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

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

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

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

5. 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

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

7. Example 2.1
FIFO Total value of inventory issued: € Closing balance of inventory: kg Value of closing inventory on 24 April: €

8. Example 2.1
LIFO Total value of inventory issued: € Closing balance of inventory: kg Value of closing inventory on 24 April: €

9. Example 2.1
Weighted average Total value of inventory issued: € Closing balance of inventory: kg Value of closing inventory on 24 April: €

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

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

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

18. 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.

19. 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.