MATERIAL COSTING

OBJECTIVE OF STUDY
Meaning Of material cost Direct Material cost Indirect Material cost Material Management Material Control Purchase control store control Control on issue of material Meaning of Inventory Inventory Control Inventory Valuation Meaning and Accounting treatment of Wastage Scrap Defectives Meaning of Depreciation

MEANING OF MATERIAL COST

Material is the first and the most important element of cost. In most of manufacturing firm, material form the single largest component of cost. The term material means any commodity or substance which is processed in factory in order to be converted into finished product. Material may be classified as follows: RAW MATERIAL: These are the basic material supplied in crude form to be used in production such as jute , cotton , rubber, timber etc COMPONENTS: These are not raw in nature rather finished parts made out of raw materials which are assembled to make finished product. E.g., Tyers and tubes in cycle industry, stabilizers in A.C and fridge manufacturing. TOOLS: Tools are appliances used in the manufacturing operation, E.g., hammers, screwdrivers, drills, milling cutters etc

SPARE PARTS: Spare parts are used for the maintenance of plant, machinery and building and for smooth running of production schedule. CONSUMABLE STORES: Consumable stores are the items used for smooth running of machines , e.g., lubricants oil, cotton waste, rags, brooms etc DIRECT AND INDIRECT MATERIAL Material may include both direct and indirect material cost. DIRECT MATERIAL COST: Direct material are those material which can be identified or readily traced with the cost objective which may be a product, a department or a territory. It include 1. Material specifically required for a process, a job, order or production order. 2. Materials transferred from one process to another 3. Requisition charges such as freight, taxes, insurance etc 4. Primary packaging materials. The term prime cost material, process material, production material and requisition material all means the same.

INDIRECT MATERIAL COST: Indirect material are those which cannot be directly traceable to finished products. E.g., oil, grease, cotton waste for machine, rags and cleaning material, nails in shoe making. Out of various factor of production, material is most flexible and controllable input. Because It does not get waste and exhausted with passage of time as labor get wasted with passage of time whether in use or not. Material can be purchased in varying quantities according to the requirements of the firm where as other element of cost can not be easily varied once established. Thats why cost and management expert puts lost of effort to control material cost. According to INDIAN ASSOCIATION OF MATERIAL MANAGEMENT, 64 paisa in rupee is spent on material, 16 paisa on labor and rest of one rupee on overheads. Thus, importance of material control lies in fact that any saving in the cost of material will go long way in reducing cost of production and improving profitability.

MATERIAL MANAGEMENT
Materials management is a function responsible for coordination of planning, sourcing ,purchasing, moving, storing and controlling materials in an optimum manner so as to provide predetermined services to the customer at a minimum cost. It is therefore desirable that every materials manager should try to apply proper materials planning, purchasing, handling, storing materials so as to achieve the desired objective of minimising materials procurement and stock holding costs. Effective materials management is essential in order to (1) provide the best service to customers, (2) produce at maximum efficiency, and (3)manage inventories at predetermined levels to stabilize investments in inventories. Material cost to be effective involves the cooperation of various departments viz: purchasing department, receiving and inspection department, stores, production and stock control department.

MATERIAL COST CONTROL Material cost control is defined as a comprehensive framework for accounting and control of material cost designed with the object of maintaining material supplies at a level so as to ensure uninterrupted production but at same time minimizing investment of fund. Material cost control is systematic control over the purchasing , storing and use of materials so as to have minimum cost of materials.

The following are the salient features of material cost control : (a) The quality and specification of materials shall commensurate with the requirements of the product, so that neither too expensive or superior nor cheap or inferior material shall be selected for use in product. (b) The purchasing shall aim at minimum price to suppliers and timely procurement and shall avoid urgent purchases at higher cost. (c) Storage of materials shall be such that there will be neither overstocking, and thereby blocking Capital, nor running out of stock and creating interruption in production process. (d) Wastage and losses shall be avoided at every stage of operation i.e. from storing till usage in production. (e) Materials should be classified and accounted for both in physical units and value in such a way that information about availability in stock can be obtained promptly so as to assist production, planning as well as timely buying.

