Chapter III

ACCOUNTING FOR MATERIALS

LEARNING OBJECTIVES
Upon completing this Chapter, you should able to:
✓ Discuss the objectives and activities of materials control;
✓ Discuss the five common control procedures used to assist management in keeping its
inventory at a minimum;
✓ Distinguish between the periodic and perpetual cost accumulation systems used to account
for materials;
✓ Cite the differences of the methods of costing materials;
✓ Define economic order quantity model and discuss its purpose; and
✓ Describe how freight costs and purchase discounts affect the cost of inventories;

MATERIALS CONTROL
The three elements of manufacturing cost are materials, direct labor, and factory overhead.
Out of the three, materials involve the highest cost. Thus, it is proper to have a good system of
materials inventory control. Materials control is systematic control over the procurement storage
and usage of materials to minimize the overall cost, hence, increasing the profitability of the
business. The main objective of materials control is to obtain the required materials at the right
price, right quantity, right quality, and from the right source. Below are detailed objectives:
• Ensure that there is a regular supply of materials to avoid interruption in the
production process when materials are needed.
• Obtain materials at favorable price without sacrificing the quality
• Provide management with timely and up-to-date material information for planning
and decision-making.
• Avoid loss or misappropriation by adopting effective internal controls.

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PROCEDURES FOR MATERIALS CONTROL

Materials management covers two aspects: physical control of materials and control of
cost. The physical control relates to the movement, access, and recording of the physical quantities,
while cost control covers the value in which the quantities should be recorded and controlled.
Materials control involves the following activities: Purchase and procurement; receipt and
inspection; storage, issuance, and consumption; stock control; and valuation.

Purchase and Procurement of Materials

Large organizations usually have a separate department called purchasing that is

responsible for purchasing materials. This function is handled by production division in smaller
organizations. The cost and quality of the product depend on the raw materials purchased, hence,
this requires skilled personnel who understands the production process and material requirements.

The typical purchasing procedures are the following:

• Receipt of purchase requisitions
• Invitation for quotations or inquiries
• Receipt of quotations from supplies
• Placement of purchases order to suppliers
• Receipt of order and inspection of items and received
• Processing of payment through accounts payable department

When the purchase requisition is completed and vendor quotation is approved, the
purchasing department issues a purchase order—a written request to a supplier for specified goods
at an agreed price. The purchase order also indicates the term of delivery and terms of payment.
This authorizes the supplier to deliver the goods and their invoice.

One of the important factors for material cost management is the establishment of effective
internal controls over purchasing function as it relates to placing an order, receiving and approval
of materials and payment of suppliers.
• Purchase order is submitted to the vendor upon receipt of the approved purchase
requisition

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 • Storekeeper receives the materials in accordance with the approved purchase
orders
• Receiving staff of storekeeper physically inspect the materials upon arrival and
quality is duly approved by the quality control department
• Accounts payable department processes the payment based on the supplier’s
invoice, accompanied by approved purchase order and proof of actual receipt of
materials

Receipt and Inspection of Materials

When materials are received, a receiving staff or storekeeper reviews the documents and
inspect the goods to ascertain accuracy and quality. A receiving report is then prepared as a proof
of receipt and inspection. When materials are rejected by the quality control department, the
supplier is informed for replacement. A sample receiving report is shown below:

Receiving Report

Supplier _________________________ Receiving Report No. ___________________

Account No. _________________________ Date Received ___________________
Purchase Order No. ____________________ Invoice No ___________________

Product/ UOM Quantity Description Quantity Quantity Bin Card

Code No. Rejected Accepted Ref. No.

Inspection report/reason for rejection:

Received by
Name of Carrier Checked by
Bill/Packaging Slip No. Inspected by
Date Entered in bin card by

3.1 Sample Receiving Report

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 Stock Storage, Issuance, and Consumption of Materials
The design, location, or layout of the warehouse or storeroom is also an important part of
the materials cost management. In order to reduce the overall cost of handling or wastage, the
following should be considered:
• Large of heavy materials should be placed near the receiving station or user departments.
• Free access should be provided for reaching the bins and racks.
• Unnecessary transfer or movement of materials from one location to another should be
avoided.
• Easy access to the storeroom for verification should be provided.

Materials Requisition Slip

Issuance of materials to production should be made in accordance with the approved
materials requisition as shown below:

Materials requisition Slip

Requisition No. ___________________________ Date _______________________

Employee ___________________________ Department _______________________
Bin No. ___________________________

Materials UOM Quantity Unit Cost Amount Job No.

Total P __________

Checked by Storekeeper
Authorized by Priced by

Exhibit 3.2 Sample Material Requisition Slip

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 Materials Transfer Slip

A transfer of materials from one department, job or activity to another should be

accompanied by approved material transfer slip. A transfer is generally made when there are excess
materials in one department and another department needs the same materials. This process is more
efficient than returning the materials to storeroom and reissue them.

Materials Transfer Slip

Department Issuing _________________________ Transfer Slip No. __________________

Department Receiving _________________________ Date __________________

Description UOM Quantity Unit Cost Amount Product/code No.

P

Total P____________

Received by/dept. _______________________ Stock Ledger No. _________________

Authorized by/dept. _______________________ Priced by _________________

Exhibit 3.3 Materials Transfer Slip

Materials Return Slip

When excess materials are returned to the storeroom, an internal document called materials
return slip should be accomplished. This document should not be used when returning materials to
the supplier. The latter should be done through another form, letter, or document, accompanied by
a gate pass.

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Materials Return Slip

Department Issuing _________________________ Return Slip No. __________________

Job No. _________________________ Date __________________

Materials Records
Description UOM
Two sets of records areQuantity Unit Cost
maintained to control the materialsAmount Product/Code
namely, the bin No.
cards and the
P
stock ledger card.
Bin cards reflect the quantities of materials received, issued, and remaining balance. Bin
card are attached to the bin where materials ate kept, hence, they are called as such. These cards
also indicate the maximum, minimum, and reordering levels.
Total P____________

Received
Exhibit Dby/dept. _______________________ Bin No. _________________
Authorized by/dept. _______________________ Priced by _________________
Sample Bin Card

Exhibit 3.4 Materials Return Slip

Materials Records

The stock ledger card indicates both the quantity and the value of materials inventory.
This is maintained by cost accounting department.

