chapter 3 accounting for materials - ibrahim sameer · chapter 3 accounting for materials ... •...

Chapter 3

Accounting For Materials Ibrahim Sameer (MBA - Specialized in Finance,

B.Com – Specialized in Accounting & Marketing)

Introduction

• What is inventory control?

• Inventory control includes the function of inventory

ordering and purchasing, receiving goods into

store, storing and issuing inventory and controlling

levels of inventory.

The Ordering, Receipt & Issue of

Raw Materials

• Every movement of a material in a business should

be documented using the following as appropriate:

purchase requisition; purchase order; GRN;

materials requisition note; material transfer note &

material return note.

Storage of Materials

• Objectives of storing materials:

• Speedy issue & receipt of materials

• Full identification of all materials at all times.

• Correct location of all materials at all times.

• Protection of materials from damage &

deterioration.

• Efficient use of storage space.

Bin Card

• A bin card shows the level of inventory of an item

at a particular stores location. It is kept with the

actual inventory and is updated by the storekeeper

as inventories are received and issued.

Stores Ledger Account

• Accounts department keep similar document like

bin card in the accounts department which include

inventory values.

Bin Card Vs. Stores Ledger

Account

• Cost details are recorded in the stores ledger

account, so that the unit cost and total cost of

each issue and receipt is shown. The balance of

inventory after each inventory movement is also

valued. The value is recorded as these accounts

form part of the costing bookkeeping records.

Free Inventory

• Managers need to know the free inventory balance

in order to obtain a full picture of the current

inventory position of an item. Free inventory

represents what is really available for future use

and is calculated as follows:

Free Inventory

Identification of Materials:

Inventory Codes (Material

Codes) • Materials held in stores are coded and classified.

Advantages of using code numbers to identify

materials are as follows:

• Ambiguity is avoided

• Time is saved

• Computerized processing is made easier.

Inventory Count (Stocktake)

• The inventory count (stocktake) 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.

Periodic Stocktaking

• Periodic stocktaking is a process whereby all

inventory items are physically counted and valued

at a set point in time, usually at the end of an

accounting period.

Continuous Stocktaking

• Continuous stocktaking is counting and valuing

selected items at different times on a rotating

basis.

• This involves a specialist team counting and

checking a number of inventory items each day, so

that each item is checked at least once a year.

Valuable items or items with a high turnover could

be checked more frequently.

Advantages of Continuous

Stocktaking Compared to

Periodic Stocktaking • 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.

Perpetual Inventory

• Perpetual inventory refers to a inventory recording

system whereby the records (bin cards and stores

ledger account) are updated for each receipt and

issue of inventory as it occurs.

• It means that there is a continuous record of the

balance of each item of inventory. OR

• It records every receipt & issue of inventory as

they occur.

Obsolete, Deteriorating & Slow

Moving Inventories & Wastage

• Obsolete inventories are those items which have

become out of date and are no longer required.

Obsolete items are written off and disposed off.

• The typical measure of output wastage is the

number of quality rejects as a percentage of

total output.

Inventory Control Levels

• Inventory costs include purchase costs, holding

cost, ordering costs and cost of running out

inventory.

Reasons for Holding Inventories

• To ensure sufficient goods are available to meet

expected demand

• To meet any future shortages.

• To take advantages of bulk purchasing discount.

• To allow production process to flow smoothly and

efficiently.

Holding Costs

• If inventories are too high, holding cost will

incurred:

• Cost of storage and stores operation.

• Insurance cost

• Risk of obsolescence.

• Deterioration

Stockout Cost (Running out of

Inventory)

• Loss of customers goodwill

• Loss of future sales due to disgruntled customers

• Labour frustration over stoppages.

• Cost of production stoppages.

Inventory Control Levels

• Inventory control levels can be calculated in order

to maintain inventories at the optimum level. The

three critical control levels are reorder level,

minimum level and maximum level.

Reorder Levels

• When inventories reach this level, an order

should be placed to replenish inventories.

• Maximum lead time is the time between placing an

order with a supplier and inventory becoming

available for use.

• Reorder Level = Maximum Usage x Maximum

Lead time

Minimum Levels

• This is a warning level to draw management

attention to the fact that inventories are

approaching a dangerously low level and that

stockouts are possible.

• Minimum Level = Reorder level – (Average Usage

x Average Lead time)

Maximum Levels

• This is also as a warning level to signal to

management that inventories are reaching

potentially wasteful level.

• Maximum Level = Reorder level + Reorder

Quantity - (Minimum Usage x Minimum Lead time)

Reorder Quantity

• This is the quantity of inventory which is to be

ordered when reaches the reorder level. If it is set

so as to minimize the total costs associated with

holding and ordering inventory, then it is known as

the economic order quantity.

Average Inventory

• The formula for the average inventory level

assumes that inventory levels fluctuates evenly

between the minimum (or safety) inventory level

and the highest possible inventory level.

• Average Inventory = Safety inventory + ½ Reorder

quantity

Lead Time

• Lead time is sometimes referred as delivery

period, so lead time is the time between placing

an order for materials and the relevant materials

being received into inventory.

Buffer Inventory

• Buffer (safety) inventory is the inventory that is

kept in reserve to cope with fluctuations in demand

& with suppliers who cannot be relied upon to

deliver the right quality & quantity of materials at

the right time. The introduction of buffer

inventory would result in the increase of average

inventory levels. The introduction of buffer

inventory would not have an effect on holding

cost, ordering cost nor the EOQ.

