How to Compute and Calculate Material Cost? (Methods) | Cost Accounting

Ascertainment of accurate cost is one of the main objectives of cost accounting. For a manufacturing company material consumption and material cost are vital aspects. Ascertainment of accurate cost depends on correct valuation of material used in the product. The material cost consists of invoice price plus freight, carriage, cartage, insurance, taxes, stores costs, etc.

Materials are issued to different departments, different orders and jobs from stores. The jobs are to be correctly charged with material consumed. But the material in stores will be of different lots received at different prices on different occasions. This makes it necessary to decide about the price to be charged to jobs which are issued with materials from different lots.

The following are essential for ascertainment of accurate material cost:

(I) Computation of total cost of material purchased.

(II) Systematised material issue procedure.

(III) Appropriate methods of pricing material issues.

(I) Computation of Total Cost of Material Purchased:

Most of the details needed to ascertain the total cost of material purchased can be obtained from the invoice sent by the supplier.

The basic purchase price has to be adjusted in the light of delivery and forwarding charges, sales tax, excise duty, etc. Similarly, transport charges and cost of containers have to be included. Any discounts receivable have to be appropriately subtracted.

(a) Discounts:

There are three types of discounts to be considered:

(i) Trade Discount:

This is a discount allowed by the supplier to compensate the buyer for the costs of ‘breaking bulk’, selling in small lots to customers, repacking, etc. The supplier is relieved from all these costs by the buyer by purchasing a large quantity. This discount is usually given by the wholesalers.

(ii) Quantity Discount or Bulk Discount:

This discount is allowed by the supplier as a measure of savings in cost which arise from the production of longer runs and the distribution of larger quantities. Part of the savings accruing to the supplier out of a large order is passed on to the buyer by means of quantity discount.

(iii) Cash Discount:

This discount is offered by the supplier to the buyer as an option. The discount is linked to payment of the invoice amount before a specified due date or within a specified number of days. The purchaser may make use of the option and obtain the discount if his cash position permits it. Generally, this discount is considered as a matter of ‘financial policy’ and not taken into account for computation of material cost.

(b) Transport and Storage Costs:

If transport cost and cost of storage in transit are not included in the invoiced price of the supplier, they may be added as the direct costs of purchase to the cost of material. If it is not possible to identify such costs with specific materials because of paying a combined amount for several materials, they may be treated as indirect expenditure and included in the overhead.

(c) Cost of Containers:

The supplier may or may not charge separately for containers. If no charges are made, no accounting treatment is required.

If container charges are made, the treatment may depend upon the following; circumstances:

(a) Non-Returnable Containers – The container costs are added to the purchase price.

(b) Returnable Containers Credited at Reduced Value on Return – The difference between the cost of containers and the amount credited by the supplier on return is added to the purchase price.

(c) Returnable Containers Credited at Full Value on Return – The cost of containers is not added to the price since no cost is incurred by the buyer.

(d) Sales Tax, Excise Duty, Insurance, Etc. – These items are added to the purchase price to ascertain the total cost of material purchased.

(II) Material Issue Procedure:

Materials kept in the stores are to be issued to production departments whenever the departments require them. The store keeper is to issue materials only when a material requisition is presented to him.

(a) Material Requisition:

It is a properly authorised document initiated by the production departments to draw the required material from stores. It has to be initiated by properly authorised person to avoid misappropriation of material.

The requisition serves as authority to the store keeper to issue materials. The store keeper puts serial number on the requisition and makes entries in the issue column of the bin card. After this the requisitions are sent to the cost office where the value of material issued is also filled up and credit is given to the material issued in the stores ledger and the job receiving the material in the job ledger is debited.

(b) Bill of Materials:

It is a document listing all the materials required with quantities required for a particular job, order or process. The bill of material serves the purpose of material requisition. The bill of material is prepared for a job of non standardised type so that estimate of all materials required for the job is made by the production department before the job is started. This is helpful to estimate material cost of the job for submitting tenders or quotations.

A specimen form of a bill of materials is given below:

Treatment of Surplus Materials:

(a) Return of Surplus Material:

Sometimes, excess materials maybe issued to production departments. When these materials are returned to stores a Material Return Note is to be prepared by the department which has the excess materials. Generally, three copies are prepared. One copy is retained by the department which is returning the material. Two copies are sent to the store keeper. The store keeper keeps one copy for making entries in the Bin card and the second copy is sent to the cost office for making entries in the stores ledger and for giving credit to the job where the material is in excess.

