts –
(I) smaller part to stock the quantity equal to the minimum stock or even
the re-ordering level, and
(II) the other part to keep the remaining quantity.
Issues are made out of the larger part; but as soon as it becomes necessary
to use quantity out of the smaller part of the bin, fresh order is placed. “Two
Bin System” is supplemental to the record of respective quantities on the bin
card and the stores ledger card.
(ii) Establishment of system of budgets: To control investment in the
inventories, it is necessary to know in advance about the inventories
requirement during a specific period (usually a year). The exact quantity of
various types of inventories and the time when they would be required can
be known by studying carefully production plans and production schedules.
Based on this, inventories requirement budget can be prepared. Such a
budget will discourage the unnecessary investment in inventories.
(iii) Perpetual inventory records and continuous stock verification:
Perpetual inventory represents a system of records maintained by the stores
department. It, in fact, comprises of: (i) Bin Cards, and (ii) Stores Ledger.
The success of perpetual inventory depends upon the following:
(a) The Stores Ledger showing quantities and amount of each item.
(b) Stock Control cards (or Bin Cards).
(c) Reconciling the quantity balances shown by (a) & (b) above.
(d) Checking the physical balances of a number of items every day
systematically and by rotation.
(e) Explaining promptly the causes of discrepancies, if any, between
physical balances and the book figures.

(f) Making corrective entries wherever required after step (e) and
(g) Removing the causes of the discrepancies referred to in step (e)

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Advantages of perpetual inventory: The main advantages of perpetual

inventory are as follows:

(1) Physical stocks can be counted and book balances adjusted as and
when desired without waiting for the entire stock-taking to be done.

(2) Quick compilation of Profit and Loss Account (for interim period) due
to prompt availability of stock figures.

(3) Discrepancies are easily located and thus corrective action can be
promptly taken to avoid their recurrence.

(4) A systematic review of the perpetual inventory reveals the existence of

surplus, dormant, obsolete and slow-moving materials, so that
remedial measures may be taken in time.

(5) Fixation of the various stock levels and checking of actual balances in
hand with these levels assist the store keeper in maintaining stocks
within limits and in initiating purchase requisitions for correct quantity
at the appropriate time.

(iv) Continuous Stock Verification: The checking of physical inventory is an

essential feature of every sound system of material control. The system of
continuous stock-taking consists of physical verification of items of
inventory. The stock verification may be done by internal audit department
but are independent of the store and production staff. Stock verification is
done at appropriate interval of time without prior notice. The element of
surprise is essential for effective control of the system.

Disadvantages of Annual/ Periodic Stock Taking: Annual stock-taking,

however, has certain inherent shortcomings which tend to detract from the
usefulness of such physical verification. For instance, since all the items have
to be covered in a given number of days, either the production department
has to be shut down during those days to enable thorough checking of
stock or else the verification must be of limited character.

On the contrary, continuous stock taking is holding more advantages. Some

of them are discussed below:

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Advantages of continuous stock-taking:

1. Closure of normal functioning is not necessary.
2. Stock discrepancies are likely to be brought to the notice and
corrected much earlier than under the annual stock-taking system.
3. The system generally has a sobering influence on the stores staff
because of the element of surprise present therein.
4. The movement of stores items can be watched more closely by the
stores auditor so that chances of obsolescence buying are reduced.
5. Final Accounts can be ready quickly. Interim accounts are possible
quite conveniently.

7. MATERIAL ISSUE PROCEDURE

Issue of material must not be made except under properly authorised requisition
slip. Usually, it is the foreman of a department who has the authority to draw
materials from the store. Issue of material must be made on the basis of first in
first out, that is, out of the earliest lot in hand. If care is not exercised in this
regard, quality of earliest lot of material may deteriorate for having been kept for
a long period.
(i) Issue against Material Requisition Note: It is the voucher of the
authority as regards to the issue of materials for use in the factory or in
any of its departments. After receipt of material requisition slip, store keeper
ensures that requisition is properly authorized and requisitioned quantity is
within the quantity specified in bill of materials. After satisfied with the
documents, store keeper issue materials and keeps one copy of the MRN to
maintain the necessary records.
(ii) Transfer of Material: The surplus material arising on a job or other units
of production may sometime be unsuitable for transfer to store because of
its bulk, heavy weight, brittleness or some other reason. It may, however, be
possible to find some alternative use for such materials by transferring them
to some other job instead of returning them to the store.

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It must be stressed that generally transfer of material from one job to

another is irregular, if not improper; in so far, it is not conducive to correct
allocation and control of material, cost of jobs or other units of production.
It is only in the circumstances envisaged above, that such direct transfer
should be made. At the time of material transfer, a material transfer note
should be made in duplicate. The disposition of the copies of this note being
are as follows:
Material Transfer

Cost Accounting Department

Note

Department Making Transfer

No copy is required for the store, as no entry in the stores records would be
called for. The Cost Accounting Department would use its copy for the
purpose of making the necessary entries in the cost ledger accounts for the
jobs affected.

Format of a material requisition note may vary on the basis of industrial

peculiarities, management information system (MIS) and accounting system
in place.
(iii) Return of Material: Sometimes, it is not possible before hand to make any
precise estimate of the material requirements or units of production.
Besides, at times, due to some technical issues or other difficulties, it is not
practicable to measure the exact quantity of material required by a
department. In either case, material may have to be issued from stores in
bulk, often in excess of the actual quantity required. Where such a condition
exists, it is of the utmost importance from the point of view of materials
control that any surplus material left over on the completion of a job
should be promptly hand over to the storekeeper for safe and proper
custody.
Unless this is done, the surplus material may be misappropriated or misap-
plied to some purpose, other than that for which it was intended. The

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material cost of the job against which the excess material was originally
drawn in that case, would be overstated, unless the job is given credit for the
surplus arising thereon.
The surplus material, when it is returned to the storeroom, should be
accompanied by a document known as a Shop Credit Note or alternatively
as a Stores Debit Note. This document should be made out; by the
department returning the surplus material and it should be in triplicate to be
used as follows:

Store Room

Shop Credit Note Cost Accounting Department

Department Returnign it

Format of a shop credit note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.

8. VALUATION OF MATERIAL ISSUES

Materials issued from stores should be priced at the value at which they are
carried in stock. But there can be a situation where the material may have been
purchased at different times and at different prices with varying discounts, taxes
etc. Because of this the problem arises as to how the material issues to production
are to be valued. There are several methods for tackling this situation. The cost
accountant should select the proper method based on following factors:
1. The frequency of purchases, price fluctuations and its range.
2. The frequency of issue of materials, relative quantity etc.
3. Nature of cost accounting system.
4. The nature of business and the type of production process.
5. Management policy relating to the valuation of closing stock.

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Several methods of pricing material issues have been evolved in an attempt to

satisfactorily answer the problem. These methods may be grouped and explained
as follows:

8.1 Cost Price Methods

(i) Specific Price Method: This method is useful, especially when materials
are purchased for a specific job or work order, as such materials are
issued subsequently to that specific job or work order at the price at which
they were purchased.
To use this method, it is necessary to store each lot of material separately
and maintain its separate account.
Advantages and Disadvantages

Advantages Disadvantages

• The cost of materials issued for • This method is difficult to

production purposes to specific operate, specially when
jobs represent actual and correct purchases and issues are
costs. numerous.

• This method is best suited for

non-standard and specific
products.

(ii) First-in First-out (FIFO) Method: It is a method of pricing the issues of

materials, in the order in which they are purchased. In other words, the
materials are issued in the order in which they arrive in the store or the items
longest in stock are issued first. Thus each issue of material only recovers the
purchase price which does not reflect the current market price.
This method is considered suitable in times of falling price because the
material cost charged to production will be high while the replacement cost
of materials will be low. But, in the case of rising prices, if this method is
adopted, the charge to production will be low as compared to the
replacement cost of materials. Consequently, it would be difficult to
purchase the same volume of material (as in the current period) in future
without having additional capital resources.

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Advantages and disadvantages

Advantages Disadvantages

• It is simple to understand and • If the prices fluctuate frequently,

easy to operate. this method may lead to clerical
error.

• Material cost charged to • Since each issue of material to

production represents actual production is related to a specific
cost with which the cost of purchase price, the costs charged
production should have been to the same job are likely to show
charged. a variation from period to period.

• In the case of falling prices, the • In the case of rising prices, the real
use of this method gives better profits of the concern being low,
results. while the profits in the books will
appear high. This may lead to
inability of the firm to meet the
materials purchase demand at the
current market price.

• Closing stock of material will be

represented very closely at
current market price.

