Management Accounting & Cost Audit

Accounting for Materials

Different procedures of accounting costs for materials and different documents necessary for
ordering, receiving and issuing materials from inventory.
Inventory Control
Inventory control includes the functions of inventory ordering and purchasing, receiving goods
into store, storing and issuing inventory and controlling levels of inventory.

Classifications of inventories

rk in progress

Controls should cover the following functions:

ordering of inventory
purchase of inventory
receipt of goods into store
Storage of goods into store
issue of inventory and maintenance of inventory at the most appropriate level.

Qualitative Aspects of Inventory Control

We may wish to control inventory for the following reasons.

if we run out of raw materials.

Ordering and Receiving 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; materials
transfer note and materials returned note.
Proper records must be kep
t of the physical procedures for ordering and receiving a consignment of materials to ensure the
following.
enough inventory is held

Purchase Requisition
Current inventories run down to the level where a reorder is required. The stores department
issues a purchase requisition which is sent to the purchasing department, authorizing the
department to order further inventory.
Purchase Order
The purchasing department draws up a purchase order which is sent to the supplier. The supplier
may be asked to return an acknowledgement copy as confirmation of their acceptance of the
order. Copies of the purchase order must be sent to the accounts department and the storekeeper
or receiving department.

Quotations
The purchasing department may have to obtain a number of quotations if either a new inventory
line is required, the existing supplier's costs are too high or the existing supplier no longer stocks
the goods needed. Trade discounts should be negotiated where possible.

Delivery Note
The supplier delivers the consignment of materials and the storekeeper signs a delivery note for
the carrier. The packages must then be checked against the copy of the purchase order to ensure
that the supplier has delivered the types and quantities of materials which were ordered.
Discrepancies would be referred to the purchasing department.

Goods Received Note

If the delivery is acceptable, the storekeeper prepares a goods received note (GRN).A copy of the
GRN is sent to the accounts department, where it is matched with the copy of the purchase order.
The supplier's invoice is checked against the purchase order and GRN and the necessary steps are
taken to pay the supplier. The invoice may contain details relating to discounts, such as trade
discounts, quantity discounts (order in excess of a specified amount) and settlement discounts
(payment received within a specified number of days).

Materials Requisition Note

Materials can only be issued against a materials/stores requisition. This document must record not
only the quantity of goods issued but also the cost centre or the job number for which the
requisition is being made. The materials requisition note may also have a column, to be filled in
by the cost department, for recording the cost or value of the materials issued to the cost centre or
job.

Material Transfers and Returns

Where materials, having been issued to one job or cost centre are later transferred to a different
job or cost centre, without first being returned to stores, a material transfer note should be raised.
Such a note must show not only the job receiving the transfer but also the job from which it is
transferred. This enables the appropriate charges to be made to jobs or cost centres. Material
returns must also be documented on a materials returned note. This document is the 'reverse' of a
requisition note, and must contain similar information. In fact it will often be almost identical to a
requisition note. It will simply have a different title and perhaps be a distinctive colour, such as
red, to highlight the fact that materials are being returned.

Computerised Inventory Control Systems

Many inventory control systems these days are computerised. Computerised inventory control
systems vary greatly, but most will have the features outlined below.
(a) Data must be input into the system. For example, details of goods received may simply be
written on to a GRN for later entry into the computer system. Alternatively, this information may
be keyed in directly to the computer: a GRN will be printed and then signed as evidence of the
transaction, so that both the warehouse and the supplier can have a hard copy record in case of
dispute. Some systems may incorporate the use of devices, such as bar code readers. Other types
of transaction which will need to be recorded include the following.
(i) Transfers between different categories of inventory (for example from work in progress
to finished goods).
(ii) Despatch, resulting from a sale of items of finished goods to customers.
(iii) Adjustments to inventory records if the amount of inventory revealed in a physical
inventory count differs from the amount appearing on the inventory records.
(b) An inventory master file is maintained. This file will contain details for every category of
inventory and will be updated for new inventory lines. A database file may be maintained.

