Chapter 3: Accounting for materials

1 Inventory Control

In manufacturing, inventory (materials) often makes up the largest cost. Businesses keep inventory
for a few main reasons:

• To serve as a buffer during high demand periods.

• To buy in bulk and get quantity discounts.

• To take advantage of seasonal or special pricing.

• To avoid production delays due to missing parts, ensuring smooth production.

• For technical needs, like allowing certain foods to mature.

Efficient inventory management requires that materials are ordered, received, and issued with
precise internal controls. This includes choosing the right materials for their intended purpose and
ensuring an organized and documented process from ordering to payment.

Accounting for Materials

Controlling purchasing requires these steps:

• Authorization: Only necessary items should be bought, with spending limits set for
authorized buyers.

• Supplier Selection: Choose suppliers based on cost and reliability, often from a pre-approved
list.

• Quality and Quantity Check: Verify received goods match the order in terms of quantity and
quality.

• Pricing Verification: Ensure payment aligns with the agreed price at the time of ordering.

A well-structured system of documentation and authorization—whether on paper or computer—is

essential to track every step and prevent issues.

Computerised Inventory Control Systems

Businesses of different sizes may use various systems for ordering and tracking inventory. Large
businesses typically rely on computerised inventory systems, enabling them to monitor levels
continuously and place orders as needed with minimal effort. Smaller businesses may still use paper
records, though this is becoming rare.

Extranet: An extranet is a secure network allowing limited access for suppliers, partners, and
authorized customers to a company’s information. It’s a way to provide access to essential data
without exposing the entire network.

Extranet Examples:

Distribution Network: Maintains communication between suppliers and distributors.

E-commerce Integration: Securely shares inventory data with partners.

Advantages of Extranets:

They enable sharing of product information and catalogues with specific trade partners.

Direct connection with customers and suppliers can increase efficiency.

Disadvantages of Extranets:

Implementation can be costly due to hardware, software, and training.

Security can be a concern, especially when dealing with sensitive data.

2 Inventory Holding and Ordering Costs

Businesses must carefully consider which items to keep in inventory and how much of each item is
necessary. Holding inventory incurs various costs, creating a trade-off between inventory expenses
and the level of service offered.

Costs of Carrying Inventory

1. Purchase Price: The initial cost of acquiring inventory.

2. Holding Costs: These include:

o Opportunity Cost: The capital tied up in inventory could be used elsewhere.

o Insurance: Cost to insure the inventory.

o Deterioration and Obsolescence: Loss of value due to spoilage or outdated items.

o Damage and Pilferage: Costs associated with loss or theft.

o Warehouse Upkeep: Maintenance costs for storage facilities.

o Labor and Administration: Staffing and managing inventory records.

3. Ordering Costs:

o Clerical and Administrative Costs: Increased costs associated with placing multiple
orders, which behave as variable costs.

o Transport Costs: Expenses incurred to deliver inventory.

4. Stock-out Costs: Consequences of not having inventory available:

o Loss of Sales: Missing out on revenue.

o Goodwill Damage: Negative impact on customer relationships.

o Production Stoppages: Halting production due to raw material shortages.

o Emergency Order Costs: Higher costs from urgent orders.

 5. Inventory Recording Systems Costs: Expenses related to maintaining accurate inventory
records.

Fixed and Variable Holding Costs

• Fixed Holding Costs: These include storage space and insurance, which may increase as
more inventory is stored.

• Variable Holding Costs: Interest on capital tied up in inventory increases with the amount of
inventory held.

Holding Cost Calculation:

• Total Annual Holding Cost = Holding Cost per Unit (Ch) × Average Inventory (Q/2)

Ordering Cost Calculation:

• Total Annual Ordering Cost = Cost of Placing an Order (Co) × Number of Orders (D/Q)

Where:

• D = Annual demand

• Q = Order quantity

Total Annual Cost of Inventory

Total Annual Cost (TAC):

• Total Cost = (Purchase Cost P × Annual Demand D) + (Ordering Costs) + (Holding Costs)

Formula:

• Total Annual Cost = PD + (Co × D/Q) + (Ch × Q/2)

This structured approach helps businesses manage inventory effectively by balancing costs and
ensuring smooth operations.

Costs of Carrying Buffer Inventory

Buffer or safety inventory serves as a safeguard against unpredictable spikes in demand, production
interruptions, supplier issues, or delays in deliveries. While it helps maintain service levels and can
lower purchasing costs by preventing critical shortages, it also comes with significant costs.

Key Costs of Buffer Inventory

1. Opportunity Cost: Cash tied up in inventory could be used elsewhere for more productive
investments.

2. Insurance Costs: Inventory requires insurance to protect against risks like damage or theft.

3. Storage Costs: Includes expenses for warehousing, heating, labor, and upkeep.

4. Liability Risks: If demand decreases or products become obsolete, excess inventory may
become a liability, resulting in losses.
Disadvantages of Inventory Levels

Low Inventory Levels

Maintaining low inventory can help reduce holding costs but poses several risks:

• Customer Dissatisfaction: Inability to meet customer demand can lead to lost sales.

