Direct Material Cost

Subject: Cost Accounting
Topic: Direct Material Cost
By: Questionscastle Academic Team Document Code: CA/IPCC/CST/00020

Direct Material is the material which is directly related to the finished good. Direct Material can be seen directly in the finished good and is major production component of finished goods. E.g. Wood in a table or chair, Plastic in computer keyboard and etc. Direct Material Cost is the cost related to direct material. The cost of purchasing, carrying and paying taxes on direct material etc is included in direct material cost. Purpose of calculating direct material cost is to identify that how much part of the total cost of product consists of direct material cost. Various levels of Material/Stock: Before calculating direct material cost one should know different levels of inventory. These are: 1. Reorder Level 2. Reorder Quantity 3. Maximum Level 4. Minimum Level 5. Average Level 6. Danger Level Reorder Level: Reorder level is the level of stock at which one should order for the purchase of material. If level of stock goes beyond reorder level it will be typical to exist any long. It can be calculated as follows: Reorder Level = Maximum Consumption x Maximum Lead Time/Delivery Period Where, Maximum Consumption = The maximum qty. of an material consumed in a organisation in appropriate time, Lead Time/Delivery Period = The time taken by supplier to supply the ordered qty. Reorder Quantity: It is the quantity which should be ordered by an organisation for purchase from the supplier at one time. Its calculation is based on the past experience of the organisation. Maximum Level: Maximum Level is the maximum level of stock which can be available in an organization at any time. In any situation stock more than maximum level will not be available in an organisation. It can be calculated as below: Maximum Level = Reorder Level + Reorder Qty (Minimum Consumption x Minimum Lead Time/Delivery Period) Minimum Level: Minimum level is the minimum level of stock that can be available in an organisation at any time. If level of stock goes below minimum level the organisation may face a problem of stock out. It is calculated as below: Minimum Level = Reorder Quantity (Average Consumption Time/Delivery Period) x Average Lead
Average Level: Average level is the average stock available in an organisation at any time: It has two formula for calculation:
Average Level = Or Average Level = Minimum Level + Danger Level: Danger Level is the level of stock below reorder level. If level of stock goes at danger level the organisation is needed to purchase material from a supplier who can supply in minimum lead time. It can be calculated as below: Danger Level = Reorder Qty x Minimum Time for emergency period (This time is taken as lower than minimum lead time if not given in question) Economic Order Quantity (EOQ) is the Optimal Reorder quantity which one should order at a time for keeping its cost (not including material cost) minimum. At EOQ, Total Ordering Cost i.e. the cost which one should bear for ordering one purchase order, equals Total Carrying Cost i.e. cost which bears for keeping the purchased goods in inventory. The formula for EOQ is: EOQ = Where, A = Annual Demand, O = Ordering Cost per order C = Carrying cost per unit per annum. The formula for calculation of EOQ is called Baumol Model. This method of calculating EOQ is not applicable where quantity discount on different purchase quantity is available. If quantity discount on different purchase quantity is available then Trial and Error Method is to be used. Safety Stock Level: Safety stock is the stock which is kept separately from regular stock in order to face any unwanted and unavoidable serious circumstance. Diesel kept in the dicci of car in a can for emergency purchase is a good example of Safety Stock Level. Back Order Cost: Back order cost is the cost which one should bear for not transferring material on time to customer. The Economic Order Quantity in this case is calculated as follow: EOQ = Where C1 = Inventory Turnover Ratio: Inventory Turnover Ratio shows the rate at which raw material is converted in to turnover i.e. finished goods. The purpose is to analyse whether inventory is utilised effectively or not. It is calculated as follows: Inventory Turnover Ratio = Where, Raw Material Consumed = Opening Stock + Purchases during the year Closing Stock Average Inventory = Inventory Conversion Period: It is the period which shows the time taken in converting inventory in to finished goods. It is calculated as follows:
Inventory Conversion Period =
ABC Analysis: It is a system of inventory control. It exercises discriminating control over different items of stores classified on the basis of investment involved. Usually the items are divided in to three categories according to their importance, namely, there value and frequency of their usage during a period. A category of items consist of only a small percentage i.e. about 10% of the total items handled by the store but requires heavy investment i.e. about 70% of total inventory value. These items can be handled effectively by using a regular scientific system which ensures neither overstocking nor shortage of these type of items. Such a system plans its total requirement of such items by making budgets. B categories of items are relatively less important as compared to category A items. They may be around 20% of the total items handled by the store and requires an investment which may also equal to almost 20% of total inventory value. In this category of items the same degree of control as was used in category A items is not warranted. The orders for such items can be placed after a periodical judgement of their stock. C categories of items do not requires much investment, it may be around 10% of total inventory value but are nearly 70% of total items handled by the store. For this category of items constant review is not required. Orders for such items can be placed after ascertain consumption requirement. It can be even once in 6months or 1 year.
VED Analysis: The VED analysis is generally used for spare parts. The requirement and urgency of spare parts is different from that of materials. Spare parts are classified as Vital(V), Essential(E), and Desirable(D). The vital spare parts are must for running the concern and must be stored adequately. The essential spare parts are also necessary but their stock may be kept at low figures. The stocking of desirable spare parts may be avoided at times. If the lead time of these spares is less, then stocking can be avoided. FSN Analysis: There are some materials which are very rapidly consumed either in actual production or in maintenance so that the stocks are replenished very frequently. These are known as fast moving items. But there are some materials which are not frequently required for consumption and these stocks are not to be replenished so frequently. The requirement may occur once in a quarter or so. These are known as slow moving items. Non-moving items are also called dormant stock. Dormant stocks are referred to those items which are not moving continuously but movement is expected soon because of their requirement in production or maintenance. If the non-moving items are not required for production or maintenance, these are to be disposed being surplus items. The loss on disposal is called as factory overhead. As a measure of material control, a regular check is required to determine the fast moving items, slow moving items and non-moving items in order to avoid any situation of over stocking or shortage in supply. It is called FSN Analysis: F=Fast Moving Items S=Slow Moving Items N=Non Moving items
Store Ledger: A store ledger is a register where all the details of all the items lying in the store are kept. In a store ledger all the details regarding purchase, issue obsolesce etc of all the materials are maintained. The store Ledger can be prepared by following methods: 1. FIFO: First In First Out. Under this method store ledger is prepared with a view that items which are brought in store i.e. purchased first are issued first. Hence issued items are valued on the basis of sequence of purchase. 2. LIFO: Last In First Out. This method is opposite to FIFO method. Here it is assumed that items bought in last i.e. purchased last are issued first. Hence issued items are valued on
3. 4.
the basis of reverse sequence of purchase. Average Price Method: Under this method all items are valued of aggregate average basis. Here price per unit is calculated by dividing unit price of materials in stock by number of purchases. Weighted Average Method: Here price is calculated on the basis of weights. Here the value of total stock is divided by total quantity to find the average price for issue of material.

Direct Material Cost

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Subject: Cost Accounting

Topic: Direct Material Cost

By: Questionscastle Academic Team Document Code: CA/IPCC/CST/00020

Inventory Conversion Period =

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