Chapter 4

ACCOUNTING FOR
MATERIALS
This chapter is the first of several that explain how the elements of cost are calculated
and accounted for. The elements of cost are materials, labour and expenses. These can
be either direct costs or indirect costs. This chapter covers syllabus area B1 (a) to (e).

CONTENTS

1 Direct and indirect materials

2 Procedures and documentation for materials

3 Pricing issues of materials

4 Accounting for materials costs

5 Inventory losses and waste

LEARNING OUTCOMES

At the end of this chapter you should be able to:

• describe the main types of material classification

• describe the procedures and documentation required to ensure the correct

authorisation, coding, analysis and recording of direct and indirect material costs

• explain, illustrate and evaluate the FIFO, LIFO and periodic and cumulative weighted
average methods used to price materials issued from inventory

• describe and illustrate the accounting for material costs

• calculate material input requirements, and control measures, where wastage occurs.

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1 DIRECT AND INDIRECT MATERIALS

In cost accounting, materials are commonly classified as either direct materials or
indirect materials

Definition Direct materials are the materials that can be directly attributed to a
unit of production, or a specific job, or a service provided directly to a
customer.

In a manufacturing business, direct materials are therefore the raw materials and
components that are directly input into the products that the organisation makes. For
example the many different components that make up a motorcar are the direct
materials of the car.

Definition Indirect materials are other materials that cannot be directly

attributed to a unit of production.

An example of indirect materials might be the oil used for the lubrication of production
machinery. This is a material that is used in the production process but it cannot be
directly attributed to each unit of finished product.

In a manufacturing business, the cost of direct materials can be charged directly to

the cost unit that uses the materials. In a jobbing business or a contracting business,
direct materials costs are charged directly to the job or contract for which they are
used.

The costs of indirect materials are charged to the cost centre that requisitions them
from the stores department and uses them.

2 PROCEDURES AND DOCUMENTATION FOR MATERIALS

The stores department is responsible for the receipt, storage and issue of materials
and components.

• Receipt of materials into store. When materials are received from suppliers,
they are normally delivered to the stores department. The stores personnel
must check that the goods delivered are the ones that have been ordered, in
the correct quantity, of the correct quality and in good condition.

• Once the materials have been received they must be stored until required by
user departments.

• Issue of materials from store. When cost centres require materials, they
submit a requisition for the materials to the stores department.

• Recording receipts and issues. Receipts of materials into store and issues of
materials must be controlled and recorded. Oddly perhaps, the responsibility for
recording receipts and issues of materials is divided between the stores
department and the costing department. Each of these departments could
maintain its own separate inventory records, although there should ideally be
one integrated inventory control system. The stores department should monitor
the quantities of materials received and issued, and ensure the safety and
security of the physical inventory. The costing department is responsible for
recording the cost of materials received into stores and for putting a value to the
cost of direct and indirect materials issued from store.

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2.1 PROCEDURES AND DOCUMENTATION FOR RECEIPTS OF MATERIALS

It is useful to have an overview of the departments involved in the purchasing process.

Stores department Notifies the purchasing department of the need to buy

materials, using a purchase requisition/inventory reorder
form.
Purchasing department Orders goods from external supplier using a purchase
order.
External supplier Delivers goods to the stores department. The goods are
accompanied by a delivery note. The external supplier
also sends a purchase invoice to the accounts
department, asking for payment for the goods.
Stores department Raises goods received note (GRN) from the delivery note
details. The goods received note is used to update the
inventory records with the quantities of goods received.
Costing department The costing department records the cost of the materials
received, using the delivery note and the purchase
invoice details.

2.2 PROCEDURES AND DOCUMENTATION FOR THE ISSUE OF MATERIALS

Requests for materials to be issued from stores to a production department or other

department are initiated and then authorised by a materials requisition note. This
document performs two functions: it authorises the storekeeper to release the goods
and acts as a source record for updating the stores records.

An example of a materials requisition document is shown below.

MATERIAL REQUISITION Serial No: ……..………..…..

