Chapter 2: Cost of Raw Materials and Supplies

Introduction

There are three main cost elements of a product; direct material costs, direct labor costs and overhead costs.

Raw materials and supplies are the assets used for the production of products and services and consumed in order to provide continuity of the operations of the business.

Classification of Raw Materials And Supplies

The assigning of the cost to cost objectives gives the classification of direct and indirect costs.

Direct Material Costs

Direct costs are the costs that can be traced easily within the cost object. These are direct material costs and direct labor costs. Direct material costs are the cost of the material used in the product which can be easily traced.

Indirect Material Costs

There may be some costs related to the cost object (product) but cannot be traced easily and also there may be some costs that are not included product like raw materials, but they are consumed for the production purposes. These types of costs are classified as indirect costs like indirect material costs, indirect labor costs and other overhead costs.

The classification of direct material and indirect material leads to several conclusions. First of all, direct materials are recognized in direct material costs where the indirect materials are recognized as overhead costs when they are consumed. Secondly, direct material costs are directly related to the product but indirect costs have to be allocated for the products produced.

Flow of Raw Materials and Supplies

The expenses for raw materials and supplies can be traced within a four-step approach:

1. Documentation and recording process
2. Determination of purchase costs
3. Determination of consumption
4. Pricing the consumption

Documentation and Recording Process

Companies purchase raw materials and supplies in order to carry out their production operations. Materials account is debited with the purchase cost of the material and/or supply. When a consumption occurs, Materials account is credited with the purchase cost. If the consumption is for the raw materials then Direct Material Expenses account is debited reciprocal with Material account. If the consumption is for the supplies, then Overhead Expenses account is debited.

When the company makes purchases the amount and the unit cost of the material is recorded into the Receipts column with the total cost. When the material is issued to the production, the amount that is issued is recorded into the Issues column.

Materials are drawn from the warehouse by the Materials Request Slip. This is the substantiating document that shows the inventory flow from the warehouse to the production plant.

Determination of Purchase Cost of Materials

The purchase cost includes the purchase price and the necessary purchase expenditures for the material to be ready for the production. The purchase price of the raw material is the main part of the cost. Besides transportation fees, insurance fees, loading and unloading fees, commissioner fees, custom fees are also added to the cost of the purchase.

Determination of Consumption

Inventories are the assets that are required in order to use in production or resell. From the perspective of raw materials and supplies, these assets are acquired for consuming in production.

When a raw material is issued in production, its cost turns into materials expense.

If the characteristic of the material issued to production allows the company to calculate the cost of the material issued, then companies can easily track the material inventory continuously. Therefore, there is no need for the companies to calculate the inventory on hand and total cost of the material issued at the end of the period.

Pricing the Consumption

The companies use inventory flow assumptions in order to identify the cost of the material issued to production and the ending inventory. These assumptions are;

• Specified Price First-in-First-Out (FIFO)
• Last-in-First-Out (LIFO)
• Highest-in-First-Out (HIFO)
• Weighted Average Cost
• Moving Average Cost
• Replacement Cost
• Standard Cost

Specified Price
In this method, every material or material batch issued to production is priced with the cost related to that purchased unit.

First-in-First-Out (FIFO) Method
In FIFO method, it is assumed that the material issued to the production is from the initial purchased material from the inventory.

Last-in-First-Out (LIFO) Method)
In LIFO method, the material issued to production is from the latest purchased material.

Highest-in-First-Out (HIFO) Method
Highest-in-first-out method states that the primary issued material to the production is the highest priced material from the inventory. This method gives the same results with LIFO when the prices continuously increase.

Weighted Average Method
In this method, an average price is calculated for a period by the relation between quantities and costs. The company calculates just one average price for the whole period.

Moving Average Method
In moving average method, an average price is calculated with every new purchase.

Replacement Cost Method
Materials are recognized on their historical costs. When the material is issued to the production its cost will be charged to the product. On inflationary economies market prices will differ from historical costs so rapidly that companies take some precautions in order to replace the materials issued to production. In this method, upon the next material purchase, the company will use the replacement cost of the material.

Standard Cost Method
In this method, all the issued materials and inventory on hand are valued at standard price.

Comparison of Methods
The quantity of issued material and the inventory on hand is the same for all the methods. Some of the methods have higher issued material costs, therefore lower inventory costs and some other vice versa. The choice of the method depends on various issues. For example, fluctuations in the prices and the frequency of purchases, inventory turnover rate, economic order quantity, traceability of the material issued, percentage cost of raw materials to the total cost of the product.

Inventory Planning and Control for Materials and Supplies

The total inventory cost of a manufactured product consists of the expenditures made for raw materials, direct labor and its fair share of overhead. Physical control or safeguarding of materials and investment control are the two aspects of materials control.

In segregation of duties principle, each operation for purchasing, receiving, storing, using and recording the material should be carried out by different personnel in order to eliminate the frauds and errors.

The second aspect for materials control is the investment control consisting order point and the economic order quantity.

The point at which a material should be ordered is called order point. It is the point where predetermined minimum level of inventory on hand is reached.

Economic Ordering Quantity

Order quantity is in direct proportion to inventory levels but inversely proportional with the number of orders. In other words, the more amounts in the order given means more inventory levels but less number of orders.

Monitoring the Inventories

There are several ways for monitoring the inventories. These are as follows:

• Min-Max Plan
• The Two-Bin System
• Order Cycling System
• ABC Analysis
• VED Analysis
• JIT System

Min-Max Plan
In this technique, a minimum and a maximum level is determined for each material in the inventory. When the inventory decreases to the minimum level, purchase order is prepared for the material to reach the maximum level.

The Two-Bin System
The two-bin system is used to determine when the materials should be replenished.

Order Cycling System
In the order cycling system each material in the inventory is checked periodically for their levels of quantity.

ABC System
ABC system classifies and ranks the inventories according to their respective costs or usages. The inventories are classified into three groups as A-B-C, where group A reflects the most important materials whereas group C reflects the least.

VED Analysis
In ABC classification of inventories, companies group their materials according to their shares in quantity and costs. But in VED analysis, companies classify their materials according to their “absence” costs.

JIT System
JIT(Just-in-Time) system is the purchase of materials just in time and just as the quantity needed. Just-in-time system is also used for production.