Dr.

Anushka Verma
Email: [email protected]
Phone: +91 8700485037 (WhatsApp Only)
There are 3 elements of cost:
1. Material
2. Labor
3. Overheads
Material represents an important asset and is the largest item of cost in almost every
manufacturing business.
Usually, more than 50% of the total product cost is material cost.
In order to ascertain the total cost, it is very essential to control the material cost.
Material cost control is a wide function, starting from the purchase of materials to its
ultimate consumption.
Material includes all commodities consumed in manufacturing.
"Material" refers to tangible substances used in production.
"Materials" and "Stores" are often interchangeable; however, "Stores" also include
tools, equipment, maintenance items, supplies, components, jigs, and fixtures.
Materials/Inventory includes raw materials, components, work-in-progress, finished
goods, and scrap.
(a) Direct Materials: (b) Indirect Materials:
Can be identified with the individual Do not form part of the finished products.
units.
Cannot be accurately allocated to a single
Form part of the finished product. product.
All costs, which are incurred to obtain Example:
direct material, are known as ‘direct
material cost.’ Consumable stores, cotton waste and
lubricating oils, required for the
Example: maintenance of machines, etc.
Leather used in shoes
Yarn for the production of cloth
Material control refers to the process of managing and overseeing the acquisition,
storage, usage, and disposal of materials within an organization.

Function of ensuring that sufficient goods are retained in stock to meet all requirements
without carrying unnecessarily large stocks.

Aims to ensure that the right materials are available in the right quantities, at the right
time, and at the right cost.
We may wish to control inventory for the following reasons.

 Holding costs of inventory may be expensive.

 Production will be disrupted if we run out of raw materials.
 Unused inventory with a short shelf life may incur unnecessary expenses
Occurs when an organization holds excessive inventory beyond what is necessary to meet
customer demand. This can lead to several problems:
1. High Carrying Costs: Excess inventory consumes valuable resources.
2. Risk of Obsolescence: may become outdated or obsolete, resulting in losses due to
markdowns, disposal costs, or write-offs.
3. Reduced Cash Flow: Capital invested in surplus inventory could be better utilized
elsewhere.
4. Higher Operating Expenses: More inventory requires additional space, handling, and
management.
5. Less Flexibility: It reduces the ability to adapt quickly to changes in demand or market
trends.
Occurs when an organization doesn't have enough inventory to meet customer
demand.
1. Stockouts can harm reputation and lead to lost sales and customer loyalty.
2. Missed sales opportunities, especially during peak periods.
3. Rush orders or expedited shipping may be needed, increasing costs and
straining supplier relationships.
4. Inefficient Production: Production may be delayed due to lack of materials,
affecting efficiency.
5. Inaccurate Demand Forecasting: Understocking often results from inaccurate
demand forecasting, emphasizing the need for effective planning.
Cost Accounting purchase procedure may
differ from concern to concern, the
important procedures are as follows:
1. Purchase Requisition

2. Selection of Suppliers

3. Purchase Order and Follow-Up

4. Receipt of Materials

5. Inspection and Testing of Materials

6. Return of Rejected Materials

7. Passing Invoices for Payment.

 Purchases of materials are initiated through purchase requisitions.
 It is a formal request by the head of the department or other authorities to the
purchase manager to purchase the specified materials.
 When the purchasing department receives a duly authorised purchase requisition,
a source of supply has to be selected.
 The important rule is to buy the best quality materials at the lowest possible price
after giving due consideration to delivery dates and other terms of purchases.
 When the supplier has been selected, the most common procedure is the
preparation of a purchase order.
 The purchase order is the form used by purchasing department authorising the
suppliers to supply the specified materials at a price and terms stated therein.
 A purchase order should be carefully prepared as it forms a basis of legal contract
between the parties concerned
The receiving department performs the function of unloading and unpacking
materials which are received by an organization.
This will need an inspection report which is sometimes incorporated in the receiving
report, indicating the items accepted and rejected, with reason.
 An inspection report is prepared to show the results of the inspection.
 This report is either prepared separately or incorporated in the goods received
note.
 In either case, the report is forwarded to the purchasing department.
Where materials received are damaged or are not in accordance with the
specifications, these are usually returned to the supplier along with a debit note,
informing him that his account has been debited with the value of materials
concerned.
When the invoices are received by the purchasing department, the process of
assembling the business paper concerned with each purchase and preparation of
vouchers begins.
Invoices are numbered serially and entered in the invoice register.
Involves counting the physical
inventory on hand at a certain
date, and then checking this
against the balance shown in the
inventory records.

