Prof.V.

RAMACHANDRAN
Times Business School,Vashi,
Navi Mumbai-400 703
(October,2011)

Material Cost
Agenda
Introduction
Components of Material Cost
Classification of Inventory
Requirements of Material Stock Control
Purchase and Stores Procedure
Methods of Pricing Material Issues
Accounting Control of Waste, Scrap, Spoilage

and Defective Items.

Introduction
Raw Materials can be defined as Goods

purchased for incorporation into products for

sale.
Direct Material constitutes one element of
production cost.
Direct Material cost
Costs incurred that can be identified easily and

indisputably with a unit of operation or costing

unit or cost centre.
For Example: Wood used in production of Tables
and chairs are direct material cost which become
part of finished product.

Introduction
Indirect Material Cost
Cost incurred on materials which cannot be
traced in the end product but required in
production process and not necessarily
built in to the end product.
For Example: Gums, thread used in binding
books.

Components of Material
Cost
Direct Material Cost The basic rate charged
by the supplier on the goods sold to the buyer.
It also includes the following items:

Indirect Taxes Sales Tax, Excise Duty, Customs

etc. included in the invoice of the supplier.

Transport, Storage, Delivery Charges
If included in the invoice price, itll form part of
Direct Material Cost.
If incurred and accumulated separately as
production overhead, These will be absorbed into
production cost and invoiced per unit or by
weight and taken as Direct Material Cost.

Components of Material
Cost
Quantity Discount, Trade Discount

Should be taken in consideration in reducing the

material cost.
Cash Discount Offered by the supplier to buyer for early
payment of dues. The cash discount is purely a financial
item and should not be considered in cost accounts.
Packing and containing charges Should be taken as
part of purchase price. i.e
the charges of packing in non returnable containers
should be included. In case of returnable containers,
the difference between the charge for returnable
containers and the amount refunded on return of
the containers should only be considered.

Illustrations

Material Cos t Component

Classification of
Inventory
ICAI has defined inventory as
Tangible property held

for sale in the ordinary course of business or

in the process of production for sale or
for consumption in the production of goods or service for
sale, including maintenance supplies and consumables other
than machinery spares.

In a manufacturing concern, inventory is classified as

follows:

Raw Materials - the materials, components, fuels etc. used in

the
manufacture of products.
Work- in-Progress - partly finished goods and materials, subassemblies etc. held between manufacturing stages.
Finished Goads - completely ready for sale or distribution.

Material Stock Control

The material stock control covers the following

areas:
Ordering,
Purchase,
Receipt,
Storage and
Issues.

CIMA defines stock control as `the systematic

regulation of stock level.'

Material Stock Control

The requirements for a better control over

materials is given below:

Centralized purchase function i.e., all the

purchases should through purchase department.

Material is purchased with authority. . Proper
planning purchase function.
Materials purchased should be of proper quality
and specification.
Standardization of materials.
Materials should be properly received and
inspected.
Planned storage of all materials in stores.
Selection of suppliers keeping in view the
quality, price and delivery.
Direct materials used in production should be
charged to production on an appropriate and
consistent pricing basis.

Material Stock Control

Indirect materials used in production and service

departments should be appropriately

apportioned and absorbed into product cost.
Proper documentation and accounting of
material receipts and issues.
Material issues only with proper authority.
Maintenance of bin cards and stores ledger and
regular reconciliation of both the records.
Adoption of perpetual inventory system and
continuous stock taking.
Fixation inventory levels i.e., maximum, minimum,
re-order and danger levels.
Proper internal checks.
Proper procedures in dealing with shortages and
discrepancies.
Proper classification and coding of materials.

