THE UNIVERSITY OF GOROKA

SCHOOL OF HUMANITIES
BUSINESS STUDIES DIVISION

Course Title: Cost Accounting 1

Course Code: HAF 213
Available: Semester 1

Module 2: Accounting For Materials

Learning Outcomes

After studying this module, you should be able to:

 Recognise the two basic aspects of materials control;

 Specify internal control procedures for materials;
 Account for materials and relate materials accounting to the general ledger;
 Account for inventories in a just-in-time (lean production) system
 Account for scrap materials, spoiled goods, and defective work.

Cost of a manufactured product

 The total cost of a manufactured product consists of direct materials, direct labour and factory
overhead.
 There are certain procedures and controls that relates to all of the cost elements.
 An effective cost control system should include the following:
1) A specific assignment of duties and responsibilities
2) A list of individuals who are authorised to approve expenditures
3) An established plan of objectives and goals
4) Regular reports showing the differences between goals and actual performance
5) A plan of corrective action designed to prevent unfavourable variances from recurring
6) Follow-up procedures for corrective measures.

Responsibility accounting is an integral part of a cost control system to achieve the above.
Responsibility accounting is the assignment of accountability for costs or production results to those
individuals who have the most authority to influence them. It requires a cost information system
that traces the data to cost centres and their managers.

Materials Control

The two basic aspects of materials control are:

1. Physical control or safeguarding of materials
 Protects materials from misuse or misappropriation through:
I. Limited access to authorised personnel only
 II. Segregation of duties to different personnel in the areas of purchasing, receiving, storage,
use and recording
III. Accuracy in recording purchase and issuance of materials

2. Control over the investment in materials

 Maintains appropriate quantities of materials in inventory
 Subsidiary ledgers of various materials should be maintained for proper control over materials.
 Order Point is the point (time) at which an item should be ordered and should be determined
when planning the level of inventory. Order point is calculated based on the following data:
I. Usage – the anticipated rate at which the material will be used;
II. Lead time – the estimated time interval between the placement of an order and the receipt
of the material
III. Safety stock – the estimated minimum level of inventory needed to protect against stock
outs (running out of stock).

To determine the quantity to be ordered, the costs of placing an order (order costs) and the cost of
carrying inventory in stock (carrying costs) must be considered.

Order costs are:

 Purchasing, Receiving, and Inspection Wages
 Telephone and Fax Charges, Software, Postage and Stationery
 Accounting and Recordkeeping

Carrying costs are:

 Storage and handling costs
 Interest, Insurance, and Property Taxes on the inventory
 Loss due to Theft, Spoilage, or Obsolescence
 Accounting and Recordkeeping

The optimal quantity to order at one time, called the Economic Order Quantity, is the order size that
minimizes the total order costs and carrying costs over a period of time, such as one year.
One formula that can be used in calculating the economic order quantity is as follows:

EOQ = 2CN/K

Where EOQ = economic order quantity, C = cost of placing an order, N = number of units required
annually, K = annual carrying cost per unit of inventory

Question: What are the two basic aspects of material control? Briefly explain them.
 Materials Control Procedures
Materials control procedures generally relate to the following functions:
i. Purchase and receipt of materials
ii. Storage of materials
iii. Requisition and consumption of materials

The diagram below summarizes the control of materials through the flow of various source
documents from procurement of materials from suppliers to placing of materials into production:

Materials procurement document flow Materials requisitioned into

production document flow

STOREROOM KEEPER PURCHASING AGENT DEPARTMENT

Prepares purchase Prepares purchase SUPERVISOR
requisition for out of order (PO) for Prepares material
stock materials materials requested. requisition

DEPARTMENT SUPERVISOR
VENDOR ACCOUNTANT
RECEIVINGCLERK
Prepares vendor's Records the purchase

Prepares returned
Prepares receiving

materials report
invoice for materials of merchandise
report of materials
supplied. received.

Key: Represent activities subsequent to purchase order preparation

For activities up to and including purchase order preparation
For activities up to and including materials placed into production
For activities up to and including materials returned to storeroom from production
For activities up to and including return of unmatched materials against PO to vendor

Accounting for Materials

A company’s inventory records should show:

(1) the quantity of each kind of material on hand; and
(2) its costs.

The materials account is a control account in the general ledger and is supported by subsidiary
materials ledger containing an individual account for each type of material carried in stock.

The balance of the materials account in the general ledger may be proven by comparing it to the
total of the individual materials ledger account balances periodically, may be weekly or monthly. Any
significant variation between the two is investigated.

