unit 2A: Material cost

Material represent the first cost element.

Material is everything which has physical attributes of measurements viz length, breadth, weight etc. whose shape and size is subjected to senses of vision and touch. In the context of cost, material represent raw material i.e. matter used in the production of goods. Material consists of major portion of costs in case of manufactured goods ranging from 50 to 80% of the total cost.

Material thus refers to cloth in case of garments/dresses, brick and cement in case of construction, wheat flour and sugar in case of biscuits, wood/timber in case of wooden furniture. Apart from such primary material other items which are of lesser value but help in production process like cloth, cotton, wires, nails, screws, lubricants, pins, adhesives etc. are also covered under the category of material.

The ascertainment and control of costs on account of material is routed through STORES as normally in a business unit all material required in the production process is stored in the stores and whatever item in whatever quantity is required is issued by store to the requesting department. In such a set up following sequence of event can be studied:

(i)                  At the start of the process or accounting period certain items are held by store in certain quantities. This holding is collectively called as stock and more precisely opening stock

(ii)                Purchases/acquisition of items are made from time to time.

(iii)               Purchases are also stored with existing stores i.e. stock

(iv)               As per the requisition/demand from production department, material are issued from time to time.

(v)                At the completion of production /job or the accounting period, residual material is held/stored by store as closing stock.

As can be seen from above, to measure and control material cost following activities need to be studied:

(1)    Purchase of Materials

(2)    Storing of Material

(3)    Issue of material to production units

Purchase rests on: Purchasing material in right quantity of right quality at right time at right price

I. Purchase cycle:

1.       Raising of indent/requisition

2.       Initiating the purchase

2A. Selection of prospective suppliers and communication of intended purchase

3.       Receiving the quotations

4.       Selecting the Supplier

5.       Issue of Purchase Order (PO)

6.       Receiving/delivery challan/GRN

7.       Inspecting of material received

8.       GRN/Storing/communicating to all concerned 

9.       Approving Invoices for payment


Meaning of two terms/concepts used in purchasing: (i) Just-in-time purchasing (ii) Centralized and De-centralized purchasing 



Other issues include: (i) Trade/Quantity/Cash discounts (ii)Taxes (iii) Transportation (iv) Location and timing of delivery (v) Unloading and Handling (vi) Penalties for defective/short/different/late supplies (vii) Payment pattern (viii) Cost of containers

I. Questions with respect to purchase of materials:

(i)                  What should be purchased? How much should be purchased.
                What are 6 R's of good purchasing?
                Quantity, Quality, Time, Price, Source and delivery

(ii)                Discounts, Transportation, Insurance, Installation and Taxes

(iii)               How purchases should be made? Description of purchase process.

(iv)               Issue of centralized purchases or decentralized purchases.

(v)                Knowing the meaning of terms like: Indent, Purchase requisition, Purchase Order, Quotation, Debit note, Credit note etc.

II. Questions with respect to Storage:

(i)                  Location and organization of stores

(ii)                General Functions of a store keeper or store in-charge.

(iii)               Centralized stores or decentralized stores

(iv)               Re-order quantity, Economic Order Quantity i.e. EOQ

(v)                Levels of stock i.e. re-order level, minimum level, maximum lever etc.

(vi)               JIT approach

(vii)             GRN

(viii)           Inspection report

(ix)               Stores ledger

(x)                 Bin Card

(xi)               Dual Bin System of storage

(xi.a)      Coding issues

(xii)             ABC system of storage

(xiii)            Gate passes

(xiv)            Perpetual vs periodic inventory

(xv)             Slow moving, obsolete and condemned stock

II. Store keeping or management of stores 

II.1 Objectives of or challenges or tasks entrusted to a stores manager/store-keeper

1) Prompt availability and supply of materials to users when demanded
2) Identification and removal of wastages, theft and accidents.
3) least possible working capital is engaged or blocked in stores function whether by way of space, quantity and other related costs.