The inventory count can be

carried out on a continuous or
periodic basis.
 The annual stocktaking is unnecessary and the disruption it causes is avoided.
 Regular skilled stocktakers can be employed, reducing likely errors.
 More time is available, reducing errors and allowing investigation.
 Deficiencies and losses are revealed sooner than they would be if stocktaking were
limited to an annual check.
 Production hold-ups are eliminated because the stores staff are at no time so busy
as to be unable to deal with material issues to production departments.
 Staff morale is improved, and standards raised.
 Control over inventory levels is improved, and there is less likelihood of
overstocking or running out of inventory.
Perpetual inventory refers to an inventory recording system whereby the records
(bin cards and stores ledger accounts) are updated for each receipt and issue of
inventory as it occurs.

Obsolete inventories are those items which have become out of date and are no
longer required. Obsolete items are written off and disposed of.
Inventory costs include purchase costs, holding costs, ordering costs and costs of
running out of inventory.
If inventories are too high, holding costs will be incurred unnecessarily. Such costs
occur for a number of reasons.
1. Costs of storage and stores operations
2. Interest charges.
3. Insurance costs
4. Risk of obsolescence
5. Deterioration
On the other hand, if inventories are kept low, small quantities of inventory will have
to be ordered more frequently, thereby increasing the following ordering or
procurement costs.
1. Clerical and administrative costs associated with purchasing, accounting for and
receiving goods
2. Transport costs
3. Production run costs, for inventory which is manufactured internally rather than
purchased from external sources
An additional type of cost which may arise if inventory is kept too low is the type
associated with running out of inventory.
There are a number of causes of stockout costs.
 Lost contribution from lost sales
 Loss of future sales due to disgruntled customers
 Loss of customer goodwill
 Cost of production stoppages
 Labour frustration over stoppages
 Extra costs of urgent, small quantity, replenishment orders
The overall objective of inventory control is, therefore, to maintain inventory levels
so that the total of the following costs is minimized.
 Holding costs
 Stockout costs
 Ordering costs
Stock level refers to the amount of inventory/materials that should be maintained by
businesses to continue their activities and avoid any situations like understocking or
overstocking.
• Understocking leads to missed sales opportunities, dissatisfied customers, and
potential damage to reputation. Overstocking ties up resources, increases holding
costs, and risks inventory obsolescence, both adversely affecting profitability and
efficiency.
Inventory control levels can be calculated in order to maintain inventories at the optimum
level.
The three critical control levels are
1. Maximum Level
2. Minimum Level
3. Re-order Leve/Ordering Level
4. Danger Level
5. Average Stock Level
Based on an analysis of past inventory usage and delivery times, inventory control levels
can be calculated and used to maintain inventory at their optimum level (in other words,
a level which minimises costs). These levels will determine 'when to order' and 'how many
to order'.
It is the stock which is fixed between the maximum and
minimum stock levels.
It is the level at which the order for the purchase of materials
is placed.
It is set generally higher than the minimum level to cover any
emergency which may arise as a result of abnormal usage of
materials or unexpected delay in obtaining fresh supplies.
Re-order level= Maximum Re-order Period x Maximum
Consumption/Usage.
OR
Re-order level= Minimum level + (Average consumption
x Average delivery time)
It is the level that describes the minimum amount of stock which must be kept in the
store all times.
This level acts as a safety measure, which is why it is known as ‘buffer stock’ or ‘safety
stock’.
The fall in the stock of the material below this level acts as a warning to the
management to procure the materials as soon as possible, otherwise, the production
process will be stopped.
Minimum stock Level = Re-ordering Level – (Normal/Average Consumption x
Normal/Average Reorder Period)
Following factors are taken into account while deciding the minimum stock level:
1. Lead Time: The time taken in processing the order and then execute it is known as lead
time. It is essential to maintain some inventory during this period to meet production
requirements.
2. Rate of Consumption will be decided on the basis of past experience and production
plans.
3. Nature of Material: If a material is required only against special orders of the customer,
