Essentials of Cost Accounting — Module 2

1. Accounting and: Control of Material Cost: Procurement & Storage Architecture In manufacturing organizations, Material Cost represents the single largest element of total product cost, frequently accounting for 50% to 70% of total manufacturing expenditure. Consequently, even a fractional percentage reduction in material waste or procurement price translates into a substantial increase in corporate operating profitability. 1.1 Direct Materials vs. Indirect Materials
2. Direct: Materials (Prime Cost) Materials that enter directly into the production process and become an identifiable, integral part of the finished good.

Can be easily and directly charged to specific cost units (e.g., leather in shoes, crude oil in petrol, steel bars in building construction).

1. Indirect: Materials (Factory Overheads) Materials used to facilitate the manufacturing process or maintain plant equipment, but which cannot be conveniently identified with a specific unit.

Apportioned to production via factory overhead absorption (e.g., lubricating oils, cotton rags, small screws, coolant chemicals). 1.2 The Material Procurement & Receiving Cycle To eliminate unauthorized purchasing and fraud, materials follow a disciplined 5-stage documentation pipeline:

1. Purchase: Requisition: Initiated by the Storekeeper or Department Head notifying the Purchasing Officer that stock has touched the Re-Order Level.
2. Request for: Quotation (RFQ) & Supplier Selection: Tenders invited from approved vendors; evaluated based on price, quality certifications, and delivery lead time.
3. Purchase: Order (PO): The legal contract sent to the selected vendor specifying item descriptions, quantities, unit prices, delivery schedule, and credit terms.
4. Goods: Received Note (GRN): Prepared by the Receiving Section upon physical arrival of goods, verifying quantity against delivery challan.
5. Inspection: Report & Bill Verification: Quality control tests raw material integrity before sending the approved invoice to the Accounts Department for payment. 1.3 Storage & Inventory Records: Bin Card vs. Stores Ledger Analytical Parameter Bin Card Stores Ledger
6. Maintained: By Storekeeper inside the physical factory warehouse.

Cost Accounting Department in the administrative office.

1. Nature of: Data Records Quantitative Quantities Only (Receipts, Issues, and Balance in kg/units).

Records Both Quantities and Monetary Values (Price, Cost of Issues, Value of Closing Stock).

1. Physical: Location Attached physically to the specific storage bin, rack, or shelf holding the material.

Maintained as loose-leaf ledger sheets or in the enterprise ERP database.

1. Recording: Timing Recorded instantly upon physical movement of materials.

Recorded after documentation arrives from stores (slight time lag).

1. Reconciliation: Value Acts as the physical verification baseline for perpetual inventory checks.

Forms the official accounting record for financial balance sheet inventory valuation. 1.4 Physical Storage Control: Two-Bin & Three-Bin Systems

1. The: Two-Bin System (Visual Control) Active Bin (Bin 1): Holds operating stock consumed for daily factory operations.

Reserve Bin (Bin 2): Holds safety stock equal to Re-Order Level. The moment Bin 1 is empty and Bin 2 is opened, a purchase requisition is automatically triggered.

1. Automated: Storage & Retrieval Systems (ASRS) Computer-controlled robotic cranes that deposit and retrieve materials from highdensity vertical racks, integrated directly with ERP barcode and RFID scanners for real-time inventory tracking.
2. Quantitative: Inventory Control Techniques & Stock Level Engineering Inventory Control is the systematic operational technique of maintaining stock levels such that uninterrupted manufacturing is guaranteed while minimizing working capital lock-in and carrying costs. 2.1 Scientific Stock Level Formulations To prevent the dual hazards of Overstocking (capital blockage, deterioration) and Understocking (factory shutdowns, lost sales), cost accountants compute five mathematical stock control levels:

• MATHEMATICAL FORMULAS: INVENTORY STOCK LEVELS CAS-6 Stock Control Engineering

1. Re-O rder: Lev el (RO L) = Maximum Co nsumptio n × Maximum Lead T ime
2. Minimum: Lev el = RO L − [ No rmal Co nsumptio n × No rmal Lead T ime ]
3. Maximum: Lev el = RO L + RO Q − [ Minimum Co nsumptio n × Minimum Lead T ime ]
4. Av erage: Sto c k Lev el = Minimum Lev el + ½ [ Re-O rder Q uantity (RO Q ) ]
5. D anger: Lev el = No rmal / Av erage Co nsumptio n × E mergenc y Lead T ime ∑ Worked Illustration: Comprehensive Stock Level Determination Operating Factory Data:

• Normal Consumption = 300 units/day | Maximum = 450 units/day | Minimum = 150 units/day.
• Lead Time to Procure: Normal = 5 days | Maximum = 8 days | Minimum = 3 days | Emergency = 2 days.
• Re-Order Quantity (ROQ / EOQ) = 2,000 units. Step 1: Re-Order Level (ROL) = 450 × 8 = 3,600 units.