4) Up-to-date records of stores for prompt information and decision making.
5) Avoiding over-stocking or under-stocking.
6) Maintaining a neat tidy and efficient stores.
7) Perpetual stock system and provision of cost audit
8) Identification of obsolete and slow moving stock

II.2 Centralized stores vs De-centralized stores:

Form control point of view, it is preferable to have one centralized store but in case of modern times large scale manufacturing units having large factory campuses with many departments, it is not practicable to have centralized stores, instead, they go with as many stores as there are production departments/units in the factory. This leads to a de-centralized set-up of stores.

Advantages and disadvantages of centralized stores:

1.       Smaller stocks-smaller working capital blocked

2.       Reduced clerical costs

3.       All facilities under one roof speeds up stores operations.

4.       Control and supervision is facilitated as all expert persons are placed at one place.

5.       Bulk buying, higher discounts and least order processing costs.

6.       Reduction in wastages and greater control over slow moving and obsolete stock.

Disadvantages:

(i)                  Increased transportation time

(ii)                Increased response time i.e. even when requisitioned goods are available with centralized stores, concerned department may get them late due to distance involved and higher processing time.

(iii)               Lack of specialization as every department in the factory carries out a specialized activity and dedicated stores can serve better as it is also specialized in that particular activity.

       

II.3 All questions of Storing function have in one way or the other need to consider Carrying costs and  also Non-carrying costs of inventory :

Carrying Costs include:

(a)    Blocking of precious working capital

(b)    Increased storage and handling costs.

(c)     Increased theft, pilferages and wastages.

(d)    Increased administrative costs like insurance premium and supervision.

(e)    Increase in obsolescence costs.

Non-carrying cost of Inventory cover costs and losses from:

(a)    Stopping of or decrease in production

(b)    Decrease in sales

(c)     Loss of existing or potential customer

(d)    Loss of Goodwill

(e)    Hasty purchases at higher prices of substitutes or sub-standard quantity material.

(f)      Loss of quantity discount

(g)    Frequent and repetitive ordering involves higher clerical costs.

(h)    Increase in Over-time wages.

Levels in Storing: As a store keeper or Store Manager, one must remain watchful to maintain the right level of stock at every time. The stock should be just right in quantity i.e. neither more than the desired level nor less than the desired level. If the quantity held as stock is more than the right level, additional or unjustified inventory carrying cost shall be incurred. On the flip side, if level of inventory is less than the desired or correct level then it will lead to a situation involving undue inventory non-carrying costs.

There are generally following levels observed in store keeping:

(i)                  Minimum Level or Safety Stock

Also known as Buffer Stock refers to ‘at least this much’ quantity of stock that should always be carried as stock in order to prevent stopping of production process or sales on account of nil stock.

Minimum level of stock helps in preventing ‘Non-carrying Costs’. However, it is also true that minimum level should be carefully fixed in order to prevent unnecessary carrying costs.

(ii)                Maximum Level

It implies the highest point up to which inventory can pile. This refers to the maximum permissible level stock can attain and beyond this level any further addition is alarming on account of unjustified inventory carrying costs. Thus maximum level prevents unjustified inventory carrying costs.

(iii)              Reorder level

Somewhere between Maximum level and Minimum level, Re-order level is created prompting the store manager to place order for fresh purchases. It acts as a trigger to initiate fresh purchases in order to maintain the necessary level of stock. 

(iv)               Danger level

It is that level below which the stock under no circumstances be allowed to fall and when the danger level is reached, the material has to be purchased at any price or some emergency arrangements like purchase of substitutes or next best material be considered.

II.4 Concept of Economic Order Quantity EOQ  (aka re-order quantity):

      It can be logically concluded that carrying cost and non-carrying costs are contradictory of each other i.e if one decreases, the other increases and vice versa. This leads to another realization i.e. for a manager, the ideal situation would be to equate the two costs i.e. to find a point where both the costs are equal. Such a level is theoretically known as ECONOMIC ORDER QUANTITY.  It represents the right size of purchase Order i.e. neither more nor less than a desired quantity keeping stock at a level where both inventory carrying and inventory non-carrying costs are minimum.

