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COST AND MANAGEMENT ACCOUNTING (SUBJECT CODE:16CCP11) II M.COM(CA)

UNIT 1

INTRODUCTION OF COST ACCOUNTING

Meaning-Objectives-Nature and Scope-Method of Costing – Classification of Cost – Preparation of cost Sheet and Tender – Inventory System – Method of Pricing material Issues – EOQ

1.Meaning

Cost: It means the total of all expenditures incurred on the production of an article.

Costing: It is the techniques and process of ascertaining costs. it enable the management to know the total cost and each elements of cost of a product. It has been defined by Weldon as, “the classifying, recording and appropriate allocation of expenditure for the determination of the costs of products or services, and the presentation of suitably arranged data for purposes of control and guidance of management.

Cost accounting: It is the accounting system set up for recording costs. It begins with the recording of income and expenditure and ends with the preparation of statements and reports of costs.

2.OBJECTIVES OF COST ACCOUNTING

1. Ascertainment of Cost: The primary objectives of the cost accounting is to ascertain cost of each product, process, job, operation or service rendered.

2. Ascertainment of Profitability: Cost accounting determines the profitability of each product, process, job, operation or service rendered. The statement of profit or losses and Balance Sheet also submitted to the management periodically.

3. Classification of Cost: Cost accounting classifies cost in to different elements such as materials, laborer and expenses. It has further been divided as direct cost and indirect cost for cost control and recording.

4. Control of Cost: Cost accounting aims at controlling cost by setting standards and compared with the actual, the deviation or variation between two is identified and necessary steps are taken to control them.

5. Fixation or Selling Prices: Cost accounting guides management in regard to fixation of selling prices of the products. It is also helpful for preparing tender and quotations.

3.Nature and Scope of Cost Accounting

PREPARED BY DR.M.PARAMESWARI


The terms ‘costing’ and ‘cost accounting’ are many times used interchangeably. However, the

scope of cost accounting is broader than that of costing. Following functional activities are

included in the scope of cost accounting:

1. Cost book-keeping: It involves maintaining complete record of all costs incurred from their

incurrence to their charge to departments, products and services. Such recording is preferably

done on the basis of double entry system.

2. Cost system: Systems and procedures are devised for proper accounting for costs.

3. Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the

important function of cost accounting. Cost ascertainment becomes the basis of managerial

decision making such as pricing, planning and control.

4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying

from the budgeted costs and fixation of responsibility for cost increases.

5. Cost comparisons: Cost accounting also includes comparisons between cost from alternative

courses of action such as use of technology for production, cost of making different products and

activities, and cost of same product/ service over a period of time.

6. Cost Control: Cost accounting is the utilization of cost information for exercising control. It

involves a detailed examination of each cost in the light of benefit derived from the incurrence of

the cost. Thus, we can state that cost is analyzed to know whether the current level of costs is

satisfactory in the light of standards set in advance.

7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports

are primarily for use by the management at different levels. Cost Reports form the basis for

planning and control, performance appraisal and managerial decision making

Advantages of Cost Accounting



1) Classification and Subdivision of Costs: In the contrast to a single profit or loss figure supplied by general accounting, the cost accounting classifies costs and income by every conceivable subdivision of the business enterprise. In a good costing system data regarding costs by departments, processes, functions, products, orders, jobs, contracts and services can easily computed. This detailed cost information for managerial control is one of the most important contributions of cost accounting.

2) Adequacy or Inadequacy of Selling Prices: Unit cost of production, administration and safe made possible by cost accounting aids management in deciding the adequacy or inadequacy of selling prices i.e. neither too high detracting business, nor too low resulting in losses to the concern. In period of depressions, slumps, or in case of competition management forced to lower prices even below cost of production and sale. In such circumstances, cost accounting will help management in deciding the proper reduction.

3) Disclosure of profitable Products: Cost Accounting will disclose activities, departments, products and territories, which bring profit and those that result in losses. Management to determine what products because of profit margin the sales department because of their greater profit margin should emphasize will use this information. What products arte unprofitable or less profitable and might be eliminated or lesser sales pressure be given to them. What activities or territories are not producing sufficient profit and should be either further improved or eliminated and what methods of production and distribution are most profitable for the firm. This will increase the overall profit of the concern.

4) Control of Material and Supplies: In a good costing system materials and supplies must be accounted for in terms of departments, jobs, units of production or service. This will eliminate altogether or reduce to the minimum misappropriations, embezzlements, deterioration, obsolescence, and losses from defective, spoiled, scrap and out of date materials and supplies.5) Maintenance of Proper Investment in Inventories: A costing system will help in the maintenance of various inventory items of materials and supplies in line with production and sale requirements. If these quantities are too small, production may stop or sales may be lost. On the other hand, if quantities of such materials and supplies are in excess of the production and sales requirements, too much working capital may unnecessarily tie up in inventories. The detailed quantity information furnished by the cost accountant at all times will go a long way in reducing or eliminating this possibility.