then the minimum stock will not be required for such materials
4. Re-ordering Level: When the quantity of materials reaches a certain level then a fresh
order is sent to procure materials again. The order is sent before the materials reach the
minimum stock level.
It is the highest level of stock that should be available with the company.
Stocking above this point indicates the locking up of capital and overstocking of
materials in the concern.
Factors to consider for maximum stock: carrying (or holding) cost of inventory,
seasonal nature of products, availability of storage facility and funds, government
policies, future price trends, availability of raw material in international markets etc.
Maximum Stock Level= Re-order level+ Re-order Quantity- (Minimum
Consumption*Minimum time required for delivery)
This is the level below the minimum stock level. When a stock reaches this level, immediate
action is needed to take for the replacement of stock.
If the stock is reached at this level, the normal lead time is not available, and hence regular
purchase procedure can not be adopted.
This may result in high-cost remedial action only.
If this is fixed below the re-order level and above the minimum level, it will be possible to take
preventive action.
Danger level = Average Consumption x Lead time for emergency purchase
Or
Danger level = Minimum stock level + ½ re-order quantiy
Average Stock Level = Minimum stock Level + 1/2 of Reorder Quantity
If the minimum stock level and average stock level of raw material A are 4,000 and
9000 units respectively, find out its reorder quantity.
If the minimum stock level and average stock level of raw material A are 4,000 and
9000 units respectively, find out its reorder quantity.
Solution:
Average stock level = Minimum stock level + ½ of Reorder Quantity
9000 = 4000 + ½ Reorder Quantity
½ Reorder Quantity = 9000 – 4000 = 5000
Reorder Quantity = 10,000 units
Calculate minimum stock level, Formulas:
maximum stock level, and re-
ordering level: Maximum Level of Stock = Reorder
Level + Reorder Quantity - (Minimum
Maximum Consumption = 300 units rate of consumption x Minimum
per day reorder period)
Minimum Consumption = 180 units per Minimum level of stock = Reorder level
day – (Average rate of consumption x
Average reorder period)
Normal Consumption =190 units per
day Reorder level or Ordering level =
Maximum rate of consumption
Reorder period = 10-15 days ×Maximum reorder period.
Reorder quantity = 2,000 units
Normal reorder period = 13 days.
Calculate minimum stock level, Reordering Level = Maximum
maximum stock level, and re-ordering Consumption x Maximum Reorder
level: period
Maximum Consumption = 300 units per = 300 units X 15 = 4,500 units
day
Minimum Stock Value = Reordering
Minimum Consumption = 180 units per day Level – (Normal Consumption x Normal
Normal Consumption =190 units per day Reordering Period)
Reorder period = 10-15 days = 4,500 – (190 X 13) = 4,500 – 2,470 =
2,030 units
Reorder quantity = 2,000 units
Maximum Stock Level = Reordering
Normal reorder period = 13 days. Level + Reorder Quantity – (Minimum
Consumption x Minimum Reorder
period)
= 4,500 + 2,000 – (180 X 10) = 4,500 +
2,000 – 1,800 = 4700 units
EOQ is the optimum or the most favorable quantity which
should be purchased each time the purchases are to be made.
Total costs of material = Buying Cost + Ordering Cost +
Carrying Cost.
Economic Order Quantity is ‘The size of the order for which
both ordering and carrying cost are minimum’.
Ordering Cost: staff posted for ordering of goods, expenses
incurred on transportation, inspection expenses of incoming
material....etc
Carrying Cost: Cost of Storage (Staff salary, Rent, Lighting,
Heating Etc.), Insurance.....etc
Assumptions underlying the EOQ:
1. Ordering cost per order and
carrying cost per unit per annum
are known and they are fixed.
2. Anticipated usage of material in
units is known.
3. Cost per unit of the material is
constant and is known as well.
4. The quantity of material ordered is
received immediately i.e lead time
is Zero.
IC is the carrying cost per unit of raw
material per annum
Suppose a company purchases raw material at a cost of $16 per unit. The annual
demand for the raw material is 25,000 units. The holding cost per unit is $6.40 per
year and the cost of placing an order is $32.
Suppose a company purchases raw material at a cost of $16 per unit. The annual
demand for the raw material is 25,000 units. The holding cost per unit is $6.40 per
year and the cost of placing an order is $32.
Concept Stock level
How much to buy? Re-order level
Carried in reserve to prevent stock-out Economic order quantity
When to buy? Minimum level of stock
Only emergency issues are made Maximum level of stock
Stock does not exceed this limit Danger level of stock