Purchase and Stores

Routine
The normal process of purchasing, storing, control and
issue of materials consists of the following documents:
Bill of Materials

Purchase and Stores

Routine
Purchase Requisition Note

Purchase and Stores

Routine
Purchase Order

Purchase and Stores

Routine
Material Inspection Note

Purchase and Stores

Routine
Goods Received Note

Purchase and Stores

Routine
Stores Requisition Note

Purchase and Stores

Routine
Material Transfer Note

Purchase and Stores

Routine
Material Return Note

Purchase and Stores

Routine
Bin Card

Purchase and Stores

Routine
Stores Ledger

Methods of Pricing Material

Issues
Actual Cost Method

Where materials are purchased specially for a specific Job, actual cost

of materials is charged to that Job. Such materials will normally be

stored separately and issued only to that particular Job.

First-in First-out Method (FIFO)

Under this method materials are issued out of stock in the order in

which they were first received into stock. It is assumed that the
first material to come into stores will be the first material to be used.
CIMA defines FIFO as "a method of pricing the issue of material
using, the purchase price of the oldest unit in the stock":
Advantages

It is easy to understand and simple to price the issues.

It is a good store keeping practice which ensures that raw
material leave the stores in a chronological order based on
their age.
It is a straight forward method which involves less clerical cost
than other methods of pricing.
This method of inventory valuation is acceptable under
standard accounting practice. . It is a consistent and realistic
practice in valuation of inventory and finished stock. . The
inventory is valued at the most recent market prices and it is near to
the valuation based or replacement cost.

Methods of Pricing Material

Issues
Disadvantages

There is no certainty that materials which have been in stock

longest will be used, if they are mixed up with other
materials purchased at a later date at different price.
If the price of the materials purchased fluctuates considerably
it involves more clerical work and there is possibility of
errors.
In a situation of rising prices, production cost is
understated.
In the inflationary market there is a tendency to under
pricing of material issues and deflationary market this the
tendency to overprice such issues.
Usually more than one price has to be adopted for a single
issue of materials.
The makes cost comparison difficult of different jobs when
they are charged with varying prices for the same materials.

This method is more suitable where the size of the raw

materials is large and bulky and its price is high and

can be easily identified in the stores separately. This
method is useful when the frequency of material
receipts is less and the market price of the material
are stable and steady

Methods of Pricing Material

Issues
Last-in First-out Method

Under this method most recent purchase will be the first

to be issued. The issues are priced out at the most

recent batch received and continue to be charged until
a new received is arrived into stock. It is a method of
pricing the issue of material using the purchase price of the
latest unit in the stock.

Advantages

Stocks issued at more recent price represent the current

market value based on the replacement cost.
It is simple to understand easy to apply.
Product cost will tend to be more realistic since material
cost is charged at more recent price.
It times of rising prices, the pricing of issues will be at a
more recent current market price.
It minimizes unrealized inventory gains and tends to show
the, conservative profit figure by valuation of inventory at
value before price rise and provides an edge against
inflation.

Methods of Pricing Material

Issues
Disadvantages
Valuation

of inventory is not acceptable in

preparation of financial accounts.
It is an assumption of a cost flow pattern and
is not intended to represent the true
physical flow of materials from the stores.
More than one price may have to be adopted
for an issue. It renders cost comparison
between jobs difficult.
It involves more clerical work and sometimes
valuation may go wrong.
In times of inflation, valuation of inventory
will not represent the current market prices.

Methods of Pricing
Material
Issues
Highest-in First-out Method (HIFO)
Under this method the materials with highest

prices are issued first, irrespective of the date

upon which they were purchased. The basic
assumption is that in fluctuating and inflationary
market, the cost of material are quickly
absorbed into product cost to hedge against
risk of inflation. This method is used when
the material is in short supply and in
execution of cost plus contracts. This method
is not popular and not acceptable under
standard accounting practices.

Methods of Pricing
Material Issues

Simple Average Cost Method

Under this method all the materials received are merged into existing
stock of materials, their identity being lost. The simple average price is
calculated without any regard to the quantities involved. The
simple average cost is arrived at by adding the different prices paid
during the period for the batches purchased by dividing the number of
batches. For example, three batches of materials received at Rs. 10, Rs.
12 and Rs. 14 per unit respectively.

The simple average price is calculated as follows:

This method is not popular because it takes into

consideration the prices of different batches but not the

quantities purchased in different batches. This method is used
when prices do not fluctuate very much and the stock
values are small in value.

