CHAPTER 2 Accounting for Materials

Review Summary
  1.   Materials control includes physical control of materials and control over the investment in materials. Effective physical control of materials involves limiting the access to stored materials, segregating the duties of employees who handle materials and materials reports, and establishing an accurate recording system for materials purchases and issues. Only authorized personnel should be permitted in material storage areas, and procedures for moving materials into and out of these areas should be well established. The following functions of materials control should be segregated to minimize opportunities for employee misappropriation: purchasing, receiving, storage, use, and recording. To ensure the accurate recording of purchases and materials issues, inventory records should document the determination of inventory quantities on hand, and cost records should provide the data needed to assign a cost to  inventories to be used in the preparation of financial statements.
2.   Controlling the materials inventory investment requires analysis and planning to determine when orders should be placed and the number of units to be ordered. The point at which the predetermined minimum level of inventory is reached, requiring the item to be ordered, is called the order point. Calculating the order point is based on the following:
        Usage—The anticipated rate at which the materials will be used.
        Lead time—The estimated time interval between placing the order and receiving the materials ordered.
        Safety stock—The estimated minimum level of inventory needed to protect against stockouts.
The order point can be calculated as follows:
(Expected Daily Usage × Lead Time) + Safety Stock
  3.   The optimal quantity of materials to order at one time, called the economic order quantity, is the order size that minimizes the total costs of placing orders and of carrying inventory in stock. Order costs include purchasing, receiving and inspection salaries and wages, communication costs, and record keeping. Carrying costs include storage and handling; interest, insurance, and property taxes on inventories; and losses due to theft, spoilage, or obsolescence. Annual order costs decrease when order size increases while annual carrying costs increase with increases in order size. The economic order quantity formula is:

The economic order quantity is the point where total order costs equal total carrying costs, unless there is a provision for safety stock.
  4.   Materials control personnel include (a) the purchasing agent who is responsible for purchasing the materials needed at the most economical price; (b) the receiving clerk who is responsible for supervising incoming shipments of material; (c) the storeroom keeper who is responsible for storing and maintaining the goods received; and (d) the production department supervisor who is responsible for supervising the operations of a particular department and who prepares or approves material requisitions.
  5.   The supporting documents used in the procurement process include (a) the purchase requisition, which is prepared by the storeroom keeper to notify the purchasing agent that additional materials should be ordered; (b) the purchase order, which is prepared by the purchasing agent describing the materials ordered, stating terms and prices, and fixing the date and method of delivery; (c) the vendor’s invoice, which the purchasing agent compares to the          purchase order to verify description of materials, price, terms of payment, method of shipment, and delivery date; (d) the receiving report, which is prepared by the receiving clerk who counts and identifies the materials received and records the shipper, the date of receipt, the materials received, and the number of the purchase order identifying the shipment; and (e) the debit-credit memorandum, which is prepared when the type, quantity, or quality of goods ordered differs from that which was shipped and adjustments must be made to the vendor’s invoice. If goods are to be returned, the purchasing agent will prepare a return shipping order.
  6.   After materials have been ordered, received, and transferred to the storeroom, they must be protected from unauthorized use. Materials should not be issued from the storeroom without written authorization in the form of a properly approved materials requisition. The materials requisition should identify the specific job or department to which the materials are issued.  Occasionally materials are returned to the storeroom because, for example, more materials were requisitioned than were actually needed for production or perhaps the wrong type of material was issued. Returned materials should be accompanied by a returned materials report.
  7.   All purchases of material should be recorded in the general ledger as a debit to Materials. The materials account is a control account supported by a subsidiary materials ledger. The individual accounts in the materials ledger are designed to show the quantity of each material on hand and its cost. When materials receipts and issues are posted to the materials ledger accounts, the balance is extended after each entry so that it may be determined when stock is falling below minimum requirements. Most companies now have automated inventory systems that utilize online information processing, such as bar coding and optical scanning technology, to update inventory records on a “real time” basis.
  8.   There are several acceptable ways of assigning costs to materials as they are issued. Under the first-in, first-out (FIFO) method of costing, the materials issued are costed at the earliest prices paid for the materials in stock, and the ending inventories are costed at the most recent purchase prices. Under the last-in, first-out (LIFO) method of costing, the materials issued are costed at the most recent purchase prices, and the ending inventories are costed at the prices paid for the earliest purchases. Under the moving average method, an average unit price is computed each time a new lot of materials is received, and the new unit price is used to cost all issues until another lot is received and a new unit price is computed. In choosing an inventory costing method, the method selected should accurately reflect the income for the period in terms of current economic conditions. Under conditions of rising prices, the LIFO method is sometimes selected because the higher priced materials are charged against the increasingly higher sales revenue, resulting in a more representative earnings picture and a lower income tax liability. The FIFO method is simpler and less expensive clerically and fairly depicts profits under stable price conditions. Many companies have adopted the middle-of-the-road position represented by the moving average method, especially now that computer programs do the computations.
  9.   All materials issued to production and those returned to stock during a period are recorded on a summary of materials issued and returned. At the end of the period, the summary provides the information necessary to record the cost of materials. The total cost of direct materials requisitioned is recorded by debiting Work in Process and crediting Materials. The total cost of indirect materials requisitioned is recorded by debiting the appropriate factory overhead account and crediting materials. Unused materials returned from the factory to the storeroom are recorded by debiting Materials and crediting Work in Process (direct materials) or Factory Overhead (indirect materials). Any materials returned to vendors should be recorded by debiting Accounts Payable and crediting Materials.  The balance of the Materials account may be proven by comparing it to the total of the individual materials ledger account balances.
10.    Periodically, the materials on hand should be physically counted and compared to the individual materials ledger accounts by someone other than the storeroom keeper or materials ledger clerk.
11.   A just-in-time inventory (JIT) system, also known as a lean production system,   significantly reduces inventory-carrying costs by requiring that raw materials be delivered only when they are ready to be used and by eliminating inventory buffers of raw materials between manufacturing cells. Many manufacturing functions that were performed in individual departments in a traditional manufacturing system are combined into work centers and manufacturing cells in a JIT system. A JIT system can significantly reduce throughput time, the time that it takes a unit of product to make it through the manufacturing process, and increase velocity, the speed with which units are produced in the system.  Successful JIT systems require a high degree of coordination with both suppliers and customers and among work centers.
11.   Scrap or waste materials may result from the production process. If the expected sales revenue from scrap is small, no entry is made for the scrap material until it is sold. At the time of sale, Cash or Accounts Receivable is debited and Scrap Revenue, Work in Process, or Factory Overhead is credited depending on whether or not the scrap can be identified with a specific job or department. If the revenue from scrap is expected to be substantial and the market value is known, Scrap Material should be debited and Scrap Revenue should be credited at the time the scrap is inventoried. Scrap Material is credited when the materials are subsequently sold.