Formula for EOQ:  

      
Here A = annual consumption in units
          B= Buying or ordering cost per order
          C = Cost per unit
          S = Storage or carrying costs as a percentage of average inventory

Alternatively

EOQ is also equal to

where S is equal to storage cost per unit per annum

Question on EOQ:

Q1 Estimated requirement of the material : 600 Units

      Cost per unit : Rs. 20/-

      Ordering cost per order : Rs.12/-

      Carrying Cost as a percentage of average inventory: 20%

Answer:  60 Units

Q.2 The annual demand for a product is 6400 units. Inventory carrying cost is Rs.1.50 per unit per annum. If the cost of single procurement is Rs.75/-, determine (i) EOQ (ii) Number of orders required per year (iii) Time between two consecutive orders
Answer : 800 units 

Q.3 Determine EOQ from the following information using tabular method
  Annual Consumption : 12,000 units
  Cost of ordering          : Rs15/- per order
  Cost of Material          : Rs.1.25 per order
   Carrying cost              : 20% of average inventory
Answer: 1200 units

Q.4 A scooter manufacturing company purchases 1000 steel part @ Rs.70 per part, for assembly. The costs per PO i.e. cost of placing an order works out to be Rs.35/- This includes the non carrying costs e.g. clerical costs, postage, stationery, freight etc.
The carrying cost per unit during the year is Rs.7/- arrived at as follows:
Return on investment @ 8% on Rs.70/-    =         5.60
Rent, taxes, insurance, handling charges etc.      4.40
Total                                                                        Rs.7.00

The carrying cost works out to be 10% on inventory price per unit. Calculate the most economical order size from the above information.

Q5. From the following information, find out the EOQ and the number of orders placed in the year:
Annual Consumption    : 120 Units
Buying Cost per order   : 20/-
Price per unit                   : Rs.100/-
Storage and Carrying Cost as a percentage of Average Inventory - 12%

      Further two more issues need to be addressed and assessed clearly in order to maintain a smooth flow of purchase-store-issue chain.

     These are:

(i)      Lead time or Ordering time i.e. the time required to replenish the stock or the time between raising of a purchase order and actual supply/availability of goods under purchase order for production.

(ii)    Normal, minimum and maximum daily usage i.e. material consumption rate in production process per day

Calculation of above levels and EOQ is based on prescribed formulae, which are listed below:

Reorder Level = Maximum consumption per day   X   Maximum Re-order period in day(s)

Danger Level = Normal consumption    X Maximum re-order period under emergency conditions.

Average Stock Level = ½ of (Minimum Level + Maximum Level)

                                                            OR

Av. Stock level is also calculated using = Minimum level + ½ of Reorder quantity

 Minimum Level = Reorder level – (Normal consumption  X  Normal reorder period)

Maximum Level =  

         Reorder level + Reorder quantity – ( Minimum Consumption X Minimum Reorder period)

Questions on levels and EOQ

Q 1 In a manufacturing company, a material is used as follows:
  Maximum Consumption         12000 units per week
  Minimum Consumption           4000 units per week
  Reorder quantity                     48000 units
Time required for delivery: minimum 4 weeks and maximum 6 weeks
Calculate: (i) Reorder lever (ii) Minimum level (iii) Maximum level (iv) Danger level and (v) Average stock level

Answer: (i) 72000 units (ii) 32000 units (iii) 104000 units (iv) 16000 units and (v) 56000 units


Q.2 A ltd. produces a product 'Red' using two components X and Y. Each unit of 'Red' requires 0.4 Kg  of X and 0.6 Kg of Y. Weekly production varies from 350 units to 450 units averaging 400 units. Delivery period for both the components is from 1 to 3 weeks. The economic order quantity for X is 600 kg and for Y is 1000 kg. Calculate:
     (i) Re-order level  (ii) Maximum level of X and (iii) Minimum level of Y
Answer: (i) 540 Kgs (ii) 1000 kg (iii) 330 kg

Q.3 Fix the Maximum and Minimum limits, Ordering and Danger level following information:
1. Average daily requirement - 12
2. Usual time to obtain supply - 2 weeks i.e 12 working days
3. Maximum requiremtn in the month of 4 weeks - 400 units.
4. Minimum requirement in this period not to fall below 200 units
5. Economic order size to be take as 2o doz.
6. Time sufficient for Emergent supply - 2 days.

