Material costing

09/05/2020 1 By indiafreenotes

Material costing is the process of determining the costs at which inventory items are recorded into stock, as well as their subsequent valuation in the accounting records. We deal with these concepts separately.

Material Costing for Initial Inventory Acquisition

A company must decide whether it will record acquired materials at their purchased prices, or if additional costs will be added, such as freight in, sales taxes, and customs duties. The addition of these other costs is allowable, but may require a certain amount of additional work. It is easier to charge these additional costs to expense as incurred, so they appear immediately in the cost of goods sold.

Overhead is not allocated to raw materials, since these items have not undergone any production activities (with which overhead is associated). Overhead is only allocated to work-in-process and finished goods inventory.

Material Costing for Subsequent Valuation

Once inventory has been received into stock, it is subject to the lower of cost or market (LCM) rule. In essence, this rule states that the recorded cost of inventory should be at the lower of its recorded cost or the market rate. From a practical perspective, this rule is usually only applied to those inventory items having the largest extended costs. Its application to low-value items would not result in any material changes, and so is avoided from an efficiency perspective.

A cost layering concept must also be applied to inventory. Cost layering refers to the order in which inventory items are charged to the cost of goods sold when units are sold to customers. Several possible cost layering concepts that can be used are:

  • Specific identification method. Assign costs to specific units of inventory, and charge these costs to expense when the specific units are sold. Usually only applies to expensive and unique inventory items.
  • First in, first out method. Assign costs based on the assumption that the earliest goods acquired are the first ones sold. If prices are increasing, this tends to result in higher profits.
  • Last in, first out method. Assign costs based on the assumption that the last goods acquired are the first ones sold. If prices are increasing, this tends to result in lower profits. This method is not allowed under international financial reporting standards.
  • Weighted average method. Uses an average of the costs of all units in stock when charging costs to the cost of goods sold.

The following are essential for ascertainment of accurate material cost:

(I) Computation of total cost of material purchased.

(II) Systematised material issue procedure.

(III) Appropriate methods of pricing material issues.

(I) Computation of Total Cost of Material Purchased:

Most of the details needed to ascertain the total cost of material purchased can be obtained from the invoice sent by the supplier.

The basic purchase price has to be adjusted in the light of delivery and forwarding charges, sales tax, excise duty, etc. Similarly, transport charges and cost of containers have to be included. Any discounts receivable have to be appropriately subtracted.

(a) Discounts:

There are three types of discounts to be considered:

(i) Trade Discount:

This is a discount allowed by the supplier to compensate the buyer for the costs of ‘breaking bulk’, selling in small lots to customers, repacking, etc. The supplier is relieved from all these costs by the buyer by purchasing a large quantity. This discount is usually given by the wholesalers.

(ii) Quantity Discount or Bulk Discount:

This discount is allowed by the supplier as a measure of savings in cost which arise from the production of longer runs and the distribution of larger quantities. Part of the savings accruing to the supplier out of a large order is passed on to the buyer by means of quantity discount.

(iii) Cash Discount:

This discount is offered by the supplier to the buyer as an option. The discount is linked to payment of the invoice amount before a specified due date or within a specified number of days. The purchaser may make use of the option and obtain the discount if his cash position permits it. Generally, this discount is considered as a matter of ‘financial policy’ and not taken into account for computation of material cost.

(b) Transport and Storage Costs:

If transport cost and cost of storage in transit are not included in the invoiced price of the supplier, they may be added as the direct costs of purchase to the cost of material. If it is not possible to identify such costs with specific materials because of paying a combined amount for several materials, they may be treated as indirect expenditure and included in the overhead.

(c) Cost of Containers:

The supplier may or may not charge separately for containers. If no charges are made, no accounting treatment is required.

(II) Material Issue Procedure:

Materials kept in the stores are to be issued to production departments whenever the departments require them. The store keeper is to issue materials only when a material requisition is presented to him.

(a) Material Requisition:

It is a properly authorised document initiated by the production departments to draw the required material from stores. It has to be initiated by properly authorised person to avoid misappropriation of material.

The requisition serves as authority to the store keeper to issue materials. The store keeper puts serial number on the requisition and makes entries in the issue column of the bin card. After this the requisitions are sent to the cost office where the value of material issued is also filled up and credit is given to the material issued in the stores ledger and the job receiving the material in the job ledger is debited.

(b) Bill of Materials:

It is a document listing all the materials required with quantities required for a particular job, order or process. The bill of material serves the purpose of material requisition. The bill of material is prepared for a job of non standardised type so that estimate of all materials required for the job is made by the production department before the job is started. This is helpful to estimate material cost of the job for submitting tenders or quotations.

Treatment of Surplus Materials:

(a) Return of Surplus Material:

Sometimes, excess materials maybe issued to production departments. When these materials are returned to stores a Material Return Note is to be prepared by the department which has the excess materials. Generally, three copies are prepared. One copy is retained by the department which is returning the material. Two copies are sent to the store keeper. The store keeper keeps one copy for making entries in the Bin card and the second copy is sent to the cost office for making entries in the stores ledger and for giving credit to the job where the material is in excess.

(b) Transfer of Surplus Materials:

Transfer of excess materials from one job to another job is to be avoided as far as possible. This is because record for transfer may not be made and actual material cost of jobs may be inaccurate. However, sometimes the material may be allowed to be transferred to avoid delays and handling charges. The transfer is to be allowed only with preparation of material transfer note so that the cost of material transferred is debited to the job receiving the material and credited to the job transferring the material.

(III) Methods of Pricing Material Issues:

The purchase prices of materials fluctuate on account of changes in the product prices, buying from different suppliers and on account of quantity discounts. Because of price fluctuations, the stock may include several lots of the same material purchased at different prices. When these materials are issued to production, it is important to consider the correct price at which these materials are charged to production.