Charge Job/
Cost Centre No: ………………….…………………..…… Date: ……………………..….

Quantity Cost office only

Code
Description or Stores
No. Rate Unit $ $
weight ledger

Authorised by: Storekeeper: Price entered by:

Received by: Bin card entered: Calculations checked:

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Notes:

1 Every item of inventory has a unique identity code. The materials requisition
note is filled in to show both the code and the description of the materials
requisitioned.

2 The materials requisition note also identifies the job or cost centre for which the
materials are issued.

3 The materials issued from stores must be given a price or value. The task of
pricing materials issued from stores is the responsibility of the costing
department. A copy of the requisition is sent to the costing department, which
calculates and enters the costs.

2.3 STORES RECORDS

In any inventory control system, there should be a continual record of the current
quantities of each item of inventory held in store. Receipts into store and issues from
store must be recorded, so that the current inventory balance can be kept up-to-date.

When the stores control system is a paper-based system, there could be two separate
inventory records:

• a bin card system, in which a stores record (a 'bin card') is kept for each item
of inventory. The bin card is held in the stores department, and is used to record
the quantities only of inventory received and issued and the current inventory
balance

• an inventory ledger system, in which a record is kept for the cost ledger for
each item of inventory. In a paper-based system, there is a stores ledger control
account for each item of inventory. This is kept up-to-date by the costing
department, and records both the quantity and value of items received into
stores, issued from stores and the current balance held in stores.

STORES LEDGER CARD

Description …...……..... Unit …………………. Location ………………... Code ……………………….…

Maximum ……………… Minimum …………… Reorder level ………….. Reorder quantity ………..…..

Receipts Issues On order

Date/ ref Quantity $ Date/ ref Quantity $ Physical Date/ ref Quantity $
balance

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Note: The purchase cost of materials excludes any Sales Tax. It includes any costs
associated with buying the materials that the business is required to pay, notably the
costs of freight and delivery ('carriage inwards' costs).

When an inventory control system is computerised, there will be just one stores
ledger record system. For each item of inventory, there is a computer record similar to
a stores ledger control account, showing both the quantities and the value of items
received and issued, and the current inventory balance.

3 PRICING ISSUES OF MATERIALS

When materials are purchased, the process of giving them a value is fairly
straightforward. The purchase cost of the items is the price charged by the supplier
(excluding any Sales Tax) plus any carriage inwards costs. The cost should be net of
any trade discount given.

When materials are issued from store, a cost or price has to be attached to them.

• When a quantity of materials is purchased in its entirety for a specific job, the
purchase cost can be charged directly to the job.

• More commonly however, materials are purchased in fairly large quantities (but
at different prices each time) and later issued to cost centres in smaller
quantities. It would be administratively extremely difficult, if not impossible, to
identify specific units of material that have been purchased with units issued to
cost centres. Consequently, when issues of materials from store are being
valued/priced, we do not try to identify what the specific units actually did cost.
Instead, materials issued from store are valued/priced on the basis of a
valuation method.

A business might use any of several valuation methods for pricing stores issued. Four
such methods are:

• First in first out (FIFO)

• Last in first out (LIFO)

• Cumulative weighted average cost (AVCO)

• Periodic weighted average

EXAMPLE

The same example will be used to illustrate each of these methods.

In November 1,000 tonnes of inventory item 1234 were purchased in three lots:
3 November 400 tonnes at $60 per tonne
11 November 300 tonnes at $70 per tonne
21 November 300 tonnes at $80 per tonne
During the same period four materials requisitions were completed for 200 tonnes
each, on 5, 14, 22 and 27 November.

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3.1 FIRST IN FIRST OUT (FIFO) METHOD

With the first in first out method of valuation, it is assumed that materials are issued
from store in the order in which they were received. In the example above, it would be
assumed with FIFO that the 400 tonnes purchased at $60 each on 3 November will be
used before the 300 tonnes bought on 11 November, and these in turn will be used
before the 300 tonnes bought on 21 November.