Economic Order Quantity (EOQ)

• The economic order quantity (EOQ) is the order

quantity which minimizes inventory costs. The

EOQ can be calculated using table, graph or

formula.

• Eg: of holding stock include warehouse rent,

interest on inventory investment & inventory theft.

Economic Order Quantity (EOQ)

Economic Batch Quantity (EBQ)

How to Calculate Annual Cost

Other Systems of Stores Control

& Reordering

• Order Cycling Method

• Under the order cycling method, quantities on

hand of each stores item are reviewed periodically

(for 1,2 &3 months).


& Reordering

• Two – Bin System

• The two bin system of stores control (or visual

method of control) is one whereby each stores

item is kept in two storage bin. When the first bin is

emptied, an order must be placed for re-supply;

the second bin will contain sufficient quantities to

last until the fresh delivery is received.


& Reordering

• Classification of materials

• This is sometimes called ABC method whereby

materials are classified A, B and C according to

their expense group A being the expensive, group

B the medium cost and group C the inexpensive

materials.


& Reordering

• Pareto (80/20) Distribution

• Pareto (80/20) distribution which is based on the

finding that in many stores, 80% of the value of

stores is accounted for by only 20% of the stores

items, and inventories of these more expensive

items should be controlled more closely.

Accounting for Materials

• Any increase in material inventory will result in a

debit entry in the material control account whilst

any reductions in materials inventory will be

shown as a credit entry in the material

Inventory Valuation

• The correct pricing of issues and valuation of

inventory are of the utmost importance because

they have a direct effect on the calculation of profit.

• Several different methods can be used in practice.

FIFO (First in, First Out)

• FIFO assumes that materials are issued out of

inventory in the order which they were delivered

into inventory; issues are priced at the cost of the

earliest delivery remaining in inventory. OR

• The first materials issued will be priced at the cost

of the earliest goods still in inventory.


• Advantages of FIFO

• It is a logical pricing method which probably

represents what is physically happening: in

practice the oldest inventory is likely to be used

first.

• It is easy to understand and explain to mangers.


• In a period of rising purchase prices, the closing

inventory valuation will be close to current

purchase price


• Disadvantages of FIFO

• FIFO can be cumbersome to operate because of

the need to identify each batch of material

separately.

• Managers may find it difficult to compare costs

and make decisions when they are charged with

varying prices for the same materials.


• In a period of high inflation, inventory issue prices

will lag behind current market value.

LIFO (Last in, First Out)

• LIFO assumes that material are issued out of

inventory in the reverse order to which they were

delivered; the most recent deliveries are issued

before earlier ones, and issues are priced

accordingly.


• Advantages of LIFO

• Inventories are issued at a price which is close to

current market value. This is not the case with

FIFO when there is a high rate of inflation.

• Managers are continually aware of recent costs

when making decisions, because the costs being

charged to their department or product will be

current costs.


• Disadvantages of LIFO

• The method can be cumbersome to operate

because it sometimes results in several batches

being only part used in the inventory records

before another batch is received.


• LIFO is often the opposite to what is physically

happening and can therefore be difficult to

explain mangers

• As with FIFO, decision making can be difficult

because of the variation in prices.

AVCO (Cumulative Weighted

Average Pricing)

• The cumulative weighted average pricing method

(or AVCO) calculates a weighted average prices

for all units in inventory. Issues are priced at this

average cost, and the balance of inventory

remaining would have the same unit valuation. The

average price is determined by dividing the total

cost by the total number of units.


Average Pricing)

• A new weighted average price is calculated

whenever a new delivery of materials is received

into store. This is the key feature of cumulative

weighted average pricing.


Average Pricing)

• Advantages of AVCO

• Fluctuation in prices are smoothed out, making it

easier to use the data for decision making.

• It is easier to administer than FIFO & LIFO,

because there is no need to identify each batch

separately.


Average Pricing)

• Disadvantages of AVCO

• The resulting issue price is rarely an actual price

that has been paid, and can run to several decimal

places.

• Prices tend to lag a little behind current market

values when there is gradual inflation.

Periodic Weighted Average

• This periodic weighted average pricing method

calculates an average price at the end of the

period, based on the total purchase in that period.

• Periodic weighted average = cost of opening

inventory + total cost of receipts / Units of opening

inventory + total unit receipt.

Remember

• FIFO uses the price of the oldest item in inventory.

When prices are rising this will be the items with

the lowest prices. Consequently costs are lower

(understated) & profits are higher (overstated).

• FIFO uses the price of the oldest item in inventory.

When prices are falling this will be the items with

the lowest prices. Consequently costs are higher

(overstated) & profits are lower (understated).

Remember

• If prices are rising then the LIFO method will

charge the more recent, higher prices to

production costs. Therefore production cost will

be lower using weighted average pricing rather

than LIFO.

Remember

• If prices are rising production cost will be higher

using LIFO rather than FIFO.

• Raw materials inventory values will be lower using

LIFO rather than weighted average method.

Questions & Answers

Thank You

Ibrahim Sameer Seek knowledge from cradle to grave

chapter 3 accounting for materials - ibrahim sameer · chapter 3 accounting for materials ... •...

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