GLOBAL RECIPROCAL COLLEGES

College of Accountancy
Caloocan City
COST ACCOUNTING AND CONTROL ML M. DELA CRUZ

AFAR-CA200
COST ACCOUNTING:
ACCOUNTING FOR MATERIALS

Materials are a key component of the production process and represent the physical goods that are used to create
a product. Accounting for materials involves tracking and recording the costs associated with acquiring, storing,
and using these materials in production. The accounting for materials will be discussed in this chapter.

Accounting for Material

Recording material costs is a critical function in cost accounting, as it helps companies monitor and manage their
spending on raw materials throughout the production process. Materials, which include raw materials,
components, and semi-finished goods, are key inputs in production and directly impact the cost of goods
manufactured (COGM) and cost of goods sold (COGS). The goal of recording material costs is to ensure that the
company’s financial records accurately reflect the true cost of materials that are purchased, used, and consumed
in production.

To effectively manage material costs, companies need to track materials at each stage—purchasing, receiving,
issuance to production, and inventory adjustments. Each of these stages involves specific actions and records that
need to be maintained in order to provide accurate and timely cost information. Let's explore each of these steps
in more detail.

Tracking and Accounting for Materials at Each Stage

1. Purchasing Materials
Purchasing materials marks the beginning of the material cost tracking process. When a company orders
raw materials, it typically does so based on production requirements or forecasts. This is usually done
through a purchase order (PO), which defines the quantity and price of materials needed. At this stage, the
material costs are recorded in the accounting system, but they are initially considered as assets rather than
expenses, as the materials have not yet been used.

The purchase order is typically sent to the supplier, and once the materials are delivered, they are received
and inspected. The purchase price is recorded in the system, and a liability is created to reflect the amount
owed to the supplier (usually recorded in accounts payable). It’s essential to track the actual cost of
materials here, as discrepancies between the estimated cost (e.g., standard cost) and the actual cost can
create purchase variances.

For clarity and ease of discussion, the standard costing system will be discussed in a separate chapter.

2. Receiving Materials
Once materials are delivered to the company, they are physically received, and the receiving process
begins. This involves verifying the quantity and quality of the received materials against the purchase
order. Upon successful inspection, a goods receipt note (GRN) is created to confirm that the materials
have been received. This step is important in ensuring that the inventory records match the physical stock.

The materials are then recorded into the inventory system at the agreed-upon purchase price, which could
be based on the actual cost (i.e., the price invoiced by the supplier) or the standard cost (a predetermined
price). At this point, the raw materials are considered part of the company’s inventory.

If there are any discrepancies—such as damaged goods or shortages—these are noted, and adjustments
are made. These discrepancies must be tracked and resolved, as they will impact the overall cost of
materials in the accounting system. Any returns to suppliers due to damaged goods or wrong specifications
will also affect the cost recorded in the inventory system.

3. Issuing Materials to Production

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Once the materials are in inventory, they are ready to be used in the manufacturing process. This is where
the material requisition form (MRF) comes into play. When materials are needed for production, the
production department submits a requisition that details the type and quantity of materials required for the
production run. This form ensures that the materials withdrawn from inventory are used for the intended
production jobs.

When materials are issued to production, they are removed from the raw materials inventory and
transferred to work-in-progress (WIP) inventory. This action reflects the consumption of materials in
production. The cost of the materials used is transferred from the raw materials account to the WIP
account, and this cost will later be included in the cost of goods manufactured once the product is
completed. It is important to track the cost of materials issued accurately because these costs will
eventually contribute to the final cost of goods sold (COGS) when the finished goods are sold.

In cost accounting, depending on the costing method used (e.g., job order costing or process costing), the
materials issued may be tracked separately for each job, batch, or production run. This helps to allocate
material costs to specific products, making it easier to assess the profitability of each product line.

4. Inventory Adjustments
Finally, at the end of each accounting period, a physical inventory count is conducted to verify that the
recorded quantities of materials in the inventory system match the actual physical quantities on hand. This
step is crucial because discrepancies can arise over time due to factors like shrinkage, theft, damage, or
errors in recording.

Any differences discovered during the physical inventory count must be reconciled. For example, if there’s
a material shortage (due to theft or damage), the inventory balance in the accounting system needs to be
adjusted, and the loss is recorded as an expense. Conversely, if more materials are found than expected,
the inventory records are updated to reflect the excess, and the corresponding asset value is increased. The
process of inventory adjustments helps ensure that financial reports reflect the true value of inventory and
the actual costs associated with material usage.

Additionally, if obsolete or unusable materials are found during the inventory count, these need to be
written off, which further affects the inventory value and costs reported. Inventory adjustments not only
impact the balance sheet but also affect the income statement, particularly through adjustments to the cost
of goods sold or inventory shrinkage expenses.