• Emergency Costs: Urgent orders to satisfy important customers may incur high costs.

• Frequent Orders: More frequent replenishment orders increase overall ordering costs.

High Inventory Levels

Conversely, holding high inventory levels can also lead to issues:

• High Storage Costs: Increased expenses associated with warehousing and management.

• Capital Costs: Cash tied up in inventory limits funds for other expenses or investments.

• Obsolescence Risk: Excess inventory of outdated products can lead to significant losses.

• Market Price Risks: Holding high levels of raw materials may result in losses if market prices
fall after purchase.

3 Systems of Inventory Control

Reorder Level

The reorder level is the quantity of inventory in hand when a replenishment order should be placed.
It is calculated based on the time it will take to receive the order (lead time) and the expected usage
during that time.

If the demand during the lead time is constant, the reorder level is calculated as follows:

Reorder Level = Maximum Usage × Maximum Lead Time

The Economic Order Quantity (EOQ)

The Economic Order Quantity (EOQ) is the optimal reorder quantity that minimizes the total costs
associated with holding and ordering inventory, ensuring that holding costs and ordering costs are at
their lowest.

The formula for calculating EOQ (or Q) is:

Q=EOQ=
Where:

• D = Demand per annum

 • Co = Cost of placing one order

• Ch = Cost of holding one unit for one year

EOQ Assumptions

Several important assumptions underlie the EOQ model:

• Demand and lead time are constant and known.

• The purchase price is constant.

• No buffer inventory is held.

This approach helps businesses determine the most cost-effective quantity to order, balancing
ordering and holding costs efficiently.

The EOQ with Discounts

Quantity Discounts

Negotiating quantity discounts with suppliers can reduce the purchase price when bulk orders are
placed. This can impact various costs associated with inventory management:

• Annual Purchase Price: Decreases due to the discount.

• Annual Holding Cost: Increases as more inventory is held.

• Annual Ordering Cost: Decreases since fewer orders are needed.

EOQ Calculation with Discounts

When calculating EOQ in the presence of quantity discounts, follow these steps:

1. Calculate EOQ Without Discounts: Begin by determining the EOQ using the standard
formula, ignoring discounts.

2. Compare with Minimum Purchase Quantity: If the EOQ is smaller than the minimum quantity
required for a bulk discount:

o Calculate total annual costs (holding, ordering, and purchase) at the EOQ level.

o Calculate these costs for the quantity that qualifies for the bulk discount.

3. Compare Total Costs: Assess the total costs from both scenarios and select the option with
the lower cost.

4. Consider Further Discounts: If additional discounts are available for larger orders, repeat the
calculations for those quantities.
Economic Batch Quantity (EBQ)
The Economic Batch Quantity (EBQ) model is designed for organizations that manufacture and store
their own products. It helps determine the most economical batch size to produce when replenishing
inventory gradually.

Key Considerations

• Production Decisions: Organizations must decide between producing large batches at long
intervals or small batches at short intervals.

• Amended EOQ Model: The EBQ modifies the traditional EOQ model to account for
production scenarios.

• Setup Costs: In the EBQ model, machine setup costs replace the ordering costs used in the
EOQ model.

• Inventory Replenishment: Unlike the EOQ, where inventory is replenished instantaneously,

the EBQ considers that inventory is replenished over time, with part of the batch being sold
or used while production continues.

Batch Size Implications

• Large Batches:

o Pros: Lower machine setup costs (fewer setups needed).

o Cons: Higher holding costs due to increased average inventory levels.

• Small Batches:

o Pros: Lower holding costs (less inventory held).

o Cons: Higher machine setup costs (more setups required).

The EBQ model ultimately helps organizations optimize production batch sizes to balance setup and
holding costs effectively.

Economic Batch Quantity (EBQ) Formula

Where:

• Q = Batch size

• D = Demand per annum

• Ch = Cost of holding one unit for one year

• Co = Cost of setting up one batch ready to be produced

 • R = Annual replenishment rate

Maximum and Minimum Inventory Levels

The maximum inventory level is determined based on various factors, including:

• Rate of Consumption: How quickly materials are used.

• Time for New Supplies: How long it takes to receive new inventory.

• Financial Considerations: Avoiding excessive capital tied up in inventory.

• Storage Space: The availability and cost of storage facilities.

• Price Fluctuations: How prices change over time.

• Specification Changes: Risks associated with altering product specifications.

• Loss Risks: Potential losses from evaporation, deterioration, etc.

• Seasonal Factors: Seasonal variations in price and availability.

• Economic Order Quantity (EOQ): Integration of optimal order quantities.

The minimum inventory level is established by considering:

• Rate of Consumption: Similar to the maximum level, understanding usage rates is essential.

• Delivery Time: The lead time required to receive new inventory.

• Stock-Out Costs: The financial impact and operational issues that arise when stock is
unavailable.

A simplified method to determine maximum and minimum inventory levels is as follows:

Minimum Level=Re-order Level−(Average Usage×Average Lead Time)

Maximum Level=Re-order Level+Re-order Quantity−(Minimum Usage×Minimum Lead Time)

Control Procedures to Minimize Discrepancies and Losses

Effective inventory control is crucial for organizations to minimize discrepancies and losses
associated with their investment in inventory and labor costs. Here are key control procedures:

Stocktaking

• Definition: Stocktaking involves verifying the physical inventory against records.

