Chapter 2: Product Costing – Materials and Labour Management Accounting: A Practical Approach Gail Sheppard © Gail Sheppard, 2011

Categories of cost allocation Specific order costing Job costing Contract costing Batch costing Continuous operation costing Process costing Service costing

Components of product costing Direct material costs Direct labour costs Direct expenses Production overhead costs Non-manufacturing costs

Direct materials + Direct labour Direct expenses = Prime cost Production overhead costs Production cost Non-production costs Total cost/full cost

Traditional approach to accounting for inventory Inventory levels fall to reorder level Purchase requisition sent to purchasing department Purchase order is raised Materials delivered Delivery note checked Goods received note signed Supplier’s invoice checked Inventory coded Stores requisition order Inventory moved to production Stores accounts system updated

Pricing inventories First in, first out (FIFO) Last in, first out (LIFO) Weighted average

Example 2.1 FIFO Total value of inventory issued: €230 000 Closing balance of inventory: 10 000 kg Value of closing inventory on 24 April: €192 000

Example 2.1 LIFO Total value of inventory issued: €226 000 Closing balance of inventory: 10 000 kg Value of closing inventory on 24 April: €196 000

Example 2.1 Weighted average Total value of inventory issued: €228 000 Closing balance of inventory: 10 000 kg Value of closing inventory on 24 April: €194 000

Points to note The number of units issued and the closing units will always be the same with each method. The profits of a company will be affected by the method of inventory valuation used during periods of inflation and deflation. FIFO and weighted average are acceptable under IAS 2 but LIFO is not.

Economic order quantity (EOQ) EOQ is a traditional approach to managing inventory levels. Trade-off between: Carrying too much inventory and incurring high inventory holding costs Carrying too little inventory and incurring high inventory ordering costs.

EOQ formulae EOQ model: 2 x total demand x cost per order √ Holding cost per unit EOQ attempts to set an order size that minimises the holding costs and ordering costs. Lead time is time that lapses between placing an order and receiving inventory.

EOQ formulae Reorder level: Maximum usage x maximum lead time The reorder level is the point or level at which an order should be placed with the supplier to replenish inventory.

EOQ formulae Maximum stock level: Reorder level – (minimum usage x minimum lead time) + EOQ This represents the maximum amount of inventory that should be held. It will avoid tying up too much working capital in inventory.

EOQ formulae Minimum stock level: Reorder level – (average usage x average lead time) Holding a minimum stock level will prevent a stock-out in production.

Safety stock Where delivery of inventories is irregular or suppliers are unreliable, a business may decide to keep a buffer stock or safety stock.

EOQ formulae Minimum stock level (where there is safety stock): Reorder level + safety stock – (average usage x average lead time)

Just in time (JIT) Japanese philosophy: inventory should not be held but should arrive just as it is needed in production. Reduce holding and inspection costs. Zero defects in production. Push system. Problem if suppliers do not deliver on time. Suitable for production where there are short set-up times, where customer demand is constant and where there is no downtime.

Materials requirement planning (MRP) Production schedule that lists materials and components so that stock levels are maintained. MRP I : originated in the 1960s. MRP II: an extension of MRP I. Computerised system that plans inventory and involves: A master production schedule A bill of materials An inventory file.