Materials Costing | Complete Guide to Inventory Management & Cost Control

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Materials costing is a fundamental aspect of cost and management accounting, helping businesses control production costs, manage inventory efficiently, and improve profitability. Effective material planning, procurement, inventory control, and cost allocation play a crucial role in optimizing manufacturing operations and minimizing wastage. Understanding concepts such as direct and indirect materials, inventory policies, purchasing procedures, and material control systems enables organizations to make informed financial and operational decisions. This guide provides a comprehensive overview of materials costing and inventory management, offering practical insights into the principles and techniques used in modern cost accounting.

Table of Content

1. Introduction
2. Components OF Primary Materials Costs
3. Features OF Ideal Inventory Policy
4. Materials Control Objectives
5. Requirements Of Materials Control
6. Elements OF Materials Control
7. Methods Of Purchasing
8. Materials Procurement Procedures

 1. Introduction

The term “material” encompasses all commodities that are consumed during the manufacturing process. It is defined as “anything that can be stored, stacked, or stockpiled.”

Material is the initial and most critical component of the product expense. The product is constructed from a substance, which is an essential component. Additionally, it is a substantial portion of the overall cost. The material cost may account for 70-80% of the total cost, contingent upon the product type.

Five broad categories may be used to classify materials for manufacturing concerns:

1. Raw Materials: Materials that are introduced into the production process in their natural or unprocessed state at the outset. The materials may be present in the final product, such as raw cotton (KAPAS) in the production of cotton textiles, or they may evaporate during the production process without contributing to the tangible output, such as coal.
2. Work-in-Process or Semi-Completed Materials: Materials that are partially completed and are either purchased from outside the organisation or produced within the organisation for assembly into a final product. For example, furniture that is unpolished and is purchased from outside the organisation and is subsequently polished in-house before being used for sale.
3. Finished Materials or Finished Goods: Finished material refers to products that are utilised in their original state without any additional value addition. For instance, an automobile is a finished product that is directly used by the consumer. For instance, finished components may serve as basic materials or semi-finished materials in the production of the final product. Automobile manufacturers utilise completed materials, including batteries, tyres, engines, and other components.
4. Maintenance and Operation: It includes supplies related to the spare-parts, consumable stores which are used in production process.
5. Scrap and others: It includes all items such as scrap, obsolete, and unsaleable items arising from production process and items which are used in office and marketing departments, etc.

The inventory for trading concern is finished goods.

Examples of inventory are as under:

1. For Manufacturing concern: For a biscuit manufacturer – raw materials, semi-finished goods, and finished products.
2. For Trading concern: Ready stock of mobile phones for sale.
3. For Service concern: In a hotel, the unoccupied room.
Material costs may be either direct or indirect.

1.1 Direct Materials

Direct materials are those that are typically incorporated into the final product and whose consumption can be associated with specific production units. Direct materials encompass not only the basic materials that are introduced at the commencement of the production process, but also all of the following:

(a) Component elements that are utilised in a product, such as the picture tube in a television set or the tyres and tubes in a car.
(b) Any material that is entirely consumed during the production process, such as fertiliser used to cultivate plants, but is used in the production process to produce the finished product.
(c) Any primary packing material, which refers to any container that is sold in conjunction with the ultimate product, such as cans for tinned food and drink and bottles for beer.

1.2 Indirect Materials

Indirect materials are those that are not easily identifiable as individual cost units. Examples include coal, grease, oil, detergent, and sandpaper.
The inventory term encompasses the stocks of raw materials, components, work-in-progress, and finished products. The Accounting Principles Board has defined it as “the sum of all tangible personal property that is either (i) currently consumed in the production of goods or services that are available for sale, (ii) is in the process of being produced for such sales, or (iii) is held for sale in the ordinary course of business.”
Materials are further classified on the basis of the nature which have to be used, such as:

(a) Raw Materials, e.g., rubber, timber, steel etc.
(b) Components, e.g., instruments
(c) Consumable stores, e.g., cotton waste, brushes
(d) Maintenance Materials, e.g., spare parts
(e) Tools, e.g., jigs and fixtures

2. Components OF Primary Materials Costs

A fundamental value of the purchase price is provided by the invoice received from the supplier. In order to determine the actual material cost, the subsequent modifications must be implemented in this value.