6) Correct Valuation of Inventories: Cost Accounting plays a basic role in the correct



valuation of inventories of finished goods, work in process, materials and supplies. The book inventory method (as opposed to physical inventory method) made possible by cost accounting system will involve the operation of the various inventory control accounts in such a manner that the balances of these accounts well be inventory valuations required for periodic financial statements. This enables the preparation of monthly financial statements without the trouble and expense of taking monthly physical inventories.

Further, the value of inventories shown by the book inventory will be more accurate than inventory values shown by the physical inventory method. If no cost system is in use and inventory values computed by physical inventory method, then the value of these inventories must either bean estimate of cost or be determined at market values. But in a cost accounting system accurate procedures and techniques are available by which inventory values can be computed in a relatively more exact fashion. The requirements of management, stockholders, creditors, employees and other groups interested in the financial statements of the firm naturally attach more emphasis on this objective of cost accounting. In most cases, this objective of cost accounting dominates the formal cost records and routines.

7) Whether to Manufacture or Purchase from Outsiders: Cost records furnish information regarding the cost of manufacturing of different finished parts, which assist management in making a decision whether to purchase these parts from outside manufacturers or manufacture them in the factory.

8) Control of Labour Cost: Orders, jobs, contracts, departments, processes, or services record cost of labour. In many manufacturing enterprises, daily time reports are prepared showing the number of hours and minutes spent and the wage rate for each worker per job or operation. This enables management to compare the current cost of labour per job or operation with some previously incurred or determined cost thus measuring the efficiency or inefficiency of the labour force and assigning the work to employees best suited for it.

9) Use of Company-wide Wage Incentive Plans: When labour cost is accounted for by jobs and operations, it is possible to use effectively wage incentive plans or bonus schemes for the remuneration of labour force. Carefully planned and administered incentive schemes are an effective means of enforcing superior performance and cost reduction. Workers are more co-operative, responsive and productive when some form of incentive offered to them for surpassing stipulated standards of perfection and performance. Cost of accounting has developed incentive plans, which are applicable not only to factory workers but also to clerks, salespersons, and other executives for above standard performance.



10) Controllable and Uncontrollable Cost: Cost accounting exhibits at each stage of production and sale the controllable and uncontrollable items in the manufacturing, selling and administrative cost thus enabling management to concentrate attention on those costs, which can reduced off , eliminated. There is very little the management can do to reduce such uncontrollable items as idle time of machines and labour, wastage in the use of materials, supplies and power can controlled much more effectively.

11) Use of Standards for Measuring Efficiency: A complete cost accounting system, generally, has a well-developed plan of standards to measure the efficiency of the organization in the use of materials, incurrence of labour and other manufacturing cost. Cora does this appraisal paring the work of factory workers, office and sales personnel and other executive with what should have done in manufacturing and selling a given quantity of units in a given period.

12) Reduction of Losses Due to Seasonal Conditions: Cost accounting provides data for making a complete analysis of losses due to idle plant and equipment or due to the use of plant and equipment beyond normal capacity, irregular employment of labour, wastes in the use of materials. It indicates cost variations between active and inactive periods and seasonal conditions in the business or industry. Seasonal fluctuations in business activity affect profoundly the earnings of the concern. In many industries, seasonal variations are responsible for higher costs and lower profits.

13) Budgeting: In a good cost accounting system, preparation of various budgets periods in advance of actual production and sale of goods is necessary. These budgets include budgeted statement of profits, budgeted cost of plant improvements, budgeted cost of production, budgeted cash receipts and payments, and so forth. These budgets show the plans of the management for future periods and they reflect the expected results of these plans. They are of great help in getting the sales manager, the works manager, and the treasurer into agreement as to a plan that can sold, manufactured and financed. In fact, the use of budgets has made costing a preventive device for the rectification of inefficiencies before they creep into the business operations or as they occur from day to day. In other words, budgeting, inculcates the habit of thinking and calculations before taking decisions.

14) Reliable Check on General Accounting: Finally, an efficient and proper system of cost accounting is a most reliable and independent check on the accuracy of the financial accounts. This check made effective through reconciliation of the balance of profit or loss shown by the costing profit and loss account and the balance of profit of profit or loss revealed by the general accounting profit and loss account.



Limitation of Cost Accounting.

Cost accounting is not free from limitations. The main limitations of cost accounting are as follows;

Not an exact science: Cost accounting has developed because of the limitations of financial accounting. Many theories have also been developed in the light of convention and basic principles. These are not static but changing with the time and circumstances. Hence, it is not an exact science but a approximate science.

No Uniform Procedures and methods: The procedures and methods of cost accounting followed by different organisations are not uniform and therefore, they provide different results from the same information.

Based on estimation and conventions: In cost accounting some elements of costs like indirect costs are charged on the basis of estimations. These are the actual cost and differs from the estimates. Thus the result derived from cost accounting becomes misleading.

4. METHODS OF COSTING

1. Job Costing:

Under this method costs are collected and accumulated for each job or work order or project

separately. Each job can be identified separately and hence becomes essential to analyze the

costs according to each job.