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 A producer has estimated annual purchase requirement of 30,000 units of a
material. Unit price of material is Rs. 50. Annual cost of carrying inventory is 20%.
Ordering cost for an order is Rs. 60. Find out Economic Order Quantity (EOQ).
 A producer has estimated annual purchase requirement of 30,000 units of a
material. Unit price of material is Rs. 50. Annual cost of carrying inventory is 20%.
Ordering cost for an order is Rs. 60. Find out Economic Order Quantity (EOQ).
Calculate the maximum stock level from the following:
EOQ-300 Units
Usage rate- 25 to 75 units per week
Reorder period- 4 to 6 weeks.
Calculate the maximum stock level from the following:
EOQ-300 Units
Usage rate- 25 to 75 units per week
Reorder period- 4 to 6 weeks.

Solution:
Maximum Stock Level = Re-order Level + Re-order Quantity (EOQ) – (Minimum Rate of
Consumption x Minimum Re-order period)
= 450 units* + 300 units – (25 units x 4 weeks) = 650 units
* Re-order Level = Maximum usages per period x Maximum Re-order period
= 75 units x 6 weeks = 450 units
Calculate the economic order quantity
from the following information.
Consumption of material per annum
10,000 kg
Ordering cost per order…Rs.50.
Cost per kg of raw material…Rs.2
Store cost…8% on inventory
Calculate the economic order quantity
from the following information.
Consumption of material per annum
10,000 kg
Ordering cost per order…Rs.50.
Cost per kg of raw material…Rs.2
Store cost…8% on inventory
When materials are issued from stores to production department a difficulty arises
regarding the price at which materials issued are to be changed.

This is because the same type of material may have been purchased in different lots
at different times at several different prices.

Methods of pricing material issues:

1. First In First Out (FIFO)
2. Last In First Out (LIFO)
3. Weighted Average Method (WAM)
Principle: Materials received first are issued first.
Inventory valuation: The inventory is priced at the latest costs.

Use case:
Material is slow moving
The size and cost of raw materials units are large
Materials are easily identified as belonging to a particular purchased lot, and
Not more than two or three different receipts of the materials are on hand at one
time.
Advantages Disadvantages
• Easy to understand and operate. • Overstates profits at the times of rising
prices.
• Inventory consists of latest purchases • If prices change frequently, similar jobs
and is valued closer to the current will have different costs.
price.
• Management has no control to influence • Adjustment for rejection and returns
recorded profits. become complicated.
• Material cost represent actual costs. • More complex calculations in case of
fluctuating prices and frequent
purchases.
• Current costs are not matched with
current revenues. 58
Principle: Materials entering production are the most recently purchased.
Inventory valuation: The inventory is priced at the oldest costs.

Use case: During a period of rising costs, LIFO produces the desirable effect of
reducing taxable income and tax liability; thereby conserving cash.
Advantages Disadvantages
• Matches current costs with current • Stock value does not represent current
revenues. market price.
• Helps in tax saving. Inventory is valued • More complex calculations in case of
at beginning-of-period prices and cost fluctuating prices and frequent
of sales are computed at current prices, purchases.
resulting in lower taxes.
• The profit of a firm can be manipulated
with the LIFO method in operation.
• It can adversely affect existing bonus
and profit-sharing plans.

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Issue of materials is priced at the average cost price of the materials in hand, a new
average being computed whenever materials are received.
Total quantities and total costs are considered while computing the average price.
The weighted average is calculated each time a purchase is made.
Issue price = Value of materials in stock/Quantities in stock
It eliminates the effect of early price.
Advantages Disadvantages
• It reduces the number of calculations to • Simplicity and convenience are lost when
be made, as each issue is charged at the there is too much change in the prices of
same price until a fresh purchase materials.
necessitates the computation of a new
average.
• The effect of early price is eliminated. • An average price is not based on actual
price incurred, and therefore is not
realistic. It follows only arithmetical
convenience.
• When prices fluctuate considerably, it • Since issues are not valued at actual cost,
smooths out the fluctuations. profit or loss may occur.

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 Store Ledger Account

Date Receipt Issue Balance

Quantity Rate Amount Quantity Rate Amount Quantity Rate Amount

63