Chapter 2 - Materials Costs

Question 1

Types of materials inventory

Answer 1

Materials inventory is the cost of:

Raw materials and components bought for use by a manufacturing business

Products bought for resale by a shop or wholesaler

Service of consumable items such as stationery bought for use

Question 2

Planning of purchases and control of materials

Answer 2

Planning for the purchase of materials and the control of materials inventory is critical to the efficiency of a business.

However, holding materials is expensive:

They have to be financed, possibly by using borrowed money

There are storage costs, including rent and rates, security, insurance

Question 3

Conflicts on a businesses policy with materials

Answer 3

The finance department will want to minimise materials inventory levels to keep costs as low as possible

The production and marketing departments will want to keep materials inventory high so that output can be maintained and new orders satisfied before customers decide to buy elsewhere.

Question 4

Perpetual inventory

Answer 4

This system records receipt and issue of inventory as the items pass in and out of the business and reorders are made accordingly. Inventory records are often kept digitally by computer, activated by the reading of bar codes. Many supermarkets work on this basis.

Question 5

Just in time

Answer 5

A method favoured by manufacturing businesses where supplies of components are delivered to the production line just as they are needed. For JIT to operate effectively, quality suppliers are needed who can be contracted to deliver goods in accordance with manufacturing schedules. In this way inventory levels are kept very low.

Question 6

Formulas

Answer 6

Businesses need to calculate when to order inventory and how much to order. Formulas can be used to help with this.

Question 7

Fixed quantity method

Answer 7

Using the fixed quantity method of reordering, materials are ordered in set amounts. For this system to operate the business should know:

The maximum inventory level

The buffer inventory level

The lead time - How long it takes for new inventory to be delivered after being ordered

The reorder level

The appropriate reorder quantity- including the maximum reorder quantity and the minimum reorder quantity

Question 8

Buffer inventory

Answer 8

Buffer inventory = Reorder level - (average usage* x average lead time)

This is the minimum inventory level to be held in order to meet unexpected emergencies. This is set by the purchasing/ procurement department.

Question 9

Reorder level

Answer 9

Reorder level = (average usage x average lead time) + buffer inventory

The reorder level is calculated so that replacement materials are delivered just as the inventory falls to the level of the buffer inventory.

Question 10

Maximum inventory level

Answer 10

Maximum inventory level = buffer inventory + maximum reorder quantity

The maximum inventory level is the highest level that the business wishes to hold. This could be because of storage space, cost of funding the inventory or business practice.

Question 11

Maximum reorder quantity

Answer 11

Maximum reorder quantity = maximum inventory level - buffer inventory

Maximum reorder quantity will when received restore inventory to the maximum level.

Question 12

Minimum reorder quantity

Answer 12

Minimum reorder quantity = average usage x average lead time

Minimum reorder quantity will, when received, restore inventory to the reorder level which also means a further order will have to be placed.

Question 13

Economic order quantity

Answer 13

This can be calculated by a mathematical formula which involves:

Ordering cost - The administration cost of placing each order. E.g stationery, postage, wages, telephone and bank charges.

Inventory holding cost - The cost of keeping the inventory on the shelves expressed as the cost of holding one unit of inventory per year. E.g rent and rates, insurance, wages, obsolescence and security.

Annual usage - The number of inventory units used per year.

Formula: square root of 2 x annual usage x ordering cost / inventory holding cost.

EOQ represents the most efficient level of order to place because it minimises the total cost of ordering and storage.

Once the EOQ has been calculated, it is used as the quantity of inventory to be ordered each time an order is placed.

Question 14

Inventory records

Answer 14

Most businesses will have records of their inventories. A separate record under both computer and manual is maintained for each type of inventory. The system is used whether the materials are held for resale or used in production. When supplies of the material are received they are entered in the inventory record and when items are sold they are shown as issues on the inventory record.

Question 15

Valuation of inventory

Answer 15

At the end of the financial year it is essential to value the inventory for use in the calculation of profit in financial statements. Counting inventory which is a physical check of the inventory held is compared with the inventory records.

The inventory held is then valued as follows:

Number of items held x cost per item = inventory value at cost

Inventory can be valued at either:

What it cost the business to buy or the net realisable value which is the actual/ estimated selling price

Inventory valuation is normally at the lower of cost and net realisable value

Question 16

Issuing of materials and goods

Answer 16

The costing process requires that a value is given to materials and goods even they if are issued.

The cost of the materials or goods at the time of issue is normally the purchase cost which is the price paid by the supplier. Purchase costs do vary so the two most commonly used methods for deciding which cost to use are either FIFO or AVCO.

Question 17

FIFO

Answer 17

First in first out is a method where the first cost prices are used first when goods are issued from stores. This means that the remaining inventory is valued at the most recent cost prices.

Question 18

AVCO

Answer 18

In this method, a weighted average cost is calculated for the inventory held at a given time using the formula:

Total cost of inventory held/ number of items held

The weighted average cost is then to attach a value to issues from stores.

A new weighted average must be calculated each time that further purchases are made.

Question 19

Comparison of FIFO and AVCO

Answer 19

Method - FIFO works on a bases that the costs used for goods sold or issued follow the order in which the goods were received. Where as with AVCO the costs do not relate to any particular batch of goods received, but uses a weighted average cost.

Calculation - It is easy to calculate costs because they relate to specific receipts. Where as it is more complex with AVCO.

Inventory valuation - Inventory valuations are based on the most recent costs of materials or goods received for FIFO. For AVCO weighted average costs are used to value closing inventory.