Materials Internal Control System

Material internal control system refer to the processes and systems put in place to ensure that materials are
effectively managed throughout the production cycle. These controls aim to optimize material usage, reduce
waste, and ensure that materials are available when needed, without overstocking or understocking. Effective
material control is crucial for maintaining cost efficiency, improving production timelines, and safeguarding the
financial health of a business.

1. Inventory Management: Tracking materials in stock, including raw materials, semi-finished goods, and
finished products, to ensure the right amount is available for production without excess or shortage. This
involves setting reorder points and using tools like just-in-time (JIT) or economic order quantity
(EOQ).
2. Material Requisition and Issuance: Materials are only issued to production upon proper authorization
through requisition forms, ensuring that only necessary materials are consumed.
3. Procurement Control: This ensures that materials are purchased according to the required specifications,
quality, and cost standards. Proper approval and vendor selection processes help maintain control over
material acquisition.
4. Quality Control: Ensuring materials meet the required quality standards before they are used in
production, minimizing waste and defects in finished products.
5. Record-Keeping and Monitoring: Accurate and timely records of all material transactions, including
purchases, usage, and inventory adjustments, are essential for tracking material costs and ensuring
efficient material flow.
6. Periodic Audits and Reconciliations: Regular checks are conducted to reconcile physical inventory with
recorded data, ensuring accuracy and identifying issues like shrinkage or discrepancies.

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By implementing a strong material control system, businesses can optimize their material usage, reduce costs,
improve production efficiency, and minimize disruptions due to material shortages or surpluses.

Inventory Management

In inventory management, Economic Order Quantity (EOQ) and Reorder Points are two critical concepts used
to optimize inventory levels and minimize costs associated with ordering and holding materials. They help
businesses determine the ideal order quantity and the best time to reorder inventory, ensuring that production runs
smoothly while minimizing excess stock and associated costs.

1. Economic Order Quantity (EOQ) Model

Economic Order Quantity (EOQ) is the optimal order quantity that minimizes the total cost of inventory.
The EOQ model seeks to find the balance between ordering costs (costs incurred each time an order is
placed) and holding costs (costs for storing inventory). By ordering the optimal quantity, a company can
minimize both of these costs, ensuring efficient inventory management.

EOQ Formula
The formula to calculate EOQ is:
2DO
EOQ =√
C

Where:
D = annual demand in units
O = Ordering cost per order (includes costs like shipping, handling, and order processing)
C = Holding or carrying cost per unit per year (includes warehousing, insurance, and depreciation costs)

Under the EOQ Model, we make the following key assumptions:

a. A fixed quantity is ordered each time an order is placed: The order quantity remains constant in
each order, regardless of fluctuations in demand.
b. Purchasing costs are constant and unaffected by the order quantity: The cost of placing an order
does not change based on the number of units ordered, meaning bulk purchasing discounts or price
changes are not considered in the model.
c. Purchase order lead time is known and constant: The time it takes to receive an order after it is
placed is predictable and does not vary, ensuring accurate planning and replenishment.
d. Adequate inventory levels are always maintained to prevent stockouts: Inventory is replenished
before stock reaches critical levels, ensuring that production or sales are not disrupted due to
insufficient stock.

Ordering Cost
The ordering cost (O) decreases as order quantity increases, because fewer orders need to be placed.
Examples are transportation (delivery costs), administrative cost of purchasing and costs of receiving and
inspecting goods.

To compute the total ordering costs, we first need to determine the number or frequency of orders placed
throughout the year. This can be calculated by dividing the annual demand (in units) by the order quantity.
Once we know the number of orders, we multiply it by the cost per order to find the total ordering costs
for the year.

D
Total Ordering Cost = ( ) xO
Order Quantity

Where:
D = annual demand in units
O = Ordering cost per order (includes costs like shipping, handling, and order processing)

Carrying Cost or Holding Cost

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The holding cost or carrying cost (C) increases as the order quantity increases, because more inventory
needs to be stored. Examples are storage costs, interest costs, spoilage and insurance.

To compute the total carrying (or holding) costs, we need to calculate the costs associated with storing and
maintaining inventory over a given period (usually a year). These costs typically include warehousing,
insurance, depreciation, and opportunity costs related to the capital tied up in inventory. Moreover, it is
important to account for the additional inventory that is maintained as a buffer to guard against fluctuations
in demand or lead time. Safety stock increases the average inventory level, which directly impacts the
carrying costs.

Order Quantiy
Total Ordering Cost = ( +SS) x C
2

Where:
SS = Safety stock (extra inventory kept as a buffer for uncertainties in demand or lead time)
C = Holding or carrying cost per unit per year (includes warehousing, insurance, and depreciation costs)

The EOQ formula seeks to find the balance where these two costs are minimized.

