CHAPTER 3 ACCOUNTING FOR MATERIALS Flashcards
what are the principle reasons a company needs inventory
In a manufacturing business inventory (materials) may be the largest item of cost. The principal reasons why a business needs inventory are as follows:
- It acts as a buffer in times when there is an unusually high rate of consumption.
- It enables the business to take advantage of quantity discounts by buying in bulk.
- The business can take advantage of seasonal and other price fluctuations (e.g. an end of season sale).
- Any delay in production caused by lack of parts is kept to a minimum, so production processes will flow smoothly and efficiently.
- It may be necessary to hold inventory for a technical reason, for example, some food items need to ‘mature’.
how does a company use internal controls ensure the inventory purchased is suitable for its purpose
It is essential that the material purchased is the most suitable for the intended purpose.
- When material is required it must be ordered, received by the stores department, recorded, issued to the manufacturing department that requires it and eventually paid for. This process needs a great deal of paperwork and strict internal controls.
- Internal control consists of full documentation and appropriate authorisation of all transactions, movements of materials and of all requisitions, orders, receipts and payments.
- If control is to be maintained over purchasing, it is necessary to ensure that:
o only necessary items are purchased
o orders are placed with the most appropriate supplier after considering price and delivery details
o the goods that are actually received are the goods that were ordered and in the correct quantity/quality
o the price paid for the goods is correct (i.e. what was agreed when the order was placed).
- To ensure that all of this takes place requires a reliable system of checking and control.
what are the procedures for ordering, purchasing and receiving materials
The procedures for ordering, purchasing and receiving materials are as follows:
- Goods or Materials requisition notes are issued by production departments. Their purpose is to authorise the storekeeper to release the goods which have been requisitioned. They may be used to update the stores records if the material is available for instant release.
- A purchase requisition is completed by the stores department (including authorisation by the relevant manager) and sent to the purchasing department.
- On receipt of a properly authorised requisition, the purchasing department will select a supplier and create an order on a purchase order form.
- The purchase order form is sent to the supplier and copies are also sent to the accounts department and the stores department.
- On receipt of the goods, the stores department will check the goods against the relevant purchase order, and check the delivery note which accompanies the goods. Full details of the goods are then entered onto a goods received note (GRN).
- A copy of the GRN is attached to the relevant purchase order and they are both sent to the purchasing department where they are matched to the relevant supplier’s purchase invoice. Once approved, the purchase invoice can be paid.
what other documentation might a business encounter in the process of purchasing stock
Other documentation a business may encounter include:
- Materials returned notes used to record any unused materials which are returned to stores.
- Materials transfer notes document the transfer of materials from one production department to another.
- Goods returned notes used to detail what is being returned to the supplier. The goods may be damaged or not as ordered.
- Credit notes are received if goods have been returned to the supplier or there is a fault with the invoice.
what are the costs of carrying inventory
Irrespective of the nature of the business, a certain amount of inventory will need to be held.
However, holding inventory costs money and the principal ‘trade-off’ in an inventory holding situation is between the costs of acquiring and storing inventory and the level of service that the company wishes to provide.
The total cost of having inventory consists of the following:
- Purchase price
- Holding costs:
o the opportunity cost of capital tied up
o insurance
o deterioration
o obsolescence
o damage and pilferage
o warehouse upkeep
o stores labour and administration costs.
- Ordering costs:
o clerical and administrative costs – the total administrative costs of placing orders will increase in proportion to the number of orders placed. They therefore exhibit the behaviour of variable costs.
o transport costs.
- Stock-out costs (items of required inventory are not available):
o loss of sales
o long-term damage to the business through loss of goodwill
o production stoppages caused by a shortage of raw materials
o extra costs caused by the need for emergency orders.
- Inventory recording systems costs:
o maintaining the stores record card.
what are he costs of holding inventory
Holding costs can be distinguished between fixed holding costs and variable holding costs:
- Fixed holding costs include the cost of storage space and the cost of insurance. Note that the cost of storage space may be a stepped fixed cost if increased warehousing is needed when higher volumes of inventory are held.