Step 2: Minimum Stock Level = 3,600 − [ 300 × 5 ] = 3,600 − 1,500 = 2,100 units.

Step 3: Maximum Stock Level = 3,600 + 2,000 − [ 150 × 3 ] = 5,600 − 450 = 5,150 units.

Step 4: Average Stock Level = 2,100 + ½(2,000) = 2,100 + 1,000 = 3,100 units.

Step 5: Danger Level = 300 × 2 = 600 units (Emergency purchase initiated immediately if stock breaches 600 units). 2.2 Economic Order Quantity (EOQ) Mathematical Optimization The Economic Order Quantity (EOQ) (developed by Ford W. Harris) represents the optimal order size that minimizes total annual inventory costs by balancing two opposing cost forces: Ordering Costs and Carrying Costs.

• MATHEMATICAL FORMULA: ECONOMIC ORDER QUANTITY (EOQ) Cost Minimization Optimization E O Q = √ [ (2 × A × O ) / C ] Where:

A: Annual Consumption Demand in Units. O: Cost of placing and receiving one order (Ordering Cost per Order).

C: Cost of carrying / storing one unit of inventory for one full year (Carrying Cost per unit per annum). ∑ Worked Illustration: EOQ & Total Inventory Cost Minimization

• Case Data: Annual Consumption ($A$) = 8,000 units | Ordering Cost ($O$) = ₹200 per order | Unit Price = ₹50 | Annual Carrying Cost = 20% of unit price ($C = 50 imes 0.20 = ext{₹10 per unit/year}$).

Step 1: Numerator = $2 imes 8,000 imes 200 = 3,200,000$.

Step 2: Division by Carrying Cost = $3,200,000 / 10 = 320,000$.

Step 3: EOQ = √(320,000) = 565.68 ≈ 566 units per order.

• Number of Orders per Year = $8,000 / 566 approx mathbf{14 ext{ orders per year}}$.

Total Annual Inventory Cost = Total Ordering Cost (14 × ₹200 = ₹2,800) + Total Carrying Cost (½ × 566 × ₹10 = ₹2,830) ≈ ₹5,630. 2.3 Evaluation of Supplier Quantity Discounts

1. Trade-Off: Dynamics Suppliers frequently offer price discounts for bulk orders larger than the EOQ. Accepting the discount lowers total purchase cost and ordering costs, but inflates average inventory carrying cost.
2. Decision: Rule A bulk quantity discount should be accepted only if the Total Annual Savings (Purchase Price Savings + Ordering Cost Savings) exceed the increase in Annual Inventory Carrying Costs. 2.4 Safety Stock (Buffer Stock) & Stockout Risk Management
3. Purpose of: Safety Stock A cushion of extra inventory held to protect against sudden demand surges and vendor lead time delays. Calculated as: Safety Stock = (Max Lead Time − Normal Lead Time) × Normal Consumption Rate.

2. Stockout vs. Carrying Cost Balance Excessive safety stock inflates working capital holding costs; inadequate safety stock leads to catastrophic assembly line shutdowns and lost customer goodwill.

1. Selective: Inventory Control Techniques: ABC, VED, FSN & JIT In large manufacturing plants holding tens of thousands of inventory items, applying equal managerial control across all materials is physically impossible and economically wasteful. Enterprises deploy Selective Inventory Control. 3.1 Master Selective Inventory Control Frameworks Control Technique Classification Basis Operational Categories & Strategic Action
2. ABC: Analysis Annual Consumption Value (Pareto 80/20 Rule).

• Category A (High Value): ~10% items, ~70% total value → Strict daily control, zero safety stock.
• Category B (Moderate): ~20% items, ~20% total value → Moderate periodic control.
• Category C (Low Value): ~70% items, ~10% total value → Simple bulk orders, loose control.

1. VED: Analysis Criticality to Production Continuity (Spare parts).

• Vital (V): Absence halts entire factory → Large buffer stock mandatory.
• Essential (E): Causes moderate operational disruption → Medium buffer stock.
• Desirable (D): Non-critical convenience items → Zero/Minimal buffer.

1. FSN: Analysis Velocity of Inventory Movement / Turnover.

• Fast-Moving (F): Rapid stock depletion → Continuous replenishment.
• Slow-Moving (S): Sluggish consumption → Strict order controls.
• Non-Moving (N): Dead stock → Disposal/liquidation to free working capital.

1. HML: Analysis Unit Purchase Price of Material. • High Price (H) | Medium Price (M) | Low Price (L).

Governs delegation of purchasing authority.

