Chapter 7 Pages 111 - 118.docx

CHAPTER 7 // MATERIALS 2.3.1 Example: Buying and costing It is Amy Alexander's first day in the costing department and she has been told to calculate the materials cost of job 1234 which has just been completed. No invoice has yet been received for the main material used, which is known as LW32. Amy...

CHAPTER 7 // MATERIALS 2.3.1 Example: Buying and costing It is Amy Alexander's first day in the costing department and she has been told to calculate the materials cost of job 1234 which has just been completed. No invoice has yet been received for the main material used, which is known as LW32. Amy uses her initiative and pops down to the purchasing department to see if they can help. They are rather busy but someone hands her a very well-thumbed catalogue and a thick file of purchase orders, all relating to the supplier of LW32. There are many orders for LW32, one of which has today's date. How should Amy go about costing the LW32 used for job 1234? Solution The quickest thing to do would be to phone up the supplier and ask what price will be charged for the order in question, but there might be good reasons for not doing this (for example not wishing to prompt an earlier invoice than usual!) It seems likely that, in the absence of the actual information, the best way of ascertaininga price for LW32 is to consult the catalogue !assuming it is up to date) _and_ to find the most recent purchase order that has been invoiced. If there Is a discrepancy, previous 1nvo1ces could be looked at to see if they show a price rise since the date of the catalogue. If the price fluctuates widely 1t might be better to calculate an average. As Amy gets to know her way around the system she will learn which are the mostreliable_sou ces of information. Possibly some suppliers make frequent errors on invoices but quote correct unit prices on delivery notes. The moral is to always be on your guard for errors. I QUESTION Materials purchase Drawa flow diagram illustrating the main documents involved in a materials purchase, from its initiation up until the time of delivery. ANSWER Material input requirements Some organisations might need to buy 'extra' materials because wastage may occur as a matter of course in some production processes. Example: Material input requirements 1 kg of Product A is manufactured from 1 kg of Material X in a process where wastage is equivalent to 3% of material input. How many kg of Material X are needed in order to produce 100 kg of Product A? 100 kg of Material X will only produce 97 kg of Product A (and there will be 3 kg of Material X wasted). 100 kg of Material X = (100 - 0.03) x 100 kg Product A = 0.97 x 100 kg of Product A = 97 kg Product A //( Therefore, in order to produce 100 kg of Product A, the company needs to buy 103.09 kg of Material X: lOO kg MaterialX = 103.09 kg Material X 0.97 Material X input Wastage (3% x 103.09 kg) Product A output Kg 103.09 (3.09) 100.00 QUESTION Wastage If JH Co produces 1 unit of Product L from 2 kg of Material W, and wastage equates to 5% of material input, how many kg of Material W should JH Co buy in order to produce 4,000 units of Product L? State your answer to the nearest kg. ANSWER 8,000 kg* = 8,421 kg Material W 4,000 units of Product Lare produced from 0_95* * * Each unit of Product L is made from 2 kg of MaterialW **( 100% - 5% wastage) Summary Material W input 5% wastage (5% x 8,421 kg) Material W processed Kg 8,421 (421) 8,000 If 8,000 kg of Material Ware processed, they will produce 4,000 units of Product L (8,000 kg+ 2 kg = 4,000 units). It is important, therefore, that any wastage is taken into account when calculating material input requirements and hence quantities of materials to be purchased. Wastage and wastage control measures )) : When wastage levels are high they are an avoidable expense. I In the previous example, wastage of materials in production was an expected part of the production process. In some production systems, some wastage cannot be avoided. On the other hand, wastage is an expense, and when wastage levels are unnecessarily high, they are an avoidable expense, reducing profit below what it should be. So what may be the causes of avoidable wastage? The most common causes of avoidable wastage are probably: Inefficiency, carelessness or other mistakes by workers, resulting in rejected items or wasteful usage of materials Badly maintained machinery or other equipment, causing unnecessary waste Poor quality of materials Failure to identify mistakes at an early stage in production and put them right before the wastage becomes excessive Holding materials in poor storage conditions, so that wastage occurs due to damage or deterioration Improved materials usage might be achieved by reducing levels of wastage, where wastage is currently high. CHAPTER 7 // MATERIALS ?,5.1 Wastage control measures Wastage can be measured in a number of ways. Typical measures include: Input wastage. Quantity of materials wasted as a percentage of the quantity of material used. Output wastage. Number of quality rejects as a percentage of total output. Rework. Rework costs as a percentage of production costs. QUESTION Reducing wastage How can wastage be reduced? ANSWER Here are some suggestions. (a} Changing the specifications for cutting solid materials. (b) Introducing new equipment that reduces wastage in processing or handling materials. (c} (d) (e) (f) Identifying poor quality output at an earlier stage in the operational processes. Using better quality materials. Even though more expensive, better quality materials might save costs because they are less likely to tear or might last longer. Better training and supervision of workers, to reduce the frequency of mistakes and inefficiencies in materials handling. Where possible, re-working rejected items of output. )) 1 , 1 Materials issued from inventory can be valued using FIFO, LIFO and weighted average methods. 