(b) Transfer of Surplus Materials:

Transfer of excess materials from one job to another job is to be avoided as far as possible. This is because record for transfer may not be made and actual material cost of jobs may be inaccurate. However, sometimes the material may be allowed to be transferred to avoid delays and handling charges. The transfer is to be allowed only with preparation of material transfer note so that the cost of material transferred is debited to the job receiving the material and credited to the job transferring the material.

(III) Methods of Pricing Material Issues:

The purchase prices of materials fluctuate on account of changes in the product prices, buying from different suppliers and on account of quantity discounts. Because of price fluctuations, the stock may include several lots of the same material purchased at different prices. When these materials are issued to production, it is important to consider the correct price at which these materials are charged to production.

There are various methods in use. They are broadly classified under the following categories:

1. Cost Price Methods:

(a) First in First out (FIFO).

(b) Last in First out (LIFO).

(c) Specific price.

(d) Base stock.

(e) Highest in first out (HIFO).

2. Derived from Cost Prices or Average Price Methods:

(a) Simple Average.

(b) Weighted Average.

(c) Periodic Simple Average.

(d) Periodic Weighted Average.

(e) Moving Simple Average.

(f) Moving Weighted Average.

3. Notional Price Methods:

(a) Standard Price.

(b) Inflated Price.

(c) Re-use Price.

(d) Replacement Price.

All the above methods are explained below in detail:

1. Cost Price Methods:

This group of methods consists of all those methods wherein each lot of material purchased is charged to various departments at the actual cost of purchase. When one lot at a particular price is exhausted, the next lot is issued at the purchase price of that lot and so on, as per the particular method used. Thus, the prices charged are always the actual purchase prices and not average or notional prices.

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

Different lots of the same material received are noted in the order in which they have entered into the stock. When an issue is made, the price of the earliest lot in the stock is charged to the receiving department. When that lot is exhausted, the next lot is issued at the respective price of that Tot. This method resembles the ‘queue’ system because the material which entered the store first goes out first.

Advantages of FIFO Method:

1. Prices are based on actual costs. No profit or loss on stocks results from using this method.

2. Stock balances are of fair commercial value representing the latest market prices.

3. This method is suitable in case of slow moving materials.

4. It is appropriate in situations of falling prices to charge the jobs with higher prices purchased earlier.

Disadvantages of FIFO Method:

1. Possibility of more clerical errors due to more number of calculations.

2. The cost of similar jobs differs if the prices fluctuate.

3. In times of rising prices, the cost of jobs does not reflect current market prices. This inflates the profits unnecessarily, resulting in higher taxes.

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

Under this method, the price of material last purchased and kept in stores in charged for the issues first and then the preceding lots purchased are issued. This method is used to take advantage, of rising prices.

Advantages of LIFO Method:

1. This method is simple to operate when issues are not too many.

2. Prices are based on actual cost. Therefore there is no possibility of profit or loss in stocks.

3. Production cost reflects latest market prices.

4. This method is suitable in case of rising prices because materials are issued at current market prices. The jobs and production are charged at the latest prices. Thus, profit on the jobs is not unnecessarily inflated.

Disadvantages of LIFO Method:

1. This method also involves tedious clerical work which may lead to clerical errors.

2. Comparison of jobs becomes difficult as they use same raw material but are charged with different prices.

3. During the period of falling prices the stocks are at high prices, which may necessitate writing off stock values to show the stocks at their market values.

(c) Specific Price Method:

This method is followed in concerns which-use-job order costing. In order to show the correct material cost of a job, materials are purchased for the job and the purchase price is charged to that job. This is done when non-standard materials are to be purchased for particular job specifications. A firm may use a standard method for pricing and when the material specifically purchased are issued for a specific job, the specific purchase price is charged to that job.

(d) Base Stock Method:

This method involves usage of any method of pricing of issues, keeping a ‘minimum stock’ of material at all times at a fixed price irrespective of the price fluctuations. Such minimum stock is not used unless an emergency arises. The method is based on the logic that stock never reaches ‘Zero’ level and an absolute minimum balance of stock is called the Base Stock and it is shown at a fixed price.

(e) Highest In First Out Method:

Under this method, the highest priced materials in stock are issued first. This method is based on the principle of consumption at the highest cost and inventor,’ value of material at the lowest possible price.

2. Derived from Cost Price Methods (or) Average Price Methods:

When materials are purchased frequently and issues to jobs or production are also made very often, cost price methods can distort the cost structure of different jobs or output. The same material is charged at different prices, sometimes even on the same day. Costing data may not be useful for comparison purpose. To avoid such grave danger, average price methods are followed by many organisations. The following are the different average price methods prevailing in practice.