The Storage of Raw Materials

Objectives of Storing Materials

identification of all materials at all times

Maintenance of correct inventory levels

Recording Inventory Levels

One of the objectives of storekeeping is to maintain accurate records of current inventory levels.
This involves the accurate recording of inventory movements. The most frequently encountered
system for recording inventory movements is the use of bin cards and stores ledger accounts.
Bin Cards
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 Accounts

Stores ledger accounts is a card for a manual system but, even when the inventory records are
computerised, the same type of information is normally included in the computer file. The running
balance on the stores ledger account allows inventory levels and valuation to be monitored.

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.
Materials in inventory X
+ Materials on order from suppliers X
– Materials requisitioned, not yet issued (X)
Free inventory balance X
Knowledge of the level of physical inventory assists inventory issuing, inventory counting and
controlling maximum and minimum inventory levels: knowledge of the level of free inventory
assists ordering.
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.
(a) Ambiguity is avoided.
(b) Time is saved. Descriptions can be lengthy and time consuming.
(c) Production efficiency is improved. The correct material can be accurately identified
from a code number.
(d) Computerised processing is made easier.
(e) Numbered code systems can be designed to be flexible, and can be expanded to include
more inventory items as necessary.
The digits in a code can stand for the type of inventory, supplier, department and so forth.

The Inventory Count (Stock-take)

The inventory count (Stock-take) 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 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 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
(a) The annual stocktaking is unnecessary and the disruption it causes is avoided.
(b) Regular skilled stocktakers can be employed, reducing likely errors.
(c) More time is available, reducing errors and allowing investigation.
(d) Deficiencies and losses are revealed sooner than they would be if stocktaking were
limited to an annual check.
(e) 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.
(f) Staff morale is improved and standards raised.
(g) Control over inventory levels is improved, and there is less likelihood of overstocking
or running out of inventory.

Inventory Discrepancies
There will be occasions when inventory checks disclose discrepancies between the physical
amount of an item in inventory and the amount shown in the inventory records. When this occurs,
the cause of the discrepancy should be investigated, and appropriate action taken to ensure that it
does not happen again.

Perpetual 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.
This means that there is a continuous record of the balance of each item of inventory. The balance
on the stores ledger account therefore represents the inventory on hand and this balance is used in
the calculation of closing inventory in monthly and annual accounts. In practice, physical
inventories may not agree with recorded inventories and therefore continuous stocktaking is
necessary to ensure that the perpetual inventory system is functioning correctly and that minor
inventory discrepancies are corrected.

Obsolete, deteriorating and slow-moving inventories and wastage

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 items may be wasted because, for example, they get broken. All wastage should be noted
on the inventory records immediately so that physical inventory equals the inventory balance on
records and the cost of the wastage written off. Slow-moving inventories are inventory items which
are likely to take a long time to be used up. For example, 5,000 units are in inventory, and only 20
are being used each year. This is often caused by overstocking. Managers should investigate such
inventory items and, if it is felt that the usage rate is unlikely to increase, excess inventory should
be written off as obsolete inventory, leaving perhaps four or five years' supply in inventory.
Inventory control levels
Inventory costs
Inventory costs include purchase costs, holding costs, ordering costs and costs of running out of
inventory.
The costs of purchasing inventory are usually one of the largest costs faced by an organisation and,
once obtained, inventory has to be carefully controlled and checked.
Reasons for holding inventories
ensure sufficient goods are available to meet expected demand

Holding Costs
If inventories are too high, holding costs will be incurred unnecessarily. Such costs occur for a
number of reasons.
(a) Costs of storage and stores operations. Larger inventories require more storage space
and possibly extra staff and equipment to control and handle them.
(b) Interest charges. Holding inventories involves the tying up of capital (cash) on which
interest must be paid.
(c) Insurance costs. The larger the value of inventories held, the greater insurance premiums
are likely to be.
(d) Risk of obsolescence. The longer an inventory item is held, the greater the risk of
obsolescence.
(e) Deterioration. When materials in store deteriorate to the extent that they are unusable,
they must be thrown away with the likelihood that disposal costs would be incurred.