PROCEDURE OF MATERIAL CONTROL The procedure for material control can be divided into three stages Purchase control Store control Control on Issue of materials PURCHASE CONTROL: Purchase control covers all aspect of purchases. Purchases are made by the purchase department. Purchase of material is one of the most important function of material management and control. Ignoring this function can be expensive. It can lead to High material wastage Low product quality Expensive machine breakdown

FUNCTION OF PURCHASE DEPARTMENT Deciding the items to be purchased based on demand. Selection of source of supplies Collecting the price information Placing the order Follow-up of order Checking the invoices Maintenance of purchase records Maintenance of vendor relations.

PURCHASE PROCEDURE In order to perform the various function of a purchase department effectively, the purchase department follows the following steps involved in purchase procedure 1. 2. 3. 4. 5. Receiving purchase requisitions. Exploring the sources of supply and selection of supplier Preparation and placing purchase order Receiving and Inspection of material Checking and passing of bill of payment.

STORE CONTROL

Purchase control should be matched with equally effective store control to avoid losses from misappropriation, damage, deterioration, evaporation and carelessness. The investment in materials constitutes a major potion of current assets, so there should be separate departments to exercise store control. All manufacturing concerns appoint a person known as the store keeper, chief storekeeper or the stores superintendent who is the incharge of the store department and is responsible for stores control STORE ( MATERIAL) RECORDS The two important stores record that are generally kept for making a record of various items of stores are Bin cards The store ledger BIN CARD A bin card makes record of the receipt and issue of material and is kept for each item of stores.

The quantity of store received is entered in the receipt column and the quantity of store issued is recorded in issued column of Bin card and balance of quantity of stores is taken after every receipt or issue, so balance can be readily seen. These cards are maintained by store keeper and store keeper is answerable for any mismatch in balance of stores A Bin card is also known as Bin tag or stock card and usually hung up or placed in shelf, rack or bin where material is kept.

STORE LEDGER This ledger is kept in the costing department and is identical with bin card except that receipt, issue and balance are shown along with their money values. This contain an account for every item of stores and makes a record of receipt, issues and balances, both in quantity and value This ledger provide information for pricing of materials issued and money value at any time of each item of stores.

CONTROL ON ISSUE OF MATERIALS Materials are received and kept in stores carefully and finally the store keeper issues them whenever those are required by production department. Material should be issued against proper authorization only. Issue of material should be recorded in proper record such as bin card and store ledger. MATERIAL REQUISITION: The store keeper should issue the material only on presentation of Material Requisition Note (MRN). It is a document which authorizes the issue of material for use. It is signed by requisitioner and authorized by higher authority. BILL OF MATERIAL: A bill of material is a list of all material required with quantities for specific job, process or order. It helps the store keeper in initiating the purchase requisition in time. TRANSFER OF SURPLUS MATERIAL: Sometimes material may be issued in excess of the requirement of a particular job or work. Material Return Note: When excess material is returned to stores, a Material Return Note is prepared in department where the material is excess.

Material Transfer Note: Sometimes, the returning of surplus materials to a store can be costly due to the distance or excessive amount of handling charges. In such case materials may be transferred directly from one department to another. The department transferring material prepares a Material Transfer Note. MATERIAL ABSTRACT OR MATERIAL ISSUE ANALYSIS Periodically an analysis of various Requisition, Material Returned Notes and Material Transfer Note should be made and a statement should be prepared which shows at a glance the value of material consumed in each job. This statement is known as Material abstract or Material issue Analysis Sheet.

INVENTORY Inventory can be referred to as sum of the value of raw

materials, fuel and lubricants, spare parts , maintenance consumable, semi-processed material and finished goods stocked at any given point of time.

Inventory holds the raw materials, work-in progress goods along with completely finished good which are considered to be a part of business assets that are, or will be ready for sales. Inventories are maintained for operational smoothness. The average business have about 30% of its working capital tied up in inventory Customer service is improved, if inventories are raised to a very high level and production schedules are flexible to meet changing demands. When companies have too little inventories, the run out of stock, manufacturing efficiency and relations with customer is bound to be affected.

INVENTORY CONTROL AND EVALUATION

Inventory control is a planned approach of determining what to order, when to order and how much to order and how much to stock so that costs associated with buying and storing are optimal without interrupting production and sales. Inventory control basically deals with two problems:

(i) When should an order be placed? (Order level), and (ii) How much should be ordered? (Order quantity). The inventory control system strikes the balance between the loss due to non-availability of an item and cost of carrying the stock of an item. Inventory control aims at maintaining optimum level of stock of goods required by the company at minimum cost to the company.