1. SDE: Analysis Market Availability & Sourcing Difficulty.

• Scarce (S): Imported/Monopoly items | Difficult (D): Hard to procure | Easy (E): Readily available. 3.2 Just-In-Time (JIT) Inventory & Kanban Systems
• Just-In-Time (JIT) Philosophy: Pioneered by Toyota (Taiichi Ohno), JIT aims for Zero Inventory by synchronizing material arrival at the factory assembly line exactly when needed in production.
• Kanban Cards: Visual signaling cards that trigger upstream supplier delivery only when a downstream workstation consumes its immediate buffer, eliminating warehouse storage entirely. 3.3 Inventory Turnover Ratio (ITR) & Stock Velocity Diagnostics
• MATHEMATICAL FORMULAS: INVENTORY TURNOVER METRICS Working Capital Efficiency I nv ento ry Turnov er Ratio (I T R) = Co st o f Material Co nsumed ÷ Av erage I nv ento ry Held I nv ento ry Ho lding P erio d (Velo c ity in D ay s) = 365 D ay s ÷ I nv ento ry Turnov er Ratio ∑ Worked Illustration: Inventory Turnover Ratio & Fast/Slow Moving Diagnostics Operating Data for Two Materials:
• Material X: Opening Stock = ₹40,000 | Purchases = ₹3,80,000 | Closing Stock = ₹60,000 → Material Consumed = ₹40,000 + ₹3,80,000 − ₹60,000 = ₹3,60,000 | Average Inventory = (₹40,000 + ₹60,000)/2 = ₹50,000.
• Material Y: Opening Stock = ₹80,000 | Purchases = ₹1,20,000 | Closing Stock = ₹1,00,000 → Material Consumed = ₹80,000 + ₹1,20,000 − ₹1,00,000 = ₹1,00,000 | Average Inventory = (₹80,000 + ₹1,00,000)/2 = ₹90,000.
• Material X: ITR = ₹3,60,000 / ₹50,000 = 7.2 Times → Velocity = 365 / 7.2 = 50.7 Days (Fast-Moving Item).
• Material Y: ITR = ₹1,00,000 / ₹90,000 = 1.11 Times → Velocity = 365 / 1.11 = 328.8 Days (Sluggish / Slow-Moving Item).
• VERDICT: Material Y ties up working capital for nearly an entire year; procurement must be slashed to avoid capital stagnation and obsolescence.

1. Methods of: Pricing Issue of Materials & Stores Ledger Accounting Because raw materials are acquired in distinct lots at fluctuating market purchase prices, cost accountants must determine the price at which materials are issued from the warehouse to production jobs. 4.1 Major Material Issue Pricing Methodologies Issue Pricing Method Operational Mechanism Impact on Cost of Production & Inventory Valuation
2. FIFO (First: In, First Out) Materials issued in the chronological order of receipt; oldest stock prices used first.

• During Inflation: Low historical costs charged to production (high accounting profits); closing inventory valued at current high market price.

1. LIFO (Last: In, First Out) Most recently purchased material lots are issued first to production.

• During Inflation: Current high purchase prices matched with revenue (lowers taxable profit); closing inventory reflects outdated low costs.

1. Simple: Average Method Issue Price = Sum of Unit Prices of all available lots in stock ÷ Total Number of Lots.

Ignores the physical quantity of units in each lot; distorts costs if lot sizes vary widely.

1. Weighted: Average Method Issue Price = Total Value of Material in Stock ÷ Total Quantity of Material in Stock. (Recalculated after every new receipt).

The Universal Global Standard (Ind AS 2 / AS 2): Smooths price fluctuations perfectly; charges true average weighted cost to production. 4.2 Worked Stores Ledger Account: FIFO vs. Weighted Average Illustration

• Transaction Log: Jan 1: Opening Stock 100 units @ ₹10 | Jan 5: Purchased 200 units @ ₹12 | Jan 10: Issued 150 units | Jan 15: Purchased 100 units @ ₹14 | Jan 20: Issued 150 units. ∑ Comparative Stores Ledger Output (FIFO vs. Weighted Average) Method 1: FIFO (First In, First Out) Computations:
• Jan 10 Issue (150 units): (100 units @ ₹10 = ₹1,000) + (50 units @ ₹12 = ₹600) = ₹1,600 Total Issue Cost. (Balance: 150 units @ ₹12 = ₹1,800).
• Jan 20 Issue (150 units): 150 units @ ₹12 = ₹1,800 Total Issue Cost.

FIFO Closing Stock on Jan 20 = 100 units @ ₹14 = ₹1,400. Total Cost of Material Issued = ₹1,600 + ₹1,800 = ₹3,400.