The application of FIFO method is illustrated below:

Material Received and Issued

Lot Date Quantity Lot Rate Amount

No. Kg. No. (`) (`)
1. July 3 600 1.00 600.00
2. July 13 800 1.20 960.00
3. July 23 600 0.90 540.00
4. August 5 400 1.10 440.00
5. August 6 1200 0.80 960.00
July 8 400 Kgs. out of (1) 1.00 400.00

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July 12 200 Kgs. out of (1) 1.00 200.00

July 22 600 Kgs. out of (2) 1.20 720.00
July 25 200 Kgs. out of (2) 1.20 240.00
200 Kgs. out of (3) 0.90 180.00
August 8 400 Kgs. out of (3) 0.90 360.00
400 Kgs. out of (4) 1.10 440.00
200 Kgs. out of (5) 0.80 160.00

The stock in hand after 8th August will be 1,000 kgs. This will be out of lot
number (5) and its value will be ` 800, i.e., @ ` 0.80 per kg.
(iii) Last-in-First-out (LIFO) Method: It is a method of pricing the issues of
materials on the basis of assumption that the items of the last batch (lot)
purchased are the first to be issued. Therefore, under this method the
prices of the last batch (lot) are used for pricing the issues, until it is
exhausted, and so on. If however, the quantity of issue is more than the
quantity of the latest lot, then earlier (lot) and its price will also be taken into
consideration.
During inflationary period or period of rising prices, the use of LIFO
would help to ensure that the cost of production determined on the above
basis is approximately the current one. This method is also useful specially
when there is a feeling that due to the use of FIFO or average methods, the
profits shown and tax paid are too high.
Advantages and Disadvantages

Advantages Disadvantages

• The cost of materials issued will • Calculation under LIFO system

be either nearer to and or will becomes complicated and
reflect the current market price. cumbersome when frequent
Thus, the cost of goods produced purchases are made at highly
will be related to the trend of the fluctuating rates.
market price of materials. Such a
trend in price of materials enables
the matching of cost of production
with current sales revenues.

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• The use of the method during the • Costs of different similar

period of rising prices does not batches of production carried
reflect undue high profit in the on at the same time may differ
income statement as it was under a great deal.
the first-in-first-out or average
method. In fact, the profit shown
here is relatively lower because the
cost of production takes into
account the rising trend of material
prices.

• In the case of falling prices profit • In time of falling prices, there

tends to rise due to lower material will be need for writing off
cost, yet the finished products stock value considerably to
appear to be more competitive stick to the principle of stock
and are at market price. valuation, i.e., the cost or the
market price whichever is lower.

• Over a period, the use of LIFO • This method of valuation of

helps to iron out the fluctuations material is not acceptable to
in profits. the income tax authorities.

• In the period of inflation LIFO will

tend to show the correct profit and
thus avoid paying undue taxes to
some extent.

It may be noted that Last in First out (LIFO) is not permitted under
Accounting Standard (AS)-2: Valuation of Inventories and Ind AS- 2:
Inventories. However, for the purpose of academic knowledge LIFO
method is included in this Study Material

ILLUSTRATION 12
The following transactions in respect of material Y occurred during the six months
ended 30th September, 2022:

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 2.54 COST AND MANAGEMENT ACCOUNTING

Month Purchase Price per unit Issued

(units) (` ) Units
April 200 25 Nil
May 300 24 250
June 425 26 300
July 475 23 550
August 500 25 800
September 600 20 400

Required:
(a) The Chief Accountant argues that the value of closing stock remains the same
no matter which method of pricing of material issues is used. Do you agree?
Why or why not? EXPLAIN. Detailed stores ledgers are not required.
(b) STATE when and why would you recommend the LIFO method of pricing
material issues?
SOLUTION
(a) Total number of units purchased = 2,500

Total number of units issued = 2,300

The closing stock at the end of six months’ period i.e., on 30th September,
2022 will be 200 units
Upto the end of August 2022, total purchases coincide with the total issues
i.e., 1,900 units. It means that at the end of August 2022, there was no
closing stock. In the month of September 2022, 600 units were purchased
out of which 400 units were issued. Since there was only one purchase and
one issue in the month of September, 2022 and there was no opening stock
on 1st September 2022, the Closing Stock of 200 units is to be valued at ` 20
per unit.
In the view of this, the argument of the Chief Accountant appears to be
correct. Where there is only one purchase and one issue in a month with no
opening stock, the method of pricing of material issues becomes irrelevant.
Therefore, in the given case one should agree with the argument of the

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Chief Accountant that the value of closing stock remains the same no matter
which method of pricing the issue is used.
It may, however, be noted that the argument of Chief Accountant would not
stand if one finds the value of the Closing Stock at the end of each month.
(b) LIFO method has an edge over FIFO or any other method of pricing material
issues due to the following advantages:

(i) The cost of the materials issued will be either nearer or will reflect the
current market price. Thus, the cost of goods produced will be related
to the trend of the market price of materials. Such a trend in price of
materials enables the matching of cost of production with current
sales revenues.
(ii) The use of the method during the period of rising prices does not
reflect undue high profit in the income statement, as it was under the
first-in-first-out or average method. In fact, the profit shown here is
relatively lower because the cost of production takes into account the
rising trend of material prices.
(iii) In the case of falling prices, profit tends to rise due to lower material
cost, yet the finished products appear to be more competitive and are
at market price.
(iv) During the period of inflation, LIFO will tend to show the correct profit
and thus, avoid paying undue taxes to some extent.
ILLUSTRATION 13
The following information is provided by Sunrise Industries for the fortnight of April,
2023:
Material Exe:
Stock on 1-4-2023 100 units at ` 5 per unit.
Purchases
5-4-2023, 300 units at ` 6
8-4-2023, 500 units at ` 7
12-4-2023, 600 units at ` 8

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Issues
6-4-2023, 250 units
10-4-2023, 400 units
14-4-2023, 500 units
Required:
(A) CALCULATE using FIFO and LIFO methods of pricing issues:
(a) the value of materials consumed during the period
(b) the value of stock of materials on 15-4-2023.
(B) EXPLAIN why the figures in (a) and (b) in part A of this question are different
under the two methods of pricing of material issues used. You need not draw
up the Stores Ledgers.
SOLUTION
(A) (a) Value of Material Exe consumed during the period
1-4-2023 to 15-4-2023 by using FIFO method.

Date Description Units Qty. (Units) Rate Amount

(`) (`)

1-4-2023 Opening balance 100 5 500

5-4-2023 Purchased 300 6 1,800

6-4-2023 Issued 100 5

1,400
150 6

8-4-2023 Purchased 500 7 3,500

10-4-2023 Issued 150 6

2,650
250 7

12-4-2023 Purchased 600 8 4,800

14-4-2023 Issued 250 7

3,750
250 8

15-4-2023 Balance 350 8 2,800

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Total value of material Exe consumed during the period under FIFO
method comes to (` 1,400 + ` 2,650 + ` 3,750) ` 7,800 and balance on
15-4-2023 is of ` 2,800.
Value of material Exe consumed during the period 01-4-2023 to
15-4-2023 by using LIFO method

Date Description Qty. Rate Amount

(Units) (`) (`)
1-4-2023 Opening balance 100 5 500
5-4-2023 Purchased 300 6 1,800
6-4-2023 Issued 250 6 1,500
8-4-2023 Purchased 500 7 3,500
10-4-2023 Issued 400 7 2,800
12-4-2023 Purchased 600 8 4,800
14-4-2023 Issued 500 8 4,000
15-4-2023 Balance 350 — 2,300*

Total value of material Exe issued under LIFO method comes to

(` 1,500 + ` 2,800 + ` 4,000) ` 8,300.
*The balance 350 units on 15-4-2023 of ` 2,300, relates to opening
balance on 1-4-2023 and purchases made on 5-4-2023, 8-4-2023 and
12-4-2023. (100 units @ ` 5, 50 units @ ` 6, 100 units @ ` 7 and 100
units @ ` 8).
(b) As shown in (a) above, the value of stock of materials on 15-4-2023:
Under FIFO method ` 2,800
Under LIFO method ` 2,300
(B) Total value of material Exe issued to production under FIFO and LIFO
methods comes to ` 7,800 and ` 8,300 respectively. The value of closing
stock of material Exe on 15-4-2023 under FIFO and LIFO methods comes to
` 2,800 and ` 2,300 respectively.
The reasons for the difference of ` 500 (` 8,300 – ` 7,800) as shown by the
following table in the value of material Exe, issued to production under FIFO
and LIFO is as follows:

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Date Quantity Value Total Value Total

Issued FIFO LIFO
(Units) (`) (`) (`) (`)
6-4-2023 250 1,400 1,500
10-4-2023 400 2,650 2,800
14-4-2023 500 3,750 7,800 4,000 8,300

1. On 6-4-2023, 250 units were issued to production. Under FIFO their

value comes to ` 1,400 (100 units × ` 5 + 150 units × ` 6) and under
LIFO ` 1,500 (250 × ` 6). Hence, ` 100 more was charged to production
under LIFO.
2. On 10-4-2023, 400 units were issued to production. Under FIFO their
value comes to ` 2,650 (150 × ` 6 + 250 × ` 7) and under LIFO ` 2,800
(400 × ` 7). Hence, ` 150 more was charged to production under LIFO.
3. On 14-4-2023, 500 units were issued to production. Under FIFO their
value comes to ` 3,750 (250 × ` 7 + 250 × ` 8) and under LIFO ` 4,000
(500 × ` 8). Hence, ` 250 more was charged to production under LIFO.
Thus, the total excess amount charged to production under LIFO comes to
` 500.
The reasons for the difference of ` 500 (` 2,800 – ` 2,300) in the value of 350
units of Closing Stock of material Exe under FIFO and LIFO are as follows:
1. In the case of FIFO, all the 350 units of the closing stock belongs to the
purchase of material made on 12-4-2023, whereas under LIFO these
units were from opening balance and purchases made on 5-4-2023,
8-4-2023 and 12-4-2023.
2. Due to different purchase price paid by the concern on different days
of purchase, the value of closing stock differed under FIFO and LIFO.
Under FIFO 350 units of closing stock were valued @ ` 8 p.u. Whereas
under LIFO first 100 units were valued @ ` 5 p.u., next 50 units @ ` 6
p.u., next 100 units @ ` 7 p.u. and last 100 units @ ` 8 p.u.