All purchase of materials on account are debited to Materials account in the general ledger and
credited to Accounts Payable.
Refer table below showing the summary of procedures involved in accounting for materials.

SUMMARY OF PROCEDURES IN ACCOUNTING FOR MATERIALS

Entry at Time of Transaction Entry at End of Accounting Period

Book of
Book of Original Subsidiary Ledger Source of Original
Transaction Source Document Entry Posting Data Entry Journal Entry
Purchase of Vendor's Invoice Purchases Materials
materials Receiving Report Purchases Journal Materials Ledger Journal None Accounts Payable
Materials
returned Return Shipping General Accounts Payable
to vendor Order General Journal Materials Ledger Ledger None Materials
Cash
Payment of Approved Cash Payments Payments Accounts Payable
Invoices Voucher Journal None Journal None Cash

Direct materials Materials Materials Ledger Materials General Work in Process

issued requisitioned None Job Cost Ledger Summary Journal Materials
Materials Ledger
Indirect Materials Factory Overhead Materials General Factory Overhead
Materials issued requisitioned None Ledger Summary Journal Materials

Direct materials
returned from
factory to Returned Materials Ledger Materials General Materials
storeroom Materials Report None Job Cost Ledger Summary Journal Work in Process
Indirect
materials
returned from Materials Ledger
factory to Returned Factory Overhead Materials General Materials
storeroom Materials Report None Ledger Summary Journal Factory Overhead

Inventory
Adjustment:
(a) Materials on
hand less than Factory Overhead
materials ledger Ledger General Factory Overhead
balance Inventory Report General Journal Materials Ledger Ledger None Materials
(b) Materials on
hand more than Factory Overhead
materials ledger Ledger General Materials
balance Inventory Report General Journal Materials Ledger Ledger None Factory Overhead

Differences in the adjustments are recorded in a factory overhead account, usually entitled
Inventory Short or Over, because they cannot be easily identified with specific jobs.

An important area of materials accounting is the costing of materials requisitioned from the store
room for factory use. This is when companies decide on the method of costing to be used: First-in
First-out (FIFO), Last-in First-out (LIFO), and Moving Average Method.

 The unit cost and the date of the purchase of materials in the storeroom or on hand is known at
time of purchase.
 Materials on hand include items purchased on different dates and different prices.
 Because items are all together in the store room it is impossible to identify an issue of materials
 In identifying a costing method, the accounting policies and the federal and state income tax
regulations must be considered.

 There are three types of materials costing methods:

1. First-in First Out (FIFO) Method

 Has the advantage of simplicity
 Assumes that materials issued are taken from the oldest materials in stock
 Materials are costed at the prices paid for the oldest materials

2. Last-in First-Out (LIFO) Method

 Assumes that materials issued are the most recently purchased materials
 Materials issued are costed at the most recent purchase prices
 Inventories on hand at the end of the period are costed at prices paid for the earliest
purchases.

3. Moving Average Method

 Assumes that materials issued at any time are simply withdrawn from a mixed group of
like materials in the storeroom.
 No attempt is made to identify the materials as being from the earliest or the latest
purchases.
 It has the disadvantage of requiring more frequent computations than the other
methods.
 A basic requirement is that an average unit price must be computed every time a new a
lot of materials are received.
 This average price must be used to cost all of materials until another lot is
purchased.

Refer following table for comparison of the costing methods using the information provided below:
Dec 1 Balance, 1000 units @ K20
10 Issued 500 units
15 Purchased 1000 units @ K24
20 Issued 250 units
26 Issued 500 units
28 Purchased 500 units @ K26
30 Issued 500 units
31 Balance, 750 units
 First-in First-Out Method
Received Issued Balance
Received
Unit Issued Unit
Date Quantity Price (K) Amount (K) Quantity Price (K) Amount (K) Quantity Unit Price (K) Amount (K)
Dec 1 1,000 20.00 20,000.00
10 500 20 10,000.00 500 20.00 10,000.00
15 1,000 24.00 24,000.00 500 20.00 10,000.00
1,000 24.00 24,000.00
1,500 34,000.00
20 250 20 5,000.00 250 20.00 5,000.00
1,000 24.00 24,000.00
1,250 29,000.00
26 250 20 5,000.00 - 20.00 -
250 24.00 6,000.00 750 24.00 18,000.00
500 11,000.00 750 18,000.00
28 500 26.00 13,000.00 750 24.00 18,000.00
500 26.00 13,000.00
1,250 31,000.00
30 500 24 12,000.00 250 24.00 6,000.00
500 26.00 13,000.00
750 19,000.00