Costs of Obtaining Inventory

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.
(a) Clerical and administrative costs associated with purchasing, accounting for and receiving
goods.
(b) Transport costs
(c) Production run costs, for inventory which is manufactured internally rather than purchased
from external sources.

Stock-Out Costs (running out of inventory)

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.

goodwill.
 .
.

Objective of Inventory Control

The overall objective of inventory control is, therefore, to maintain inventory levels so that the
total of the following costs is minimised.

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.
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
minimizes costs). These levels will determine 'when to order' and 'how many to order'.

Reorder Level
When inventories reach this level, an order should be placed to replenish inventories. The reorder
level is determined by consideration of the following.

The maximum lead time is the time between placing an order with a supplier, and the inventory
becoming available for use.
FORMULA TO LEARN
Reorder level = maximum usage X maximum lead time

Minimum level
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.
FORMULA TO LEARN
Minimum level = Reorder level – (average usage X average lead time)

Maximum level
This also acts as a warning level to signal to management that inventories are reaching a potentially
wasteful level.
FORMULA TO LEARN
Maximum level = reorder level + reorder quantity – (minimum usage x minimum lead time)
Question
A large retailer with multiple outlets maintains a central warehouse from which the outlets are
supplied. The following information is available for Part Number SF525.
Average usage 350 per day
Minimum usage 180 per day
Maximum usage 420 per day
Lead time for replenishment 11-15 days
Reorder quantity 6,500 units
Reorder level 6,300 units
(a) Based on the data above, what is the maximum level of inventory?
A 5,250 B 6,500 C 10,820 D 12,800
(b) Based on the data above, what is the approximate number of Part Number SF525 carried
as buffer inventory?
A 200 B 720 C 1,680 D 1,750
ANSWER
(a) Maximum inventory level = reorder level + reorder quantity – (min usage x min lead time)
= 6,300 + 6,500 – (180 x 11)
= 10,820
The correct answer is C.

Using good multiple choice question technique, if you were resorting to a guess you should have
eliminated option A. The maximum inventory level cannot be less than the reorder quantity.
(b) Buffer inventory = minimum level
Minimum level = reorder level – (average usage x average lead time)
= 6,300 – (350 x 13)
= 1,750.
The correct answer is D.
Option A could again be easily eliminated. With minimum usage of 180 per day, a buffer inventory
of only 200 would not be much of a buffer.

Reorder quantity
This is the quantity of inventory which is to be ordered when inventory reaches the reorder level.
If it is set so as to minimise 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 fluctuate evenly between
the minimum (or safety) inventory level and the highest possible inventory level (the amount of
inventory immediately after an order is received, ie safety inventory + reorder quantity.
FORMULA TO LEARN
Average inventory = safety inventory + ½ reorder quantity.

QUESTION
A component has a safety inventory of 500, a reorder quantity of 3,000 and a rate of demand
which varies between 200 and 700 per week.
The average inventory is approximately:
A 2,000 B 2,300 C 2,500 D 3,500

ANSWER
Average inventory = safety inventory + ½ reorder quantity
= 500 + (0.5 x 3,000)
= 2,000

Economic order quantity (EOQ)

The economic order quantity (EOQ) is the order quantity which minimises inventory costs. The
EOQ can be calculated using a table, graph or formula.
FORMULA TO LEARN
EOQ = √(2 x C0 x D/ CH)

Where, CH = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
D = demand during the time period

Economic order theory assumes that the average inventory held is equal to one half of the reorder
quantity (if an organisation maintains some sort of buffer or safety inventory then average
inventory = buffer inventory + half of the reorder quantity). There are certain costs associated with
holding inventory. These costs tend to increase with the level of inventories, and so could be
reduced by ordering smaller amounts from suppliers each time. On the other hand, there are costs
associated with ordering from suppliers: documentation, telephone calls, payment of invoices,
receiving goods into stores and so on. These costs tend to increase if small orders are placed,
because a larger number of orders would then be needed for a given annual demand.