Thus, under FIFO, the value of closing stock increased by ` 500.

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(iv) Base Stock Method: Minimum quantity of stock under this method is
always held at a fixed price as reserve in the stock, to meet the state of
emergency, if it arises. This minimum stock is known as base stock and is
valued at a price at which the first lot of materials is received and remains
unaffected by subsequent price fluctuations.
This method of valuing inventory is different from other methods of valuing
issues, as the base stock of materials are valued at the original cost, whereas,
materials other than the base are valued using other methods like FIFO, LIFO
etc. This method is not an independent method as it uses FIFO or LIFO.
Advantages and disadvantages of this method depend upon the use of the
other method viz., FIFO or LIFO.

8.2 Average Price Methods

(i) Simple Average Price Method: Under this method, materials issued are
valued at average price, which is calculated by dividing the total of rates at
which different lot of materials are purchased by total number of lots. In this
method quantity purchased in each lot is ignored. However, the price of
stock of that lot which is completely sold out is not considered for taking
average price.
Example - 1: During the month of April, a company has made five purchases
as follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
14th April, 210 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ ` 11 each.
The issue price under Simple Average Price Method would be calculated as
below:
`10 + `12 + `12 + `15 + `11
= ` 12 each
5 lots

This method is suitable when the materials are received in uniform lots of
similar quantity, and prices do not fluctuate considerably.

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Advantages and Disadvantages:

Advantages Disadvantages
• This method is simple to use for • This method does not provide right
an entity which orders materials stock valuation when standard
in a lot of standard quantity, as quantity for purchase in a lot is not
only price per lot is taken to specified.
calculate average price
• In a stable price environment, • When price of materials fluctuates
this method gives a price which and the entity chooses to
approximates to the current customise the order quantity, the
market price. price under this method may differ
substantially from the current
market price.

(ii) Weighted Average Price Method: Unlike Simple Average Price method,
this method gives due weightage to quantities also. Under this method,
issue price is calculated by dividing sum of products of price and quantity by
total number quantities.
Example - 2: During the month of April, a company has made five purchases
as follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
14th April, 210 units @ `12 each;

21st April, 50 units @ `15 each and

28th April, 140 units @ ` 11 each.
The issue price under Weightage Average Price Method would be calculated
as below:
{( ` 10×200 units)+( ` 12×150 units)+( ` 12×210 units)
+( ` 15×50 units)+( ` 11×140 units)}
=
(200+150+210+50+140) units

` 8,610
= = ` 11.48 each
750 units

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This method is useful in case when quantity purchased under each lot is
different and price fluctuates frequently.
Advantages and Disadvantages:

Advantages Disadvantages
• It smoothens the price • Material cost does not represent
fluctuations, if at all it is there, actual cost price and therefore, a
due to material purchases. different profit or loss will arise
out of such a pricing method.

• Issue prices need not be • It may be difficult to compute,

calculated for each issue unless since every time lot is received,
new lot of materials is received. it would require re-computation
of issue prices.

8.3 Market Price Methods

(i) Replacement Price Method: Replacement price is defined as the price at
which it is possible to purchase an item, identical to that which is being
replaced or revalued. Under this method, materials issued are valued at the
replacement cost of the items. This method pre-supposes the determination of
the replacement cost of materials at the time of each issue; viz., the cost at
which identical materials could be currently purchased. The product cost
under this method is at current market price, which is the main objective of
the replacement price method.
This method is useful to determine true cost of production and to value
material issues in periods of rising prices, because the cost of material
considered in cost of production would be able to replace the materials at
the increased price.
(ii) Realisable Price Method: Realisable price means a price at which the
material to be issued can be sold in the market. This price may be more
or may be less than the cost price at which it was originally purchased. Like
replacement price method, the stores ledger would show profit or loss in
this method too.

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8.4 Notional Price Methods

(i) Standard Price Method: Under this method, materials are priced at some
predetermined rate or standard price irrespective of the actual purchase
cost of the materials. Standard cost is usually fixed after taking into
consideration the following factors:
(i) Current prices,

(ii) Anticipated market trends, and

(iii) Discount available and transport charges etc.
Standard prices are fixed for each material and the requisitions are priced at
the standard price. This method is useful for controlling material cost and
determining the efficiency of purchase department. In the case of highly
fluctuating prices of materials, it is difficult to fix their standard cost on
long-term basis.

Advantages Disadvantages
• The use of the standard price • The use of standard price does
method simplifies the task of not reflect the market price and
valuing issues of materials. thus results in a different or
incorrect profit or loss.
• It facilitates the control of • The fixation of standard price
material cost and the task of becomes difficult when prices
judging the efficiency of fluctuate frequently
purchase department.
• It reduces the clerical work.

(ii) Inflated Price Method: In case material suffers loss in weight due to natural
or climatic factors, e.g., evaporation, the issue price of the material is inflated
to cover up the losses.
(iii) Re-use Price Method: When materials are rejected and returned to the
stores or a processed material is put to some other use, other than for the
purpose it is meant, then such materials are priced at a rate quite different
from the price paid for them originally. There is no final procedure for
valuing use of material.

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9. VALUATION OF RETURNS & SHORTAGES

9.1 Valuation of Materials Returned to the Vendor
Generally, materials are checked for quality, before dispatching to the store; and if
any issues arise such as not meeting the quality requirements or any specification
or are considered unfit for production due to any reason, due notice is made and
materials are returned to the vendor. However, even if any substandard quality is
noticed, before or after reaching the store, such materials can also be returned to
the vendor.
The price of the materials to be returned to the vendor should include its invoice
price plus freight, receiving and handling charges etc. Strictly speaking, the
materials returned to the vendor should be returned at the stores ledger price and
not at invoice price. But in practice, only invoice price is considered and the gap
between the invoice price and stores ledger price is charged as overhead. In stores
ledger, the defective or sub-standard materials are shown in the issue column at
the rate shown in the ledger, and the difference between issue price and invoice
cost is debited to an inventory adjustment account.

9.2 Valuation of Materials Returned to Stores

When materials requisitioned for a specific job or work-in progress are found to
be in excess of the requirement or are unsuitable for the purpose, they are
returned to the stores. There are two ways of treating such returns.
(1) Such returns are entered in the receipt column at the price at which they
were originally issued, and the materials are kept in suspense account, to be
issued at the same price, against the next requisition.

(2) Include the materials in stock, as if they were fresh purchases at the original
issue price.

9.3 Valuation of Shortages during Physical Verification

Materials found short during physical verification should be entered in the issue
column and valued at the rate as per the method adopted, i.e., FIFO or any other.

[Kindly refer Illustration 14 at Page no. 2.68]

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10. TREATMENT OF NORMAL AND ABNORMAL

LOSS OF MATERIALS
Loss of materials during handling, storage, process may occur any of the following
forms:

Loss of Material

Waste Scrap Spoilage Defectives Obsolescence

(i) Waste: The portion of raw material which is lost during storage or
production and discarded. The waste may or may not have any value.
Treatment of Waste
Normal- Cost of normal waste is absorbed by good production units.
Abnormal- The cost of abnormal loss is transferred to Costing Profit and
loss account.
(ii) Scrap: The materials that result from production which are discarded and
disposed-off without further treatment. Generally, scrap has either no value
or insignificant value. Sometimes, it may be reintroduced into the process as
raw material.
Treatment of Scrap
Normal- The cost of scrap is borne by good units and income arises on
account of realisable value is deducted from the cost.
Abnormal- The scrap account should be charged with full cost. The credit is
given to the job or process concerned. The profit or loss in the scrap
account, on realisation, will be transferred to the Costing Profit and Loss
Account.
(iii) Spoilage: It is the term used for materials which are badly damaged in
manufacturing operations, that do not meet the specification required by
the customers and they cannot be rectified economically and hence taken
out of the process to be disposed off in some manner without further
processing.