Methods of Pricing
Material Issues

Weighted Average Cost Method

It is a perpetual weighted average system where the issue price is
recalculated every time after each receipt taking into
consideration both the total quantities and total cost while
calculating weighted average price. For example, three batches of
material received in quantities of 1,000 units @ Rs. 15, 1,300 units @ Rs.
16 and 800 units @ Rs. 14.
The weighted average price is calculated as follows:

This method tends to smooth out the fluctuations in price and

reduces the number of calculation to be made, as each issue is

charged at the same price until a fresh batch of material is
received.
This method is easier as compared to FIFO and LIFO, as there is no
necessity to identify each batch separately.
But this method increases the clerical work in calculation of new
average every time a new batch is received.
The issue price calculated rarely represents the actual purchase
price.

Methods of Pricing
Material
Issues
Periodic Average Cost Method

Under this method, instead of recalculating the simple or

weighted average cost every time there is a receipt, an average

for the accounting period as a whole is computed. The average
price is calculated for all the materials issued during the period
is computed as follows :

Methods of Pricing
Material
Issues

Standard Cost Method

Under this method, material issues are priced at a

predetermined standard issue price. Any variance

between the actual purchase price and standard issue
price is written off to the profit and loss account. Standard
cost is a predetermined cost set by the management prior to the
actual material costs being known and the standard issue price
is used for all issues to production and for valuation of closing
stock. If initially the standard price is set carefully then it
reduces all the clerical work and errors tremendously
and the stock recording procedure is simplified. The
realistic production cost comparisons can be made easier
by eliminating fluctuations in cost due to material price
variance. In a situation of fluctuating prices, this method
is not suitable.

Methods of Pricing
Material Issues

Replacement Cost Method (Market Price Method)

The replacement cost is a cost at which material identical to that is to be

replaced could be purchased at the date of pricing material issues as

distinct from the actual cost price at the date of purchase. The
replacement price is the price of replacing the material at the time of
issue of materials or on the date of valuation of closing stock. This
method is not acceptable for standard accounting practice since it reflects
a cost which has not really been paid. If stock are held at replacement
cost for balance sheet purposes when they have been bought at a lower
price, an element of profit which has not yet been realized will be built
into the Profit and Loss Account. This method is advocated by charging
the market price of material to the Job or Process, make it easier to
determine the profitability of the Job or Process. This method is suitable
particularly in the inflationary tendency of market prices of materials.
Where there is no precise market for particular materials, it would be
difficult in ascertainment of replacement prices for the material issues.

Methods of Pricing
Material
Issues
Next in First-out Method (NIFO)
This method is a variant of replacement cost method. Under

this method the price quoted on the highest purchase order

or contract is used for all issues until a new order is placed.

Base Stock Method

Under this method, a specified quantity of material is always
held in stock and is price at its original cost as buffer or base
stock and any issue of materials above the base stock
quantity is price under any one of the methods discussed
above. This method indicates how prices are moving over a
longer period of time. But this method is not popular and
accepted under standard accounting practice since it would
result in stock valuation totally unrealistic.

Important Considerations in Selection of Material

Pricing Method
The following factors should be given due

consideration in selection of method in pricing

issues of materials and valuation of stocks
Method of production or process ,Nature of

materials used
Quantum of materials used in the organization
Frequency of purchases and issues
Bulkiness and the price of the materials Economic
batch quantity
Tendency of inflation or deflation Violent
fluctuation in prices
Rate of stock turnover
Reutilization and mechanization of stores
procedures.

Important Considerations in
Selection of Material Pricing
Accounting practice acceptable in valuation of
inventory
Method

Sensitivity of profit calculations to the pricing method

adopted
Normal losses due to evaporation etc.
The objective of charging material coat to production on
consistent and realistic basis Trade and industry practice
in materials purchase, pricing of issues and valuation of
stocks
System of costing prevailing in the organization
Level of usage of standard costing in the organization
Possibility of adoption of different pricing methods for
different classes of materials . The system prevailing for
adjustment of difference between actual cost and cost under
pricing method adopted.