Stock Ledger Card

Material ________________________ Folio No. ________________________

Code No. ________________________ Maximum ________________________
UOM ________________________ Minimum ________________________

Received Issued Balance

Date RR Qty. Unit Amt. MR Qty. Unit Amt. Qty. Unit Amt.
No. Cost No. Cost Cost

Exhibit 3.5 Sample Stock Ledger Card

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INVENTORY CONTROL METHODS
Controlling of stock level is an important part of materials cost management. Sufficient stock
levels should be maintained in order to avoid overstocking or stock-out. Overstocking may lead to
spoilage, obsolescence, and damage or quality deterioration. On other hand, stock out may result
to interruption of production process, and eventually, loss of profit.

The following are the primary stock control methods that are often used by many companies
in their production operations.

Two Bin System

This method is used for materials that are considered inexpensive and/ or non-essential. This
is used to establish a connection between the order and reorder procedures. In this method, the
stock is sorted in two bins or plies. The first bin, which is the larger bin, is used up from the time
the stock is purchased until the reorder. The second bin is used from the time the reorder is placed
until the order is actually received. The second bin has a considerable amount of standby that can
be used for emergencies.

Min-Max Method
There are two levels that are being established in this method- the minimum and maximum
stock level. When the stock reaches the minimum level, an order is placed to replenish the stock.
The minimum level is determined to avoid stock out. The maximum level is the level that the stock
should not exceed, as it will create problems such as high storage costs or spoilage/wastage that
will put a considerable pressure on the finances of the company.

Order Cycling System

In this method, a review of the entire inventory is done at regular intervals, such as 30 days,
60 days or 90 days. After the review, a purchase order is immediately placed for stock items with
low quantities that will not last up to the next review interval. Important materials have generally
shorter review cycle than less important items.

Automatic Order System

It is commonly used by companies with a computerized environment. In this method, an
order is automatically placed when the stock level reaches a predetermined level or order point
quantity.

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ABC System
This involves the classification of different types of inventories according to the type or
degree of control required. This is based on the assumption that an entity should not exercise the
same degree of control on all inventory items. This technique categorizes inventories into three
group—A, B, and C. Group A represent the largest inventory value while Group C is the lowest.
Group B stands the midway, which requires less attention than Group A but more than Group C.
The ABC system is simple and probably the most effective of all stock control methods.

Example 1:
Consider the following inventory summary. The task of ABC system is to
properly classify the inventory into three categories.

Item No. Units Unit Cost Total Cost % Based % Based

Group on Total on Total
Units Cost
______
1 3,000 P200.00 P600,000 6% 40%
2 6,000 50.00 300,000 12% 18% 20% 60% A

3 8,000 30.00 240,000 16% 16%

38% 27% B
4 11,000 15.00 165,000 22% 11%

5 12,000 10.00 120,000 24% 8%

44% 13% C
6 10,000 7.50 75,000 20% 5%

Total 50,000 P 1, 500,000 100% 100%

Although Group A represents only 18% of the total inventory quantities, it is the most
important in terms of investment involved as it comprised 60% of the total inventory. The entity
should direct most of its inventory control efforts to the items included in this group. Group B
deserves more attention that Group C, but less than Group A. Although Group C has the largest
share in terms of quantities of about 44%, it deserves the least attention as it represents only
13% of the total cost inventories.

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ECONOMIC ORDER QUANTITY MODEL (EOQ)
In a continuous or fixed order quantity system, when stock reaches a specific level
(referred to as reorder point), a fixed amount is ordered. In order to determine the optimal order
size that minimizes order costs, a traditional model called economic order quantity (EOQ) is used.
EOQ is also known as economic lot size.

Basic EOQ Model

EOQ refers to the level of inventory order that minimizes the total cost associated with
inventory management. The EOQ model has the following basic assumptions:
• The annual usage (consumption) of a particular inventory is known.
• The inventory usage is steady over time.
• Orders made to replenish the inventory are received at exactly the point in the time
when inventories reach zero.
• Ordering and carrying costs are constant over the given range of inventory level.
Example: Assume that an entity’s annual inventory requirement is 3,600 units. The ordering costs
are P50 per order while the annual carrying costs are expected to be P1 per unit. The entity can
procure inventories in several lots as following: 3,600 units, 1,800 units, 900 units, 600 units, and
360 units. Determine which of these order quantities the EOQ is:
Tabular Approach
The total costs each order size can be calculated and presented in tabular format. The column
that shows the lowest total inventory cost will be the EOQ.

A. Order Size 3,600 1,800 900 600 360

B. No. of Orders. 1 2 4 6 10
C. Cost per Order ₱50 ₱50 ₱50 ₱50 ₱50
D. Total Ordering Cost (BxC) ₱50 ₱100 ₱200 ₱300 ₱500

E. Carrying Cost per Unit ₱1 ₱1 ₱1 ₱1 ₱1

F. Average Inventory (units) 1,800 900 450 300 180
G. Total Carrying Cost (ExF) ₱1,800 ₱900 ₱450 ₱300 ₱180

H. Total Cost (D + G) ₱1,850 ₱1,000 ₱650 ₱600 ₱680

No. Of orders = total inventory requirement /order size

Average inventory = order size/ 2

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Order size = number of units per order
No of orders = Annual requirement divided by order size
Total Order cost = No. of orders x Cost of Order
Average Inventory = Order size divided by 2
Total Carrying cost = Average Inventory x Carrying cost per unit
Total Order and Carrying Cost = Total Order plus total Carrying cost

From the table above, it can be seen that order size of 600 units, the sum of ordering costs
and carrying costs is the lowest. Therefore, this is the EOQ.