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Treatment of Spoilage

Normal- Normal spoilage (i.e., which is inherent in the operation) costs are
included in costs, either by charging the loss due to spoilage to the
production order or by charging it to the production overhead so that it is
spread over all the products.

Any value realised from spoilage is credited to production order or

production overhead account, as the case may be.

Abnormal- The cost of abnormal spoilage (i.e., arising out of causes not
inherent in manufacturing process) is charged to the Costing Profit and Loss
Account. When spoiled work is the result of rigid specification, the cost of
spoiled work is absorbed by good production while the cost of disposal is
charged to production overhead.

(iv) Defectives: It signifies those units or portions of production which do not

meet the quality standards. Defectives arise due to sub-standard materials,
bad-supervision, bad-planning, poor workmanship, inadequate-equipment
and careless inspection.

The defectives which can be re-made as per the quality standard by using
additional materials are known as reworks. Reworks include repairs,
reconditioning and refurbishing.

Defectives which cannot be brought up to the quality standards are known

as rejects. The rejects may either be disposed-off or re-cycled for production
process.

Treatment of Defectives:

Normal- An amount equal to the cost less realisable value on sale of

defectives are charged to material cost of good production.

Abnormal- Material cost of abnormal defectives are not included in material

cost but treated as loss after giving credit to the realisable value of such
defectives. The material cost of abnormal loss is transferred to costing profit
and loss account.

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Reclamation of loss from defective units

In the case of articles that have been spoiled, it is necessary to take steps to
reclaim as much of the loss as possible. For this purpose:

(i) All defective units should be sent to a place fixed for the purpose;

(ii) These should be dismantled;

(iii) Goods and serviceable parts should be separated and taken back into
the stock;

(iv) Parts which can be made serviceable by further work should be

separated and sent to the workshop for the purpose and taken into
stock after the defects have been removed; and

(v) Parts which cannot be made serviceable should be collected in one

place for being melted or sold off.

Printed forms should be used to record quantities for all purposes

aforementioned.
Difference between Waste and Scrap

Waste Scrap

1. It is connected with raw 1. It is the loss connected with the

material or inputs to the output
production process.

2. Waste of materials may be 2. Scraps are generally

visible or invisible. identifiable and has physical
substance.

3. Generally, waste has no 3. Scraps are termed as

recoverable value. by-products and has small
recoverable value.

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Difference between Scrap and Defectives

Scrap Defectives
1. It is the loss connected with the 1. This type of loss is connected
output with the output as well as the
input.
2. Scraps are not intended but 2. Defectives also are not
cannot be eliminated due to intended but can be eliminated
the nature of material or through a proper control
process itself. system.
3. Generally, scraps are not used 3. Defectives can be used after
or rectified. rectification.
4. Scraps have insignificant 4. Defectives are sold at a lower
recoverable value. value from that of the good
one.

Distinction between Spoilage and Defectives: The difference between

spoilage and defectives is that while spoilage cannot be repaired or
reconditioned, defectives can be rectified and transferred, either back to the
standard production or to the seconds.
The problem of accounting for defective work is in relation to the costs of
rectification or rework.
(v) Obsolescence: Obsolescence is defined as “the loss in the intrinsic value of
an asset due to its supersession”. In simple words, obsolescence refers to the
loss in the value of an asset due to technological advancements.

Treatment: Materials may become obsolete under any of the following

circumstances:
(i) where it is a spare part or a component of a machinery that is used in
manufacturing and is now obsolete;
(ii) where it is used in the manufacturing of a product which has now
become obsolete;
(iii) where the material itself is replaced by another material due to either
improved quality or fall in price.

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In all the three cases, the value of the obsolete material held in stock is a
total loss and immediate steps should be taken to dispose it off at the best
available price. The loss arising out of obsolete materials is an abnormal loss
and it does not form part of the cost of manufacture.
ILLUSTRATION 14
Imbrios India Ltd. is recently incorporated start-up company back in the year 2019.
It is engaged in creating Embedded products and Internet of Things (IoT) solutions
for the Industrial market. It is focused on innovation, design, research and
development of products and services. One of its embedded products is LogMax, a
system on module (SoM) Carrier board for industrial use. It is a small, flexible and
embedded computer designed as per industry specifications. In the beginning of the
month of September 2022, company entered into a job agreement of providing 4800
LogMax to NIT, Mandi. Following details w.r.t. issues, receipts, returns of Store
Department handling Micro-controller, a component used in the designated
assembling process have been extracted for the month of September, 2022:

Sep. 1 Opening stock of 6,000 units @ ` 285 per unit

Issued 4875 units to mechanical division vide material requisition no.
Sep. 8
Mech 009/22
Received 17,500 units @ ` 276 per unit vide purchase order no.
Sep. 9
159/22
Issued 12,000 units to technical division vide material requisition no.
Sep. 10
Tech 012/22
Returned to stores 2375 units by technical division against material
Sep. 12
requisition no. Tech 012/22.
Received 9,000 units @ ` 288 per units vide purchase order no. 160/
Sep. 15
2222
Returned to supplier 700 units out of quantity received vide purchase
Sep. 17
order no. 160/22.
Issued 9,500 units to technical division vide material requisition no.
Sep. 20
Tech 165/22

On 25th September, 2022, the stock manager of the company expressed his need to
leave for his hometown due to certain contingency and immediately left the job
same day. Later, he also switched his phone off.

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As the company has the tendency of stock-taking every end of the month to check
and report for the loss due to rusting of the components, the new stock manager, on
30th September, 2022, found that 900 units of Micro-controllers were missing which
was apparently misappropriated by the former stock manager. He, further, reported
loss of 300 units due to rusting of the components.
From the above information you are required to prepare the Stock Ledger account
using ‘Weighted Average’ method of valuing the issues.
SOLUTION
Store Ledger of Imbrios India Ltd. (Weighted Average Method)

Date Receipts Issues Balance of Stock

Qty Rate Amount Qty Rate Amount Qty Rate Amount

Sep.
(kg.) (`) (`) (kg.) (`) (`) (kg.) (`) (`)

1 - - - - - - 6,000 285.00 17,10,000

8 - - - 4,875 285.00 13,89,375 1,125 285.00 3,20,625

9 17,500 276.00 48,30,000 - - - 18,625 276.54 51,50,625

10 - - - 12,000 276.54 33,18,480 6,625 276.54 18,32,145

12 2,375 276.54 6,56,783 - - - 9,000 276.54 24,88,928

15 9,000 288.00 25,92,000 - - - 18,000 282.27 50,80,928

17 - - - 700 288.00 2,01,600 17,300 282.04 48,79,328

20 - - - 9,500 282.04 26,79,380 7,800 282.04 2199948

30 - - - 900* 282.04 2,53,836 6,900 282.04 19,46,112

30 - - - 300** - - 6,600 294.87 19,46,112

* 900 units is abnormal loss, hence it will be transferred to Costing Profit & Loss
A/c.
** 300 units is normal loss; hence it will be absorbed by good units.

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11. CONSUMPTION OF MATERIALS

Any product that is manufactured in a firm entails consumption of resources like
material, labour etc. The management for planning and control must know the
cost of using these resources in manufacturing process. The consumption of
materials takes place when it is used in the manufacturing of the product.
It is important to note that the amount of materials consumed in a period by a
cost object need not be equal to the amount of material available with the
concern. For example, during any period, the total of raw material stock available
for use in production may not be equal to the amount of materials actually
consumed and assigned to the cost object of the production. The difference
between the material available and material consumed represents the surplus
stock or stock of material at the end of the period.

11.1 Identification of Materials

For the identification of consumption of materials with products of cost centres
the followings points should be noted:
1. It is required that the concern should follow coding system for all materials,
so that each material is identified by unique code number.
2. It is required that each product of a cost centre should be given a unique
code number so that the direct material issued for production of particular
product of a cost centre can be collected against the code number of that
product.
However, it may not be possible to allocate all materials directly to
individual product of a cost centre e.g. maintenance materials, inspection
and testing materials etc. The consumption of these materials are collected
for cost centre and then charged to individual product by adopting suitable
overhead absorption rate of cost centre.
Cost for cost centre
Overhead absorption rate of cost centre =
Base relating to cost centre
(e.g. labour hrs. or machine hrs.)

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3. Each issue of materials should be recorded. One way of doing this is to use a
material requisition note. This note shows the details of materials issued for
the product of cost centre or the cost centre which is to be charged with
cost of materials.
4. A material return note is required for recording the excess materials
returned to the store. This note is required to ensure that original product of
cost centre is credited with the cost of material which was not used and that
the stock records are updated.
5. A material transfer note is required for recording the transfer of materials
from one product of cost centre to other or from one cost centre to other
cost centre.
6. The cost of materials issued would be determined according to stock
valuation method used.