1 1_ J Just-in-time inventory policy The implicit assumption in the Amy Alexander example above was that materials were bought specifically for individual jobs and therefore that each order could be identified with a particular job. This is possible in practice. Certainly, keeping large quantities of inventory is something to be avoided in the business environment of the new millennium. Holding inventory means that you have to have n somewhere to put it and so it takes up space that could be used for other purposes. Often it means employing somebody to look after it, perhaps 24 hours a day if it is very valuable. Ideally, you should receive an order for so many items of the product in question, buy exactly the right quantity of materials to make that many items and be left with no inventories of finished goods, work in progress or raw materials. This is known as the just-in-time (JIT) approach, that is, the just-in-time purchasing of inventories to meet just-in-time production of goods ordered. From the point of view of costing, there is very little difficulty with the JIT approach. The materials costs of each production run are known because the materials used were bought specially for that run. There was no inventory to start with and there is none left over. Buffer inventory However the approach more common in practice is to keep a certain amount of inventory in reserve to cope with fluctuations in demand and with suppliers who cannot be relied upon to deliver the right ·quality and quantity of materials at the right time. This reserve of inventory is known as buffer inventory ·(or safety inventory). Buffer inventory may also be held when it is more economical to purchase /)3 inventory in greater quantities than required (in order to obtain bulk purchase discounts). The valuation of buffer inventory is one of the most important elements of your studies at this level. Inventory valuation The inventory valuation problem Suppose, for example, that you have 50 litres of a chemical in inventory. You buy 2,000 litres to allow for the next batch of production. Both the opening inventory and the newly-purchased inventory cost $2 per litre. Opening inventory Purchases You actually usel ,600 litres, leaving you with 450 litre_s. You know that each of the 1,600 litres used cost $2' as did each of the 450 litres remaining. There Is no costing problem here.. Now suppose that in the following month you decide to uy 1,300 litres, but have to pay $2.10 per l1tr because you lose a 10c discount if buying under 1,500 litres. Cost Total Opening inventory Purchases Litres 450 1,300 1,750 per litre $ 2.00 2.10 cost $ 900 2,730 3,630 For the next batch of production you use 1,600 litres, as before. What did the 1,600 litres used cost, and what value should you give to the 150 litres remaining in inventory? We need to know the cost of the litres that we have used so that we know how much to charge for the _.,, final product and so that we can compare this cost with the equivalent cost in earlier or future periods. We also need to know the cost of closing inventory both because it will form part of the usage figure in the next period and for financial accounting purposes. Closing inventory is often a significant figure in the financial statements and it appears in both the statement of profit or loss (income statement) and the statement of financial position. We therefore have to use a consistent method of pricing the litres which provides a reasonable approximation of the costs of the inventory. Inventory valuation methods There are a number of different methods of valuing inventory. FIFO - First in, first out This method values issues at the prices of the oldest items in inventory at the time the issues were made. The remaining inventory will thus be valued at the price of the most recent purchases. Say, for example, ABC Co's inventory consisted of four deliveries of raw material in tt last month: Units 1 September 1,000 at $2.00 8 September 500 at $2.50 15 September 500 at $3.00 22 September 1,000 at $3.50 If on 23 September 1,500 units were issued to production, 1,000 of these units would be price at $2 (the cost of the 1,000 oldest units in inventory), and 500 at $2.50 (the cost of the next oldest 500). 1,000 units of closing inventory would be valued at $3.50 (the cost of the 1,000 most recent units received) and 500 units at $3.00 (the cost of the next most recent 500). LIFO - Last in, first out This method is the opposite of FIFO. Issues will be valued at the prices of the most recent purchases; hence inventory remaining will be valued at the cost of the oldest items. In the example above it will be 1,000 units of issues which will be valued at $3.50, and the other 50 111/= CHAPTER 7 // MATERIALS I units issued will be valued at $3.00. 1,000 units of closing inventory will be valued at $2.00, and 500 at $2.50. (cl Weighted average pricing methods There are two main weighted average pricing methods: cumulative and periodic. Cumulative weighted average pricing With this method we calculate an average cost of all the litres in inventory whenever a new delivery is received. Periodic weighted average pricing The periodic weighted average pricing method involves calculating a new inventory value at the end of a given period (rather than whenever new inventory is purchased, as with the cumulative weighted average pricing method). The periodic weighted average pricing method is easier to calculate than the cumulative weighted average method, and therefore requires less effort, but it must be applied retrospectively since the costs of materials used cannot be calculated until the end of the period. (d) Standard cost Under the standard costing method, all issues are at a predetermined standard price. You will study standard costing in more detail if you go on to study for the FMA Management Accounting exam. Example: FIFO, LIFO and