Mathematical Approach

The formula method is easy to use and it produces an exact figure. The formula that can be
used is:

2CN
EOQ = K

Where:
EOQ = Economic Order Quantity
C = Cost of placing an Order
N = Annual requirements needs
K = Carrying Cost per Unit

Using the above example, the EOQ is calculated as follows:

2 x 20,000 x P15.00
EOQ = P0.80
= 800 units

Reorder Point
While EOQ model determines the size of an order to be acquired to minimize the overall
costs, another issue in inventory management is the determination as to when should the orders be
replaced. Reorder point is a point at which an order (equal to the EOQ) should be placed with the
suppliers in the order to replenish the current stock equal to the EOQ. The standard formula to
calculate the reorder point is as follows:

Reorder point = Lead time in days X Average daily usage

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 Lead time refers to period of placing an order with the supplier and receiving materials
ordered. This is the number of days required by the supplier to process the order and to fulfil the
delivery of the goods. Average usage means the quantity of inventory that is equal to the
consumption during the lead time.
Assume that an entity has an average consumption (daily usage) of 3,000 units. The
number of days required to receive the inventories after placing the order is 10 days (lead time).
The reorder point is calculated as follows:

Reorder point = 10 days X 3,000 units = 30,000 units

Therefore, the entity should place an order for replenishing the stock of inventory as soon
as the level reaches 30,000 units. The size of the order should equal to the EOQ.

Safety Stock
There are some limitations when using the EOQ model and reorder point because actual
demands may significantly fluctuate from time to time in which actual usage will exceed the
expected level. In, addition, there may be also some delays in shipment of inventories after in order
is placed due to labor strike, transportation problems, floods, etc. The increase in consumption or
slower delivery would result to inventory shortage. This means that the production will be disrupted
and some customers will be alienated. Therefore, it is important to maintain sufficient safety margin
by having additional inventory as butter or cushion in case of stock-out situations. This is referred
to as safety stock.
Assume the use of same data above (without safety stock), the revised order point may be
computed assuming safety stock is 5,000 units.
10 days (lead time) x 3,000 (average daily usage) 30,000
Safety Stock 5,000
Revised Order Point 35,000

RECORDING OF MATERIALS
Under Philippine Accounting Standards (PAS) No. 2, Inventories, the cost of
inventories shall comprise all costs of purchase, costs of conversion, and other costs incurred in
bringing the inventories to their present location and condition. Accordingly, raw materials are
initially recorded in the books based on the approved purchase order or invoice received from
suppliers as adjusted for the following costs.

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DISCOUNTS:
1. Trade Discount- reduction from the list price. Generally given in terms of
percentage (15%, 10%, 5%) and it is used to encourage sales. It is not recorded in
the books of the buyer.
Example:
Assume that an entity purchased materials and supplies and is allowed a trade discount of
10%. Total list of all purchases made during the month were P300,000. The entries to record the
purchase and subsequent payment are:
To record Purchase:
Raw materials inventory (P300,000 * 90%) P270,000
Accounts payable P 270,000

To record Payment:
Accounts Payable P270,000
Cash P270,000

2. Purchase Discount- granted to customers to encourage early payment of accounts

or purchase in volumes. Discount terms vary considerably such as “2/10, n/30”
which means 2% discount is deducted from the invoice price if paid within 10 days,
net in 30 days.
a. When take method- purchases and liabilities are recorded at gross
amounts at the time of purchase. The discount is only recognized when
the account is paid within the discount period.
b. When not taken method- purchases and liabilities are recorded at net at
the time of purchase; when payment is made after the lapse of the discount
period, the discount is not availed of is charged to a “Purchase Discount
Lost” account. It is called “When not taken method “ because even if the
account is paid within the discount period, no “Purchase Discount” is
recorded and therefore readers of the financial statements would not know
that the company has availed of the discount.
c. When offered method- purchases are recorded at net and the liability is
recorded at gross, the difference is charged to an “Allowance for Purchase
Discount” account. When payment is made after the lapse of the discount.

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Example: The Anabelle Company purchased materials listed at P40,000; terms, 2/15, n/30 August
1. Assume payments as follows:
a) Full payment is made on August 14.
b) Full payment is made on August 30.
Required: entries to record the purchase and payments assuming:
1) When taken method is used.
2) When not taken method is used.
3) When offered method is used.
1) When taken method is used
August 1 Materials 40,000
Accounts Payable 40,000

14 Accounts Payable 40,000

Purchase Discount 800
Cash 39,200

30 Accounts Payable 40,000

Cash 40,000

2) When not taken method is used

August 1 Materials 39,200
Accounts Payable 39,200

14 Accounts Payable 39,200

Cash 39,200

30 Accounts Payable 39,200

Purchase Discount Lost 800
Cash

3) When offered method is used

August 1 Materials 39,200

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 Allowance for purchase Discount 800
Accounts Payable 40,000

14 Accounts Payable 40,000

Allowance for Purchase Discount 800
Cash 39,200

30 Accounts Payable 40,000

Purchase Discount Lost 800
Allowance for purchase Discount 800
Cash 40,000

INVENTORY SYSTEM
There are two types of inventory systems to account for materials issued to production and
ending inventories:

Periodic Inventory System

Under the periodic inventory system, purchases of materials are debited to “Purchases”
account. To determine the value of the inventories on hand at the end of the period, physical count
must be performed. The cost of materials used is determined by subtracting the ending inventories
from the materials available for use (i.e., sum of beginning inventories and total purchases made
during the period). There are different methods of costing materials which relates to the flow of
cost, rather than the actual flow of physical quantities.

Perpetual Inventory System

Perpetual inventory system provides control over the flow of physical quantities of good
through the use of stock ledger card. Materials purchases are recorded using the “Material
Inventory” account rather than a purchase account. Movements in inventories are recorded in stock
ledger card, hence, the inventory balance reconciles to the physical quantities on hand.

Method of Costing Materials

Because of the high volume of raw materials purchases occur at various times and at different
prices, it is important to establish a costing method to facilitate the assigning of the costs to
inventories.
The following methods are commonly used:
1. Specific identification
2. First-in, first out (FIFO)
3. Last-in, last-out (LIFO)
4. Average method

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Specific Identification
This method is used for materials that are readily differentiated or not interchangeable, high
value, and low volume. When materials are issued, the actual unit cost of the specific material is
used and charged to the job cost sheet. The remaining units on hand are also valued at their actual
unit costs to determine the ending inventory at the end of the period.