11.2 Monitoring Consumption of Materials

For monitoring consumption of materials, a storekeeper should periodically
analyse the various material requisitions, material return notes and material
transfer notes. Based on this analysis, a material abstracts or material issue
analysis sheet is prepared, which shows at a glance the value of material
consumed in manufacturing each product. This statement is also useful for
ascertaining the cost of material issued for each product.
Format of Material Abstract
Week Ending............

Material Amount Product Nos. Total Overheads

requisition (`) for (Indirect
or Transfer Product Material
Note or charged)
Returned 101 102 103 104 105 106
Note No. (`) (`) (`) (`) (`) (`) (`)
— — — — — — — — —

Total

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The material abstract statement serves a useful purpose. It, in fact, shows the
amount of material to be debited to various products & overheads. The total
amount of stores debited to various products & overheads should be the same as
the total value of stores issued in any period.

11.3 Basis for Consumption Entries in Financial Accounts

Every manufacturing organisation assigns material costs to the products for two
purposes.

Firstly, for external financial accounting requirements, in order to allocate the

material costs incurred during the period between cost of goods produced and
inventories; secondly to provide useful information for managerial
decision-making requirements. In order to meet external financial accounting
requirements, it may not be necessary to accurately trace material costs to
individual products.

Some products costs may be overstated and others may be understated. But this
may not matter for financial accounting purposes, as long as total of individual
materials costs transactions are recorded i.e., transactions between cost centre
within the firm are recorded in a manner that facilitates analysis of costs for
assigning them to cost units.

The consumption entries in financial accounts are made on the basis of total cost of
purchases of materials after adjustment for opening and closing stock of materials.

Following equation is applicable here:

Consumption of Materials = Opening Stock of materials + Purchases – Closing Stock

of materials

The stock of materials is taken at cost or net realisable value, whichever is less.

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SUMMARY
♦ Material Control: It is the systematic control over the procurement, storage
and usage of materials to maintain even flow of materials and avoiding at the
same time excessive investment in inventories.
♦ Material Requisition Note: Document used to authorize and record the issue
of materials from store.
♦ Purchase Requisition Note: Document is prepared by the storekeeper to
initiate the process of purchases.
♦ Purchase Order: It is a written request to the supplier to supply certain
specified materials at specified rates and within a specified period.
♦ Goods Received Note: This document is prepared by receiving department
which unpacks the goods received and verify the quantities and other details.
♦ Material Transfer Note: This document is prepared when the material is
transferred from one department to another.
♦ Material Return Note: It is a document given with the goods being returned
from factory back to the stores.
♦ Bin Card: A prime entry record of the quantity of stocks, kept on
in/out/balance, held in designated storage areas.
♦ Stores Ledger: A ledger containing a separate account for each item of
material and component stocked in store giving details of the receipts, issues
and balance both in terms of quantity and value.
♦ Minimum Level: It is the minimum quantity, which must be retained in stock
ROL- (Avg. consumption × Avg. Lead time)
♦ Maximum Level: It is the maximum limit up to which stock can be stored at
any time
ROL + ROQ – (Min consumption × Min Lead Time)

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♦ Re order Level: It is the level at which new order needs to be placed

Maximum lead time × Maximum Usage
Or
Minimum level + (Average rate of consumption × Average time to obtain fresh
supplies).
♦ Average Inventory Level = Minimum level + 1/2 Re-order quantity
Or
Maximum level+Minimum level
=
2
♦ Danger Level: The level where normal issue of materials is stopped, and only
emergency materials are issued.
Danger level = Average consumption × Lead time for emergency purchases.
♦ Stock-out = Stock out is said to be occurred when an inventory item could not
be supplied due to insufficient stock in the store.
♦ Just-in-time (JIT) Inventory management: JIT is a system of inventory
management with an approach to have zero inventories in stores. According to
this approach material should only be purchased when it is actually required for
production.
♦ ABC analysis: Items are classified into the following categories:
A Category: Quantity less than 10 % but value more than 70 %
B Category: Quantity less than 20 % but value about 20 %
C Category: Quantity about 70 % but value less than 10%
♦ Fast Moving, Slow Moving and Non-Moving (FSN) Inventory: Under this
system, inventories are controlled by classifying them on the basis of frequency
of usage.
♦ Vital, Essential and Desirable (VED): Under this system of inventory analysis,
inventories are classified on the basis of its criticality for the production function
and final product.

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♦ High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system,
inventory is classified on the basis of the cost of an individual item, unlike ABC
analysis where inventories are classified on the basis of overall value of inventory.
♦ Two bin system: If one bin items exhausts, new order is placed and in the mean
time, quantity from pthe smaller bin is used or issued.
♦ First-in First-out method: The materials received first are to be issued first when
material requisition is received. Materials left as closing stock will be at the price
of the latest purchases.
♦ Last-in First-out method: The materials purchased last are to be issued first
when material requisition is received. Closing stock is valued at the oldest
available stock price.
♦ Simple Average Method: Material Issue Price
Total of unit price of each purchase
=
Total number of Purchases
♦ Weighted Average Price Method: This method gives due weightage to
quantities purchased and the purchase price to determine the issue price.
Total cost of material in stock
Weighted Average Price =
Total quantity of materials

♦ Various Material Losses

(a) Wastage: Portion of basic raw material lost in processing, having no
recoverable value
(b) Scrap: The incidental material residue coming out of certain manufacturing
operations, having low recoverable value.
(c) Spoilage: Goods damaged beyond rectification, to be sold off without
further processing.
♦ Defectives: Goods which can be rectified and turned out as good units by the
application of additional labour or other services.

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TEST YOUR KNOWLEDGE

Multiple Choice Questions (MCQs)
1. Direct material can be classified as
(a) Fixed cost
(b) Variable cost
(c) Semi-variable cost.
(d) Prime Cost
2. In most of the industries, the most important element of cost is
(a) Material
(b) Labour
(c) Overheads
(d) Administration Cost
3. Which of the following is considered to be the normal loss of materials?
(a) Loss due to accidents
(b) Pilferage
(c) Loss due to breaking the bulk
(d) Loss due to careless handling of materials.
4. In which of following methods of pricing, costs lag behind the current
economic values?
(a) Last-in-first out price

(b) First-in-first out price

(c) Replacement price
(d) Weighted average price

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5. Continuous stock taking is a part of

(a) Annual stock taking

(b) Perpetual inventory

(c) ABC analysis.

(d) Bin Cards

6. In which of the following methods, issues of materials are priced at

pre-determined rate?

(a) Inflated price method

(b) Standard price method

(c) Replacement price method

(d) Market price method.

7. When material prices fluctuate widely, the method of pricing that gives absurd
results is

(a) Simple average price

(b) Weighted average price

(c) Moving average price

(d) Inflated price.

8. When prices fluctuate widely, the method that will smooth out the effect of
fluctuations is

(a) Simple average

(b) Weighted average

(c) FIFO

(d) LIFO

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9. Under the FSN system of inventory control, inventory is classified on the basis
of:
(a) Volume of material consumption
(d) Frequency of usage of items of inventory
(c) Criticality of the item of inventory for production
(d) Value of items of inventory
10. Form used for making a formal request to the purchasing department to
purchase materials is a - :
(a) Material Transfer Note
(b) Purchase Requisition Note
(c) Bill of Materials
(d) Material Requisition Note

Theoretical Questions
1. STATE how normal and abnormal loss of material arising during storage are
treated in Cost Accounts?
2. DISTINGUISH clearly between Bin cards and Stores Ledger.
3. DISCUSS the accounting treatment of defectives in Cost Accounts.
4. EXPLAIN the concept of "ABC Analysis" as a technique of inventory control.
5. DISTINGUISH between Re-order level and Re-order quantity.
6. EXPLAIN how is slow moving and non-moving item of stores detected and
what steps are necessary to reduce such stocks?
7. WRITE short notes on any three of the following:

(i) Danger Level

(ii) Just in Time Inventory Management
(iii) Maximum stock level and Minimum Stock level
(iv) Obsolescence

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Practical Problems
1. Anil & Company buys its annual requirement of 36,000 units in 6 instalments.
Each unit costs ` 1 and the ordering cost is `25. The inventory carrying cost is
estimated at 20% of unit value. FIND the total annual cost of the existing
inventory policy. CALCULATE, how much money can be saved by Economic
Order Quantity?
2. A Company manufactures a special product which requires a component
‘Alpha’. The following particulars are collected for the year 2022-23:

(i) Annual demand of Alpha 8,000 units

(ii) Cost of placing an order ` 200 per order
(iii) Cost per unit of Alpha ` 400
(iv) Carrying cost p.a. 20%
The company has been offered a quantity discount of 4 % on the purchase of
‘Alpha’ provided the order size is 4,000 components at a time.
Required:
(i) COMPUTE the economic order quantity
(ii) STATE whether the quantity discount offer can be accepted.
3. The complete Gardener is deciding on the economic order quantity for two
brands of lawn fertilizer - Super Grow and Nature’s Own. The following
information is collected:

FERTILIZER
Super Grow Nature’s Own
Annual demand 2,000 bags 1,280 bags
Relevant ordering cost per purchase ` 1,200 ` 1,400
order
Annual relevant carrying cost per bag ` 480 ` 560

Required:
(i) COMPUTE EOQ for Super Grow and Nature’s own.

