Cost Accounting - Material Costing (EOQ and Stock Levels)

 

Cost Accounting - Material Costing

Economic order quantity (EOQ) and

Stock Levels

 

Part A: Discussion of basic theories including various relevant formulas and tables.

Part B: Four Illustrations with solutions.

Part A

Introduction

The term materials include physical commodities used to make the final end-product. The raw materials make up an important part of cost of manufacturing in many cases. Therefore, proper planning and control of material cost is one of the most important functions of cost accounting. Material control refers to the management activities which ensure that required quantity and quality of materials are available at proper time with the objective of minimising the material cost per unit.

 

Direct and indirect material

Direct materials are those materials which can be identified or readily traced with the products or production departments. Direct materials include:

(a)          Materials specifically required for a process, a job order or a production order;

(b)          Materials transferred from one process to another process;

(c)          Requisition charges such as carriage inwards, freight inwards, import duties, octroi duties, insurance on incoming materials, etc.; and

(d)          Primary packing materials.

Indirect materials are the materials of minor importance. These materials are not directly traceable to finished products. Examples of indirect materials are oil, grease, and cleaning materials for janitors (i.e. caretakers).

 

Economic order quantity (EOQ)

EOQ is the purchase order size which takes into account the optimum combination of stock holding costs (also referred to as the inventory carrying costs) and costs of placing a purchase order (also referred to as the ordering costs) and which minimises the total material costs as well as the material costs per unit of output.

 

The major components of inventory carrying cost are:

(1)     The cost of money invested in the stocks (i.e. interest costs);

(2)  The cost incurred on the physical storage facilities such as rent of the storage space, cost of maintenance and handling of materials, etc;

(3)     Salaries to stores personnel;

(4) Losses in stores due to pilferage, wastage, evaporation, breakage, etc.

The major components of ordering cost are:

(1)     The cost of typing and printing the purchase order;

(2)     The cost of mailing the purchase order;

(3)     Transportation cost for incoming materials, etc.

 

Methods for determining the EOQ

1.  EOQ by algebraic formula

EOQ =

(2RCo/Ci) ^ (½)

 

 Where,

R =	Average / Normal rate of consumption per annum
Co =	Ordering cost per order
Ci =	Inventory carrying cost per unit per annum = Purchase price p.u. × Carrying cost %-age p.a.

 

Important notes:

(i)    If purchase orders are placed for EOQs, the total ordering cost p.a. shall be equal to the total carrying cost p.a.

(ii)    Assumptions in regard to the calculation of EOQ are:

(a)          There is a known stock-holding cost,

(b)          There is a known constant ordering cost per order,

(c)          Price per unit of material is constant and known,

(d)          Rate of consumption is fixed and known, and

(e)          Replenishment of materials is made instantaneously.

 

2.  EOQ by table

Sl. No.	Particulars	Order Sizes (Q)
1	Price p.u. (P) (Rs)
2	No. of orders (R÷Q)
3	Average inventory (Q÷2)
4	Co (Rs)
5	Ci (Rs)
6	Ordering cost (Rs) [2 × 4]
7	Inventory carrying cost (Rs) [3 × 5]
8	Total Purchase price (P×R) (Rs)
9	Total material cost (Rs) [6 + 7 + 8]

 

  Where,

No. of orders	Annual consumption ÷ Order size
Average inventory	½ of order size
Ordering cost	No. of orders x Co
Inventory carrying cost	Average inventory x Ci
Total purchase price	Purchase price per unit x Annual consumption
Total material cost	Ordering cost + Inventory carrying cost + Total purchase price

 

Important notes:

(1) The order size, against which the total material cost is the minimum, is the EOQ.

(2)    Number of orders can be in fractional figure as per the going concern concept.

(3)  If the purchase price per unit varies as the order size, EOQ can be calculated only by table. In   other words, EOQ can be calculated by algebraic formula, only when the purchase price per unit is      fixed or constant.

(4)  Total of ordering cost and carrying cost per annum (when the order size is EOQ as calculated by the algebraic formula)

= (2RC_oC_i) ^ (½)

(5)    Total Material Cost (TMC)

=  Total Ordering Cost + Total Inventory Carrying Cost + Total   Purchase Price

=  [(R ÷ Order Size) × C_o] + [(Order Size ÷ 2) × C_i] + [R × Price p.u.]

 

Stock Levels

An important function of a storekeeper is to requisition the store items (materials, spares, parts, tools, etc.) for replenishment. Following stock levels have to be kept in view by the storekeeper at the time of requisitioning the store items.