OBJECTIVE OF INVENTORY CONTROL 1.To ensure adequate supply of products to customer and avoid
shortages as far as possible. 2. To make sure that the financial investment in inventories is minimum (i.e., to see that the working capital is blocked to the minimum possible extent). 3. Efficient purchasing, storing, consumption and accounting for materials is an important objective. 4. To maintain timely record of inventories of all the items and to maintain the stock within the desired limits. 5. To ensure timely action for replenishment. 6. To provide a reserve stock for variations in lead times of delivery of materials. 7. To provide a scientific base for both short-term and long-term planning of materials.

EVALUATION OF INVENTORY OR MATERIAL COSTING

The method of Inventory valuation is of great importance to management for the following reasons. 1.It determines the amount of firms investment in inventory i.e., how much money is blocked and influences the firms profits. 2. The method of valuing stock for balance sheet purpose is quite different from method of valuing for costing purpose. In financial accounting, inventory is valued at cost price or market price which ever is lower. In Cost Accounting , inventory is valued at cost of production.

For this purpose , inventory can be classified as Raw material and stores Work in progress Finished goods PRINCIPAL BASES OF INVENTORY VALUATION ACTUAL COST: The actual cost of raw-material, WIP and finished goods is most logical method of valuing inventory. Cost Accounting Rules also provide Inventory to be valued at cost.

 LOWER OF THE COST OR MARKET PRICE: Under this method, Inventory is valued at lower of the cost or market price. Market price may be lower than cost in following case -Price level are declining -Inventories are becoming obsolete because of technological and other changes. This method is conservative in approach and may show lower income.

REPLACEMENT METHOD: Under this method, the inventories are valued at a price that would have to be paid for those items on inventory date. This method is not approved by tax authorities and accountant. SELLING PRICE METHOD: The use of this method in inventory valuation is accepted only in certain cases such as valuation of scrap, spoiled, waste material.

VALUATION OF RAW MATERIAL: Cost Accounting rules provide that raw material, stores and spare parts to be always valued AT COST.

VALUATION OF WORK-IN-PROGRESS:

The most important point in valuation of WIP is the stage of its completion. Establishment and administration expenses are not taken into consideration for valuation of WIP.
VALUATION OF FINISHED GOODS: Finished goods is valued at total cost of production

METHODS OF VALUING MATERIAL OR MATERIAL COSTING

Materials are issued from the stores to the job or work orders as per the requirements. Material price always keep fluctuating in accordance to market condition. The stock of material includes the purchases made at different times at different prices. There is a need to know about the price at which the material should be issued. The Important method applied for pricing material issues are

COST PRICE METHOD: FIFO method LIFO method HIFO method Average price method MARKET PRICE METHOD Replacement price Realizable value STANDARD PRICE METHOD Current standard price Basic standard price

COST PRICE METHOD FIRST IN FIRST OUT( FIFO) METHOD In this method, material received first are issued first. First come first serve is basis of accounting. Closing stock of material is valued at the latest price of purchase under this method. This method of material issue is considered to be more suitable in times when the prices in market show declining trends because the higher price of material purchased earlier is recovered and the closing stock is valued at current market price. LAST IN FIRST OUT(LIFO) METHOD: Under this method, material purchased last are used first. This method is also known as replacement cost method as material are issued at current cost to job or work orders. This method is suitable when the prices are rising because material will be issued from latest consignment at a price which is near to current price level.

HIGHEST IN FIRST OUT (HIFO) METHOD: In this system, the material with highest price is issued first. It is based on assumption that stock should be valued at the lowest possible price. If the price in market is fluctuating, this system is suitable as the cost of highest purchased material is realized first.

AVERAGE PRICE METHOD The principle on which the average cost method is based is that all of the materials in store are so mixed up that an issue cannot be made from a particular lot of purchases and therefore , it is proper if the materials are issued at the average cost of material in store. Average may of two type -Simple Arithmetic AverageSuppose , following are three lots of materials in stock when the material is to be issued 1000 unit purchased @ Rs.10 2000 unit purchased @ Rs.11 3000 unit purchased @ Rs.12 simple average price= 10 + 11+ 12\3= Rs.11

Weighted Arithmetic Average Based on above example, 1000X 10+ 2000X 11+ 3000X 12 _____________________________= Rs.11.33 1000+2000+3000 MARKET PRICE METHOD: Market price can either be the replacement price or the realizable price. The Replacement price is used in case of items which are held in stock for use in production while realizable price is used in respect of items which are kept in stock for sale. Under this method, materials are issued at a price at which they are replaced. Thus material are issued at market price prevailing on date of issue. This method is considered to be best when quotation have to be sent because quotation sent would reflect latest competitive condition so far material is concerned. This method matches current revenue with current cost , useful in measuring the operating results of firm. This method does not cover the cost price of material from production because materials are issued at market price which may be more or less than cost price. It make store ledger complicated by introducing element of profit or loss. This method is rarely used.