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(ii) For the EOQ, WHAT is the sum of the total annual relevant ordering
costs and total annual relevant carrying costs for Super Grow and
Nature’s own?
(iii) For the EOQ, COMPUTE the number of deliveries per year for Super
Grow and Nature’s own.
4. A Company uses three raw materials A, B and C for a particular product for
which the following data apply:

Raw Usage per Re-order Price Delivery period Re- Minimum

Material unit of quantity per (in weeks) order level
Product (Kgs.) Kg. level (Kgs.)
(Kgs.) (Kgs)

Minimum Average Maximum

A 10 10,000 10 1 2 3 8,000 ?

B 4 5,000 30 3 4 5 4,750 ?

C 6 10,000 15 2 3 4 ? 2,000

Weekly production varies from 175 to 225 units, averaging 200 units of the
said product. COMPUTE the following quantities:
(i) Minimum stock of A,
(ii) Maximum stock of B,
(iii) Re-order level of C,
(iv) Average stock level of A.
5. (a) EXE Limited has received an offer of quantity discounts on its order of
materials as under:

Price per ton (` ) Ton (Nos.)

1,200 Less than 500

1,180 500 and less than 1,000
1,160 1,000 and less than 2,000
1,140 2,000 and less than 3,000
1,120 3,000 and above.

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The annual requirement for the material is 5,000 tons. The ordering cost
per order is `R 1,200 and the stock holding cost is estimated at 20% of
material cost per annum. You are required to COMPUTE the most
economical purchase level.

(b) WHAT will be your answer to the above question if there are no
discounts offered and the price per ton is ` 1,500?

6. From the details given below, CALCULATE:

(i) Re-ordering level

(ii) Maximum level

(iii) Minimum level

(iv) Danger level.

Re-ordering quantity is to be calculated on the basis of following information:

Cost of placing a purchase order is ` 4,000

Number of units to be purchased during the year is 5,00,000

Purchase price per unit, inclusive of transportation cost is ` 50

Annual cost of storage per unit is ` 10.

Details of lead time : Average - 10 days, Maximum - 15 days Minimum- 5 days,

for emergency purchases- 4 days.

Rate of consumption: Average: 1,500 units per day,

Maximum: 2,000 units per day.

7. G. Ltd. produces a product which has a monthly demand of 4,000 units. The
product requires a component X which is purchased at ` 20. For every finished
product, one unit of component is required. The ordering cost is
` 120 per order and the holding cost is 10% p.a.

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 2.82 COST AND MANAGEMENT ACCOUNTING

You are required to CALCULATE:

(i) Economic order quantity.
(ii) If the minimum lot size to be supplied is 4,000 units, what is the extra
cost, the company has to incur?
(iii) What is the minimum carrying cost, the company has to incur?
8. ‘AT’ Ltd. furnishes the following store transactions for September, 2022:
1-9-22 Opening balance 25 units value ` 162.50

4-9- 22 Issues Req. No. 85 8 units

6-9- 22 Receipts from B & Co. GRN No. 26 50 units @ ` 5.75 per unit
7-9- 22 Issues Req. No. 97 12 units

10-9- 22 Return to B & Co. 10 units

12-9- 22 Issues Req. No. 108 15 units
13-9- 22 Issues Req. No. 110 20 units
15-9- 22 Receipts from M & Co. GRN. No. 33 25 units @ ` 6.10 per unit
17-9- 22 Issues Req. No. 121 10 units
19-9- 22 Received replacement from B & Co.
GRN No. 38 10 units
20-9- 22 Returned from department, material
of M & Co. MRR No. 4 5 units
22-9- 22 Transfer from Job 182 to Job 187 in
the dept. MTR 6 5 units
26-9- 22 Issues Req. No. 146 10 units
29-9- 22 Transfer from Dept. “A” to
Dept. “B” MTR 10 5 units
30-9- 22 Shortage in stock taking 2 units
PREPARE the priced stores ledger on FIFO method and STATE how would you
treat the shortage in stock taking.

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 MATERIAL COST 2.83
2.83

9. The following information is extracted from the Stores Ledger:

Material X
Opening Stock Nil

Purchases:
Jan. 1 100 @ ` 1 per unit
Jan. 20 100 @ ` 2 per unit
Issues:
Jan. 22 60 for Job W 16
Jan. 23 60 for Job W 17
Complete the receipts and issues valuation by adopting the First-In-First-Out,
Last-In-First-Out and the Weighted Average Method. TABULATE the values
allocated to Job W 16, Job W 17 and the closing stock under the methods
aforesaid and discuss from different points of view which method you would
prefer.

Case Scenarios
1. The purchase committee of A Ltd. has been entrusted to review the material
procurement policy of the company. The chief marketing manager has
appraised the committee that the company at present produces a single
product X by using two raw materials A and B in the ratio of 3:2. Material A is
perishable in nature and has to be used within 10 days from Goods received
note (GRN) date otherwise material becomes obsolete. Material B is durable in
nature and can be used even after one year. Material A is purchased from the
local market within 1 to 2 days of placing order. Material B, on the other hand,
is purchased from neighbouring state and it takes 2 to 4 days to receive the
material in the store.
The purchase price of per kilogram of raw material A and B is `30 and `44
respectively exclusive of taxes. To place an order, the company has to incur an
administrative cost of `1,200. Carrying cost for Material A and B is 15% and
5% respectively. At present material A is purchased in a lot of 15,000 kg. to
avail 10% discount on market price. GST applicable for both the materials is
18% and the input tax credit is availed.

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 2.84 COST AND MANAGEMENT ACCOUNTING

The sales department has provided an estimate that the company could sell
30,000 kg. in January 2024 and also projected the same trend for the entire
year.
The ratio of input and output is 5:3. Company works for 25 days in a month
and production is carried out evenly.
The following queries/ calculations to be kept ready for purchase committees’
reference:
(i) For the month of January 2024, what would be the quantity of the
materials to be requisitioned for both material A and B:
(a) 9,000 kg & 6,000 kg respectively
(b) 18,000 kg & 12,000 kg respectively
(c) 27,000 kg & 18,000 kg respectively
(d) 30,000 kg & 20,000 kg respectively.
(ii) The economic order quantity (EOQ) for both the material A & B:
(a) 13,856 kg & 16,181 kg respectively
(b) 16,197 kg & 17,327 kg respectively
(c) 16,181 kg & 17,165 kg respectively
(d) 13,197 kg & 17,165 kg respectively
(iii) What would the maximum stock level for material A:
(a) 18,200 kg.
(b) 12,000 kg.
(c) 16,000 kg.
(d) 16,200 kg.
(iv) Calculate saving/ loss in purchase of Material A if the purchase order
quantity is equal to EOQ.
(a) Profit of ` 3,21,201.
(b) Loss of ` 3,21,201.
(c) Profit of ` 2,52,500.
(d) Loss of ` 2,52,500.

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 MATERIAL COST 2.85
2.85

(v) What would the minimum stock level for material A:

(a) 1,800 kg.
(b) 1,200 kg.
(c) 600 kg.
(d) 2,400 kg.