 

1.        Maximum stock level

Maximum stock level represents the upper limit beyond which the quantity of any item is not    normally allowed to rise. The main object of establishing this limit is to ensure that unnecessary working capital is not blocked in stores.

Maximum stock level = P + Q − R_min x L_min

 

2.        Minimum stock level

Minimum stock level represents the lower limit below which the stock of any item should not normally be allowed to fall. The main object of determining this limit is to protect against stockout of a particular item of stock. [Stockout is a situation when demand for an item of stock is greater    than its current inventory level.]

Minimum stock level = P − R_avg x L_avg

 

3.        Reorder level

Reorder level is fixed between the minimum and maximum stock levels. When stock of a material reaches at this point, the storekeeper should initiate action for the purchase of material.

Reorder level (P) = R_max x L_max

                      OR ALTERNATIVELY

Reorder level (P) = Safety stock + Normal lead time consumption = Safety stock + R_avg x L_avg

4.        Average stock level

Average stock level = ½ (Minimum stock level + Maximum stock level)

                      OR ALTERNATIVELY

Average stock level = Minimum stock level

+ ½ (Reorder quantity)

 

5.        Danger level

Danger level = R_avg x Lead time for emergency purchases

 

6.        Safety stock

Safety stock = (Annual demand ÷ 365) x (L_max – L_avg)

 

  Where,

1	Lmax =	Maximum lead time (days, months, etc.)
2	Lavg =	Average lead time (days, months, etc.)
3	Lmin =	Minimum lead time (days, months, etc.)
4	Rmax =	Maximum rate of consumption per lead time unit
5	Ravg =	Average rate of consumption per lead time unit
6	Rmin =	Minimum rate of consumption per lead time unit
7	Q =	Reordering quantity (i.e. reordering size)
8	Lead time =	Time or duration elapsed from the date of placement of order to the date of receipt of store items

 

 Part B

Illustration: 1

A company manufactures a special product which requires a component ‘Alpha’. The following particulars are collected for the year 2021.

1	Annual demand of Alpha	8,000 units
2	Cost of placing an order	Rs 200 per order
3	Cost per unit of Alpha	Rs 400
4	Carrying cost % p.a.	20%

 

The company has been offered a quantity discount of 4% on the purchase of ‘Alpha’ provided the order size is 4,000 components.

Required:

(a)          Compute the economic order quantity.

(b)  Advise whether the quantity discount offer can be accepted.

 

Solution: 1

Illustration: 2

From the following particulars with respect to a particular item of materials of a manufacturing company, calculate the best quantity to order:

Ordering quantities (tonnes)	Price per tonne (Rs)
Less than 250	6.00
250 but less than 800	5.90
800 but less than 2,000	5.80
2,000 but less than 4,000	5.70
4,000 and above	5.60

 

The annual demand for the material is 4,000 tonnes. Stock holding costs are 20% of material cost p.a. The delivery cost per order is Rs 6.00.

 

Solution: 2

Illustration: 3

 From the details given below, calculate:

(i)               Re-ordering level

(ii)            Maximum level

(iii)           Minimum level

(iv)         Danger level

 

Re-ordering quantity is to be calculated on the basis of following information:

(a)          Cost of placing a purchase order is Rs 20;

(b)          Number of units to be purchased during the year is 5,000;

(c)          Purchase price per unit including transportation cost is Rs 50;

(d)          Annual cost of storage per units is Rs 5;

(e)          Details of lead time: Average 10 days, Maximum 15 days, Minimum 6 days. For emergency purchases 4 days;

(f)    Rate of consumption: Average: 15 units per day, Maximum: 20 units per day.

 

Solution: 3

Illustration: 4

M/s Tubes Ltd. is the manufacturers of picture tubes for T.V. The following are the details of their operation during the year 2021:

Average monthly market demand	2,000 Tubes
Ordering cost	Rs 100 per order
Inventory carrying cost	20% per annum
Cost of tubes	Rs 500 per tube
Normal usage	100 tubes per week
Minimum usage	50 tubes per week
Maximum usage	200 tubes per week
Lead time to supply	6 – 8 weeks

 

Compute from the above:

(a)         Economic order quantity. If the supplier is willing to supply quarterly 1,500 units at a discount of 5% is it worth accepting?

(b)                   Re-order level

(c)                    Minimum level of stock

(d)                   Maximum level of stock

Solution: 4