STANDARD PRICE METHOD: Standard price is the predetermined price and both the receipt and issues will be valued at this price. This price is neither cost price nor market price. This method is used by concern which follow standard costing. Standard price can be of two types Basic standard price- The basic standard price is the ideal standard price fixed for long periods so as to help forward planning. Current standard price- Current standard price is basic standard price which has been adjusted to provide for permanent change in cost on account of prevailing current price The standard price do not recover the cost of material from production because material is not issued at cost price but issued at a predetermined price which may be higher or lower than cost price.

ACCOUNTING TREATMENT OF WASTAGE, SCRAP AND DEFECTS

Material loss may take place in the form of Wastage Scrap Defect The problem of wastage, Scrap and defects is bound to arise in almost all manufacturing concern, so there is difference between quantity of output and the input. Methods of treatment of these losses and interpretation given to these terms vary from one industrial concern to another because of different in situations arising in different concern. WASTAGE Wastage is defined as discarded substance having no value. some wastage are inevitable. such wastage may arise due to inherent nature of materials, chemical reaction, evaporation, drying, sublimation of goods etc Waste may be inform of dust, gas, smoke which arises in the course of manufacturing process.

Waste may be visible or invisible. Invisible waste is waste due to drying , evaporation. Visible waste is waste due to smoke, gas, etc. Waste has no measurable value and create problem in disposal. Waste is further classified as Normal waste Abnormal Waste NORMAL WASTAGE: It is the loss which is unavoidable on account of inherent nature of material. Some material such as liquid material lose their weight due to evaporation. Similarly some material( coal) which is wasted in loading and unloading. Material may be wasted by breaking the bulk into smaller parts. Normal Waste is unavoidable and as such reduced to some extent if there is strict control but cannot be totally eliminated.

TREATMENT The normal wastage loss is recorded in terms of quantity. The effect of such waste is to reduce quantity of output and to calculate the cost per unit of output. The cost of normal waste is recovered from the good output because its the principle of costing that all normal expense\Loss which are necessarily to be incurred should be included in the cost of production. Example Suppose Units Amount Total cost of input(Labor, material) 2000 13300 Less: normal waste @ 5% 100 Cost of normal output 1900 13300 Cost per unit = 13300/1900=Rs.7 Control should be exercised over the quantum of waste. For example, 100Kg of material is purchased at a price of Rs.2 per Kg. Normal wastage is 10%. The actual quantity available will be 90 Kg. In this case issue price of material will be taken as 2.22 per Kg( 200/90).

ABNORMAL WASTAGE: Any loss caused by unexpected or abnormal condition such as sub-standard materials, carelessness, defective storage, defective workmanship, obsolescence due to irregular issues accident etc or loss in access of margin anticipated for normal process loss should be regarded as abnormal waste. The value of abnormal waste is calculated with the following formula Value of Abnormal waste =Normal cost of normal output _______________________ X AB units Normal output Suppose Units Amount Total cost of input 2000 13300 Less: Normal waste@ 5% 100 ______________ Cost of normal output 1900 13300 Less: Value of abnormal waste 50 350* ______________ Cost of output 1850 12950 * 13300\1900X 50= 350

All the cases of abnormal waste should be thoroughly investigated and steps should be taken to prevent their recurrence in future. Responsibility should be fixed on purchasing, storage , production and inspection departments to maintain standards. Abnormal loss should be transferred to costing profit and loss account and not to be added to cost of production. SCRAP Scrap is defined as discarded material having some value. It is the residue incidentally obtained from manufacturing processes It is of small Value Normally such value is recoverable without further processing Example: metals form stamping operation, chipping of wood, offcut of sheet metals, saw dust and trimming of timber. Material loss of the nature of scrap is quite normal in engineering industries, where operation like drilling, boring, turning etc are carried on.