- Variable holding costs include interest on capital tied up in inventory. The more inventory that is held, the more capital that is tied up.
how can holding inventory costs be calculated
Holding costs can be calculated as follows
- Total annual holding cost = holding cost per unit of inventory (Ch) × average inventory (Q/2).
- Where average inventory held is equal to half of the order quantity Q.
what are the costs of ordering inventory and how can it be calculated
Costs of ordering inventory
Ordering costs can be calculated as follows:
- Total annual ordering cost = cost of placing an order (Co) × number of orders (D/Q).
- Where the number of orders in a year is expected annual demand D divided by the order quantity Q.
how do you calculate he total annual cost of inventory
Total annual cost of inventory
- The Total Annual Costs (TAC) is the total of purchasing costs P multiplied by annual demand D plus total ordering costs (Co × D/Q) and total holding costs (Ch × Q/2):
- Total annual cost = PD + (Co × D/Q) + (Ch × Q/2)
costs of carrying buffer inventory
- Buffer or safety inventory allows you to meet unpredictable peaks in demand, and it allows you to protect your customers from production breakdowns, supplier failures, or delays in deliveries from suppliers. It can also reduce the cost of purchasing as inventory levels should never get to a critical level.
- However, buffer inventory ties up cash that could be better invested in other parts of the business. It costs money in terms of the opportunity cost (what else the cash could be being used for), the cost to insure the inventory, the cost to store the product, and the cost of theft or damage.
- Buffer inventory could also end up being a huge liability if the demand falls or the product becomes obsolete before you can use the inventory.
disadvantages of low inventory levels
- To keep the holding costs low it may be possible to reduce the volume of inventory that is kept but this can cause some problems:
- Customer demand cannot always be satisfied; this may lead to loss of business if customers become dissatisfied.
- In order to fulfil commitments to important customers, costly emergency procedures (e.g. special production runs) may become necessary in an attempt to maintain customer goodwill.
- It will be necessary to place replenishment orders more frequently than if higher inventories were held, in order to maintain a reasonable service. This will result in higher ordering costs being incurred.
disadvantages of high inventory levels
- To reduce the problems mentioned above management may consider holding high levels of inventory but again this can have issues:
- Storage or holding costs are very high; such costs will usually include rates, rent, labour, heating, deterioration, etc.
- The cost of the capital tied up in inventories, i.e. the cash spent to buy the inventory is not available to pay other bills.
- If the stored product becomes obsolete, a large inventory holding of that item could, at worst, represent a large capital investment in an unsaleable product whose cash value is only that of scrap.
- If a great deal of capital is invested in inventory, there will be proportionately less money available for other requirements such as improvement of existing production facilities, or the introduction of new products.
- When a high inventory level of a raw material is held, a sudden drop in the market price of that material represents a cash loss to the business for having bought at the higher price. It follows that it would seem sensible to hold higher inventories during an inflationary period and lower inventories during a period of deflation.
what is the reorder level and how is it calculated
Reorder level
- The reorder level is the quantity of inventory in hand when a replenishment order should be placed. It is calculated with reference to the time it will take to receive the order (the lead time) and the possible requirements during that time.
- If the demand in the lead time is constant, the reorder level is calculated as follows:
- Reorder level = Maximum usage × Maximum lead time
what is the economic order quantity (EOQ) and how is it calculated
- The EOQ is the reorder quantity which minimises the total costs associated with holding and ordering inventory (i.e. holding costs + ordering costs) are at a minimum.
- We can estimate the EOQ graphically by plotting holding costs, ordering costs and total costs against different levels of re-order quantities.
EOQ formula
The formula for the EOQ (or Q) is as follows:
Q = EOQ = square root of 2Co D/Ch
Where:
D = Demand per annum
Co = Cost of placing one order
Ch = Cost of holding one unit for one year
Note that the formula for the EOQ is provided in your exam. You must make sure that you know what the different symbols represent so that you can use the formula correctly.
what are the assumptions in the EOQ formula
EOQ assumptions
There are a number of important assumptions related to the EOQ that you should note:
Demand and lead time are constant and known
Purchase price is constant
No buffer inventory is held.