Q.4 The particulars of A and B materials are as follows:
Normal Usage                 10 units per week each
Minimum Usage               5 units per week each
Maximum Usage             15 units per week each
Re-order Quantity             A -60 units
                                               B - 100 units
Re-order Period                  A : 3 to 5 weeks
                                               B: 2 to 4 weeks

Calculate for each material : (a) Re-order level, (b) Minimum Level, (c) Maximum level and (d) Average stock level

Q.5 A company uses 'A', 'B' and 'C' materials in the manufacture of its products. The following information is given in respect of materials:

Weekly production varies from 75 to 125 units, averaging 100 units. find out the following:
Find out the following:
(a) Minimum Stock of A
(b) Maximum Stock of B
(c) Re-order Level of C
(d) Average Stock Level of A
Ans: (a) 1400 kgs. (b) 5200 (c) 2000 (d) 5400

II.5 Classification and codification of materials:

For efficient storage of material, various items have to be meticulously classified. Further it is also desirable that they are coded in view of error-free and fast recording of material flow which in turn leads to updated information about the acquisition, consumption and balance of various materials speedily and accurately.

Classification example: In a building construction unit, material may be classified on the basis of functions like structure, wooden work, plumbing, electricity etc. Cement, brick, gravel, bricks etc. may classify under material belonging to ‘structure’ class or category.

Coding may be numeric, alphabetic, alphanumeric etc. Codes should be (i) exclusive (ii) Clear (iii) Brief (iv) Elastic/Scalable (v) Mnemonic i.e. easy to use/remember

II.6 Stores Records:

(i)                  Inventory Records : Stores ledger and Bin Cards

(ii)                Documents: Delivery Challans, Goods Received Notes, Bill of Material, Material Requisition /Indent, Material Return Note, Material Transfer Note.

      Stores ledger shows the complete detail of movement or flow of material i.e. every increase by way of purchase, transfer and return and likewise every decrease by way of issue, return, transfer etc. of materials is recorded in the stores ledger with detail of date, received from/issued to, quantity of material, value in rupees, approval document reference (i.e. PO no., Invoice No. etc.) and resultant balance after every such movement is recorded. From above, it is easily conceivable that stores ledger is the most important book or records in the working of stores.

Bin Cards: Bin cards are attached to the container or receptacle viz. almirah, rack, cabinet, chest, drawer, drum etc. showing : Bin number, material description, material code, Minimum level, Re-order quantity, Re-order level, Receipt quantity, Issued quantity and balance quantity and verification remarks.

Distinction between Bin cards and Stores ledger

S.NO.	Point of difference	Bin Card	Stores Ledger
1.	Value of material	Not recorded	Recorded
2.	Location	Placed at the bin	Office
3.	Purpose	Prompt and brief i.e. real-time information for physical control	Detailed information for financial and cost control

       Material Requisition Note or Indent: It should contain the identification of requisitioning department, date of preparation, description and quantity required of various materials, prepared by.., checked by…., and approved by… identification markers, should be issued in duplicate, and authorize the stores to issue material.

      Bill of Material: In case of Job work units, whenever a particular job is undertaken by the production department, it prepares a list of materials and their respective quantities that would be needed to complete the job. Thus this arrangement eliminates the need for raising different and piecemeal requisitions to stores again and again. This saves lot of efforts and time of concerned staff of both the departments i.e. requisitioning and stores. Many a times Bill of Material is pre-printed if the job is of routine and homogeneous nature. Planning and control of job costs so far material cost component is concerned also become easier. Similarly, stores manager is also aware of the current and prospective demand of the jobs enabling him to maintain the necessary levels of inventory and supplies.