The closing inventory at the end of November is 200 units. These consist of 200 of the
most recently purchased units.

The stores ledger account for inventory item 1234 is summarised below.
Date Receipts Issues Balance
No. $
3 Nov 400 × $60 400 24,000
5 Nov 200 × $60 200 12,000
11 Nov 300 × $70 500 33,000
14 Nov 200 × $60 300 21,000
21 Nov 300 × $80 600 45,000
22 Nov 200 × $70 400 31,000
27 Nov 100 × $70
100 × $80 200 16,000
Note that each successive consignment into stores is exhausted before charging
issues from stores at the next price.

Using this method the total value of materials issued is $53,000 and the value of
closing inventory is $16,000.

3.2 LAST IN FIRST OUT (LIFO) METHOD

With the last in first out method of pricing, it is assumed that materials issued from
stores are the units that were acquired the most recently of those still remaining in
inventory.

In this example, the 200 tonnes issued on 5 November will therefore consist of
materials purchased on 3 November, the 200 tonnes issued on 14 November will
consist of materials purchased on 11 November and the 200 tonnes issued on
22 November will consist of materials purchased on 21 November. The materials
issued on 27 November will consist of the remaining 100 tonnes bought on
21 November and the 100 tonnes bought on 14 November.

The closing inventory at the end of November consists of 200 of the tonnes bought on
5 November.

The stores ledger control account for item 1234 using LIFO would be as follows.
Date Receipts Issues Balance
No. $
3 Nov 400 × $60 400 24,000
5 Nov 200 × $60 200 12,000
11 Nov 300 × $70 500 33,000
14 Nov 200 × $70 300 19,000
21 Nov 300 × $80 600 43,000
22 Nov 200 × $80 400 27,000
27 Nov 100 × $80
100 × $70 200 12,000

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Using this method the total value of materials issued is $57,000 (more than under
FIFO) and the closing inventory value is $12,000 (less than FIFO). When prices are
rising this will always be the case.

3.3 CUMULATIVE WEIGHTED AVERAGE COST (AVCO) METHOD

With the cumulative weighted average cost method of pricing material issues, all
quantities of an item of inventory are valued at a weighted average cost. A new
weighted average cost is calculated each time that there is a new delivery into stores.
A weighted average price is usually calculated to the nearest cent.

Cumulative weighted average price =

Inventory value of items in stores + Purchase cost of units received

Quantity already in stores + Quantity received

The price so calculated is used to value all subsequent issues until the next
consignment of the inventory is received into stores and a new weighted average cost
is calculated.
Item 1234
Receipts (issues) Weighted
average price
Date Quantity Purchase price Value (issue price)
$ $ $
3 Nov 400 60 24,000 60
5 Nov (200) (12,000) 60
––––– –––––– –––––
200 12,000 60
11 Nov 300 70 21,000
––––– ––––––
Balance 500 33,000 66 (W1)
14 Nov (200) (13,200) 66

300 19,800 66
21 Nov 300 80 24,000
––––– ––––– ––––––
Balance 600 43,800 73 (W2)
22 Nov (200) (14,600) 73
27 Nov (200) (14,600) 73
––––– –––––– –––––
30 Nov (bal) 200 14,600 73
––––– –––––– –––––
A new average cost price calculation is required after each new receipt.

Workings:

(W1) $33,000/500 = $66

(W2) $43,800/600 = $73

Using this method the total value of materials issued is $54,400 and the closing
inventory value is $14,600. These figures are between the FIFO and LIFO valuations.

A variation on the AVCO method is the periodic weighted average cost method.

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3.4 PERIODIC WEIGHTED AVERAGE COST METHOD

With the periodic weighted average cost method of pricing inventory an average price
is calculated at the end of the period which is then used to price all issues.