First-in, First-out (FIFO)

This method assumes that materials are used in the order in which they are received. Hence,
the costs of the first lot are charged to the production when materials are issued. As a result, ending
inventories are valued at the most recent (latest) purchase price.

FIFO- Periodic
When perpetual inventory system is used, a stock card is used to record the costs assigned to units
issued and to cost relating to the units on hand:
December 1 Inventory 400 units at P10 ₱4,000
12 Purchase 600 units at P12 7,200
16 Issue 500 units
18 Purchase 300 units at P15 4,500
20 Issue 200 units
25 Purchase 400 units at P14 5,600
28 Issue 400 units

The inventory on December 30 shows 600 units on hand. Under periodic inventory system, the
most recent record would be assigned to units as follows:
From September 25 purchase 400 units at P14 5,600
From September 18 purchase 200 units at P15 3,000
Total 600 units 8,600

If the ending inventory is valued at P8,600, the cost of materials issued is P12,700 computed as
follows:
Materials, September 1 4,000
Purchases (7,200 + 4,500 +5,600) 17,300
Total materials available for use 21,300
Less: Materials, Sept. 30 8,600
Direct Materials Used 12,700

FIFO- Perpetual
Date Received Issued Balance
12/1 400 at P10 P4,000

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 600 at P12 400 at P10 4,000
12/12
600 at P12 7,200
400 at P10
12/16
100 at P12 500 at P12 6,000
300 at P15 500 at P12 6,000
12/18
300 at P15 4,500
200 at P12 300 at P12 3,600
12/20
300 at P15 4,500
400 at P14 300 at P12 3,600
12/25 300 at P15 4,500
400 at P14 5,600
300 at P12 200 at P15 3,000
12/28
100 at P15 400 at 14 5,600
8,600
Last-in, First-out (LIFO)
This method is based on the assumption that the last stock received is issued first to
production. Hence, ending inventories are valued using the earliest purchase price. The Philippine
Accounting Standards (PAS) No. 2, Inventories, does not permit the use of the LIFO method to
measure the cost of inventories.

Average Method
This method calculates the average price from prior purchases and when assigns the
average cost to all issuances. The average cost for periodic and perpetual system is determined as
follows:
a. Weighted average method is used for periodic system based on the assumption that
units issued should be charged at an average cost, such average being influenced or
weighted by the number of units acquired at each price. The inventory at the end is
computed by multiplying the weighted average cost per unit by the units on hand.

Illustrative Problem:
Beginning 400 units at P10 4,000
Purchases 600 units at P12 7,200
300 units at P15 4,500
400 units at P14 5,600
21,300

21,300
Weighted average unit cost=
1,700
12.53

Inventory, December 30 (600 units x P12.53) 7,518.00

b. Moving average method is used for perpetual system in which average unit cost is
calculated after every purchase. Hence, the average unit cost remains the same until

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 new purchases are received. The new average unit cost is assigned to the subsequent
issuances.

SPOILED UNITS, DEFECTIVE UNITS, SCRAP MATERIAL, AND WASTE MATERIAL IN A

JOB ORDER COST SYSTEM
The terms spoiled units, defective scrap material and waste material are not synonymous
and they should not be used interchangeably. The following are their respective definitions:
Spoiled Units- units that do not meet production standards and are either sold for their salvage
value or discarded. When spoiled units are discovered, they are taken out of production and no
further work is performed on them.

Defective Units- units that do not meet productions standards and must be processed further in
order to be salable as good units or as irregulars.

Scrap Material- left over from production process that cannot be put back into production for the
same purpose, but may be usable for a different purpose or production process or which may be
sold to outsiders for a nominal amount.

Waste Material- left over from production process that has no further use or resale value and may
require cost for their disposal.

Two Methods of Accounting for Spoiled Materials

The method to account for spoiled materials depends on the reason for such spoilage:
1. Charged to specific job- this method is used if the reason for the spoilage is the job itself
because it requires exacting specifications, or a difficult, intricate or complicated
manufacturing process.

Entry: Spoiled Goods xxx

Work in Process xxx

The amount debited to spoiled goods and credited to work in process is equal to the number
of units spoiled multiplied by the estimated sales value per unit.

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 2. Charged to all production- this method is used if the reason of spoilage is considered
normal to the process and the number does not exceed the limit set by the company. With
this method, all units manufactured during the period are charged with an individual cost
which is added to the factory overhead rate. The unit cost originally charged will not
increase anymore even if there are spoiled units discovered later on.

Entry: Spoiled Goods xxx

Factory Overhead Control xxx
Work in Process xxx

The amount debited to spoiled goods is equal to the number of units spoiled multiplied by
the estimated sales value per unit. The amount credited to work in process is equal to the total
costs incurred or charged to spoiled units. The loss is charged to factory overhead control.

If the number of units spoiled exceed the limit set by the company, or if the reason is not
considered normal to the process, the loss on the spoiled units is charged to a loss account.

Example:
Job XYZ called for making of 4,000 with these unit costs:
Direct materials P15.00
Direct labor 13.00
Factory Overhead * 12.00
*factory overhead includes a P1.00 allowance for spoiled work
When the order was completed, 200 rejected units, a normal number were sold for P18.00 each.

Required: (a) Entries if the loss is charged to all production

(b) Entries if the loss is charged to the specific job.

