Accounting

ACCOUNTING FOR MATERIALS
Principles of Cost Accounting, 17th Edition, Edward J. VanDerbeck, ©2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for
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Learning Objectives
• Recognize the two basic aspects of
materials control.
• Specify internal control for materials.
• Account for materials and relate materials
accounting to the general ledger.
• Account for inventories in a just-in-time
(lean production) system.
Learning Objectives (cont.)
• Account for scrap materials, spoiled goods,
and defective work.
A Cost Control System
• The major function of a cost control
system is to keep expenditures within the
limits of a preconceived plan.
• An effective cost control system is
designed to control the actions of people
responsible for expenditures because
people control costs. Costs do not control
themselves.
• An effective cost control system should
include the following:
• A specific assignment of duties and
responsibilities.
• A list of individuals who are authorized to
approve expenditures.
• An established plan of objectives and goals.
• Regular reports showing the differences
between goals and actual performance.
• A plan of corrective action designed to prevent
unfavorable variances from recurring.
• Follow-up procedures for corrective measures.
Materials Control
• The two basic aspects of materials control
are :
• the physical control or safeguarding of
materials
• control over investments in materials
Physical Control of Materials
• Limited Access – only authorized
personnel should have access to material
storage areas.
• Segregation of duties- segregation of
employee duties to minimize
opportunities for misappropriation of
assets.
• Accuracy in recording – accurate recording
of the purchase and issuance of materials.
Investment Control of
Materials
• Maintaining the appropriate level of raw
materials is one of the most important
objectives of materials control.
• An inventory of sufficient size and variety
for efficient operations must be
maintained.
• Management should consider other
working capital needs in determining
inventory levels.
Materials
• Adequate planning and control is required.
• Management must determine:
• When orders must be placed
• How many units should be ordered
Materials
• Order point must be determined; order
point is a minimum level of inventory that
should be determined for each type of raw
material, and inventory records should
indicate how much of each type is on
hand.
Materials
• Order point is based on the following data:
• Usage – the anticipated rate at which the
material will be used.
• Lead time – the estimated time interval
between the placement of the order an the
receipt of the material.
• Safety Stock - estimated minimum level of
inventory needed to protect against stockouts
Economic Order Quantity
(EOQ
• The optimal quantity to order at one time.
• Minimizes the total order and carry costs
over a period of time.
Inventory Management in
Organizations
• Inventory management includes planning,
coordinating, and controlling activities
related to the flow of inventory into,
through, and out of an organization.
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Costs Associated with
Goods for Sale, overview
• Managing inventories to increase net
income requires effectively managing
costs that fall into these six categories:
1. Purchasing costs.
2. Ordering costs.
3. Carrying costs.
4. Stockout costs.
5. Quality costs.
6. Shrinkage costs.
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Goods for Sale, details
1. Purchasing costs—the cost of goods

acquired from suppliers, including
incoming freight costs. Usually this is the
largest cost category of goods in
inventory.
2. Ordering costs—the costs of preparing
and issuing purchase orders, receiving
and inspecting the items included in the
orders, and matching invoices received,
purchase orders, and delivery records to
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make payments. 16
Goods for Sale, details, cont’d
3. Carrying costs—the costs that arise while goods
are being held in inventory. These costs include
the opportunity cost of the investment tied up in
inventory, and costs associated with storage.
4. Stockout costs—the costs that arise when a
company runs out of a particular item for which
there is customer demand (stockout). The
company must act quickly to meet the demand or
suffer the costs of not meeting it.
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Costs Associated with Goods for Sale,
details, concluded
5. Costs of Quality – the costs incurred to prevent
and appraise, or the costs arising as a result of,
quality issues. Recall from chapter 19, there are
four categories of quality costs:
1. Prevention.
2. Appraisal.
3. Internal failure.
4. External failure.
6. Shrinkage costs—costs that result from theft by
outsiders, embezzlement by employees,
misclassifications and clerical errors. Shrinkage
is measured by the difference between the cost
of inventory on the books vs the cost of the
physical count.
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The First Step in Managing
Goods for Sale: the economic order
quantity
• The first decision in managing goods for
sale is how much to order of a given
product.
• Economic order quality (EOQ) is a
decision model that calculates the
optimal quantity of inventory to order
under a given set of assumptions.
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Basic EOQ Assumptions
• There are only ordering and carrying costs.
• The same quantity is ordered at each reorder
point.
• Demand, purchase-order lead time, ordering costs,
and carrying costs are known with certainty.
• Purchasing costs per unit are unaffected by the
quantity ordered. (Therefore, purchasing costs are
irrelevant.)
• No stockouts occur.
• Managers consider the costs of quality and
shrinkage costs only to the extent that these costs
affect ordering or carrying costs.
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EOQ Formula-results in the
quantity that minimizes annual
relevant total costs
D = Demand in units for specified period