weighted average pricing methods The following transactions should be considered in order to demonstrate FIFO, LIFO and weighted average pricing methods. TRANSACTIONS DURING MAY 20X3 Opening balance, 1 May Receipts, 3 May Issues, 4 May Receipts, 9 May Issues, 11 May Receipts, 18 May Issues, 20 May Closing balance, 31 May Market value per unit Quantity Unit cost Total cost on date of transaction Units $ $ $ FIFO FlFO assumes that materials are issued out of inventory in the order in which they were delivered into inventory: issues are priced at the cost of the earliest delivery remaining in inventory. Using FIFO, the cost of issues and the closing inventory value in the example would be as follows. Date of issue Quantity issued Value Units 4 May 200 100 o/s at $2 100 at $2.10 11 May 400 300 at $2.10 100 at $2.12 20 May 100 100 at $2.12 Cost of issues Closing inventory value 200 100 at $2.12 100 at $2.40 $ 200 210 630 212 212 240 $ 410 842 212 1,464 452 l,91 * * The cost of materialsissued plus the value of closing inventory equals the cost of purchases plus the value of opening inventory ($1,916). The market price ofpurchased materials is rising dramatically. In aperiod of inflation, there isa tendency with FIFO formaterials to be issued at a cost lower than the current market value, although closing inventories tend to be valued at a cost approximating to current market value. LIFO LIFO assumes thatmaterials are issued out of inventory in_the reverse order towhich the were delivered: the most recent deliveries are issued before earlier ones, and are priced accordingly. Using LIFO, the cost of issues and the closing inventory value in the example above would be as follows. Quantity Date of issue issued Units Valuation $ $ 4 May 200 200 at $2.10 420 11 May 400 300 at $2.12 636 100 at $2.10 210 846 20 May 100 100 at $2.40 240' Cost of issues 1,506 Closing inventory value 200 100 at $2.10 210 100 at $2.00 200 410 1,916 Notes The cost of materials issued plus the value of closing inventory equals the cost of purchases plus the value of opening inventory ($1,916). In a period f inflation there is a tendency with LIFO for the following to occur. Materials are issued at a price which approximates to current market value. Closing inventories become undervalued when compared to market value. (cl Cumulative weighted average pricing The cumulative weighted average pricing method 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 into store is. received. This is the key feature of cumulative weighted average pricing. CHAPTER 7 // MATERIALS In our example, issue costs and closing inventory values would be as follows. Date Received Issued Balance Total inventory value Unit cost Units Units Units $ $ $ Opening inventory 100 200 2.00 3 May 400 840 2.10 * 500 1,040 2.08 4 May 200 (416) 2.08 416 300 624· 2.08 9 May 300 636 2.12 11 May 400 18 May 100 * 600 200 * 300 20 May 100 Closing inventory value 200 * A new inventory value per unit is calculated whenever a new receipt of materials occurs. Notes 1 The cost of materials issued plus the value of closing inventory equals the cost of purchases plus the value of opening inventory ($1,916). 5 2 In a period of inflation, using the cumulative weighted average pricing system, the value of material issues will rise gradually, but will tend to lag a little behind the current market value at the date of issue. Closing inventory values will also be a little below current market value. (d) Periodic weighted average pricing Under the periodic weighted average pricing method, a retrospective average price is calculated for all materials issued during the period. The average issue price is calculated for our example as follows. Cost of all receipts in the period + Cost of opening inventory Number of units received in the period + Number of units of opening inventory $1,716+$200 800+100 Issue price= $2.129 per unit Closing inventory values are a balancing figure. The issue costs and closing inventory values are calculated as follows. Date of issue Quantity issued Units Valuation $ 4 May 11 May 20 May Cost of issues Value of opening inventory plus purchases Value of 200 units of closing inventory (at $2.129) 200 X $2.129 400 X $2.129 100 X $2.129 426 852 213 1,491 1,91.6 ====.. 117 Which method is correct? This is a trick question, because there is no one correct method. Each method has advantages and disadvantages. The advantages and disadvantages of the FIFO method are as follows. Advantages _ _ _. It isa logical pricing method which probably represents what 1s physically happening: in practice th oldest inventory is likely to be used first. It is easy to understand and explain to managers. The closing inventory value can be near to a valuation based on the cost of replacing the inventory. Disadvantages FIFO can be cumbersome to operate because of the need to identify each batch of material separately. Managers may find it difficult to compare costs and make decisions when they are charged with varying prices for the same materials. The advantages and disadvantages of the LIFO method are as follows. Advantages Inventories are issued at a price which is close to current market value. This is not the case with FIFO when there is a high rate of inflation. Managers are continually aware of recent costs when making decisions, because the costs being charged to their department or products will be current costs. Disadvantages The method can be cumbersome to operate because it sometimes results in several batches being only part-used in the inventory records before another batch is received. LIFO is often the opposite of what is physically happening and can therefore be difficult to explain to managers. As with FIFO, decision making can be difficult because of the variations in prices. The advantages and disadvantages of weighted average pricing are as follows. 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.