elements of costs

8/22/2019 Elements of Costs

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Elements

MATERIAL: It refers to raw materials used forproduction.

LABOUR:The aggregate of all human physical andmental effort used in creation of goods and services.

OVERHEADS: Resource consumed or lost incompleting a Process, that does not contribute directlyto the end product. Also called burden cost.


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Materials The term Materials refers to substances and

commodities other than fixed assets introduced andconsumed in the productive process of anorganization.

It includes the following: Raw Materials

Spare parts and components Consumable stores

Packing materials

Materials may be direct or indirect.


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Materials Control

In almost all manufacturing concerns, materials constitute alarge proportion of total cost.

An efficient system of material control will lead to a significantreduction in the cost of production.

Materials control means the regulation of the functions of anorganization relating to the procurement, storage and usage ofmaterials in such a way so as maintain an even flow ofproduction without excessive investment in material stock.

The materials control is divided in 3 stages: Purchase Control Storage Control

Issue Control


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Materials Control (Contd.)

Objectives of Materials Control Availability of Materials Avoidance of wastage Avoidance of out-of-stock danger Economy in purchasing Effective utilization of materials

Methods/Ways/Techniques of Materials Control Centralized Vs. Decentralized Purchasing

ABC Analysis Just-In-Time (JIT) System Fixation of Various Stock Levels Economic Order Quantity


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Centralized Vs. Decentralized Purchasing

Centralized purchasing means that purchases are made by thespecialized department

Decentralized purchasing means each branch or department makesits own purchases.

Some advantages of Centralized purchasing: Since purchases are in bulk, they can be economical due to favorable

terms such as higher trade, cash discount, lower transport costs, etc. Purchase department can employ qualified and experienced staff,

having knowledge and skills, in order to avoid reckless and haphazardpurchasing.

Usually, centralized purchasing is preferred but in some cases, wherehighly technical or precious materials are required, the purchasescan be made by individual departments.


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ABC Analysis

ABC Analysis is also known as Always Better Control. To have an effective and proper control on stores, all

the items of stores should be classified in 3groups/categories on the basis of investment involved:

Category A:Heavy Investment, very tight control,complete and accurate records, frequent review.

Category B: Substantial Investment but not as muchas Category A, less tightly controlled, good records,

regular review. Category C:Not much of Investment required,

simplest controls possible, minimal records, largeinventories, periodic review and reorder.


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Just-In-Time (JIT) System

It is a system in which purchases are contracted so thatreceipt and usage of the material to the maximumextent possible coincide.

This means raw materials are purchased Just-In-Timeto proceed to production process.

This system ensures maximum economy in material

handling costs, ordering costs and stock holding costs. The chances of pilferage, leakage, spoilage, etc is

reduced to the minimum.


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Economic Order Quantity (EOQ)

EOQ is the size of the order which gives maximumeconomy in purchasing any material.

It involves 3 kinds of costs: Cost of Purchase

Cost of Acquiring costs (Ordering Costs): Orderingcosts will be greater if orders are placed more frequently

and of lower quantities. Cost of Holding Inventory (Carrying Costs):The larger

the volume of inventory, higher will be the inventorycarrying costs and vice versa.


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EOQ Model

Re

levantTotalCo

sts(Dollars

)

2,000

4,000

6,000

8,000

10,000

5,434

600 1,200 1,800 2,400988EOQ

Annualrelevantcarrying costs

Annual relevanttotal costs

Annual relevantordering costs

Order Quantity (Units)


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Assumptions of EOQ Model

The same quantity is ordered at each re-order point.

Demand, ordering costs, carrying costs and purchase-order lead time is known with certainty.

Purchasing costs per unit are unaffected by the

quantity ordered.


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EOQ Model

C

AB2EOQ =

Where, A = Annual Demand in units for a specified time period

B = Relevant ordering/ Buying costs per purchase order

C = Relevant carrying costs of one unit in stock

Example: Compute the Economic Order Quantity from the data givenbelow:

Annual usage of materials 6000 unitsCost per unit Rs. 24Buying Cost per order Rs. 60

Cost of carrying inventory 20%


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EOQ ModelDecision Model

What are the relevant total costs (RTC)?

RTC = Annual relevant ordering costs + Annualrelevant carrying costs

RTC =

Q can be any order quantity, not just the EOQ.