Periodic weighted average price =

Cost of opening inventory + Cost of all receipts in the period

Units in opening inventory + Units received

The stores ledger control account for the item 1234 would be as follows:
Item 1234
Receipts (Issues) Periodic
Weighted
Date Quantity Purchase price Value Average price
(issue price)
3 Nov 400 60 24,000
11 Nov 300 70 21,000
21 Nov 300 80 24,000
––––– ––––––
1,000 69,000 69.00
5 Nov (200) (13,800) 69.00
14 Nov (200) (13,800) 69.00
22 Nov (200) (13,800) 69.00
27 Nov (200) (13,800) 69.00
30 Nov (bal) 200 13,800 69.00
Using this method the total value of materials issued is $55,200 and the closing
inventory value is $13,800. Note that using this method the cost of issues cannot be
calculated until the end of the period.

ACTIVITY 1

You are given the following information about one line of inventory held by Tolley plc.

Assuming that there are no further transactions in the month of May, what is the value
of the issues made on 1 March and 1 May and what would be the inventory valuation,
using (i) the FIFO valuation method (ii) LIFO and (iii) AVCO (iv) Periodic weighted
average pricing?

How does the inventory pricing method used impact on the profit made on
sales?
Units Cost Sales price
$ $
Opening inventory 1 January 50 7
Purchase 1 February 60 8
Sale 1 March 40 10
Purchase 1 April 70 9
Sale 1 May 60 12
For a suggested answer, see the ‘Answers’ section at the end of the book.

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3.5 COMPARISON OF VALUATION METHODS – THE EFFECT ON PROFIT OF

THE INVENTORY VALUATION METHOD SELECTED

A business can choose whichever method of inventory valuation it wants to use. FIFO
and weighted average costs are both acceptable for financial reporting, whereas LIFO
is not. However, in cost accounting, the rules of financial reporting do not apply, and
businesses can use LIFO should they wish.

If the purchase price of materials stayed the same indefinitely, every inventory
valuation method would produce the same values for stores issues and closing
inventory. Differences between the valuation methods is usually only significant during
a period of price inflation, because the choice of valuation method can have a
significant effect on the value of materials consumed (and so on the cost of sales and
profits) and on closing inventory values.

The relative advantages and disadvantages of FIFO, LIFO and AVCO are therefore
discussed below, particularly in relation to inflationary situations.

Method Advantages Disadvantages

FIFO • Produces current values • Produces out-of-date production
for closing inventory. costs and therefore potentially
overstates profits.
• Complicates inventory records as
inventory must be analysed by
delivery.
LIFO • Produces realistic • Produces unrealistically low
production costs and closing inventory values.
therefore more • Complicates inventory records as
realistic/prudent profit inventory must be analysed by
figures. delivery.
Weighted • Simple to operate – • Produces both inventory values
average price calculations within the and production costs which are
inventory records are likely to differ from current
minimised. values.

Whichever method is adopted it should be applied consistently from period to period.

4 ACCOUNTING FOR MATERIALS COSTS

Within the inventory control system, there is an stores ledger control account for each
item held in stores.

This stores ledger control account records details of all receipts of the material as well
as all issues of the material to production.

The information in a stores ledger account can be presented in the form of a T

account, for double entry bookkeeping purposes, as follows.
Stores ledger control account – item 2345
$ $
Opening balance b/d X Issues X
Receipts X Closing balance c/d X
–––– ––––
Balance b/d X X
–––– ––––
X

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There is an account for each item of inventory in the inventory control system, but in
the cost ledger accounting system, there is an stores ledger control account for all
items of inventory in total. In other words, the materials cost ledger account shows in
total all of the entries that have taken place in the individual stores ledger control
accounts. The materials cost ledger account therefore records the total materials
purchases for the organisation, and the total value of materials issued to production as
direct materials or to cost centres as indirect materials.

4.1 PURCHASE OF MATERIALS

When materials are purchased and the purchases are recorded in the cost accounts,
the credit side of the entry will be to either cash (cash purchases) or creditors (credit
purchases). The debit entry is in the stores ledger control account, recording the
purchase cost of the materials.