1. Loss is charged to all Production

a) Work in Process 160,000 Materials (4,000 x P15.00)
Materials 60,000 Labor (4,000 x P13.00)
Payroll 52,000 Overhead (4,000 x P12.00)
Factory Overhead Applied 48,000

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 b) Spoiled Goods 3,600 Spoiled 200 x P18
Factory Overhead Control 4,400 WP 200 x P40
Work in Process 8,000

c) Finished Goods 152,000

Work in Process 152,000

2. Loss is charged to Specific Job

a) Work in Process 156,000 Materials (4,000 x P15.00)
Materials 60,000 Labor (4,000 x P13.00)
Payroll 52,000 Overhead (4,000 x P11.00)
Factory Overhead Applied 44,000

b) Spoiled Goods 3,600 Spoiled 200 x P18

Work in Process 8,000

c) Finished Goods 152,400

Work in Process 152,400

Under this method, loss is charged to all production, the unit cost of the completed units
remains at P40.00. In spite of the spoiled units, unit cost remained the same because the increase
was made at the start (when P1.00 was added to the factory overhead rate as allowances for spoiled
work). All units process during the period, even those jobs without spoiled units, will absorb the
additional P1.00. Upon completion of the job, even if there were spoiled units, the unit cost will be
the same as the amount originally charged to the job.
On the other hand, under the method loss charged to specific job, it will be noted that the
factory overhead rate was recorded at the original amount of P11.00 (allowance of P1.00 for spoiled
work was not added). The remaining perfect units in the job will absorb the loss on the spoiled,
resulting in an increase in the unit cost (152,400/ 3,800 units = P40.105/ unit), the increase in the
unit cost of P1.105 (P40.105- P39) may be computed as follows:
Cost of spoiled (200 x P39) P7,800
Less amount recovered from sale (200 x P18) 3,600
Loss on spoiled goods 4,200

The loss in spoiled goods will be absorbed by the remaining good units (4,200 divided by 3,800
units= P 1.105/ unit)

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Two Methods of Accounting for Defective Materials
The accounting problem for defective units is the additional costs to be incurred in
reprocessing the units to convert them into perfect articles.
The method to account for spoiled materials depends on the reason for such spoilage:
1. Charged to specific job- same for the spoiled units, if the reason for the spoilage is the job itself,
the additional costs incurred (materials, labor and overhead) will be charged to all units in the
job.
Entry: Work in Process xxx
Materials xxx
Payroll xxx
Factory Overhead Applied xxx

2. Charged to all production- if the reason of spoilage is considered normal to the process and
the number does not exceed the limit set by the company, then the additional costs incurred
will be charged to all units being processed during the period.

Entry: Factory Overhead Control xxx

Materials xxx
Payroll xxx
Factory Overhead Applied xxx
Example:
Job XYZ called for making of 4,000 with these unit costs:
Direct materials P15.00
Direct labor 13.00
Factory Overhead * 12.00
*factory overhead includes a P1.00 allowance for spoiled work
During processing, 300 units were found to be defective and required the following total
additional costs: materials – P2,000; labor- P4,000; and overhead- P2,000

Required: (a) Entries if the loss is charged to all production

(b) Entries if the loss is charged to the specific job.

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 1. Additional cost is charged to all production:
a) Work in Process 160,000
Materials 60,000
Payroll 52,000
Factory Overhead Applied 48,000

b) Factory Overhead Control 8,000

Materials 2,000
Payroll 4,000
Factory Overhead Applied 2,000

c) Finished Goods 160,000

Work in Process 160,000

The cost of the finished goods will remain at the original amount charged to the job
(160,000 divided by 4,000 units [ P40,000)

2. Additional cost is charged to specific job:

a) Work in Process 156,000

Materials 60,000
Payroll 52,000
Factory Overhead Applied 44,000

b) Factory Overhead Control 8,000

Materials 2,000
Payroll 4,000
Factory Overhead Applied 2,000

c) Finished Goods 164,000

Work in Process 164,000

The unit cost of the completed units increased from the original P39.00 to P41.00 (164,000
divided by 4,000 units). All units in the job will share in the cost incurred to re- process the defective
units.

Accounting for Scrap Material

A cost accounting system should provide a method of costing and control for scrap as it
does for spoilage and defective units. When the amount of scrap produced exceeds the norm, it
could be an indication of inefficiency. A predetermined rate for scrap should be prepared as a guide
for comparison with the actual scrap those results. If large differences occur, management should

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find the reason and correct the problem. Scrap materials have commonly been accounted for in
either of the following ways:
1. If the scrap recovered can be traced to a specific job, the entry is:
Scrap/ Scrap Materials xxx
Work in Process xxx
The amount recovered for the scrap will be entered negative ( ) on the materials
section of the job order cost sheet.

2. If the scrap recovered are not traceable to a specific job, the entry is
Scrap/ Scrap Materials xxx
Miscellaneous Income xxx

3. If the scrap recovered are from factory supplies, the entry is:
Scrap/ Scrap Materials xxx
Factory Overhead Control xxx

Accounting for Waste Material

The cost of disposing waste materials may be allocated, either to all jobs (included in the
factory overhead application rate) or to specific jobs (not included in the factory application rate)
1. If the cost of disposing waste materials is allocated to all jobs, the entry is:
Factory overhead control xxx
Accounts Payable xxx

2. If the cost of disposing the waste materials is allocated to a specific job, the entry is
Work in Process xxx
Accounts Payable xxx

Waste exceeding a specified normal level (based on past experience) indicates

inefficiencies somewhere in the production process and signs management to take corrective action.
Although the cost of disposing of waste materials is minimal as compared to the total
production costs, in some manufacturing and service corporations it may involve significant
expenditure. For example, a chemical manufacturer may have toxic waste which requires special
packaging before disposal and thus results in an expensive disposal cost.

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 The cost of disposing of most type of waste is expected to increase significantly I the near
future as existing garbage dumps fill up and more elaborate and expensive forms of disposal must
be developed.

STOCK VALUATION
Stock valuation procedures cover activities such as recording inventories when received,
recording the cost of materials issued and determining the value of the ending inventories using
either periodic or perpetual system based on different pricing methods.
Materials issued to production should be valued based on the amount they are carried in
stock. The previous sections discussed the different methods of pricing stock issuances and their
effect on the closing stock. However, it should be noted that the method used for the valuation of
closing stock for financial reporting purposes differs from the method used in cost accounting.

Lower of Cost or Net Realizable Value

For financial reporting purposes, inventories should be measured at the lower of cost and
net realizable value (NRV). This valuation method follows the principle of conservatism because
it recognizes losses or declines in the market value as they occur while any increases in value are
recognized only when inventory is sold.
NRV is the estimated selling price in the ordinary course of business, less estimated of
completion and the estimated costs necessary to make the sale.
Historical cost is the actual purchase price of goods or services at the date of acquisition.
Market value (replacement cost) represents the cost to replace an existing asset or
inventory.
The following are the principal procedures in applying the lower of cost or NRV:
• If the value of inventory declines below its original cost due to obsolescence, spoilage or
damaged goods, or for any other reasons, the inventory is written down below cost. If the
NRV is lower than cost, the ending inventory is written down to NRV. The loss is then
charged to cost of goods sold in the period in which the loss occurred. The corresponding
credit (valuation allowance) is presented as a deduction from inventory cost in the balance
sheet.
• In the subsequent period, if the NRV is higher than cost, no adjustment is recorded because
inventories already reflected the cost. However, a reversal of the previous valuation
allowance (up to the amount of original write-down) is required.