P = Relevant ordering costs per purchase order
C = Relevant carrying costs of one unit in stock for
the time period used for D
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Ordering and Carrying Costs
Illustrated
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When to order (assumes certainty
of demand and lead time)
• The second decision in managing goods for
sale is when to order a given product.
• Reorder point—the quantity level of
inventory on hand that triggers a new
purchase order.
Reorder Number of units sold Purchase Order

Point = per unit of time X Lead Time
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Ordering Points Illustrated
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Safety Stock (demand and lead
time uncertain)
• Safety stock is inventory held at all times
regardless of the quantity of inventory
ordered using the EOQ model.
• Safety stock is a buffer against unexpected
increases in demand, uncertainty about lead
time, and unavailability of stock from suppliers.
• Managers use a frequency distribution based
on prior daily or weekly levels of demand to
compute safety-stock levels.
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Estimating Inventory-Related
Relevant Costs and their effects
The relevant costs are categorized as follows:
Carrying costs – see next slide

Stockout costs – the cost of expediting an
order from a supplier
Ordering costs – those ordering costs that
change with the number of orders placed
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Carrying Costs
• Relevant inventory carrying costs consist
of relevant incremental costs and the
relevant opportunity cost of capital.
• Relevant incremental costs—those costs of
the purchasing firm that change with the
quantity of inventory held.
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Opportunity Costs
• Relevant opportunity cost of capital—
the return foregone by investing capital
in inventory rather than elsewhere.
• It is calculated as the required rate of
return multiplied by the per-unit costs of
acquiring inventory, such as the
purchase price of units, incoming freight,
and incoming inspection.
• Opportunity costs are also computed on
investments if these investments are
affected by changes in inventory levels. 20-
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Cost of a Prediction Error
• Three steps in determining the cost of a
prediction error:
1. Compute the monetary outcome from the
best action that could be taken, given the
actual amount of the cost per purchase
order.
2. Compute the monetary outcome from the
best action based on the incorrect amount of
the predicted cost per purchase order.
3. Compute the difference between steps 1 and
2.
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Calculating EOQ
• EOQ = Economic
Order Quantity
• C = Cost of placing an
order
EOQ = 2CN
• N = Number of units
required annually K
• K = Annual carrying
cost per unit of
inventory
Materials Control Procedures
• Materials control procedures generally
related to the following functions:
• Purchase an receipt of materials
• Storage of materials
• Requisition and consumption of materials
Materials Control Personnel
• Personnel involved in materials control
usually include
• Purchasing Agent
• Receiving Clerk
• Storeroom Keeper
• Production Department Supervisor
Control During Procurement
• Documents commonly used in procuring
materials include:
• Purchase requisitions
• Purchase Orders
• Vendor’s invoices
• Receiving reports
• Debit-credit memoranda
Control During Procurement
Control During Storage and
Issuance
• Materials Requisition
• Returned Materials Report
Figure 2-9 Materials Requisition. (Authorization to withdraw materials from storeroom.)
Accounting for Materials
• A company’s inventory records should
show (1) the quantity of each kind of
material on hand and (2) its cost.
• The materials accounting system must be
integrated with the general ledger.
• Purchases of materials on account are
recorded as a debit to Materials in the
general ledger.
Accounting for Materials
• Materials account is a control account that
is supported by a materials ledger.
Flow of materials and costs
• Flow of materials is the order in which
materials are actually issued for use in the
factory.
• Flow of costs is the order in which unit
costs are assigned to materials issued.
Cost Flow Methods
• First-In, First Out (FIFO) Method – the
materials issued are assumed to be taken
from the oldest materials in stock.
• Last-In, First Out (LIFO) Method – the
materials issued are assumed to be taken
from the most recent purchase prices.
• Moving Average Method – assumes that
the materials issued at any time are simply
withdrawn for a mixed group of materials.
Interrelationship of Materials
Documents and Accounts
Just-in-Time Materials Control
• In a just-in-time inventory system (lean
production system), materials are
delivered to the factory immediately prior
to their use in production.
Just in Time Materials Control
Just in time and Cost Control
• Throughput time – the time it takes a unit
to make it through the manufacturing
system.
• Velocity – speed at which units are
produced in the system.
• Nonvalue-added activities – operations
that add costs but do not add value to the
product for its customers, such as moving,
storing, and inspecting the inventories.
Just-in-Time Purchasing
• Just-in-time (JIT) purchasing, a method of
managing purchases so the materials or
goods are delivered just as needed for
production or sales.
• JIT purchasing is not guided solely by the
EOQ model because that model only
emphasizes the tradeoff between relevant
carrying and ordering costs.
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JIT Purchasing, concluded
• JIT reduces the cost of placing a purchase
order because:
• Long-term purchasing agreements define price
and quality terms. Individual purchase orders
covered by those agreements require no
additional negotiation regarding price or
quality.
• Companies are using electronic links to place
purchase orders at a small fraction of
traditional methods (phone or mail).
• Companies are using purchase-order cards
(similar to consumer credit cards). 20-
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Relevant Costs in JIT Purchasing
Relevant costs for the EOQ model are the carrying and
ordering costs.