Reasons for Discrepancies in

Stock
Items
The possible reasons for discrepancy between physical stock and
stock shown in records may be due to the following:

Shortage of material due to spoilage, evaporation, wastage

in material handling, breakdown in handling and storing.

Increase in weight due to absorption of water etc.
Items of material placed in wrong location.
Pilferage and theft from stores by insiders and outsiders.
Issue and receipt of stock without proper recording and
maintenance of stores
recording and accounting.
Stock returns not recorded properly.
Stock issues to production departments without proper recording in
stock card and stores ledger.
Arithmetical errors in calculating the balances in bin card.
Clerical errors in stores ledger.
Supplier supplies a different quantity of material than is mentioned
in the delivery challan.
Discrepancy due to improper weighing of material.

Steps to Avoid
Discrepancies
Steps to be taken to avoid discrepancies in physical stock

and stock shown in records are as follows :

Entry into the stores should be restricted only to

authorized persons.
Material requisition should be signed only by the
authorised persons.
Proper maintenance of stores records like Bin
Card/Stock Card, Stores Ledger etc.
Regular check by independent staff to detect and correct
mistakes.
Issue of material only against proper requisition slip.
Recording of all movements of stock.
Physical verification and counting at the time of
receipt and issue of material.
Use of FIFO method for stock issues for avoidance of
deterioration and obsolescence.

Accounting Procedure for Material

Shortages
Action to be taken and to

record the information:

The units shown in the

stock card and stores

ledger is to be compared
and further check it with
the physical verification
of units.
If any excess or shortfall
of units is found,
investigate the reasons.
After identification of
reasons for excess or
shortfall of units, the
following accounting
entries are to be passed :

Methods of Pricing
Material Issues

Illus trations

EOQ (Economic Order

Quantity

EOQ (Economic Order

Quantity

EOQ (Economic Order

Quantity

Stock Levels

Stock Levels Illustration

Stock Levels Illustration

Methods of Pricing
Material Issues

Waste
Waste is a material loss during production or storage due to
evaporation, chemical reaction unrecoverable residue, shrinkage etc.,
Wastage may be visible or invisible wastage. Wastage may be normal
waste incidental to manufacturing activities or abnormal waste which
is in excess of material loss over the normal losses. Necessary steps
should be taken to minimize abnormal wastage.
Control on waste can be achieved in the following aspects:
Quantity Control: It involves maintenance of detailed records of

quantities with an object to detect shrinkage, breakage, loss etc.

Establishments of output ratios are much helpful in control of waste.
Normal allowances of waste can be fixed with technical assessment
and past experience, special features of material and process etc. An
organization should establish a systematic procedure for feedback of
achievements against standards laid down for wastage. The causes of
abnormal wastage should be studied in detail and responsibility should
be fixed for wastages. Better material handling systems will also help
in control of waste.

Methods of Pricing
Material Issues

Quality Control: Wastage may also arise from loss of control on

process or poor quality of material. The management should fix

responsibilities on purchase, stores, production and maintenance
departments to ensure achievement on standards.
Accounting of Waste: For accounting purpose waste may be
classified into normal wastage and abnormal wastage.
Normal Wastage: being a normal feature and arising in a process
or operation usually through standard set for the normal percentage
of visible and invisible wastes that may be anticipated to arise in
various manufacturing process or operation. Therefore, normal
wastage should be regarded as part of the production cost. The
good units in the process should absorb the cost of waste.
Abnormal Wastage: It is in excess of the standard percentage of
wastage set up to account for the normal wastage. The cost of
abnormal waste should be excluded from the total cost and charged
to costing profit and loss account.

If any value is realized from the waste, the process account

concerned may be credited.