A

Q P +

Q

2C

AP

Q+

QC

2or


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Fixation of Stock levels

In order to maintain a proper balance between under-stocking and over-stocking, a storekeeper must fixvarious levels of stock:

Maximum Level

Minimum Level/Safety Stock Level

Re-Order Level Danger Level

Average Stock Level


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Maximum Level: The level above which quantity ofinventory should not be allowed to be kept, else itwould lead to over-stocking and blocking capitalunnecessarily.

= Re-order level + Re-order Quantity (Minimum Consumption XMinimum Re-order Period)

Minimum Level/ Safety Stock Level: The level below whichquantity of inventory should not be allowed to fall in normalcircumstances.

= Re-Order level (Normal Consumption X Normal Re-Order Period

Re-Order Level: The level at which purchase request isinitiated for replenishment of stock.

= Maximum Consumption X Maximum Re-order Period


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Danger Level: The level below which the actual stockof material should not be allowed to fall in normal

circumstances.= Minimum Consumption X Minimum Re-Order Period

Average Stock level: It indicates the average stock held

by an enterprise during a year.= Minimum Level + Maximum Level /2

OR

= Minimum Level + (Re-Order Quantity)


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Units

Weeks

Minimum level

Reorder level

Maximum level

500

1000

1500

Danger level


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Question:

Two components X and Y are used as follows: Normal Usage: 600 units per week each Maximum Usage: 900 units per week each Minimum Usage: 300 units per week each Re-order Quantity: X 4,800 units and Y 7,200 units

Re-Order period: X 4 to 6 weeks and Y 2 to 4 weeks

Calculate for each component(a) Re-Order level(b) Minimum level(c) Maximum Level(d) Danger Level(e) Average Stock Level


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Inventory Systems

Periodic inventory System: It is a method ofrecording inventory at the end of the accounting yearafter making a physical verification of the quantity inhand.

Perpetual Inventory System: It is a system of

recording inventory after each receipt and issue. Underthis system, stock registers are regularly maintainedand gives the balance of inventory at any time desired.


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Pricing of Issues of Material

There are a number of methods available for pricing ofissues of materials, the popular ones are:

First In First Out (FIFO)

Last In Last Out (LIFO)

Weighted Average Method


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Question:

Following transactions took place in respect of materials: August 4 Received 500 units @ Rs. 2 each August 18 Received 350 units @ Rs. 2.10 each August 19 Issued 600 units August 24 Receipts 600 units @ Rs. 2.20 each August 25 Issued 450 units August 26 Received 500 units @ Rs. 2.30 each August 28 Issued 510 units August 30 Issued 100 units

Calculate the value of closing stock of materials according to: FIFO Method LIFO Method Weighted Average Method

S L d (FIFO M h d)


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Stores Ledger (FIFO Method)Receipts Issues Balance

Quantity Rate Amt Quantity Rate Amt Quantity Rate Amt

Aug 4 500 2 1000 - - - 500 2 1000

Aug 18 350 2.10 735 - - - 500 2 1000

350 2.10 735

Aug 19 - - - 500 2.00 1000

100 2.10 210 250 2.10 525

Aug 24 600 2.20 1320 - - - 250 2.10 525

600 2.20 1320

Aug 25 - - - 250 2.10 525

200 2.20 440 400 2.20 880

Aug 26 500 2.30 1150 - - - 400 2.20 880

500 2.30 1150

Aug 28 - - - 400 2.20 880

110 2.30 253 390 2.30 897

Aug 30 - - - 100 2.30 230 290 2.30 667

Stores Led er (LIFO Method)


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Stores Ledger (LIFO Method)Date Receipts Issues Balance

Quantity Rate Amt Quantity Rate Amt Quantity Rate Amt

Aug 4 500 2 1000 - - - 500 2 1000

Aug 18 350 2.10 735 - - - 500 2 1000

350 2.10 735

Aug 19 - - - 350 2.10 735

250 2.00 500 250 2 500

Aug 24 600 2.20 1320 - - - 250 2.00 500

600 2.20 1320

Aug 25 - - - 450 2.20 990 250 2.00 500

150 2.20 330

Aug 26 500 2.30 1150 - - - 250 2.00 500

150 2.20 330

500 2.30 1150

Aug 28 - - - 500 2.30 1150 250 2.00 500

10 2.20 22 140 2.20 308

Aug 30 - - - 100 2.20 220 250 2.00 500

40 2.20 88


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Stores Ledger (Weighted Average Method)