QUESTION
EOQ and holding costs
A manufacturing company uses 25,000 components at an even rate during a year. Each order
placed with the supplier of the components is for 2,000 components, which is the EOQ. The
company holds a buffer inventory of 500 components. The annual cost of holding one component
in inventory is $2.
What is the total annual cost of holding inventory of the component?
A $2,000 B $2,500 C $3,000 D $4,000
ANSWER The correct answer is C.
[Buffer inventory + (EOQ/2)] x Annual holding cost per component
= [500 + (2,000/2)] x $2 = $3,000

Economic Batch Quantity (EBQ)

The economic batch quantity (EBQ) is a modification of the EOQ and is used when resupply is
gradual instead of instantaneous.
EBQ = √(2 x C0 x D/ CH(1-D/R)

Where R = the production rate per time period (which must exceed the inventory usage)
Q = the amount produced in each batch
D = the usage per time period
C o = the set-up cost per batch
C H = the holding cost per unit of inventory per time period
Typically, a manufacturing company might hold inventories of a finished item, which is produced
in batches. Once the order for a new batch has been placed, and the production run has started,
finished output might be used before the batch run has been completed.

A company is able to manufacture its own components for inventory at the rate of 4,000 units a
week. Demand for the component is at the rate of 2,000 units a week. Set-up costs for each
production run are $50. The cost of holding one unit of inventory is $0.001 a week. Required
Calculate the economic production run.
ANSWER
Q = √(2 x 50 x 2000/0.001(1 – 2000/4000))
= 20,000 units (giving an inventory cycle of 10 weeks)

Bulk discounts
The solution obtained from using the simple EOQ formula may need to be modified if bulk
discounts (also called quantity discounts) are available.
To decide mathematically whether it would be worthwhile taking a discount and ordering larger
quantities, it is necessary to minimise the total of the following.

The total cost will be minimised at one of the following.

-discount EOQ level, so that a discount is not worthwhile
At the minimum order size necessary to earn the discount

Order Cycling Method

Under the order cycling method, quantities on hand of each stores item are reviewed periodically
(every 1, 2 or 3 months). For low-cost items, a technique called the 90-60-30 day technique can
be used so that, when inventories fall to 60 days' supply, a fresh order is placed for a 30-day supply
so as to boost inventories to 90 days' supply. For high-cost items, a more stringent stores control
procedure is advisable so as to keep down the costs of inventory holding.

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 bins. When the first bin is emptied, an order must be placed for resupply;
the second bin will contain sufficient quantities to last until the fresh delivery is received. This is
a simple system which is not costly to operate but is not based on any formal analysis of inventory
usage and may result in the holding of too much or too little inventory.

Classification of materials
Material items may be classified as expensive, inexpensive or in a middle-cost range. Because
of the practical advantages of simplifying stores control procedures without incurring unnecessary
high costs, it may be possible to segregate materials for selective stores control.
(a) Expensive and medium-cost materials are subject to careful stores control procedures to
minimise cost.
(b) Inexpensive materials can be stored in large quantities because the cost savings from careful
stores control do not justify the administrative effort required to implement the control.
This selective approach to stores control is sometimes called the ABC method whereby materials
are classified A, B or C according to their expense – group A being the expensive, group B the
medium-cost and group C the inexpensive materials.