ANSWERS
Answers to the MCQs
1. (b) 2. (a) 3. (c) 4. (b) 5. (b) 6. (b)

7. (a) 8. (b) 9. (b) 10. (b)

Answers to the Theoretical Questions

1. Please refer paragraph 10
2. Please refer paragraph 5.2
3. Please refer paragraph 10
4. Please refer paragraph 6.4
5. Please refer paragraph 6.1
6. Please refer paragraph 6.4
7. Please refer paragraph 6.1, 6.3, 6.1, 10

Answers to the Practical Problems

1. (a) Total Annual Cost in Existing Inventory Policy

(`)

Ordering cost (6 orders @ ` 25) 150

Carrying cost of average inventory (36,000 ÷ 6) = 6,000

units per order

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 2.86 COST AND MANAGEMENT ACCOUNTING

Average inventory = 3,000 units

Carrying cost = 20% of ` 1 × 3,000 = 3,000 × 0.20 600

Total cost A 750

(b) Total Annual Cost in E.O.Q

2×36,000×25
EOQ = = 3000 units
` 1×20%
(`)
No. of orders = 36,000 ÷3,000 units = 12 orders

Ordering cost (12 × `Rs 25) = 300

Carrying cost of average inventory (3,000 × 0.20) ÷ 2 = 300

Total Cost B 600

Savings due to E.O.Q ` (750 – 600) (A – B) 150

Note: As the units purchase cost of ` 1 does not change in both the
computation, the same has not been considered to arrive at total cost
of inventory for the purpose of savings.
2. (i) Calculation of Economic Order Quantity
2AO 2 ×8,000 units × `200
EOQ = = = 200 units
C ` 400×20 / 100

(ii) Evaluation of Profitability of Different Options of Order Quantity

(a) When EOQ is ordered

(`)
Purchase Cost (8,000 units × ` 400) 32,00,000
Ordering Cost [(8,000 units/200 units) × ` 200] 8,000
Carrying Cost (200 units × `400 × ½ × 20/100) 8,000
Total Cost 32,16,000

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 MATERIAL COST 2.87
2.87

(b) When Quantity Discount is accepted

(`)
Purchase Cost (8,000 units × ` 384*) 30,72,000
Ordering Cost [(8,000 units/4000 units) × ` 400
200]
Carrying Cost (4000 units × ` 384 × ½ × 1,53,600
20/100)
Total Cost 32,26,000

*Unit Cost `400

Less Quantity Discount @ 4% = 16
Purchase Cost = 400- 16 = `384
Advise – The total cost of inventory is lower if EOQ is adopted.
Hence, the company is advised not to accept the quantity
discount.

2AO
3. EOQ =
C

Where,
A = Annual Demand
O = Ordering cost per order
C = Inventory carrying cost per unit per annum
(i) Calculation of EOQ

Super Grow Nature’s Own

2 × 2,000 × 1,200 2 × 1,280 × 1,400

EOQ = EOQ =
480 560

= 10,000 or 100 bags = 6,400 or or 80 bags

© The Institute of Chartered Accountants of India

 2.88 COST AND MANAGEMENT ACCOUNTING

(ii) Total annual relevant cost = Total annual relevant ordering costs +
Total annual relevant carrying cost

Super Grow Nature’s Own

Number of Orders 2,000/100 =20 orders 1,280/80 =16 orders

= Annual Require-
ment ÷EOQ

Ordering Cost 20 × 1200 = ` 24000 16 × 1400 = `22,400

Carrying Cost ½ × 100 × 480 = ½ × 80 × 560 =

`24,000 `22,400

Total of Ordering =` 24,000+ ` 24,000 = ` 22,400 + ` 22,400 =

and Carrying Cost ` 48,000 ` 44,800

(iii) Number of deliveries for Super Grow and Nature’s own fertilizer per
Annual demand for fertilizer bags
year =
EOQ

Super Grow Nature’s Own

2,000 bags = 1,280 bags = 16 orders.
= = 20 orders
100 bags 80 bags

4. (i) Minimum stock of A

Re-order level – (Average rate of consumption × Average time
required to obtain fresh delivery)
= 8,000 – (200 × 10 × 2) = 4,000 kgs.
(ii) Maximum stock of B
Re-order level + Re-order quantity – (Minimum consumption ×
Minimum delivery period)

= 4,750 + 5,000 – (175 × 4 × 3)

= 9,750 – 2,100
= 7,650 kgs.

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 MATERIAL COST 2.89
2.89

(iii) Re-order level of C

Maximum delivery period × Maximum usage
= 4 × 225 × 6 = 5,400 kgs.

OR
Re-order level of C
= Minimum level of C + [Average rate of consumption × Average
time required to obtain fresh delivery]
= 2,000 + [(200 × 6) × 3] kgs = 5,600 kgs.
(iv) Average stock level of A
= Minimum stock level of A + ½ Re-order quantity of A
= 4,000 + ½ × 10,000 = 4,000 + 5,000 = 9,000 kgs
OR
Average Stock level of A
Minimum stock level of A + Maximum stock level of A
=
2
(Refer to working note)
4,000 + 16,250
= 10,125 kgs
2
Working note:
Maximum stock of A = ROL+ ROQ – (Minimum consumption ×
Minimum re-order period)
= 8,000 + 10,000 – [(175 × 10) × 1] = 16,250 kgs

© The Institute of Chartered Accountants of India

 2.90 COST AND MANAGEMENT ACCOUNTING

5. (a)

Total Order No. Cost of Ordering Carrying cost Total Cost

annual size of inventory cost p.t. p.a (4+5+6)
require (Tonne) orders A × Per tonne A/q × 1/2× q × 20% (`)
ment (q) A/q cost ` 1200 of cost p.t.
(A) (`) (`) (`)

1 2 3 4 5 6 7

5,000 400 12.5 60,00,000 15,600 48,000 60,63,600

(13)*

Ton (5,000×`1200) (200 × ` 240)

500 10 59,00,000 12,000 59,000 59,71000

(5,000 × ` 1180) (250 × ` 236)

1,000 5 58,00,000 6,000 1,16,000 59,22,000

(5,000× ` 1160) (500 × ` 232)

2,000 2.5 57,00,000 2,28,000

(3)* 3,600 59,31,600

(5,000×` 1140) (1,000×`228)

3,000 1.666 56,00,000 3,36,000

(2)* 2,400

(5,000×` 1120) (1,500×`224) 59,38,400

* Since number of orders cannot be in decimals, thus 12.5 orders are

taken as 13 orders, 2.5 are taken as 3 order and 1.66 orders are taken
as 2 orders.
The above table shows that the total cost of 5,000 units including
ordering and carrying cost is minimum (` 59,22,000) when the order size
is 1,000 units. Hence the most economical purchase level is 1,000 units.
(b) If there will are no discount offer then the purchase quantity should be
equal to EOQ. The EOQ is as follows:

2AO
EOQ =
C

where A = annual inventory requirement,

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 MATERIAL COST 2.91
2.91

O = ordering cost per order and

C = carrying cost per unit per annum.

2×5,000 units × `1,200

= = 200 units
20% × `1,500

6. Basic Data:
A (Number of units to be purchased annually) = 5,00,000 units
O (Ordering cost per order) = ` 4,000

C (Annual cost of storage per unit) = ` 10

Purchase price per unit inclusive of transportation cost = ` 50
Computations:
(i) Re-ordering level = Maximum usage per period × Maximum
(ROL) lead time
= 2,000 units per day × 15 days
= 30,000 units
(ii) Maximum level = ROL + ROQ – [Min. rate of consumption ×
Min. lead time] (Refer to working notes 1 and 2)
= 30,000 units + 20,000 units – [1,000 units per
day×5 days]
= 45,000 units

(iii) Minimum level = ROL–Average rate of consumption×

Average re-order-period
= 30,000 units – (1,500 units per day × 10
days)
= 15,000 units
(iv) Danger level = Average consumption × Lead time for
emergency purchases
= 1,500 units per day × 4 days
= 6,000 units

© The Institute of Chartered Accountants of India

 2.92 COST AND MANAGEMENT ACCOUNTING

Working Notes:
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2

X units / day + 2,000 units per day

1,500 units per day = or X
2

= 1,000 units per day.

2 × 5, 00, 000 units × ` 4, 000

2. Re-order Quantity (ROQ)= =20,000 units
10

7. (a) (i) Economic order quantity:

A (Annual requirement or Component ‘X’)
= 4,000 units per month × 12 months
= 48,000 units
C (Purchase cost p.u.) = ` 20
O (Ordering cost per order) = ` 120
Ci (Holding cost) = 10% per annum

2AO 2×48,000units× `120

E.O.Q. = = = 2,400 units
C 10%of `20
i

(ii) Extra cost incurred by the company:

A. Total cost when order size is equal 4,000 units:
Total cost = Total ordering cost + Total carrying cost
A
= × O + 1 Q (Ci)
Q 2

=  48,000 units × ` 120  +  1 × 4,000 units ×10% × ` 20 

 4,000 units  2 
= ` 1,440 + ` 4,000 = ` 5,440

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 MATERIAL COST 2.93
2.93

B. Total cost when order size is equal EOQ i.e. 2,400 units:

Total cost =  48,000 units 1

×`120  +  × 2,400 units × 10% × ` 20 
 

 2,400 units  2 

= ` 2,400 + ` 2,400 = ` 4,800

Extra cost that the company has to incur = (A) – (B)

= ` 5,440 – ` 4,800
= ` 640
(iii) Minimum carrying cost: Carrying cost depends upon the size of
the order. It will be minimum on the least order size. (In this part
of the question the two order sizes are 2,400 units and 4,000
units. Here 2,400 units is the least of the two order sizes. At this
order size carrying cost will be minimum.)
The minimum carrying cost in this case can be computed as
under:
1
Minimum carrying cost = × 2,400 units × 10% × ` 20 = ` 2,400.
2
8. Working Notes:
1. The material received as replacement from vendor is treated as fresh
supply.
2. In the absence of any information, the price of the material returned
from a user department on 20-9-22 has been taken at the price of the
latest issue made on 17-9-22. In FIFO method, physical flow of the
material is irrelevant, and issue price is based on first in first out.
3. The issue of material on 26-9-22 is made out of the material received
from a user department on 20-9-22.
4. The entries for transfer of materials from one job and department to
another on 22-9-22 and 29-9-22 respectively, do not affect the store
ledger. However, adjustment entries to calculation of cost of respective
jobs and departments are made in cost accounts.
5. The material found short as a result of stock taking has been written
off at relevant issue price.