Scrap is further classified as 1. LEGITIMATE SCRAP: This represent scrap which can be predetermined in advance due to experience of manufacturing operations. It arises due to nature of operation such as turning, boring, punching on metal etc 2. ADMINISTRATIVE SCRAP: It arises due to change in administrative action such as , change in method of production 3. DEFECTIVE SCRAP: It arises due to use of inferior quality of material or bad workmanship or defective machines. Such scrap is abnormal because it arises due to abnormal reasons. ACCOUNTING TREATMENT A. When scarp is sold: (i) Treatment by neglect: This treatment is applicable when scrap is of very little value, market is uncertain and is treated as income in profit and loss statement. This method is not suitable for control of scrap as detailed record of scrap is not kept and scrap cost is not shown as element of cost in cost sheet. (ii) Credited to job or work-in-progress account: If the value of scrap is significant and the quantity varies from job to job, the sale value of scrap is credited to job account. It assume here that scrap is identifiable to each job.

(iii) Credited to manufacturing overhead: When the scrap cannot be identified with the individual job, sale of scrap is credited to manufacturing overhead account. The effect of this credit is to reduce the overhead recovery rate. (iv) Incase of abnormal scrap: When actual scrap is in excess of the pre-determined quantity( normal quantity), the cost of excess scrap is transferred to costing profit and loss account after deducting there from the sale proceeds of such excess scrap. B. When Scrap is reprocessed: The scrap can be reprocessed into useful material for subsequent production of basic products. For example, the scrap materials from sheets of metal from which parts have be stamped may be melted and again formed into sheets from which more units may be stamped. If the scrap is used for reprocessing, the most recent acquisition price is considered to be appropriate basis for passing entry. CONTROL OF SCRAP: Designing stage Selection of right material and equipments Selection of skilled personnel Determination of acceptable limit Scrap report

DEFECTIVES Defective units are those which do not meet quality standards and are reworked for rectification of defects by application of material , labor, and salvaged to the point of either standard product or sub-standard product to be sold as seconds. Defective are that portion which can be rectified at some extra cost of re-operation. Defective may arise due to -Sub-standard material -Poor workmanship -Poor maintenance of machines -Wrong tool setting -Faulty design of products -Bad supervision -Careless inspection -Poor working condition Rectification of defective is advisable only when the cost of rectification is low and more profitable than to sell as defective unit

Defective may be classified as Defective work, which require additional labor, material and additional use of factory service to be brought back to the stage of standard production or second Defective finished goods, i.e., finished goods which have been in stock for long and have become defective. Defective production returned by customer for not being up to specification or sample.

ACCOUNTING TREATEMENT (i) Treatment of Neglect: When defective work has a nominal value, the loss is completely absorbed by good units. For example , if 20000 Kg are poured in foundry at cost of Rs 10000 and on examination 1000 kg are found to be defective, the unit cost would be 10000/19000= Rs .526 per Kg (ii) If the defective work is identified with specific job or department, the cost of rectification is charged to specific job or department. (iii)If the defective work is not identified with particular job or department, the cost of rectification is added to factory overhead. (iv)If defective production is due to abnormal reason, the rectification cost is transferred to costing profit and loss account.

DEPRECIATION
Depreciation is a permanent, continuing shrinkage in the book value of the fixed asset. and gradual

It is charged on fixed assets only It is nothing to do with market value of asset It is charged on permanent basis Once depreciation is charged, it reduces the value of fixed asset

CAUSES OF DEPRECIATION Physical depreciation: It is caused by wear and tear when the asset is in use and from erosion , rust , rot and decay from being exposed to wind, rain, sun and other element of nature

Economic Factors: These factors are those which causes asset to become out of use even though it is in good condition such as Obsolescence and inadequacy. Time Factor: There are certain asset with fixed period of life such as lease, patents and copyrights. Depletion: Some assets are of wasting character perhaps due to the extraction of raw material from them. E.g., Natural resources such as mines, quarries and oil wells. Accident: Asset may reduce in value due to meeting of an accident.
DEPRECIATION ACCOUNTING

Depreciation Accounting is system of accounting which aims to distribute the cost of asset less salvage , over the estimated useful life of the unit in a systematic and rational manner.

NEED FOR PROVIDING DEPRECIATION To know the correct profits To show the true financial position To make provision for replacement of asset Following basic factors are taken while calculating amount of depreciation 1. The total cost of asset including all freight, insurance and installation charges 2. The scrap value of asset 3. Estimated number of years of its usefulness. METHODS OF DEPRICATION Fixed instalment method Diminishing Balance method

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