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Accounting for Materials in Managerial Accounting

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Introduction to Materials Control

Materials are one of the elements of cost. Materials control involves taking consideration of the aspects of ordering and purchasing; receiving of goods into store; storing and issuing materials; and controlling the levels of materials


Ordering, Receipt and Issue of Materials

It is important that every movement of materials is recorded. The documents are used to record materials movement

Purchase requisition

This is a document prepared by the stores department and sent to the purchasing department authorizing the purchase of materials. It is prepared when a level which needs materials to be replenished is reached.

Purchase order

This is a document prepared by the purchasing department and is sent to a supplier. Copies must be sent to the accounts department and storekeeper.

Quotations

These are documents obtained by the purchasing department for various reasons including supplier becoming expensive such that there is need for a new supplier.

Delivery note

This is the document that accompanies the materials delivered by the supplier and must be signed by the storekeeper.

Goods received note (GRN)

This is a document signed by the storekeeper after checking that the materials conform with those ordered.


Materials Requisition Note

Materials can only be issued when a materials requisition note is raised. It must show the quantity of materials and the cost centre or job to which the materials are issued.


Materials Transfer Note

If materials are transferred to another department or job before being returned to the stores then the stores will issue a materials transfer note. Whereas if materials are returned back to the stores the stores issues a materials returned note.


The Storage of Raw Materials

Objectives of storing materials

  1. To ensure that materials are received and issued with speed;
  2. To ensure that materials are fully identified at all times;
  3. Ensuring that materials are protected from damage and deterioration
  4. To ensure that correct inventory levels are maintained.


Recording Materials Levels

There are two systems that are used to record inventory levels namely bin cards and stores ledger accounts.


The Materials Count

The physical materials count involves counting the physical materials that the firm has on hand and then checking the results against balance reflected in the inventory records. The count can be some using any of the following methods:

  1. Periodic inventory count. This is where all items are counted and there value ascertained at a set point in time, for example, at the end of a financial year.
  2. Continuous inventory count. This is where selected items are counted and valued at different times and this is done on a rotating basis.
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Materials Control Levels

1. Materials costs

The costs associated with materials include purchase costs, holding costs, ordering costs and costs of running out of materials.

Reasons for holding materials

The reasons for holding materials include:

  1. Meeting any future shortages;
  2. Taking advantage of any bulk purchase discounts;
  3. Ensuring sufficient materials are available to meet anticipated demand

2. Holding costs

These are costs associated with holding (keeping) materials and they include:

  1. Storage costs, for example staff and equipment to handle the materials, space, etc;
  2. Insurance costs. More inventory of materials means large premiums likely to be paid;
  3. Risk of obsolescence. This risk increases with the time materials are held.

3. Ordering costs

Ordering or procurement costs will be increased if low levels of materials are held since orders will have to be made frequently. Ordering costs include:

  1. Transportation costs
  2. Clerical and administrative costs such as telephone calls and stationery required to make

4. Stockout costs

These include:

  1. Low morale among labourers due to production stoppages;
  2. Loss of contribution due to loss of sales;
  3. Small but expensive replenishments just to keep production running;
  4. Lost customer goodwill


The Objectives of Materials Control

The objective of materials control is therefore to minimise the total of ordering costs, holding costs and stockout costs.


Materials Control Levels

Calculating materials control levels will help the firm to hold optimum levels of materials. The levels are calculated based on an analysis of past usage and times of delivery. These levels will help to establish ‘how much to order’ and ‘when to order’. There are three critical materials control levels.

  1. Re-order level. This is the level which when reached an order should be placed to replenish the inventory of materials. It is calculated by taking into account the maximum usage of materials and the maximum lead time. Lead time is the period of time that elapses between placing an order and receiving the materials from a supplier. Re-order level is equal to Maximum usage times Maximum lead time.
  2. Minimum level. This is a level set to act as a warning to management that materials are approaching a low level that is dangerous and stockout may occur. Minimum level is equal to Re-order level minus (average usage times average lead time).
  3. Maximum level. This is a level set to act as a warning to management indicating that materials may reach a potentially wasteful level. Maximum level is equal to Re-order level plus Re-order quantity minus (minimum usage times minimum lead time)

Apart from the three critical inventory levels explained above it is also important to determine the quantity that must be ordered (re-order quantity). A firm can decide to order any quantity (in which case you know it may end up holding too much or too little materials), however, a special type of re-order quantity is the economic order quantity discussed below.


The Economic Order Quantity (EOQ)

The economic order quantity is the re-order quantity which when ordered puts the combined costs at a minimum. Materials holding costs, materials purchase costs and materials runout costs together are also called combined costs.

The following are the assumptions made in the calculation of the EOQ:

  1. The materials holding cost is constant and is known;
  2. The ordering cot is constant and is known;
  3. The rate of demand (usage) is constant and is known;
  4. The price per unit is constant and is known.

The EOQ can be calculated using a table, graph of formula.

EOQ is equal to square root of 2CoD divide by Ch.

  1. Where Ch is equal to cost of holding one unit of inventory for one time period.
  2. Co is equal to cost of ordering a consignment for a supplier
  3. D is equal to demand during the time period.


Valuation of Materials

The materials in store will usually not comprise one uniform price but rather different prices. Several methods can be used to value materials issued from stores. The following are the methods used:

1. The first -In, First -out (FIFO) method

This is where the price of the materials that were first to be bought is used to value issues from the stores.

Advantages of FiFO include:

  1. It is logical as it probably presents what is physically happening – practically old materials are likely to be issued (used) first.
  2. The valuation of the materials can be nearer to a valuation based on replacement cost.

Disadvantages of FIFO include:

  1. Materials valuation is cumbersome using FIFO since each batch of materials has to be identified separately.
  2. The prices of remaining materials may be far behind the current market prices in times of high inflation.

2. The Last -In, First -Out (LIFO) method

This is where the price of the materials that were last to be bought is used to value issues from the stores.

Advantages of LIFO include:

  1. Materials issue price is close to market value.
  2. Managers are made to be continually aware of recent costs because their departments are charged with current costs.

Disadvantages of LIFO include:

  1. Materials valuation is cumbersome using FIFO since each batch of materials has to be identified separately.
  2. LIFO, unlike FIFO, represents the opposite of what is physically happening and so difficult to explain to managers.

3. The Weighted Average Cost (AVCO) method

This is where the materials are issued at a weighted average cost.
Weighted average cost is equal to Total cost of materials in store divide by Total number of units (quantity) of materials in store. Each time a new batch is received a new weighted average cost has to be calculated.

Advantages of AVCO method include:

Unlike with FIFO and LIFO, there is no need to identify each batch separately and so AVCO is easier to use.

Disadvantages of AVCO method include:

  1. The issue price will rarely be the same as the price that was paid
  2. The issue price can run into several decimals

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