Quantity discount: This is a concession that the supplier provides to the purchaser in order to encourage the placement of substantial orders. The discount frequently fluctuates in accordance with the size of the order; that is, the greater the quantity ordered, the greater the discount, provided that it remains within established boundaries. A quantity discount is permitted by a supplier as a representation of the cost reductions that result from the production and distribution of goods on a large scale. A portion of the savings that the supplier benefits from is transferred to the purchaser in the form of a quantity discount. The material cost is determined by subtracting the quantity discount from the purchase price.

Trade discount: This is a concession granted by the supplier to a buyer who is required to resell the material. For example, the manufacturer may grant a discount to the wholesaler. Expenses (e.g., storage, repacking) and profits of the dealer who is providing a service to assist the original supplier in distribution are intended to be covered. This discount is also subtracted from the purchase price to determine the material cost.

Cash discount: This discount is permitted by the supplier to a purchaser in order to promote the prompt payment of the invoice. For example, a 2% discount may be applicable if payment is made within 30 days, and a 4% discount may be applicable if payment is made within 7 days. The treatment of cash discount is a topic of debate among cost accountants, as it is a form of interest on capital. In general, it is regarded as a pecuniary and non-costing item, and as a result, it is not incorporated into cost accounts.
Goods and Services Tax and other taxes: The purchase price should include items such as customs duty, etc.

Transport expenses: These encompass dock fees, insurance, and sea, land, and air freight for materials acquired. The supplier may include all of these charges in the purchase price. However, if the price does not include them, they should be added to the purchase price. In the event that it is not feasible to do so (e.g., due to insignificant costs or delayed invoicing), these may be categorised as factory overheads.

Cost of containers: The supplier may or may not charge a distinct amount for containers. No adjustment to the purchase price is necessary if no such charge is incurred. Nevertheless, if containers are separately charged, all associated expenses should be incorporated into the purchase price.
This includes (i) the cost of the containers if they are not returnable, and (ii) the difference between the cost of the container and the amount refunded upon its return, if the container is returnable.

3. Features OF Ideal Inventory Policy

In order to ensure the uninterrupted flow of production, it is imperative to prevent production stoppages caused by material shortages. In terms of overheads, sales denial, or frantic purchases, such production stoppages are extremely expensive.

Optimal investment in materials: The profitability of the business is reduced as a result of excessive investments due to overstocking of materials, which results in the locking of large capital without any returns and an increase in storage costs.

Purchasing economy: Supplies should be procured at the lowest feasible cost without compromising their quality, reliability, or consistency.

Strict quality control: A rigorous quality control system should be implemented. Authorisation should be granted for the procurement of basic materials of the appropriate quality. A report should be generated and initialled by the individual who has tested the material for the purpose of assigning responsibility for its repair. This report should be completed at the time of receipt.

Material storage: Material should be stored in a manner and at a location that minimises the cost and time of handling. Material can be conveniently located and provided to the user departments with minimal effort. The time spent on material tracing and ensuring that it reaches the user department should be minimised.

Control over the payment of materials: Ensure that no payment is made for materials that were not ordered but were received, for materials that were not received, or for materials of defective quality.

Authorised issues: Guarantee that no issue from the store is implemented without the appropriate authorisation.

The storekeeper must be held accountable for all issues.

Reduce wastage: Reducing wastage during the management of materials in the user department, during their issues, and during their receipt in stores. It is imperative to establish standards for waste at each stage and to investigate any waste that exceeds these standards.