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 • This rule can be applied either directly on each inventory item, to each category or group,
or to the total of inventory.

Example:
The following information was provided as of December 31, 2018. Determine the lower
cost or NRV:

Historical cost ₱80,000

Replacement cost 60,000
Estimated selling price 70,000
Estimated cost to complete and sell 2,000
Net realizable value (₱70,000 – 2,000) 68,000

Answer: The amount of inventory that should be reported on the balance sheet as of
December 31, 2018 should be ₱68,000.

Example:
The following inventory information was obtained from the records of Crush Company as
of December 31, 2018.

Cost NRV Lower of Cost or NRV

Inventory Quantity Per Unit Per Unit Total Per Unit Total By Item By Group
A1 1,200 ₱90 ₱108,000 ₱85 ₱102,000 ₱102,000
A2 700 70 49,000 78 54,600 49,000
Group A 2,100 157,000 156,600 151,000 ₱156,600

B1 900 30 27,000 36 32,400 27,000

B2 800 10 8,000 8 6,400 6,400
Group B 2,100 35,000 38,800 33,400 35,000
Total 4,200 ₱192,000 ₱195,400 ₱184,400 ₱191,600

The total inventory cost of ₱192,000 is the amount that appears on the cost accounting
records. For financial reporting purposes, the amount to be reported on the balance sheet should
not exceed this amount based on the lower of cost or NRV principle.

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Lower of cost or NRV by item
A comparison of historical cost and NRV is performed in respect to each line item of the
inventory separately. The lower amount is then assigned as the value of the closing stock for each
item. This method will provide the lowest value of closing inventory. In the example above, the
closing inventory to be reported on the balance sheet would be ₱184,400. The difference of ₱7,600
(₱192,000 minus ₱184,400) is reported as an expense during the period.

Lower of cost or NRV by group

The lower of cost or NRV is determined for each group of similar items separately. In the
previous example, the closing inventory to be reported on the balance sheet would be ₱191,600.
The difference of ₱400 (₱192,000 minus ₱191,600) is reported as an expense during the period.

Lower of cost or NRV by total

Lower cost or NRV is determined on the entire inventory, rather than by group or by item.
In the example above, the value of closing inventory on the balance sheet would be ₱192,000.
Because in this example, the lower amount reflects the actual cost of inventories no adjustment is
necessary.

Application of Lower of Cost or NRV to inventories

To reflect the lower of cost or NRV to inventories, a valuation account (contra-asset
account) is generally used, rather than changing the cost on the individual stock ledger cards.
Appropriate account such as allowance for inventory write-down may be used. The amount
reported on the balance sheet is equal to the cost, net of allowance.

Any write down to NRV is recognized as an expense in the period in which the write down
occurs. Any reversal should be recognized in the income statement in the period in which the
reversal occurs.

Example: To illustrate, assume the following data as of December 31:

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 Cost NRV Credit Balance
(amount per materials (determined from (required allowance)
ledger card) information outside of
the accounting
records)
December 31, 2016 ₱270,000 ₱260,000 ₱10,000
December 31, 2017 320,000 312,000 8,000
December 31, 2018 285,000 290,000 0

On December 31, 2016, the balance sheet should reflect inventory value of ₱260,000
because NRV was lower than cost. The adjusting entry to recognize the decline in inventory is:

Debit Credit
Loss on inventory write-down ₱10,000
Allowance for inventory write-down ₱10,000
Balance sheet presentation 12/31/2016
Inventory, at cost ₱270,000
Less: Allowance for inventory write-down 10,000
Inventory at lower of cost or NRV ₱260,000

On December 31, 2017, the lower of cost or NRV was ₱312,000 which is the amount that should
be reported on the balance sheet. Hence, the allowance account should have a credit balance of
₱8,000.
Allowance as of December 31, 2016 ₱10,000
Allowance as of December 31, 2017 8,000
Recovery in 2017 ₱2,000

The adjusting entry to recognize the recovery is:

Debit Credit
Allowance for inventory write-down ₱2,000
Allowance for inventory write-down ₱2,000
Balance sheet presentation 12/31/2017:
Inventory, at cost ₱320,000

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 Less: Allowance for inventory write-down 8,000
Inventory at lower of cost or NRV ₱312,000

On December 31, 2018, the balance sheet should report the lower of cost or NRV of
₱285,000. In order for the balance sheet to reflect this amount, the balance of the allowance should
be zero.

Allowance as of December 31, 2017 ₱8,000

Allowance as of December 31, 2018 0
Recovery in 2018 ₱8,000

The adjusting entry to recognize the recovery is:

Debit Credit
Allowance for inventory write-down ₱8,000
Allowance for inventory write-down ₱8,000

Balance sheet presentation 12/31/2018:

Inventory, at cost ₱285,000
Less: Allowance for inventory write-down 0
Inventory at lower of cost or NRV ₱285,000

The loss on inventory write-down is presented as an addition to the cost of goods sold,
while the recovery is presented as deduction from cost of goods sold as shown below:

Income statement presentation (within cost of goods sold):

Finished goods inventory, January 1 ₱xxx
Cost of goods manufactured xxx
Cost of goods available for sale xxx
Finished goods inventory, December 31 (xxx)
Cost of goods sold, unadjusted xxx
Loss on (recovery from) inventory write-down xxx
Cost of goods sold ₱xxx

REVIEW QUESTIONS

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 1. What are the major objectives of materials control?
2. Discuss the procedures for material control.
3. What are the usual documents used to control the movement of materials?
4. What is the difference between a purchase requisition and a purchase order?
5. Differentiate periodic from perpetual inventory systems.
6. What are the three methods of costing materials?
7. What is the economic order quantity and how it is calculated?
8. Discuss the effect of stock returns on the ending inventories and how stock returns are
entered on the stock ledger card.
9. Discuss the concept of lower of cost or net realizable value.
10. What are the methods of accounting for spoiled, defective and scrap materials?