Location of Stores: Stores can be centralized or de-centralized

Advantages of centralized stores: 

(i) Minimum blockage of funds/working capital

(ii) Savings in clerical costs

(iii) Quicker decision making/processing

(iii) Accounting control is easier

(iv) Administrative control is easier

Disadvantages of centralized stores:

(i) Centralized stores lack specialization

(ii) Locational disadvantages may creep in

(iii) Transportation costs are higher

(iv) Physical distance and even communication fails may disrupt production

With the help of above points, advantages and disadvantages of de-centralized stores can also be thought of.

General Functions of a stores manager:

(i) To keep stock of materials at right level

(ii) To maintain the working of stores in coordination of production, purchase and accounts departments

(iii) To provide timely and accurate reports to management for example ABC analysis, slow moving stock, stock turnover and input-output ratios.

(iv) To prevent wastages, thefts and pilferages.

(v) To maintain adequate arrangements for safe and proper storage

(vi) To support fair stock taking and 

III. Questions with respect to issue of material

(i)              Pricing of issues i.e. FIFO method, LIFO method, Average Method, Weighted average method, Standard Price Method, Replacement Cost Method, Market price method.

(ii)                Material return

      (iii) Material transfer note

IV. Material Losses: 

(i) Waste (ii) Scrap (iii) Spoilage (iv) Defectives

Issue	Waste	Scrap	Spoilage	Defectives
Meaning	That portion of material which is lost in production process with no or negligible recovery value. Wastage normally occurs during initial phases.	Incidental residue from manufacturing process, of small value and further processing not possible or viable. It is physically available.	Refers to material damaged in production process beyond repair. Normally occurs later in production process.	Production units which are below prescribed standards. They can be reworked or rectified and refurbished to the desired level.
Normal/Abnormal	Generally Normal but beyond accepted/standard levels is considered avoidable or abnormal	Generally normal/Unavoidable due to nature of production.	Abnormal i.e. can be avoided	Pre-dominantly abnormal.
Realizable value	Nil	Nominal or insignificant	Yes, sometimes sold as ‘seconds’	Yes, after reworking/refurbishing they are saleable.
Control	Through input-output ratios. Abnormal or avoidable wastages should be checked	Standard Input/output ratios. Abnormal levels to be checked.	Normal spoilage  levels should be preset and communicated.	Here reworking costs are also to be considered for control. Defectives should not be more than standards.
Accounting	Wastage which is normal should be    charged to   production.       While abnormal or avoidable wastages should be charged to p&l account.	-As other income      - As credit to process      - As credit to p&l account.	Normal spoilage cost is borne by good units. Abnormal spoilage cost is charged to P&L A/c	If defectives relate to a particular production process, they should be charged to that process only. Otherwise, treated as Factory overheads. Abnormal defectives to be charged to P&L account.
e    Examples	Loss due to transportation, loading-unloading, spilling, mis-handling, shrinking, evaporation etc.	In case of furniture industry, utensil industry…..	Left shoe smaller than the right shoe, faulty print on clothing material, medicines with wrong composition etc	Electronic goods, a pair of shoes with separated heel etc. i.e. both can be repaired/refurbished.

In case of spoilage and defectives, general assumption is that they occur due to faulty raw material, bad workmanship, mis-handling etc. If the responsibility of particular production department or process can be fixed, then it should be charged to the process or department responsible. Again, if they are inherent and natural i.e. normal, the 

       However, if the reason of sopilage or defective is such as is beyond the management control on account of factors like riots, natural calamity etc. same should be treated as abnormal and charged to the costing profit and loss account.Defectives are reworked to bring them to the level of good units. This cost is either allocated to a particular department or charged to costing profit and loss account. Here it is to be seen that value addition as a result of reworking/refurbishing should exceed the cost of reworking/refurbishing.