2. Reorder Point
Reorder Point is the inventory level at which a new order should be placed to replenish stock before it
runs out. The reorder point ensures that materials are available when needed, preventing stockouts while
avoiding unnecessary inventory buildup. However, since there are often uncertainties in demand or lead
time (such as fluctuations in customer demand or delays in delivery), businesses also need to account for
a buffer stock to cover these uncertainties. This buffer stock is known as safety stock.

The formula to calculate the reorder point is: Reorder Point = (D x L) + SS

Where:
D = demand rate per unit of time
L = Lead time (time taken to receive an order after placing it)
SS = Safety stock (extra inventory kept as a buffer for uncertainties in demand or lead time)

Safety Stock
Safety stock is the extra inventory held by a business to protect against uncertainties in demand or supply. It acts
as a buffer to prevent stockouts when actual demand exceeds expectations or when there are delays in the supply
chain, such as longer lead times or unexpected disruptions. Safety stock ensures that a business has enough
inventory to meet customer demand even during periods of unpredictability, such as fluctuations in demand or
supply delays.

To calculate for the safety stock: Safety Stock = Maximum Lead Time Usage – Normal Lead Time Usage.

Maximum Lead Time Usage (Maximum Lead Time x Average Usage) is the inventory required to cover demand
during the longest possible lead time, while Normal Lead Time Usage (Normal Lead Time x Average Usage) is
the inventory needed to meet demand during the average or expected lead time.

Inventory Systems

In inventory management, businesses often choose between the perpetual inventory system and the periodic
inventory system, depending on their operational needs and resources.

1. Perpetual Inventory System

The perpetual inventory system continuously tracks inventory levels in real time, updating the records
every time inventory is purchased or sold. This system often relies on technology, such as barcode
scanning or RFID, to automate the tracking process, providing an accurate, up-to-date view of stock at all
times. Its main advantages include providing real-time data, helping prevent stockouts and overstocking,
and enabling better decision-making. However, it can be more expensive to implement and maintain due
to the need for technology and continuous monitoring.

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2. Periodic Inventory System

The periodic inventory system updates inventory records at specific intervals, such as monthly or
annually, based on physical counts of inventory conducted at the end of the period. While this system is
simpler and less costly to implement, it has the drawback of providing less accurate inventory data, as
updates are only made periodically. The lack of real-time tracking can lead to issues such as stockouts or
overstocking between inventory counts, making it harder to make timely decisions regarding
replenishment or pricing. However, it can be a good option for businesses with low transaction volumes
or limited resources for automation.

Inventory Costing Methods

Under the Philippine Financial Reporting Standards (PFRS), inventory costing methods are used to determine
how the cost of inventory is calculated and recognized in the financial statements. The PFRS provides guidelines
on the acceptable methods of inventory valuation, particularly under PAS 2 – Inventories. These methods aim to
allocate costs for items held in inventory and ensure that the reported value of inventory reflects its true cost.

The most common inventory costing methods under PFRS are First-In, First-Out (FIFO), Weighted Average Cost
(WAC), and Specific Identification. Notably, Last-In, First-Out (LIFO) is not permitted under PFRS for inventory
valuation.

1. First-In, First-Out (FIFO)

Under the FIFO method, it is assumed that the first items purchased or produced are the first ones sold or
used. In other words, the earliest inventory items are allocated to cost of goods sold (COGS) first, while
the remaining inventory is valued at the most recent purchase prices. The inventory on hand at the end of
the reporting period is valued at the most recent purchase prices.

In periods of rising prices (inflation), FIFO results in lower COGS and higher profit because the older
(cheaper) inventory is used up first. The ending inventory will reflect more current (higher) costs.

2. Weighted Average (WA) Cost

The Weighted Average Cost (WAC) method calculates a single, average cost for all units in inventory
during the period, based on the total cost of goods available for sale (both beginning inventory and
purchases). This average cost is then applied to both COGS and the remaining inventory. Each unit of
inventory is assigned the same cost (average cost) regardless of when it was purchased or produced.

The WAC method smooths out price fluctuations since all inventory is valued at the same cost. In periods
of rising or falling prices, the COGS and ending inventory are less sensitive to price changes compared to
FIFO.

3. Specific Identification Method

The Specific Identification method tracks the actual cost of each individual item in inventory. This method
is commonly used for high-value or unique items, such as cars, jewelry, or custom-made products, where
each item can be specifically identified. Each item in inventory is recorded at its actual cost, and the cost
of goods sold is based on the actual cost of the specific items sold.

The COGS reflects the actual cost of the items sold, so there is no averaging or assumption of the flow of
costs. This method is more precise but impractical for businesses with large volumes of similar items.