Inventory management includes purchasing costs,
stockout costs, costs of quality and shrinkage costs.
JIT relevant costs include:
Purchasing costs
Ordering costs
Opportunity costs
Carrying costs
Stockout costs
Quality costs
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JIT Purchasing and
Supply-Chain Analysis
• Supply chain describes the flow of goods, services,
and information from the initial sources of
materials and services to the delivery of products
to consumers.
• Supply chain members share information and
plan/coordinate activities.
• Supplier evaluations are critical to JIT purchasing
implementation.
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Just in Time and Cost Flows
Backflush Costing
Traditional normal or standard-costing systems use
sequential tracking in which the recording of the journal
entries occurs in the same order as actual purchases and
progress in production.
As a reminder, the 4 stages are:
Purchase of Direct Materials & Incurring of
Conversion costs*
Production resulting in WIP
Completion of Good finished units of product*
Sales of finished goods*
* Indicates a trigger point for journal entries
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Backflush Costing, cont’d
• Backflush costing omits recording some of the
journal entries relating to the stages from the
purchase of direct materials to the sale of finished
goods.
• Because some stages are omitted, the journal entries for a
subsequent stage use normal or standard costs to work
backward to “flush out” the costs in the cycle for which
journal entries were not made.
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Backflush Costing, concluded
• Backflush costing does not necessarily
comply with GAAP.
• However, inventory levels may be immaterial,
negating the necessity for compliance.
• Backflush costing does not leave a good
audit trail—the ability of the accounting
system to pinpoint the uses of resources at
each step of the production process.
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Scrap, Spoiled Goods, and
Defective Work
• Scrap materials may result naturally from
the production process.
• Spoiled units have imperfections that
cannot be economically corrected. The
loss can be treated as part of the job or
charged to factory overhead.
• Defective work has imperfections that are
correctable. The extra costs are either
charged to the job or factory overhead.
Accounting for Scrap Materials
• If the scrap value is small:
Cash……..XXX
Scrap Revenue XXX
Accounting for Scrap Materials
• If the scrap value is relatively high:
Scrap Materials XXX
Scrap Revenue
Cash XXX
Scrap Materials XXX
Inventory Management, Materials
Requirements Planning (mrp) & jit
production
Materials requirements planning (MRP)—a
“push-through” system that manufactures
finished goods for inventory on the basis of
demand forecasts.
JIT production is a “demand-pull” approach
and is also called lean production. Each
component in a production line is produced as
soon as, and only when, needed by the next
step in the production line.
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MRP Information Inputs
• To determine outputs at each stage of
production, MRP uses:
1. The demand forecasts for final products.
2. A bill of materials detailing the materials, components,
and subassemblies for each final product.
3. Information about a company’s inventories of materials,
components, and products.
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MRP, process
• Taking into account the lead time required to
purchase materials and to manufacture
components and finished products, a master
production schedule specifies the quantity and
timing of each item to be produced.
• Once production starts as scheduled, the output
of each department is pushed through the
production line.
• Maintaining accurate inventory records and
costs is critical in an MRP system.
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Inventory Management, MRP and JIT
Production
JIT (lean) production is a “demand-pull”
manufacturing system that manufactures each
component in a production line as soon as, and
only when, needed by the next step in the
production line.
Demand triggers each step of the production
process, starting with customer demand for a
finished product and working all the way back to
the demand for direct materials at the beginning
of the process.
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JIT Production Goals
• JIT production systems result in close
coordination among work-stations.
• Smooths the flow of goods.
• Achieves low quantities of inventory.
• JIT aims to simultaneously:
• Meet customer demand in a timely manner.
• Produce high quality products.
• Generate the lowest possible costs.
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Features of JIT Production
systems
Production is organized in manufacturing cells, which
are work areas with different types of equipment
grouped together to make related products.
Workers are hired and trained to be multi-skilled (cross-
trained).
Defects are aggressively eliminated.
Setup time and manufacturing cycle time are reduced.
Suppliers are selected on the basis of their ability to
deliver quality materials in a timely manner.
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Costs and Benefits of JIT
Production
• Lower overhead costs
• Lower inventory levels, lower carrying
costs
• Heightened emphasis on improving quality
by eliminating the specific causes of
rework, scrap, and waste
• Lower manufacturing cycle times
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Enterprise Resource Planning (ERP)
Systems
ERP systems are frequently used in conjunction with JIT
production.
An ERP system is an integrated set of software modules
covering a company’s accounting, distribution,
manufacturing, purchasing, human resources and other
functions.
Real-time information is collected in a single database and
simultaneously fed into all of the software applications,
giving personnel greater visibility into the company’s end-
to-end business processes.
Companies believe that an ERP system is essential to
support JIT initiatives because of the effect it has on lead
time.
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Enterprise Resource Planning (ERP)
Systems, concluded
• The challenge, when implementing ERP