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 2.94
2.94
Stores Ledger of AT Ltd. for the month of September, 2022 (FIFO Method)
RECEIPT ISSUE BALANCE
Date GRN Qty. Rate Amount Requisi- Qty. Rate Amount Qty. Rate Amount
No Units (`) (`) tion No Units (`) (`) Units (`) (`)
2.94

MRR
No.

1 2 3 4 5 6 7 8 9 10 11 12

© The Institute of Chartered Accountants of India

1-9-22 — — — — — — — — 25 6.50 162.50

4-9-22 — — — — 85 8 6.50 52 17 6.50 110.50

17 6.50
6-9-22 26 50 5.75 287.50 — — — — 398.00
50 5.75

5 6.50
7-9-22 — — — — 97 12 6.50 78 320.00
50 5.75

6.50
10-9-22 — — — — Return 10 5.75 57.50 262.50
40 5.75

5 6.50
12-9-22 — — — — 108 90 30 5.75 172.50
10 5.75

13-9-22 — — — — 110 20 5.75 115 10 5.75 57.50

COST AND MANAGEMENT ACCOUNTING

10 5.75
15-9-22 33 25 6.10 152.50 — — — — 210.00
25 6.10
 17-9-22 — — — — 121 10 5.75 57.50 25 6.10 152.50

25 6.10
19-9-22 38 10 5.75 57.50 — — — — 210.00
10 5.75

5 5.75

20-9-22 4 5 5.75 28.75 — — — — 25 6.10 238.75

10 5.75

5 5.75 20 6.10
26-9-22 — — — — 146 59.25 179.50

© The Institute of Chartered Accountants of India

5 6.10 10 5.75

18 6.10
30-9-22 — — — — Shortage 2 6.10 12.20 167.30
10 5.75
MATERIAL COST
2.95
 2.96 COST AND MANAGEMENT ACCOUNTING
2.96
2.96
9. From the point of view of cost of material charged to each job, it is minimum
under FIFO and maximum under LIFO (Refer to Tables). During the period of
rising prices, the use of FIFO give rise to high profits and that of LIFO low
profits. In the case of weighted average, there is no significant adverse or
favourable effect on the cost of material as well as on profits.
From the point of view of valuation of closing stock, it is apparent from the
above statement, that it is maximum under FIFO, moderate under weighted
average and minimum under LIFO.
It is clear from the tables that the use of weighted average evens out the
fluctuations in the prices. Under this method, the cost of materials issued to
the jobs and the cost of material in hands reflects greater uniformity than
under FIFO and LIFO. Thus, from different points of view, weighted average
method is preferred over LIFO and FIFO.
Statement of receipts and issues by adopting First-in-First-Out Method
Particulars Receipts Issues Balance
Date Units Rate Value Units Rate Value Units Rate Value
No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
100 1 100
Jan. 20 Purchase 100 2 200 — — —
100 2 200
Issue to Job 40 1 40
Jan. 22 — — — 60 1 60
W 16 100 2 200
Issue to Job 40 1 40
Jan. 23 — — — 80 2 160
W 17 20 2 40

Statement of receipts and issues by adopting Last-In-First-Out method

Receipts Issues Balance
Date Particulars Units Rate Value Units Rate Value Units Rate Value
No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
100 1 100
Jan. 20 Purchase 100 2 200 — — —
100 2 200

Issue to Job 100 1 100

Jan. 22 — — — 60 2 120
W 16 40 2 80
Issue to Job
Jan. 23 — — — 40 2 80 80 1 80
W 17
20 1 20

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 MATERIAL COST 2.97

Statement of Receipt and Issues by adopting Weighted Average method

Date Particulars Receipts Issues Balance

Units Rate Value Units Rate Value Units Rate Value

No. (`) (`) No. (`) (`) No. (`) (`)

Jan. 1 Purchase 100 1 100 — — — 100 1 100

Jan. 20 Purchase 100 2 200 — — — 200 1.50 300

Jan. 22 Issue to Job — — — 60 1.50 90 140 1.50 210

W 16

Jan. 23 Issue to Job — — — 60 1.50 90 80 1.50 120

W 17

Statement of Material Values allocated to Job W 16, Job 17 and

Closing Stock, under aforesaid methods
FIFO LIFO Weighted Average
(`) (`) (`)
Material for Job W 16 60 120 90
Material for Job W 17 80 100 90
Closing Stock 160 80 120
300 300 300

Answers to the Case Scenarios

1.
i. (d) ii. (a) iii. (b) iv. (b) v. (c)

(i) (d) Monthly Production of X = 30,000 kgs.

30,000
Raw Material Required = ×5 = 50,000 kgs.
3
50,000
Material A = ×3 = 30,000 kg.
5
50,000
Material B = ×2 = 20,000 kg.
5

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 2.98 COST AND MANAGEMENT ACCOUNTING

(ii) (a) Calculation of Economic Order Quantity (EOQ):

2×Annual consumption× Order cost
Material A =
Carrying cost per unit p.a.

2×(30,000×12)×1,200
=� = 13,856 kg.
15% of 30

2×(20,000×12)×1,200
Material B =� = 16,181 kg.
5% of 44

(iii) (b) Calculation of Maximum Stock level: Since, the Material A is

perishable in nature and it required to be used within 10 days,
hence, the Maximum Stock Level shall be lower of two:
(a) Stock equal to 10 days consumption
30000
= ×10 days = 12,000 kg.
25
(b) Maximum Stock Level for Material A:
Re-order Quantity + Re-order level – (Min consumption* × Min.
lead time)
Where,
Re-order Quantity = 15,000 kg.
Re-order level = Max. Consumption* × Max. Lead time
= 30,000/25 × 2 days = 2,400 kg.
Maximum stock Level = 15,000 kg. + 2,400 kg. -
(30,000/25 × 1 day)
= 17,400 – 1,200 = 16,200 kg.
Stock required for 10 days consumption is lower than the
maximum stock level calculated through the formula. Therefore,
Maximum Stock Level will be 12,000 kg.
(*Since, production is processed evenly throughout the month
hence material consumption will also be even.)

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 MATERIAL COST 2.99

(iv) (b) Calculation of Savings/ loss in Material A if purchase quantity

equals to EOQ.
Purchase Quantity = Purchase Quantity =
15,000 kg. EOQ i.e. 13,856 kg.
Annual 3,60,000 kg. 3,60,000 kg.
consumption (30,000 × 12 months) (30,000 × 12 months)
No. of orders 30 30
[Note- (i)] (3,60,000 ÷ 12,000) (3,60,000 ÷ 12,000)
Ordering Cost (a) `36,000 `36,000
(`1200 × 30) (`1200 × 30)
Carrying Cost (b) `30,375 `31,176
[Note- (ii)] (15% of `27 × 7,500) (15% of `30 × 6,928)
Purchase Cost (c) `97,20,000 `1,08,00,000
(for good (`27 × 3,60,000) (`30 × 3,60,000)
portion)
Loss due to `24,30,000 `16,70,400
obsolescence (d) [`27 × (30 × 3,000)] [`30 × (30 × 1,856)]
[Note- (iii)]
Total Cost [(a) + ` 1,22,16,375 ` 1,25,37,576
(b) + (c) + (d)]

Purchasing of material -A at present policy of 15,000 kg. saves `

3,21,201.
Notes: (i) Since, material gets obsolete after 10 days, the
quantity in excess of 10 days consumption i.e. 12,000 kg. are
wasted. Hence, after 12,000 kg. a fresh order needs to be given.
(ii) Carrying cost is incurred on average stock of Materials
purchased.
(iii) the excess quantity of material becomes obsolete and loss
has to be incurred.
(v) (c) Minimum Stock Level for Material A
= Re-order level – (Average Consumption Rate x Average Re-
order Period)
= 2400 – (1200 x 1.5) = 600 kgs

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 2.100 COST AND MANAGEMENT ACCOUNTING

Re-order level = Max. Consumption* × Max. Lead

time
= 30,000/25 × 2 days = 2,400 kg.
Average Consumption Rate = (30,000/25 + 30,000/25)/2
= 1,200 Kg
Average Re-order Period = (1 + 2)/2 =1.5 Days
Stock required for 10 days consumption is lower than the
maximum stock level calculated through the formula. Therefore,
Maximum Stock Level will be 12,000 kg.
(*Since, production is processed evenly throughout the month
hence material consumption will also be even.)

© The Institute of Chartered Accountants of India