Last-in First-Out Method

Received Issued Balance
Received
Unit Issued Unit
Date Quantity Price (K) Amount (K) Quantity Price (K) Amount (K) Quantity Unit Price (K) Amount (K)
Dec 1 1,000 20.00 20,000.00
10 500 20 10,000.00 500 20.00 10,000.00
15 1,000 24.00 24,000.00 500 20.00 10,000.00
1,000 24.00 24,000.00
1,500 34,000.00
20 250 24 6,000.00 500 20.00 10,000.00
750 24.00 18,000.00
1,250 28,000.00
26 500 24 12,000.00 500 20.00 10,000.00
250 24.00 6,000.00
750 16,000.00
28 500 26.00 13,000.00 500 20.00 10,000.00
250 24.00 6,000.00
500 26.00 13,000.00
1,250 29,000.00
30 500 24 12,000.00 500 20.00 10,000.00
250 24.00 6,000.00
- 26.00 -
750 16,000.00

Moving Average Method

Received Issued Balance
Received
Unit Issued Unit
Date Quantity Price (K) Amount (K) Quantity Price (K) Amount (K) Quantity Unit Price (K) Amount (K)
Dec 1 1,000 20.00 20,000.00
10 500 20.00 10,000.00 500 20.00 10,000.00
15 1,000 24.00 24,000.00 500 22.67 11,333.33
1,000 22.67 22,666.67
1,500 34,000.00
20 250 22.67 5,666.67 1,250 22.67 28,333.33
26 500 22.67 11,333.33 750 22.67 17,000.00
28 500 26.00 13,000.00 750 24.00 18,000.00
500 24.00 12,000.00
1,250 30,000.00
30 500 24.00 12,000.00 750 24.00 18,000.00
Analysis of FIFO, LIFO, and Moving Average Materials Issue Costing Methods
 Not one method best suits all financial situations, therefore, the method chosen should be the
one that most accurately reflects the income for the period in terms of the current economic
situation.
 One factor to consider is the effect the costing method has on reported income for tax purposes.
A higher taxable income will attract higher taxes.
 In an inflationary environment, LIFO is sometimes adopted so that the higher prices of the most
recently purchased materials may be charged against the increasingly higher sales revenue. The
resulting lower gross margin is assumed to reflect a more accurate picture of earnings because
the firm will have to replace its inventory at the new higher costs and also results in a smaller tax
liability for the firm. Refer ending inventory balances using the three different methods of costing
above.
 It is important to realise that differences between the three methods usually will not be as
extreme.
 Companies that turn their inventory over very rapidly will not be as concerned with the choice of
methods as will companies that hold their inventory for a longer time.
 However, companies should carefully analyse economic conditions and examine the tax
regulations that pertain to LIFO.
 If there should be a downward trend of prices, these companies would probably desire to change
to the FIFO method to have the same competitive advantages that were gained by using LIFO
when prices were rising.

Just-in-Time Materials Control

Managers ask important questions when planning to change a cost accounting system to JIT system:
 What are some of the costs that should be affected by the introduction of a JIT system?
 Should customers reap any benefits from the change to JIT?
 Will the company have to make any changes to the way that inventory is accounted for under a
JIT system?

In a Just-in-Time (JIT) inventory system, also known as a lean production system; materials are
delivered to the factory immediately prior to their use in production.

This system reduces inventory carrying costs by requiring that the raw materials be delivered just in
time to be placed into production.

Furthermore, many manufacturing functions that were performed in individual departments in a

traditional manufacturing system are combined into work centres, called manufacturing cells.

The JIT "pull” manufacturing system credit is, “Don’t make anything for anybody until they ask for
it.”
For JIT to work successfully, a high degree of coordination and cooperation must exist between the
supplier and the manufacturer, among manufacturing work centres, and between the manufacturer
and the customer.
Performing all the production in one or two manufacturing cells has many advantages:
 Fewer and shorter movements of materials;
 Production of smaller lot sizes because other products do not also have to be produced in
the same cell;
 More worker motivation and satisfaction due to the teamwork approach within the cell;
 Workers learn all the tasks performed in the cell, and they also perform maintenance when
“pull” production results in downtime.

“Backflush” costing is the name of the accounting system used with lean manufacturing. It derives its
name from the fact that costs are not “flushed out” of the accounting system and charged to the
products until the goods are completed and sold.