systems, is to strike the proper balance
between the lower cost and reliability of
standardized systems and the strategic
benefits that accrue from customization.
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Performance Measures and
Control in JIT
Financial performance measures such as inventory
turnover ratio, which is expected to increase.
Nonfinancial performance measures of time,
inventory, and quality such as:
 Number of days of inventory on hand: expected to decrease.
 Units produced per hour: expected to increase
 % of scrapped/rework over total units started: expected to
decrease.
 Manufacturing cycle time: expected to decrease.
 Setup time: expected to decrease.
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Lean Accounting
• Another simplified product costing system
that can be used with JIT systems is lean
accounting.
• When a company utilizes JIT production, it
has to focus on the entire value chain of
business functions in order to reduce
inventories, lead times and waste.
• The improvements that result have led some
companies with JIT systems to develop
organizations structures and costing systems
that focus on value streams. 20-
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Lean accounting and Value
streams
Value streams are all the value-added activities
needed to design, manufacture, and deliver a given
product or product line to customers.
Lean accounting is a costing method that focuses on
value streams, as distinguished from individual
products or departments, thereby eliminating waste
in the accounting process.
Tracing more costs as direct costs to value streams
is possible because companies using lean
accounting often dedicate resources to individual
value streams.
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Lean accounting and value
streams, concluded
Lean accounting is much simpler than traditional
product costing because calculating actual product
costs by value streams requires less overhead
allocation.
Critics of lean accounting charge that it does not
compute the costs of individual products, which
makes it less useful for making decisions.
Critics of lean accounting charge that it excludes
certain support costs and unused capacity costs.
A final criticism is that, like backflush costing, it
does not correctly account for inventories under
GAAP.
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ACCOUNTING FOR MATERIALS

1. Purchasing costs—the cost of goods

D = Demand in units for specified period

Reorder Number of units sold Purchase Order

The relevant costs are categorized as follows:

Carrying costs – see next slide

• The challenge, when implementing ERP

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