EXAMPLE

Ogden Ltd is a small company that was set up at the beginning of May 20X4 by the
issue of $20,000 of shares for cash. Ogden Ltd purchases three types of material: A,
B and C. During the month of May 20X4 the purchases of each type of material were
as follows:

Material A
3 May $2,000
24 May $9,000
Material B
6 May $5,000
10 May $3,000
21 May $7,000
Material C
1 May $4,000
7 May $4,000
28 May $4,000
Purchases of materials A and B are for cash and material C is on credit of 45 days.

Record these transactions in the individual stores ledger control accounts as

well as the cash and creditor accounts.

SOLUTION
Stores ledger control account Material A
$ $
3 May 2,000
24 May 9,000

Stores ledger control account Material B

$ $
6 May 5,000
10 May 3,000
21 May 7,000

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Stores ledger control account Material C

$ $
1 May 4,000
7 May 4,000
28 May 4,000

Cash account
$ $
1 May Share capital a/c 20,000 3 May Material A 2,000
6 May Material B 5,000
10 May Material B 3,000
21 May Material B 7,000
24 May Material A 9,000

Payables account
$ $
1 May Material C 4,000
7 May Material C 4,000
28 May Material C 4,000
Note: The stores ledger control account would include all of the entries for Materials
A, B and C.

4.2 ISSUES OF MATERIALS

Materials issued from stores are recorded as a credit entry in the stores ledger control
account. The value or cost of the materials issued is determined by whichever
valuation method is used (FIFO, LIFO, weighted average cost, etc).

The corresponding double entry is to:

• a work-in-progress account, for direct materials

• an overhead account, for indirect materials. (This can be a production

overhead, administration overhead or selling and distribution overhead,
according to the function of the cost centre that obtains the materials.)

Continuing the example from paragraph 4.1, now suppose that Ogden Ltd made the
following issues of materials in June:

Material A Direct material to production $7,000

Material B To selling and distribution $3,000
To administration $4,000
Material C Indirect material to production $3,000

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The ledger accounts would be completed as follows.

Stores ledger control account
$ $
Opening balance 38,000 WIP (Material A) 7,000
Selling and distribution
overhead (Material B) 3,000
Administration overhead
(Material B) 4,000
Production overhead
(Material C) 3,000
Closing balance (bal. fig.) 21,000
–––––– ––––––
38,000 38,000

Work-in-progress (WIP)
$ $
Stores control 7,000

Production overhead control

$ $
Stores control 3,000

Administration overhead
$ $
Stores control 4,000

Selling and distribution overhead

$ $
Stores control 3,000

5 INVENTORY LOSSES AND WASTE

5.1 MATERIAL INPUT REQUIREMENTS

In some manufacturing processes, there is wastage or loss of inventory. When

wastage is expected during processing, the department using the materials should
allow for the losses when it orders materials.

Wastage is usually measured as a percentage of the quantities of materials input.

Input – Wastage = Output

For example, if wastage is 3% of input, output will be 97% of input. In formula terms:

100%
Input = Output ×
(100% – wastage rate percentage)

So if the required output is 500 units, the input material requirements are:

100
Input = 500 units ×
(100 – 3)

= 515.5 units, say 516 units.

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ACTIVITY 2

In a production process, there is usually a wastage rate of 5% of input. Materials cost

$8 per kilogram. The required output is 1,520 kilograms.

What quantity of input materials should be required, and what will they cost?

For a suggested answer, see the ‘Answers’ section at the end of the book.

5.2 CONTROL MEASURES

If wastage is a normal part of the production process, control measures should be

calculated and actual wastage rates compared to the control measures to check that
the wastage rates are as expected. If wastage is greater or less than expected, the
reasons why this has happened must be investigated and action taken as necessary.

Wastage may be greater than expected:

• if labour is less experienced than expected and make more mistakes when
using the material

• if a machine is old or poorly maintained and there are more breakdowns and
errors than expected

• if the production process has changed

• if the estimate of the control rate for wastage was too low.

EXAMPLE

A business expects wastage to be 5% of material input. In a period actual material

input was 250 kg and 230 kg of finished output was produced.

