Material Cost

What is Material Cost?

The word ‘MATERIAL’ in simple terms means all the commodities or components which are used in the process to manufacture a product. Thus, the word ‘Material Cost’ simply means the direct material cost incurred to manufacture a product. It is also known by the name of the cost of direct material and cost of raw material.  The process of identifying the costs of materials required to manufacture a product is Material Costing. Cost Accounting Standard (CAS-6) deals with the Material Cost.

Objectives of Material Costing

• Controlling cost
• Reduction of cost

After learning about the purpose of material costing, a major question of “how to minimize the costs associated with the material cost?” arises. The answer for this is through inventory management techniques.

Inventory Management Techniques

Inventory Management is all about procuring, controlling and stocking. It is an approach to keep track of the flow of inventory. A well-planned system of inventory defines (a)what (b)how much and (c)where to purchase and (d)where to keep inventory.

Let us talk about some of the significant Inventory Management Methods in this article.

Deciding different levels of stock

To overcome the problems of over-stocking or under-stocking of materials, a decision regarding the levels of stock should be taken by the management in order to reduce the inventory cost.

Maximum Level

It is the upper limit of the quantity of stock to be kept in by the management. It should not maintain the materials more than this level. Otherwise, it will increase the storage cost.

Maximum Level of Inventory = Reorder level + EOQ – (Minimum rate of usage * Minimum lead time)

Average Level

It is half of the minimum plus the maximum level of stock held.

Average Level of Inventory = Minimum level + (1/2 Re-order quantity) OR (Minimum level + Maximum level)/2

Re-order Level

It is the level of inventory where the latest supply of materials is required to be received.

Re-order Level of Inventory = Maximum usage * Maximum lead time

Minimum Level

It is the least level of the stock that management should maintain all the time. Stock held below this level means there is a probability of production getting interrupted due to insufficient materials.

Minimum Level of Inventory = Reorder level – (Average used * Average lead time)

Danger Level

It is the level where the issue of material temporarily ceases. It is an alarming situation for the organization and should always be avoided. Instant actions are required to be taken to refill the stock once it reaches the danger level.

Danger Level of Inventory = Minimum usage * Minimum time for emergency purchase

Economic Ordering Quantity (EOQ)

It is the order size where both the order cost as well as carrying costs are the least.

Ordering costs: The cost related to the creation and processing of orders with suppliers. It is also known as buying costs.

Carrying costs: It is the cost of holding items in inventory. Also termed as Holding costs.

EOQ = √(2AO / C)

A= Annual demand of raw materials in units

O= Cost of making one order

C= carrying cost of one unit per annum

ABC Analysis

It is the method that is based on the idea of putting the product as per their category of importance. Grade A is given to the product being the most valuable and Grade C is given to the product being the least important. It is based on the belief that not all products are of equal value and therefore more attention is given to the product having greater importance in terms of time and value.

First in First Out (FIFO) Method

Under this, the inventories move out in the order of their purchase which means the oldest items move out first.

Last in First Out (LIFO) Method

This method is the opposite of FIFO where the purchases made recently are sold first.

FIFO vs LIFO:

Basis for comparison	FIFO	LIFO
Meaning	Method, where, the oldest order of stock is sold first.	Method, where, recently arrived stock is sold first.
Restriction	No such restrictions.	Not recommended by IFRS
Inflation	Income tax shows a higher amount	Income tax shows a minimum amount
Deflation	Deflated amount of tax on revenues is shown.	The larger amount of tax on revenue is shown.
Stock in hand	Represents the latest stock.	Represents the oldest stock.

Summary

We first get the general idea about what is material, material cost & material costing. Then we learn about how to control cost and how to reduce it are the two main objectives of material costing. Following that we learn about what is inventory management technique and under that, we discuss about five methods: Setting of various stock levels, EOQ, ABC Analysis, FIFO and LIFO method with its brief comparison.

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