Methods of Pricing
Material Issues

Scrap
Scrap is the residue material that has a recovery value. It is
incidental residue from the materials used in manufacturing
operations which is recoverable and measurable without processing,
Control For control purpose scrap may be classified into the following:

Legitimate Scrap : Predetermined or anticipated in advance due to

experience in manufacturing operations.
Administrative Scrap: Results from administrative decision e.g., change in
design or withdrawal from saleable lots or for some other reasons,
Defective Scrap: Resulting from poor quality of raw material, negligent
handling of material etc.

Scrap can be controlled in the following ways:

Material specification at product design-stage: Selection of right material

and equipment.
Selection of right type of personnel with proper training and
experience.
Determination of acceptable limits of scrap.
Reporting the source of waste, quantum of waste.
Specific areas of responsibility.

Methods of Pricing
Material Issues

Accounting of Scrap - The accounting treatment of scrap is based on

the following

considerations:

If the value of the scrap is negligible, the good units should bear
the cost of scrap and any income realized will be treated as other
income.
When the value of scrap is considerable and identifiable with the
process or job., the cost of the scrap will be transferred to scrap
account and any realization from sale of such scrap will be
credited to the job or process account and any unrecovered
balance in the scrap account will be transferred to Costing Profit
and Loss Account.
If the scrap value is significant and it cannot be identified with
particular job or process, then the net sales realization after deducting
the selling cost is transferred to either Material or Factory
Overhead Account. This method will reduce the cost of material or
factory overhead to the extent of sale proceeds of scrap.

Methods of Pricing
Material Issues

Spoilage
Spoilage is the production that fails to meet quality or dimensional requirements
and these are so damaged in manufacturing operations that they are not capable
of rectification economically and hence taken out of the process and disposed of
without further processing. If spoilage is well within the limits, it is regarded as
normal spoilage. The limits of spoilage are laid down after thorough study of
material, men, processes and operating conditions. If spoilage exceeds the limits
of normal spoilage, it is referred to as abnormal spoilage requiring prompt quick
action.
Control of spoilage can be achieved in the following ways:
Control through predetermined standards.
Control through fixation of individual responsibility.
Prompt and systematic reporting of spoilage.
Accounting of Spoilage - The Accounting treatment of Spoilage is as follows:
If the cost of Spoilage is normal and inherent in the process or operation, then the cost of
Spoilage is absorbed by charging either to the specific production order or to product
overheads.
The cost of abnormal spoilage arise in the process is charged to Costing Profit and

Loss Account. If spoilt units are reused as raw material in the same process, no
separate accounting treatment is required and if, spoilage is used for any other
process or job, a proper credit should be given to relevant process account or job
account.

Methods of Pricing
Material
Issues
Defective
Defectives represent the part of production that does not meet

dimensional or quality specifications of a product but which

can be reworked by additional application of material, labor
and/or processing and made it into saleable condition either
on first or seconds depending upon the characteristic of the
product.

Causes for Defective Work

Poor quality of material
Lack of skill or training.
Inadequate supervision.
Damage in material handling.
Defective or improper tooling and the equipment.
Deficiencies in production design.
Inadequate inspection.

Methods of Pricing
Material
Issues
Defective work can be classified into the following:

Defective in the raw material stage itself.

Defective after some stage of processing with some labor

and overhead spent on it.

Defective finished goods due to storage for too long a time.
Defective finished goods returned by purchaser not being up
to specification or sample.
Control For control of defective requires a basis for evaluation

of performance. Standards may be fixed for occurrence of

defective work, giving proper weight age to different conditions
i.e., nature of material used, workmanship required etc.

Methods of Pricing
Material
Issues
Accounting of Defectives - The accounting treatment of
defectives is as follows :
Normal Defectives: If the defectives are of normal and within

the standard limit, any of the following accounting methods are

adopted :

The cost of rectification of normal defective is charged to good units.

Where a particular department is, identified and responsible for
defective work, the rework costs are charged to that department.
Where it cannot be identified from which department the defectives
caused, then the rework or reprocess costs are to be charged to the
general overheads.
If normal defectives are easily identifiable with specific jobs, the rework
costs are debited to that particular job or process.

If the defectives are of abnormal nature, the rework cost should

be charged to the Costing Profit and Loss Account.

Thank
You