Compare the actual wastage rate with the expected wastage rate.

SOLUTION

The actual wastage rate is 20/250 × 100% = 8%

This is higher than the expected wastage rate of 5% and the reasons for the difference
should be investigated.

CONCLUSION
This chapter has explained in detail the procedures concerned with ordering, receiving,
storing and issuing materials. It has illustrated the accounting techniques used to value
materials. For your examination, it is important to have a working knowledge of the inventory
valuation methods, particularly FIFO, LIFO and AVCO. You should also be able to compare
these methods, particularly during a period of rising or falling prices.

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KEY TERMS
Direct materials – materials that can be directly attributed to a unit of production, or a
specific job or a service provided directly to a customer.

Indirect materials – materials that cannot be directly attributed to a unit of production.

FIFO – first in first out method of inventory valuation.

LIFO – last in first out method of inventory valuation.

AVCO – weighted average method of inventory valuation.

SELF TEST QUESTIONS

Paragraph

1 Distinguish between direct materials and indirect materials. 1

2 Which document is used to record materials issued from stores? 2.2

3 Under the LIFO method of inventory valuation at what price is closing

inventory valued, the most recently or the earliest-purchased units of the
item of inventory? 3.2

4 What are the advantages and disadvantages of the weighted average

price method of inventory valuation? 3.5

5 What double entry is used to record the issue of materials from stores to
a production overhead cost centre? 4.2

6 What formula can be used to calculate the required quantity of input

materials, given a required output quantity and a wastage rate expressed
as a percentage of input quantities? 5.1

EXAM-STYLE QUESTIONS

1 ABC Ltd had an opening inventory of $880 (275 units valued at $3.20 each) on 1 April.

The following receipts and issues were recorded during April:

8 April receives 600 units at $3.00 each

15 April receives 400 units at $3.40 each
30 April issues 925 units

Possible inventory values:

A $2,935

B $4,040

C $2,932

D $2,850

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(i) What would be the value of the issues under LIFO?

(ii) What would be the total value of issues under AVCO?

(iii) What would the total value of issues under FIFO?

2 W Ltd has closing inventory at 31 July of 400 units valued at $10,000 using LIFO.
Inventory movements in July were:

5 July 300 units bought for $25/unit

10 July 500 units issued
15 July 400 units bought for $22/unit
20 July 200 units issued

What was the value of the opening inventory?

A $11,200

B $10,000

C $9,400

D Cannot be found

The following information relates to Questions 3, 4, 5 and 6.

Inventory movements of component AB1 for the month of March were as follows:

8 March 4,000 received, total cost $20,000

15 March 3,900 issued
19 March 1,200 received, total cost $7,200
21 March 1,100 issued
24 March 2,800 received, total cost $21,000

3 What is the inventory valuation at 31 March on a LIFO basis?

A $22,100

B $22,500

C $15,000

D $18,000

4 What is the value of the issue made on 21 March using a FIFO basis?

A $6,600

B $5,500

C $8,250

D $6,500

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5 What is the inventory valuation at 31 March on a cumulative weighted average basis?

A $18,075

B $18,500

C $22,185

D $22,046

6 A company uses FIFO inventory pricing and has a high level of inventory turnover. In
a period of rising prices, the closing inventory valuation is:

A close to current purchase prices

B based on the prices of the first items received

C much lower than current purchase prices

D lower than if LIFO inventory pricing were used.

7 A and B are in business, buying and selling goods for resale. During September 20X3
the following transactions occurred:

September 1 Balance brought forward NIL

September 3 Bought 200 units at $1.00 each
September 7 Sold 180 units
September 8 Bought 240 units at $1.50 each
September 14 Sold 170 units
September 15 Bought 230 units at $2.00 each
September 21 Sold 150 units

The value of stock using the cumulative weighted average method of stock valuation
to the nearest $) is:

A $174

B $285

C $314

D $340

For the answers to these questions, see the ‘Answers’ section at the end of the book.

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