How to Calculate Cost of Materials? [With Methods] | Cost Accounting

Costs of direct materials are charged directly to a particular job or batch or process. Costs of indirect materials are included in overheads. The objectives of material accounting are to charge cost of materials to different jobs, batches, and processes on a realistic and consistent basis; and to provide a satisfactory basis for the valuation of inventories.

An important issue in accounting for direct materials is the selection of the appropriate cost formula to price the issue of materials that are interchangeable. A material is interchangeable in the sense that when they are placed in the bin they lose their identity. Standard speaker that are used in a particular type of audio system is an example of interchangeable material. A firm purchases that speaker periodically.

Speakers received in different batches, when placed in the bin, mingle with each other and it becomes almost impossible to identify a particular speaker with the batch in which it was received. If the prices of speakers received in different batches are different, the firm has to make certain accounting assumptions to determine the amount that will be charged to a particular batch of audio system towards the cost of the speaker. Cost formulas capture those assumptions.

Specific Identification Method:

Materials purchased for a specific job or a batch or process can be identified with the job, batch, or process. Therefore, the job, batch, or process is charged with the actual cost of the material. E.g., a job order for the production of a large compressor is charged with the actual cost of motors and castings purchased specifically for the job.

First-In-First-Out Method (FIFO):

FIFO method assumes that materials are issued in a strictly chronological order. Under this method the price of the earliest delivery in stock is considered for pricing materials issued to production. The assumption that material received first is issued first is only an accounting assumption. Physical movement of material may not be in that order.

Last-In-First-Out Method (LIFO):

This method assumes that the latest receipt of the material in stock is issued first. The assumption that material received last is issued first is only an accounting assumption. Physical movement of material may not be in that order.

Weighted-Average Cost Method:

In this method issue prices are calculated by dividing the value of the stock on the date of issue by the quantities in hand. Weighted average rate is calculated every time a fresh lot is received. In absence of fresh receipt, the weighted average price remains the same after each issue.

Other Methods:

i. Base Stock Method:

This method assumes that a fixed minimum stock is always carried at the orig­inal cost. The issues are priced using one of the conventional methods (i.e. FIFO and LIFO).

ii. Simple Average Price:

This is an average price of the lots in stock, irrespective of the quanti­ties involved.

iii. Periodic-Simple Average Price:

In this method, the issue price is calculated at the end of the period. The issue price is calculated with reference to the purchase during the period. Therefore, the opening stock does not enter into the calculation.

iv. Periodic-Weighted Average Price:

In this method, the issue price is calculated at the end of the period. The issue price is calculated with reference to the purchase during the period. Therefore, the opening stock does not enter into the calculation.

v. Moving-Simple Average Price:

In this method, the issue price is calculated by dividing the total of the periodic simple average prices of a given number of periods (including the period in which the material to be priced is issued) by the number of periods. The moving average price uses a number (say 3, 5, or 7) of periodic simple average prices, the last of which is that of the period in which the material is used.

vi. Moving-Weighted Average Price:

In this method, the issue price is calculated by dividing the total of the periodic-weighted average prices of a given number of periods (including the period in which the material to be priced is issued) by the number of periods.

vii. Standard Price:

Under this method, each issue is priced at a predetermined standard price. This method is used when the firm has a full standard costing system. Careful consider­ation of all the factors (such as quantity to be purchased, prevailing prices and likely fluc­tuations, and estimated incidental expenses) is essential in setting standard prices.

viii. Replacement Price:

Replacement price is current market price of the material. At the point of every issue, the replacement price is determined and the same is applied in pricing the particular issue.

ix. Next-In-First-Out (NIFO) Method:

In this method, issues are priced at the next price, i.e., price of the material which has been ordered (latest order) but not yet received. This is an attempt to value issues at an actual price, which is closer to the current market price and should be the replacement price.

Choice of the Method:

International Financial Reporting Standard (IFRS) restricts the choice to FIFO and average cost pricing method for the purpose of valuing inventories for the purpose of financial reporting to outsiders, including investors. There is no such restriction for internal reporting.

Most firms use weighted average method to price issue of materials because it smoothes price fluctuations and it is easy to operate. However, a firm which has a definite pattern of material movement uses FIFO or LIFO depending on which of the two is appropriate. Firms which has full standard costing system, uses the standard price method for pricing issues.

Replacement cost method is the most appropriate method for use in determining the product cost for the purpose of pricing decision. However, it is difficult to operate. Therefore, it is not in common use.