Method 2: Weighted Average Method Computations:

• Jan 10 Issue (150 units): Total Stock Value = ₹1,000 + ₹2,400 = ₹3,400 for 300 units → Rate = ₹3,400 / 300 = ₹11.33/unit → Issue Cost = 150 × ₹11.33 = ₹1,700. (Balance: 150 units @ ₹11.33 = ₹1,700).
• Jan 15 Stock after receipt: ₹1,700 + ₹1,400 = ₹3,100 for 250 units → New Weighted Rate = ₹3,100 / 250 = ₹12.40/unit.
• Jan 20 Issue (150 units): 150 units @ ₹12.40 = ₹1,860 Total Issue Cost.

Weighted Average Closing Stock = 100 units @ ₹12.40 = ₹1,240. Total Cost of Material Issued = ₹1,700 + ₹1,860 = ₹3,560. 4.3 Specialized & Notional Material Issue Pricing Methods Specialized Method Accounting Mechanism Managerial Purpose

1. Base: Stock Method A fixed minimum quantity of stock is carried permanently at historical acquisition cost as a fixed asset; issues beyond base stock follow FIFO or LIFO.

Ensures emergency strategic reserves are never depleted or revalued at inflated prices.

1. Standard: Price Method Materials issued at a predetermined scientific benchmark price; price differences transferred to Material Price Variance Account.

Measures purchasing department efficiency and stabilizes production job costs.

1. Inflated: Price Method Issue rate increased above invoice price to cover unavoidable normal material losses (e.g., timber seasoning shrinkage, evaporation).

Automatically recovers normal material loss costs directly from production.

1. HIFO (Highest: In, First Out) Issues priced at the highest cost lot available in stores, regardless of purchase date.

Ultra-conservative costing; charges maximum cost to production during cost-plus contracts. 4.4 Comparative Synthesis of Material Issue Pricing Methods Economic Condition FIFO Method LIFO Method Weighted Average Method

1. Period of: Rising Prices (Inflation) Low issue cost → High profit → High tax liability.

High issue cost → Lower profit → Tax savings. Averages out price spikes → Smoothed profits.

1. Balance: Sheet Closing Stock Value Valued at current realistic market prices (Accurate).

Valued at outdated, understated historical costs. Valued at weighted representative average cost.

1. Regulatory: Compliance (Ind AS 2 / AS 2) Permitted & Recognized globally.

Strictly Prohibited under IFRS and Ind AS 2. Universally Recommended & Adopted.

1. Inventory: Verification Systems & Accounting Treatment of Material Losses To ensure financial balance sheet integrity and detect pilferage, stores inventory must undergo periodic or continuous physical verification. 5.1 Periodic vs. Perpetual Inventory Systems
2. Periodic: Inventory System Physical stocktaking conducted only at the end of the accounting year. Requires temporary factory closure; errors and store thefts are detected only months after occurrence.
3. Perpetual: Inventory System A continuous recording system comprising Bin Cards and Stores Ledger sheets paired with Continuous Physical Verification. Factory operations never stop; discrepancies are investigated immediately. 5.2 Classification & Accounting Treatment of Material Losses Loss Classification Inherent Technical Nature Accounting Treatment in Cost Accounts
4. Normal: Waste Unavoidable, natural loss arising from evaporation, shrinkage, or chemical cutting.

• Absorbed by Good Production: The cost of normal waste is inflated into the unit cost of good production output.

1. Abnormal: Waste Avoidable loss arising from negligence, machine fires, theft, or substandard handling.

• Excluded from Product Cost: Transferred directly as a loss to the Costing Profit & Loss Account.

1. Scrap: Incidental residue (metal shavings, wood sawdust) having small recovery sales value.

Credited to Factory Overhead or Works Cost: Net sales proceeds deducted from Material Cost or Works Overhead.

1. Spoilage: Damaged goods that cannot be repaired and must be sold as seconds or scrap.

Normal spoilage absorbed into job cost; abnormal spoilage charged to Costing P&L.

1. Defectives: Units with minor flaws that can be economically re-worked into perfect finished goods.

Cost of re-work rectification charged to Factory Overheads or specific job (if customer error). 5.3 Accounting Entries for Material Discrepancies & Losses Nature of Material Event Debit Entry Credit Entry

1. Material: Scrap Realized for Cash Cash / Bank / Debtors Account Factory Overhead Control Account (or Cost of Material Consumed)
2. Abnormal: Material Wastage / Spoilage Costing Profit & Loss Account Stores Ledger Control Account
3. Normal: Material Shrinkage & Evaporation Factory Overhead Control Account Stores Ledger Control Account
4. Re-working: Cost of Normal Defectives Factory Overhead Control Account Wages / Stores / Direct Expense Control Account