Pareto (80/20) Distribution

A similar selective approach to stores control is the 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.
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.
Valuing inventory in financial accounts
Inventories are valued at the lower of cost and net realisable value. In practice, inventories will
probably be valued at cost in the stores records throughout the course of an accounting period.
Only when the period ends will the value of the inventory in hand be reconsidered so that items
with a net realisable value below their original cost will be revalued downwards, and the inventory
records altered accordingly.
Charging units of inventory to cost of production or cost of sales
It is important to be able to distinguish between the ways in which the physical items in inventory
are actually issued. In practice a storekeeper may issue goods in the following way.

By comparison, the cost of the goods issued must be determined on a consistently applied basis,
and must ignore the likelihood that the materials issued will be costed at a price different to the
amount paid for them. This may seem a little confusing at first, and it may be helpful to explain
the point further by looking at an example.
Inventory valuation Suppose that there are three units of a particular material in inventory.
Units Date received Purchase cost
A June 20X1 $100
B July 20X1 $106
C August 20X1 $109
 In September, one unit is issued to production. As it happened, the physical unit actually issued
was B. The accounting department must put a value or cost on the material issued, but the value
would not be the cost of B, $106. The principles used to value the materials issued are not
concerned with the actual unit issued, A, B or C. Nevertheless, the accountant may choose to make
one of the following assumptions.
(a) The unit issued is valued as though it were the earliest unit in inventory, ie at the purchase cost
of A, $100. This valuation principle is called FIFO, or first in, first out.
(b) The unit issued is valued as though it were the most recent unit received into inventory, ie at
the purchase cost of C, $109. This method of valuation is LIFO, or last in, first out.
(c) The unit issued is valued at an average price of A, B and C, ie $105.

Advantages and disadvantages of the FIFO method

Advantages Disadvantages
It is a logical pricing method which probably FIFO can be cumbersome to operate because
represents what is physically happening: in of the need to identify each batch of material
practice the oldest inventory is likely to be separately.
used first.
It is easy to understand and explain to Managers may find it difficult to compare
managers. costs and make decisions when they are
charged with varying prices for the same
materials.
The inventory valuation can be near to a In a period of high inflation, inventory issue
valuation based on replacement cost. prices will lag behind current market value.

LIFO (last in, first out)

LIFO assumes that materials 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 and disadvantages of the LIFO method
Advantages Disadvantages
Inventories are issued at a price which is close The method can be cumbersome to operate
to current market value. because it sometimes results in several batches
being only part-used in the inventory records
before another batch is received.
Managers are continually aware of recent costs LIFO is often the opposite to what is physically
when making decisions, because the costs happening and can therefore be difficult to
being charged to their department or products explain to managers.
will be current costs.
As with FIFO, decision making can be difficult
because of the variations in prices.
Changing from LIFO to FIFO or from FIFO to LIFO
You may get an assessment question which asks you what would happen to closing inventory
values or gross profits if a business changed its method from LIFO to FIFO or vice versa. You
may find it easier to think about this using diagrams.
Let's consider a very simple example where four barrels of inventory are purchased during a month
of rising prices, and two are used. There is no opening inventory.

Cost
1 Jan $100 per barrel LIFO – these barrels would be FIFO – these barrels would
19 Jan $150 per barrel left as closing inventory $250 be issued to production first
(and charged to cost of sales) $250)

20 Jan $200 per barrel LIFO – these barrels would be FIFO – these barrels would be
31 Jan $250 per barrel issued to production first (and left as closing inventory $450
charged to cost of sales) $450
Notice the rising prices
As you can see, during a period of rising prices, the closing inventory value using LIFO would be
$250 and using FIFO would be higher at $450. The charge to cost of sales will be lower using
FIFO and therefore the gross profit will be higher.
AVCO (cumulative weighted average pricing)
The cumulative weighted average pricing method (or AVCO) calculates a weighted average price
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. 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.

Advantages and disadvantages of AVCO

Advantages
Fluctuations in prices are smoothed out,
making it easier to use the data for decision
making.
It is easier to administer than FIFO and LIFO
because there is no need to identify each batch
separately.
Disadvantages
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.