(a) Simple Average Price Method:

When the variance between purchase prices is very little, this method is the most suitable one. Here the total of the prices of materials in the stock (from which the material to be priced could have been drawn) is divided by the number of prices used to ascertain the’ simple average price’. Irrespective of the quantities, the average of the prices is found. One lot may be 5 Kgs and another lot may 5,000 Kgs. But the prices per Kg of both lots are taken for average purpose.

It should be noted that for the purpose of physical movement of materials, FIFO (First in First Out) method is assumed which forms the basis of simple average method. Thus, the prices of earlier lots are left out of simple average calculation, as and when materials are issued and older lots are exhausted.

Advantages:

1. It is simple and easy to calculate the issue price.

2 This method reduces the effect of fluctuation of prices by averaging the price.

Disadvantages:

1. This method does not take into account the quantity purchased at each price. This may lead to absurd results.

2. As the actual price is not used, Profit or Loss on material will usually arise.

3. The Value, of closing stocks under this method is absurd. When price fluctuates sharply, the closing stock shows credit balance, that is negative figure!

(b) Weighted Average Price Method:

The weighted average price is calculated by dividing the value of stock in the stores by the quantity in the stock from which materials are to be issued. As this method takes into account the relative weights, it reduces the effect of fluctuations in prices.

The method is different from all other methods because in this method prices are calculated on receipt of material and not at the time of issue of materials.

Advantages:

1. This method is suitable where the prices vary very much from one purchase to another. As it uses quantities for calculation of average prices, the fluctuations are evened out.

2. The basis of calculation in the method is simple as the price is calculated by dividing the value of materials by their quantity.

3. A new price is calculated when new materials are purchased. All the subsequent issues are made at the price calculated until next lot is received. Thus, the clerical work is simplified and reduced.

4. The stock balance reflects fair prices which may be taken for financial statements.

Disadvantages:

1. This method is more complicated than simple average price as it takes into account the total quantity and value.

2. Since actual price is not used, Profit or Loss may arise in material cost by using this method.

3. Where receipts are numerous, calculations will be many and may result in errors.

4. The price may have to be taken upto three or four decimal places to calculate the correct value of large quantities. Otherwise, approximation may lead to difference in accounts.

(c) Periodic Simple Average Method:

Under this method the total value of the purchases is divided by the total number of prices during the accounting period to find average price. This method is similar to that of simple average price with the exception that only one price is to be calculated periodically. This method is adopted in costing continuous processes’ where each individual order is absorbed into the general cost of production.

(d) Periodic Weighted Average Method:

This price is calculated by dividing the total value of’ materially the total quantity of material purchased and received during the accounting period. This method takes into account the quantities as well and therefore it is used when prices fluctuate substantially. This method is used in process industries.

(e) Moving Simple Average Method:

This is a price which is calculated by dividing the total of periodic simple average prices of a given number of periods by the number of periods. This method is used when there are high fluctuations in material prices.

(f) Moving Weighted Average Method:

This price is calculated by dividing the total of periodic weighted average prices of a given number of periods by the number of periods.

The effect of Price fluctuations is dampened by using this method as in the case of moving simple average price method.

3. Notional Price Methods:

This group of methods are either predetermined prices or some other prices other than the original purchase prices, not even the average of the purchase price. Thus, the prices charged under these methods are completely different from the actual purchase prices.

(a) Standard Price Method:

This price is predetermined price fixed on the basis of all factors affecting the price. A standard price is fixed and the actual price is compared with the standard price. If actual price is more than the standard price, loss occurs and if actual price is less than the standard price, a profit will be obtained. While operating the pricing method the issue price is uniform for all quantities issued. The loss or profit on material is termed as ‘Material price variance’.

Advantages:

1. This method is relatively simple to operate as a single issue price is used during the accounting period.

2. Comparison of jobs becomes easier as the issue price is same.

3. It eliminates clerical errors as issue price is fixed.

4. This method facilitates ascertaining efficiency or otherwise of material purchases.

Disadvantages:

1. This method may show profit or loss on issue and closing stock may show absurd figures.

(b) Inflated Price Method:

This method aims at covering the costs of contingencies in addition to the purchase price. The issue price includes purchase price plus losses due to evaporation, wastage in handling and storage, carrying costs, etc. This method aims at recovering the full material cost.

(c) Re-Use Price Method:

This method is followed in pricing of materials issued for ‘re-use’. Materials originally purchased for a particular purpose but returned to the stores from the concerned department may be reissued to another department for a different purpose. The price charged is the normal price of material used for such works and not the original purchase price. Usually, material loss is incurred when re-use price method is employed.

(d) Replacement Price Method:

The current market price of materials is charged on the issues. The method is used to reflect the production cost at current market prices. This method shows profit during rising prices and losses during falling prices on the material issues. Stocks also do not represent correct values.