Refer table below showing journal entries for Traditional and Backflush Accounting for costs through
a manufacturing process:

JOURNAL ENTRIES FOR TRADITIONAL AND BACKFLUSH ACCOUNTING

TRANSACTION JOURNAL ENTRIES: Traditional System JOURNAL ENTRIES: Backflush System

A. Purchase of Materials K50,000.00 Raw and In-Process K50,000.00

raw materials Accounts Payable K50,000.00 Accounts Payable K50,000.00
B. Raw materials
requisitioned to Work in Process K50,000.00
production Materials K50,000.00 No entry
C. Direct Labour Work in Process K25,000.00
cost Materials K25,000.00 No entry
D. Manufacturing
overhead costs Factory Overhead K75,000.00 Conversion Costs K75,000.00
incurred Various credits K75,000.00 Various Credits K75,000.00
E. Transfer of
factory overhead Work in Process K75,000.00
costs to WIP Factory Overhead K75,000.00 No entry
Finished Goods K150,000.00
F. Completion of Finished Goods K150.000.00 Raw and In-Process K 50,000.00
all products Work in Progress K150,000.00 Coversion Costs K100,000.00
G. Sale of all Cost of Goods Sold K150,000.00 Cost of Goods Sold K150,000.00
products Finished Goods K150,000.00 Finished Goods K150,000.00

Question: Explain briefly the JIT or lean production cost system.

Scrap, Spoiled Goods and Defective Work

Scrap is an unexpected by-product of the production of the primary product.

Scrap materials may result naturally from the production process, or they may be spoiled or
defective units that result from avoidable or unavoidable mistakes during production process.

Because the sale of imperfect items tends to damage a company’s reputation, most companies
introduce quality control techniques that prevent imperfect items from being sold.
Since scrap, spoiled goods, and defective work usually have some value, each of their costs is
accounted for separately.

Accounting for scrap materials

The procedures to use in accounting for scrap are determined by the expected sales value of the
scrap. When the scrap value is small, no entry is made for it until the scrap is sold, at which time the
following journal entry would be made:

Cash (Accounts Receivable)…………………………………….XXX

Scrap Revenue……………………………………………………………XXX

The revenue from scrap is usually reported as “Other Income” in the income statement.

If the accountant chooses to treat the revenue as a reduction in manufacturing costs, then Work in
Process and the individual job in the job cost ledger may be credited if the scrap can be readily
identified with a specific job. If the scrap cannot be identified with a specific job, Factory Overhead
may be credited.

When the value of the scrap is relatively high, an inventory file should be prepared and the scrap
transferred to controlled materials storage area.

If both the quantity and market value of the scrap are known, the following journal entries are made
to record the inventory and the subsequent sale:

Scrap Materials………………………………………………………..xxx
Scrap Revenue (or Work in Process or
Factory Overhead)………………………………………………….xxx
Transferred scrap to inventory

Cash (Accounts Receivable)………………………………………xxx

Scrap Materials…………………………………………………………xxx
Sold scrap at inventoried market value

Accounting for Spoiled and Defective Work

Spoilt or defective goods are not by-products but imperfect units of the primary product.

The loss associated with spoilt goods may be treated as part of the cost of the job or department
that produced the spoilt units, or the loss may be charged to Factory Overhead and allocated among
all jobs or departments.
Generally, Factory Overhead is charged unless the loss results from a special order and the spoilage
is due to the type of work required on that particular order.
In both cases, the spoilt goods are recorded in Spoiled Goods Inventory at the expected sales price.
If the unrecovered costs of spoilage are to be charged to Factory Overhead, the following journal
entry is recorded:
Spoiled Goods Inventory………………………………………..xxx
Factory Overhead…………………………………………………..xxx
Work in Process (Job #)………………………………………………….xxx

If the loss from spoilage is caused by the unique production requirements of Job #, the entry to
record the market value is as follows:
Spoiled Goods Inventory………………………………………..xxx
Work in Process (Job #)………………………………………………..xxx

The procedures explained above apply also to the defective work. However, there are also additional
costs for correcting the defective work.
If these costs are incurred on orders that the company regularly produces, they are charged to
Factory Overhead using the following journal entry:
Factory Overhead………………………………………………….xxx
Materials…………………………………………………………………….xxx
Payroll…………………………………………………………………………xxx
Factory Overhead……………………………………………………….xxx
Recognized costs of correcting defective units

For special orders, the additional costs are charged to the specific job on which the defective work
occurs using the following journal entry:
Work in Process…………………………………………………….xxx
Materials…………………………………………………………………….xxx
Payroll…………………………………………………………………………xxx
Factory Overhead……………………………………………………….xxx
Charged Job # with cost of correcting defective work

An inventory account is not established for defective work because the defects are corrected and
the units become first quality merchandise.