Control of pilferages, leakages, and other losses: A system should be implemented to prevent material pilferages. Special controls must be implemented for materials that are susceptible to theft. Slow-moving and fast-moving materials should be identified by the system on a consistent basis. Additionally, items that are stationary should be identified. This will aid in the regulation of future purchases of these materials and the prevention of losses. Frequently, it is more advantageous to dispose of non-moving items than to maintain them in store and incur storage expenses.

Misappropriation control: Guarantee that no materials are misappropriated, as leakages in the system have a propensity to recur.

Material information that is consistent and reliable: A record of the stock position, minimum and maximum levels, special issues associated with specific materials, and a list of reliable suppliers should be maintained for each type of material. This will facilitate the placement of an order for the appropriate quantity at the appropriate time and with the appropriate supplier.

4. Materials Control Objectives

Following are the objectives of materials control:

1. Material investment must be minimised to prevent overstocking.
2. Minimal wastage: In order to prevent losses resulting from larceny or deterioration, it is necessary to provide appropriate storage facilities for various types of materials.
3. Purchasing economy: Materials should be acquired at a reasonable price.
4. No understocking: The investment in materials that are understocked will result in a delay or halt in production. It may lead to a decrease in profitability.
5. Material information: This system should provide comprehensive and current accounting information regarding the availability of materials.

5. Requirements Of Materials Control

Material control necessitates the following:

1. Effective coordination among all departments, including the purchase, inspection, storage, accounting, and payment departments.
2. A well-defined purchase procedure is necessary to guarantee the most favourable price and terms and conditions.
3. It is necessary to use appropriate standard forms to ensure the proper placement of the order and the recording of the receipt of the materials.
4. Appropriate material expenditures are necessary to ensure that the least amount of money is spent on material purchases.
5. It is necessary to conduct a thorough review of overtransactions that involve the purchase of materials and equipment.
6. It is necessary to store materials in a secure manner.
7. A perpetual inventory system and continuous stock collecting system are necessary.
8. A proper system is necessary to retain material and distribute it to the appropriate department at the appropriate time and in the appropriate quantity.
9. Proper accounts must be maintained to demonstrate the costs of materials during the receipt and consumption phases.
10. A material stock account that accurately depicts the purchase of materials, the issuance of materials from stock, the balance of inventory, the return of products to vendors, the presence of obsolete stock, and the presence of spoilt or defective units is necessary.

6. Elements OF Materials Control

Necessary components and elements of Material Control are:

1. Materials procurements
2. Material receipt
3. Material examination.
4. Material storage
5. Distribution of materials
6. Inventory records maintenance
7. Stock audit.

7. Methods Of Purchasing

Centralised and localised purchasing are the two primary categories into which purchasing can be divided.

7.1 Centralised Purchasing

In a large organisation, there are numerous manufacturing entities. Centralised procuring is advantageous in these circumstances. The benefits of centralised purchasing include:

1. Expert and specialised knowledge is accessible.
2. Bulk purchases generate advantages.
3. The purchasing cost and the selling price may be both reduced.
4. Greater control can be exercised due to the extensive knowledge of market conditions.
5. Centralising the purchasing process is advantageous when materials must be imported.
6. Ease and economy in the compilation and consultation of results.
7. It has the potential to capitalise on market fluctuations.
8. Inventory investments may be diminished.
9. Additional benefits include consistent purchasing policies and undivided responsibility.

When making a decision about centralisation, it is important to consider the geographical separation of facilities, the homogeneity of products, the type of material purchased, the location of supplies, and other factors.

7.2 Decentralised Purchasing

The benefits of localised purchasing or decentralisation of purchases include:

1. Each plant may have its own unique requirements. Special consideration may be given to this matter.
2. Suppliers can be contacted directly.
3. The time gap between indenting and receiving materials can be minimised.
4. The technical requirements of each plant can be determined.

8. Materials Procurement Procedures

The acquisition of basic materials for a business’s production or service delivery is known as material procurement. It is an essential component of supply chain management and can have a substantial effect on a company’s financial performance. The procurement of raw materials for a business entails the following steps. The procurement process includes the identification and selection of vendors, the negotiation of prices and terms, and the awarding of contracts. The documentations aspects of the material procurement are explained hereunder.