MULTIPLE CHOICE QUESTIONS

1. Discounts not taken on materials purchased should be charged to:
a. Raw materials inventory
b. Deferred cost
c. Revenues
d. Cost of goods sold
2. [AICPA] The economic order quantity formula assumes that:
a. Periodic demand for the good is known.
b. Carrying costs per unit vary with quantity ordered.
c. Costs of placing an order vary with quantity ordered.
d. Purchase costs per unit differ due to quantity discounts.
3. [AICPA] Which changes in costs are most conducive as switching from traditional
inventory ordering system to a just-in-time ordering system?
Cost per purchase order Inventory unit carrying costs
a. Increasing Increasing
b. Decreasing Increasing
c. Decreasing Decreasing
d. Increasing Decreasing

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4. [AICPA] As a consequence of finding a more dependent supplier, Dee Co. reduced its
safety of raw materials by 80%. What is the effect of this safety stock reduction on Dee’s
economic order quantity?
a. 80% decrease
b. 64% decrease
c. 20% increase
d. No effect
5. [AICPA] Bell Co. changed from a traditional manufacturing philosophy to a just-in-time
philosophy. What are the expected effects of this change on Bell’s inventory turnover and
inventory as a percentage of total assets reported on Bell’s balance sheet?
Inventory turnover Inventory percentage
a. Decrease Decrease
b. Decrease Increase
c. Increase Decrease
d. Increase Increase
6. [AICPA] The benefits of a just-in-time system for raw materials usually include:
a. Elimination of non-value adding operations
b. Increase in the number of suppliers, thereby ensuring competitive bidding.
c. Maximization of the standard delivery quantity, thereby lessening the
paperwork for each delivery.
d. Decrease in the number of deliveries required to maintain production.
7. [AICPA] In Belk Co.’s “just-in-time” production system, cost per set-up were reduced
from ₱28 to ₱2. In the process of reducing inventory levels. Belk found that there were
fixed facility and administrative costs that previously had not been included in the carrying
cost calculation. The result was an increase from ₱8 to ₱32 per unit per year. What were
the effects of these changes on Belk’s economic lot size and relevant costs?
Lot size Relevant costs
a. Decrease Increase
b. Increase Decrease
c. Increase Increase
d. Decrease Decrease
8. [AICPA] The economic order quantity formula assumes that:
a. Purchase costs per unit differ due to quantity discounts.
b. Costs of placing an order vary with quantity ordered.

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 c. Periodic demand for the good is known.
d. Erratic usage rates are cushioned by safety stocks.
9. The reorder level is calculated as:
a. Maximum reorder period x maximum consumption
b. Minimum reorder period x minimum consumption
c. (minimum consumption + maximum consumption) / 2
d. Maximum consumption – minimum consumption

10. Which of the following is not an inventory valuation method?

a. FIFO
b. LIFO
c. Weighted Average
d. EOQ
11. Which of the following statements regarding safety stock is correct?
a. The greater the risk of running out of stock, the smaller the safety of stock
necessary.
b. The higher the profit margin per unit, the larger the safety stock necessary.
c. The larger the opportunity cost or inventory, the larger the safety stock necessary.
d. The higher the uncertainty with forecasted demand, the smaller the safety stock
necessary.
12. If EOQ = 240 units, order costs are ₱4.00 per order, and carrying costs are ₱0.50 per unit,
what is the usage in units?
a. 1,920
b. 3,600
c. 3,840
d. 7,200
13. If annual demand is 5,000 units, ordering cost is ₱50 per order, holding cost is ₱2 per unit
per year, then the optimal order quantity is:
a. 50 units
b. 100 units
c. 353 units
d. 500 units

14. Determine the reorder point from the given data:

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 Average daily sale 20 units
Lead time 14 days
Safety stock 40 units
a. 280 units
b. 320 units
c. 560 units
d. 580 units
15. Victoria Corporation provided the following transactions from the materials ledger for the
month of March:

Opening balance:
March 1 50 units @ ₱4.00
Received:
March 5 100 units @ ₱5.00
March 12 200 units @ ₱4.50
Issued:
March 2 30 units
March 18 150 units
Using the moving average method, at what amount should Victoria report as raw materials
inventory as of March 31?
a. ₱765
b. ₱777
c. ₱786
d. None of the above
16. Refer to the data for Victoria Corporation. Using the weighted average method, at what
amount should Victoria report as raw materials inventory as of March 31?
a. ₱765
b. ₱777
c. ₱786
d. None of the above

17. Compute the value of closing stock from the following data using LIFO method:

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 Opening balance:
August 1 70 units @ ₱4.00
Purchases:
August 5 50 units @ ₱5.00
August 12 100 units @ ₱4.50
Requisitions:
August 2 50 units
August 18 150 units
a. ₱80
b. ₱85
c. ₱86
d. ₱90
18. Bloomberg & Co. shows the following data in its books:
Opening inventory 100 units @ ₱8.00 per unit
Purchases 100 units @ ₱10.00 per unit
Issuances: 150 units
If Bloomberg reported closing inventory value of ₱400, which of the following method
was used?
a. FIFO
b. LIFO
c. Moving average
d. Weighted average

19. The following transactions occurred during the month of September:

Sept. 1 Opening stock, 800 units at ₱10 each
Sept. 4 Purchased, 700 units at ₱11 each
Sept. 9 Issued, 1,000 units
Sept. 13 Purchased, 900 units at ₱12 each
Sept. 16 Purchased, 300 units at ₱13 each
Sept. 18 Issued, 500 units
Sept. 21 Issued, 400 units
Sept. 28 Purchased, 200 units at ₱14 each
Sept. 30 Issued, 600 units
How much is the cost of ending inventories using FIFO method:

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 a. ₱4,000
b. ₱4,800
c. ₱5,400
d. ₱5,600
20. Kaira Company has annual inventory demand of 3,600 units. The ordering cost is ₱100 per
order while the annual carrying cost is expected to be ₱1 per unit. Khris can procure
inventories in several lots as follows: 2,000, 1,000, 5,000, and 200 units. Determine the
EOQ.
a. 200 units
b. 500 units
c. 1,000 units
d. 2,000 units
21. Jordan Company uses periodic inventory system. The following information was provided
for the year 2015:
Materials purchased during the year ₱42,000
Materials available for use 55,000
Materials issued to production 30,000
How much did closing materials inventory exceed the opening materials inventory?
a. ₱12,000
b. ₱13,000
c. ₱25,000
d. ₱30,000

22. The cost accountant of BB Company made available the following records for the year
ended December 31, 2018:
Inventories
January 1 December 31
Raw materials ₱264,000 ₱310,000
Work in process 219,000 228,000
Finished goods 171,000 143,000
Raw materials used for the year 122,000
Total manufacturing costs incurred for the year
(including direct materials, direct labor and applied 882,000
overhead at the rate of 60% of direct labor)

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 How much is the raw materials purchased?
a. ₱76,000
b. ₱122,000
c. ₱168,000
d. ₱177,000

23. Aoyama Corporation is a local manufacturer that uses a job order costing. Manufacturing
overhead is applied using a predetermined rate based on direct labor cost. The cost ledger
shows the following information for the month of August:
Work in Process Inventory
Balance, August 1 ₱250,000 Goods manufactured ₱296,000
Materials used 120,000
Direct labor 100,000
Applied FOH 80,000

Aoyama had three outstanding jobs in ending work in process that are expected to be
delivered in the following month:
• Job #108 with direct materials of ₱35,000 and direct labor of ₱20,000
• Job #109 with direct materials of ₱45,000 and direct labor of ₱25,000
• Job #110 with applied overhead of ₱28,000
The total cost of direct materials in work in process inventory at August 31 was:
a. ₱102,350
b. ₱106,000
c. ₱110,000
d. ₱120,000

24. Refer to the data for Aoyama Corporation. How much is the cost of materials charged to
Job #110?
a. ₱22,350
b. ₱26,000
c. ₱30,000
d. ₱40,000

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 25. Vile Company uses a job order costing system. The storeroom provided the following
transaction summary for Material XY for the month of June:
Quantity Unit Cost Total
June 1 Beginning balance 2,000 ₱1.4 ₱2,800
6 Received from supplier 5,000 1.5 7,500
10 Issued to production 4,000
14 Received from supplier 2,500 1.7 4,250
19 Issued to production 1,600
25 Issued to production 1,000
If Material XY had ending inventory of ₱4,850, Vile used which of the following methods?
a. FIFO
b. LIFO
c. Weighted average
d. Moving average

26. Refer to the data for Vile Company. If Material XY had ending inventory of ₱4,150, Vile
used which of the following methods?
a. FIFO
b. LIFO
c. Weighted average
d. Moving average

27. Refer to the data for Vile Company. If Material XY had ending inventory of ₱4,568, Vile
used which of the following methods?
a. FIFO
b. LIFO
c. Weighted average
d. Moving average

PROBLEMS
P3-1 Mary Company’s provided the following information for the recent fiscal year:
Annual Inventory requirement 4,000 units
Cost per unit (other than carrying and ordering costs) P90.00
Cost of placing each order P250.00

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 Carrying cost per unit P2.00
Ginza has the following alternative order size in units: 4,000, 2,000, 1,000, 500, and 400.
Required: Determine the EOQ using the following:
a. Tabular approach
b. Mathematical approach

P-3-2 Lorna Company predicts that 10,000 units of materials will be used during the year. The
expected daily usage is 40 units. The expected lead time is 6 days, and there is a safety stock of
300 units. Aeon expects that the cost of materials will be P480 per unit. It anticipates that it will be
cost P200 to place each order. The annual carrying coast is P1.00 per unit.
Required:
a. Calculate the order point.
b. Calculate the economic order quantity.
c. Calculate the total ordering and carrying costs at EOQ point.

P3-3 Alexis Company runs a computer supplies company. During the first few months of the year,
the accounting records shows the following transactions:
January Opening stock of 400 units at a cost of P30.00 each
February Bought 200 units at a cost of P35.00 each
March Sold 350 units for P50.00 each
April Bought 120 units at a cost of P38.00 each
May Sold 280 units for P50.00 each
Total operating expenses during the period amounted to P50.00.

Required:
a. Calculate the ending inventory using FIFO, LIFO, and Average method
b. Determine the net income under each method

P3-5 A supplier sells MF Tires to dealers. The annual demand is approximately 1,000 tires. The
supplier pays P50 for each tire and estimates that the annual holding cost is 20 percent of the total
value of tires. It costs approximately P25 to place an order. The supplier currently orders 80 tires
per month.

Required:

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 a. Calculate ordering, holding, and total inventory costs for the current ordered quantity.
b. Determine the EOQ.
c. How many orders will be placed per year using the EOQ?
d. Calculate ordering, holding, and total inventory costs for the EOQ and also determine the
change in total inventory cost.

P3-6 Harry Company’s Job 1 for the manufacture of 2,200 T- shirts was completed during
September 2018 at the following unit costs:
Direct materials P20.00
Direct Labor 18.00

Factory overhead (includes an allowance of P1 for spoiled work) 18.00

Final inspection of Job 1 discloses 200 spoiled T-shirts which were sold to a jobber for P6,000.

a. Assume that spoilage loss is charged to all production during September. What would be
the unit cost of the good units produced on Job 1?
b. Assume instead that the spoilage loss is attributable to exacting specification of Job 1 and
is charged to this specific job. What would be the unit cost of good coats produced on Job
1?

P3-7 Job Y incurred the following costs for the manufacture of 200 units of motors:
Original cost accumulation:
Direct materials 13,200
Direct labor 16,000
Factory overhead (150% of direct labor) 24,000
Direct costs of reworked 10 units:
Direct materials 2,000
Direct labor 3,200

The total rework costs were attributable to exacting specifications of Job Y and the full
rework costs were charged to the specific job. The cost of Job Y was:

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