2. Chapter Outline
1. Classification of materials
i. Direct material
ii. Indirect material
iii. Work-in-progress
iv. Finished goods
v. Inventory
2. Stock control
i. Carrying costs
ii. Ordering costs
iii. Stock-out costs
iv. Lead time
v. Economic order quantity (EOQ)
vi. Reorder level (ROL)
3. 3. Stock valuation methods
i. The perpetual inventory system
ii. The periodic inventory systems
iii. First-In-First-Out Method
iv. Weighted Average Method
4. Classification of materials
Materials can be classified as either direct or indirect
Direct Material
Raw material that is converted into a finished product by the manufacturing process.
This material is visible in the final product, that is, it can (easily) be physically traced to the final
product.
Example: Steel in the manufacturing of motor vehicle and wood in the manufacturing of a table.
Indirect materials
Materials used in the manufacturing process that contributes to the conversion of the direct
material.
This material cannot be physically (easily) traced to the final product.
Example: Glue, nails or screws used in the manufacturing of a table
5. Classification of materials
Work-in-progress
Raw material that has been partially converted in the product process.
This material cannot be classified as raw materials or as a finished product.
Work-in-progress consist of a portion of all three cost elements – materials, labour and overheads
Finished goods
Products that have passed through the entire production process and have been completed.
Inventory
All materials (direct and indirect), work-in-progress and finished goods that the enterprise has at
any given point
6. Stock Control
The system that a firm uses to control it’s investment instock, which includes:
Recording and monitoring stock levels
Forecasting future demand
Deciding when to order and how much to order
The main objective of stock control is to minimize in total the costs associated with stock.
These costs can be classified into three groups:
Carrying (holding) costs
Ordering costs
Stock-out costs
7. Stock Control
Carrying (holding costs)
Costs associated with the storage of the stock. These include:
Storage charges
Stores staffing
Stores equipment and maintenance
Material handling costs
Security and insurance
The carrying costs can be calculated as: Average stock * Carrying cost per unit
Ordering costs
Costs associated with obtaining the stock. These include:
Administrative costs of purchasing
Transportation costs
The ordering costs are calculated as: Number of orders * Costs per order
The number of orders can be calculated as: Annual demand / Order size
8. Stock Control
Stock-out costs
Costs associated with not having sufficient stock to meet the customers’ needs.
These costs tend to be intangible and include:
The loss of contribution and profit owing to being out of stock
Loss of future sales
Lead time
Time taken from when an order is placed with the supplier, to when it arrives on the business’s
premises.
Economic order quantity (EOQ)
The optimum quantity that should be ordered that will minimize the total combined ordering and
carrying costs.
EOQ =
2 𝑥 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑥 𝑂𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 (ℎ𝑜𝑙𝑑𝑖𝑛𝑔) 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
9. Stock Control
Reorder level (ROL)
The level of stock at which another order should be placed.
Reorder level depends on the lead time and the usage during the lead time.
It allows for the worst situation to occur without the danger of running out of stock.
ROL = Maximum usage * Maximum lead time; or
ROL = (Average usage * Average lead time) + Safety stock
10. Stock Valuation Methods
Perpetual inventory system
Inventory accounts are updated after each transaction.
Inventory quantities are continuously updated.
Gross profit can be determined without an inventory count.
Physical inventory on hand can be checked against the trading inventory account.
The inventory account reflects the inventory on hand at any moment in time.
Individual items of inventory can be more easily monitored, especially if one has a computerized
system that updates the inventory record at the till.
Periodic inventory system
The value of ending inventory is determined at the end of each accounting period by a physical
stock count.
A purchases account is used when the periodic method of recording inventory is in operation
11. Stock Valuation Methods
First-in-first-out method
Physical stock count is done at the end of the accounting period to determine the inventory on hand (closing
balance).
The cost of most recent purchase is used, after which the cost of goods sold can be computed.
Material that is purchased first is used(issued) first. The oldest stock is issued first at the price at which it
was originally purchased.
Weighted-average-method
Periodic Inventory System
The weighted average unit cost is used to calculate the cost of goods sold and the cost of ending inventory.
The weighted average unit cost is computed using the following formula: =
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑠𝑎𝑙𝑒
Perpetual Inventory System
The new material that is purchased is added to the material already in stock
An average price must be determined after each purchase.