Date Receipts Issues Balance

Quantity

Rate Amt Quantity

Rate Amt Quantity

Rate Amt

Aug 4 500 2 1000 - - - 500 2 1000

Aug 18 350 2.10 735 - - - 850 2.04 1735

Aug 19 - - - 600 2.04 1225 250 2.04 510

Aug 24 600 2.20 1320 - - - 850 2.15 1830

Aug 25 - - - 450 2.15 968 400 2.15 862

Aug 26 500 2.30 1150 - - - 900 2.24 2012

Aug 28 - - - 510 2.24 1141 390 2.24 870

Aug 30 - - - 100 2.24 224 290 2.24 646


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Inventory Valuation Methods

(a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon thecost of material bought earliest in the period, while the cost of inventory is basedupon the cost of material bought later in the year. This results in inventory beingvalued close to current replacement cost. During periods of inflation, the use ofFIFO will result in the lowest estimate of cost of goods sold among the threeapproaches, and the highest net income.

(b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon thecost of material bought towards the end of the period, resulting in costs thatclosely approximate current costs. The inventory, however, is valued on the basis ofthe cost of materials bought earlier in the year. During periods of inflation, the useof LIFO will result in the highest estimate of cost of goods sold among the threeapproaches, and the lowest net income.

(c) Weighted Average: Under the weighted average approach, both inventory and thecost of goods sold are based upon the average cost of all units bought during theperiod. When inventory turns over rapidly this approach will more closelyresemble FIFO than LIFO.

(d) Specific Identification method :This method determines specific costs for eachunit in stock. This method is suitable when the stock is not homogenous, less in

quantity and high in value.


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Which is the Best method for

inventory valuation ???Inventory valuation affects the profit and loss account aswell as the balance Sheet

FIFO more realistic inventory value but unrealisticprofitLIFO - more realistic profit but outdated inventoryvalueWAC - the average of the two

Accounting Standard does not allow the use of LIFO.Under Income Tax law any method may be adoptedbut it should be followed consistently.


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Material Losses

There is usually a difference between the input ofmaterial in a process and the output. This differencerepresents loss of materials.

Material Losses may be in the following forms:

Waste

Scrap Spoilage

Defectives


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Waste: It is the portion of basic raw materials lost in theprocess having no recoverable value. E.g. smoke, gas, dust, etc. It may be visible (sawdust, ash, sand, dust) or invisible

(evaporation, shrinkage).

Waste can be normal (bound to rise) or abnormal (due toexternal factors but is not a part of cost).

Scrap:It is the portion of visible wastage of materials havinglow money or use value. In normal practice, the sale value ofscrap is deducted from the cost of materials or factory

overheads (Recoverable). Spoilage: Those materials or components which are so

damaged in the manufacturing process that they cannot berepaired or reconditioned (Irrecoverable). Some spoilage can be sold as seconds while some that are badly

spoiled are sold as scrap. Spoilage can be normal or abnormal.

Defectives: They are generally semi-finished or finishedproducts which are not according to standard specificationsbut can be rectified.

It may be due to normal or abnormal reasons.


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Labour Labour means human efforts engaged in the process of

production.

Labour may be direct or indirect.

Direct labour is the labour which can be identified withthe production process.

Indirect labour means the labour which is not directlyengaged in the production but engaged to assist directlabour. E.g. Supervisory staff, storekeepers, foreman,time-keepers, watchmen, etc.


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Labour Control Labour costs represent 20 to 25% of the total cost of the product.

There is a need for an effective control over labour costs. There are mainly 5 departments in an organization for labour control:

Personnel Department: Performs functions of recruitment, selection,training and induction of various grades of workers, also looks afterfixation of wages, promotion and discharge of employees.

Engineering Department: Prepares plans and specification for eachjob schedule for production in order to reduce labour turnover rate.

Time Keeping Department: Maintains records of effective utilizationof labour time.

Pay Roll Department: Involves computation of gross wages, deductions

to be made and disbursement of pay. Cost Accounting Department: Collects and analyses all costs related to

labour. This department prepares wages abstract or analysis sheet to givea number of information that facilitates decision-making.

elements of costs

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