 • Methods:

o Periodic Stocktaking: Inventory of all items is checked on a specific date, typically

at the end of an accounting period.

o Continuous Stocktaking: Selected items are counted on a rotating schedule, with

valuable items checked more frequently.

• Discrepancy Investigation: Any differences between recorded and physical inventory must
be investigated, usually indicating recording errors.

• Adjustment: Once discrepancies are identified, adjust the records to reflect the actual
inventory count.

• Management of Slow-Moving and Obsolete Items: Items that are slow-moving or obsolete
should be reported to management for potential disposal and write-off.

Other Control Issues and Procedures

Issue Control Procedure

Ordering goods at inflated prices Use standard costs for purchases; request quotes for special
items.

Fake purchases Separate ordering and purchasing roles; implement physical

controls over materials.

Shortages on receipts Verify all goods upon delivery; obtain delivery signatures.

Losses from inventory Conduct regular stocktaking; enforce physical security

measures.

Writing off obsolete or Control oversight by responsible officials for all write-offs.
undamaged inventory

Losses after issue to production Maintain accurate records of all inventory issues; establish
standard usage allowances.

Implementing these control procedures helps organizations maintain accurate inventory records,
reduce losses, and improve overall efficiency.

Valuing Inventory
Perpetual Inventory

Perpetual inventory is a system that records the inflow (receipts) and outflow (issues) of inventory
continuously, maintaining updated balances for each item. Most companies utilize automated or
computerized systems for this purpose.
Importance of Inventory Valuation

• Financial Reporting: Accurate inventory valuation is essential for financial statements.

• Costing: Helps determine pricing based on inventory consumed.

4 Inventory Valuation Methods

Businesses typically use one of the following methods to assign costs to inventory:

1. FIFO (First In First Out)

o Assumes that inventory items are sold in the order they were acquired.

o Advantages:

▪ Reflects physical flow of goods.

▪ Inventory values are based on current prices.

▪ Accepted by accounting standards.

o Disadvantages:

▪ Can inflate profits in times of rising prices.

▪ May complicate cost comparisons.

2. LIFO (Last In First Out)

o Assumes that the most recently purchased items are sold first.

o Advantages:

▪ Current prices for issues reduce reported profits during inflation.

o Disadvantages:

▪ Often not accepted by tax authorities and accounting standards.

▪ May result in outdated inventory valuations.

3. AVCO (Average Cost)

o Calculates a weighted average cost for all items in inventory.

o Advantages:

▪ Simplifies accounting and is acceptable under regulations.

▪ Ensures consistency in inventory valuation.

o Disadvantages:

▪ May not reflect actual purchase prices accurately.

 ▪ Can lag behind current market values.

5 Just In Time (JIT)

Just In Time (JIT) is a production and inventory management philosophy focused on minimizing
inventory levels and producing goods only as needed. This approach seeks to eliminate all forms of
waste, including excess inventory, overproduction, and defects, thereby enhancing efficiency and
responsiveness to customer demand.

JIT Definitions

• JIT Production: A system where production is driven by actual demand for finished products,
with components produced only as they are needed for the next stage of production.

• JIT Purchasing: A method of contracting for materials such that their receipt aligns closely
with their usage, minimizing stock levels.

Philosophy and Principles

JIT is not merely a production technique, but a comprehensive management philosophy

characterized by:

• Continuous Improvement (Kaizen): A commitment to enhancing processes gradually.

• Elimination of Waste: A focus on reducing overproduction, inefficient processes, excess

inventory, and defects.

Requirements for JIT Operation

To effectively implement JIT, organizations must ensure:

• High Quality: Both materials and production systems need to be reliable.

• Speed: The production system must operate quickly to fulfill customer orders promptly.

• Flexibility: The system should be adaptable to varying order sizes and immediate customer
demands.

Benefits of JIT

• Reduced cash tied up in inventory.

• Decreased storage space requirements.

• Improved product quality.

• Enhanced production flexibility and coordination.

• Development of reliable and supportive supplier relationships.

Challenges of JIT

Despite its advantages, JIT presents several challenges:

 • It necessitates predictable demand and flexible suppliers.

• There is a lack of safety stock, which can lead to disruptions in production if unforeseen
issues arise.

6 Accounting for Inventory – The Material Inventory Account

Materials held in stores are classified as assets and recorded as inventory in a company's statement
of financial position.

Structure of the Material Inventory Account

The material inventory account functions as a ledger to record all transactions related to materials.
The accounting entries are structured as follows:

• Debit Entries: Reflect increases in inventory, indicating the acquisition of materials.

o Purchases: When materials are bought and added to inventory.

o Returns to Stores: When materials initially issued to production are returned to

inventory.

• Credit Entries: Reflect decreases in inventory, indicating the removal of materials.

o Issues to Production: When materials are allocated to production processes,

decreasing inventory levels.

o Returns to Suppliers: When materials are returned to suppliers, reducing the

inventory held by the company.