8.1 Bill of Materials

A Bill of Materials is a detailed list of materials that includes the quantity, material codes, and specifications of each material that is necessary for a specific operation, process, or production unit of standardised nature or as per normal production process. Substitute materials will also be specified.

The engineering or planning department prepares it for the submission of a quotation and subsequent to the receipt of a work order. A method of documenting the materials necessary for the execution of the specified job activity. The Bill of Materials serves as an authorisation for the Stores Department to procure materials and for the relevant department to requisition materials from the stores. This is an advance notification to the relevant departments regarding the completion of the task, or work order. It is distributed to the following departments: (a) the Purchase Department, (b) the Stores Department, (c) the Cost Accounts Department, and (d) the Product Department. The Figure 3.1 indicates the format of Bill of Materials.

8.2 Advantages of Bill of Materials

The advantages of documenting materials required for execution of a specific order are as follows:

1. It acts as a guide in planning the execution of job, process or product units by documenting all materials required for that specified work.
2. It is a base for action to be initiated by the Stores Department in placing the purchase requisition with the purchase department.
3. The information mentioned in the bill of materials acts as a standard with which any deviation can be detected and remedial measures are taken if deviations take place.
4. It is a good control measure on material cost.
5. The material cost to be charged to a particular unit, job or process can easily be determined before hand.
6. It helps in submission of tenders and quotations.
7. It is a planning exercise for the proposed production or work.
8. It serves as an advance intimation to stores department about the raw material requirement.

8.3 Stores Requisition Note

It is also called ‘Materials Requisition Note’. When Production or other departments require material from the stores, it raises a requisition, which is an order on the stores for the material required for execution of the work order. This note is signed by the department in-charge of the concerned department. It is a document which authorise the issue of a specified quantity of materials. Any person who requires materials from the stores must submit Stores Requisition Note. The Storekeeper should only issue materials from stores against such a properly authorised requisition and this will be entered in the Bin Card and Stores Ledger. A copy of the requisition will be sent to the Costing Department for recording the cost or value of materials issued to the cost centre or job. It will include the cost centre or job number for which the requisition is being made. A specimen Stores Requisition Note is as per Figure 3.2. 

Table 3.1: Difference between Bill of Materials and Stores Requisition Note

 8.4 Purchase Requisition Note

CIMA defines Purchase Requisition as “an internal instruction to a buying office to purchase goods or services. It states their quantity and description and elicits a purchase order”. The manager in-charge of Purchase Department should obtain requisition from the Stores in-charge, departmental head or similar person requiring goods before placing orders on suppliers. If the present stock runs down to the reorder level, then the stores department sends a Purchase Requisition to Purchase Department, authorising the department to order further stock. The specimen of Purchase Requisition Note is given as per Figure 3.3 below.

8.5 Tender or Quotation or Request for Proposal

Tender is a formal notification inviting interested vendors to submit their bid or quotation for the specified material or service. This is a process to govern the opening, evaluation and selection of the vendors for the required material under specified terms and conditions, so that fairness of the selection can be ensured.
Quotation is a formal statement of promise made by an interested vendor in response to a tender notification to supply the goods or services required by a buyer at specified description and terms and conditions.
Request for Proposal (RFP) is like tender; this is also a selection process among the eligible vendors. This is a process of gathering information about the rate, quantity, technology, services and support etc., from the selected vendors who may be interested in supplying required material or service under specified terms and conditions.

8.6 Purchase Order

The resulting quotations or tender or RFP received as per 3.8.4 will be compared, and the order will be placed with the suppliers who offer the required products at competitive prices. The organisation’s procedure determines the quantity of copies of the routing of Purchase Orders. Typically, the Supplier, Department originating the Purchase Requisition, Inspection Department, and Accounting Department will receive copies of the purchase orders. The Purchase Order specimen is provided as per Figure 3.4:

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