APPENDIX
Backflush Costing System

Backflush costing is a simplified accounting method used for inventory and cost management, primarily in
manufacturing environments. It is typically applied when a company uses a just-in-time (JIT) production
system or operates in an environment where inventory levels are minimized, and there is no need for detailed
tracking of costs at every stage of production. This system helps in reducing the complexity of tracking and
recording costs as it "flushes" or allocates the costs to the finished goods at the end of the production process,
rather than allocating costs to raw materials, work-in-progress, and finished goods at each production stage.

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How Backflush Costing Works

In backflush costing, the process of costing is streamlined by postponing the assignment of costs to the inventory
accounts until after the production is completed. The system works as follows:
1. Direct Material Costs: Instead of tracking material costs as they are used in the production process (i.e.,
at each stage of production), the material costs are "flushed" or assigned to the finished goods inventory
at the end of the production run, based on the quantity of goods completed. The cost is allocated in one
single step, after the production is finished.
2. Direct Labor and Overhead Costs: Similarly, labor and overhead costs, which would typically be
assigned to work-in-progress during the production process, are instead allocated directly to the finished
goods inventory after production is completed.
3. Simplified Costing: Instead of using detailed work-in-progress accounts and tracking costs at each stage
of production (materials, labor, overhead), the backflush costing system simplifies the process by
calculating the costs at the end of the period or production cycle and "flushing" them to finished goods,
assuming a predetermined standard cost or cost per unit.
4. Production Trigger: Backflush costing typically relies on a production trigger—usually, the completion
of a specific batch or order—that activates the "flushing" process. For example, when a batch of goods is
completed, the system records the corresponding direct material, direct labor, and overhead costs based
on predetermined standards.

Trigger Type Triggers Best Suited For

One-Trigger Backflush 1. Production Completion Simplified systems with minimal
tracking and fast production
cycles.
Two-Trigger Backflush 1. Production Completion Companies that want to match
2. Sale or Shipment production costs with actual sales
or shipments.
Three-Trigger Backflush 1. Production Completion Companies requiring physical
2. Transfer to Finished Goods tracking of goods post-production
3. Sale or Shipment before they are sold.
Four-Trigger Backflush 1. Production Completion Manufacturing environments
2. Transfer to Finished Goods with potential scrap or waste that
3. Sale or Shipment needs separate accounting.
4. Scrap or Loss

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DISCUSSION DRILLS
Drill 200-1
Danbury Company sells 60,000 products evenly throughout the year. The cost of carrying one unit in inventory
for one year is ₱24 and the order cost per order is ₱50.

Required:
1. What is the economic order quantity?
2. If Danbury Co. buy in economic order quantities, what would be the total ordering costs be?
3. If Danbury Co. buy in economic order quantities, what would be the total carrying costs per year be?

Drill 200-2
Bridgerton Inc. estimates a need for 225,000 of Material X1 next year at a cost of ₱300 per unit. The estimated
carrying cost is 20% and the cost to place an order is ₱1,200.

Required: Compute the EOQ and the number of orders per year.

Drill 200-3
Featherington Company uses 75,600 units of raw material C100 per year. The number of days before the goods
ordered would be received amounted to 15 days. Assume that the number of working days per year is 360 days
and the raw material is required evenly throughout the year.

Required:
1. What is the reorder point?
2. Assume that the company experiences delay in the delivery of the material. The maximum delay amounted
to 5 days. How many units of safety stock should the company maintain?
3. (Use the same assumption in requirement no. 2) what would be the new reorder point?

Drill 200-4
The inventory stock card of Basset Corporation on February 2025 is as follows:

Units Purchased
Date Units Sold
Quantity Unit Price
Feb 01 10,000 100
Feb 15 5,000
Feb 20 15,000 110
Feb 22 00,500 100
Feb 28 5,500

Required:
1. Compute the ending inventory cost using: (a) Moving Average Method; (b) FIFO Method.

Drill 200-5
The Whistledown Manufacturing Company has a cycle time of 1.5 days, uses a Raw and In Process (RIP) account,
and charges all conversion costs to Cost of Goods Sold. At the end of each month, all inventories are counted,
their conversion cost components are estimated, and inventory account balances are adjusted. Raw material cost
is backflushed from RIP to Finished Goods (FG). The following information is for May:

Beginning balance of RIP account, including ₱600 of conversion cost........................................ ₱005,500

Beginning balance of FG account, including ₱2,000 of conversion cost...................................... 6,000
Raw materials received on credit.................................................................................................. 173,000
Ending RIP inventory per physical count, including ₱850 conversion cost estimate.................... 6,200
Ending FG inventory per physical count, including ₱1,550 conversion cost estimate.................. 4,900

Required: Prepare all the journal entries that involve the RIP account and/or the FG account.

You will not always be motivated; so, you must learn to be disciplined.
Alexandra Martin

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