Normally production consists of distinct jobs or lots so that order number can identify costs. A

job card is prepared for each job for cost accumulation. This method is suitable for Printers,

Machine tool manufacturers, Foundries, and general engineering workshops.

2. Contract Costing:

Contract costing does not in principle differ from job costing. When the job is big and spread

over long period of time, the method of contract costing is used. A separate account is kept for

each individual contract. Civil engineering contractors, constructional and mechanical

engineering firms, builders, etc use this method.



In contracts, when it is agreed to pay an agreed sum or percentage to cover overheads and profit

to the contractors, it will be termed as ‘cost plus costing’. The term cost here refers to the prime

cost. Usually government contracts are assigned in this basis.

3. Batch Costing:

This is an extension of job costing. A batch may represent a number of small orders or group of

identical products passed through the factory in batch. Each batch is treated as a cost unit and

cost is ascertained separately.

The cost per unit is determined by dividing the cost of the batch by the number of units produced

in a batch. The manufacturers of biscuits, garments, spare parts and components mainly use this

method.

4. Process Costing:

A process refers here to a stage of production. If a product passes through different stages, each

distinct and well defined, then in order to ascertain the cost at each stage or process, the process

costing is used. Under this method, a separate process account is prepared and all costs incurred

in that process are charged.

Normally the finished product of one process becomes the raw material of the subsequent

process and a final product is obtained in the last process. As the products are manufactured in

continuous process, this is also known as continuous costing. Process costing method is

generally followed in textile units, chemical industries, refineries, tanneries, paper manufacture,

etc.

5. Operation Costing:

It is a further refinement of process costing. It is suitable to industries where mass or repetitive

production is carried out or where the goods have to be stocked in semi-finished stage, to enable



the execution of special orders, or for the convenient use in later operations. In this method, the

cost unit is an operation. It is used in cycle manufacturing, automobile units, etc.

6. Unit Costing:

This is also known as single or output costing. This method is suitable for industries where the

manufacture is continuous and units are identical. This method is applied in industries like

mines, quarries, cement works, brick works, etc.

In all these industries there is natural or standard unit of cost, for example, tone of coal in

collieries, tone of cement, one thousands of bricks, etc. The object of this method is to ascertain

the cost per unit of output and the cost of each element of such cost.

Here the cost account takes the form of cost sheet or statement prepared for a definite period.

The cost per unit is determined by dividing the total expenditure incurred during a given period

by the number of units produced during that period.

7. Operating Costing:

This is suitable for industries, which render services as distinct from those, which manufacture

goods. This is applied in transport undertakings, power supply companies, gas, water works,

municipal services, hospitals, hotels, etc.

It is used to ascertain the cost of services rendered. There is usually a compound unit in such

undertakings, for example, tone - kilometers or passenger-kilometers in transport companies,

kilo-watt-hour in power supply, patient-day in hospitals, etc.

8. Multiple Costing:

It is also called as composite costing. It represents the application of more than one method of

costing in respect of the same product. This is suitable for industries where a number of



component parts are separately produced and subsequently assembled into a final product. In

such industries each component differs from others as to price, materials used, and

manufacturing processes.

5. COST CLASSIFICATION

Elements of cost

Material Labour Other expenses

Direct Indirect Direct Indirect Direct Indirect



Overhead

Factory Administration Sales Distribution

1) According to variability :

Fixed costs or period costs are those costs which remains constant irrespective of the volume of output e.g., factory rent, insurance etc.

Variable costs or product costs are those costs which will vary in direct proportion to the output, e.g., direct materials, direct labour, power etc.

Semi-variable costs are those costs which are partly fixed and partly variable, e.g., telephone charges.

2) Accounting to controllability:

Controllable costs are those costs which are not within the control of management eg., rent of building

3) According to normality

Normal cost: It is normally incurred at a given level of output and it forms part of the of cost production.

Abnormal cost: It is not normally incurred at a given level of output and therefore, it is charges to costing profit and loss account.

4) According to managerial decision:

Marginal cost: It is the total variable cost comprising of prime cost and variable overheads.

Out of pocket cost: It is a cost which gives rise to cash expenditure. Differentials cost: It is the change in costs due to change in the level of activity or method

of production. Sunk costs: It is a cost which cannot be recovered due to the permanent closure of a plant. Shut down costs: It is the cost incurred on the plants kept idle due to the temporary

suspension of activities.



Imputed costs or notional cost: It is the cost in respect of which no actual expenditure is incurred e.g., rent of one building, interest on capital etc. Therefore, it appears only in the cost accounts.

Replacement cost: It is the cost at which asses can be replaced. Opportunity cost: It is the cost which may be earned from the alternative use of a

productive capacity. Avoidable cost: It is the cost which can be eliminated on the discontinuation of a product

or department, e.g., salary of clerks in that department. Unavoidable cost: It is which cannot be eliminated on the discontinuation of a product or

department, e.g., salary factory manager.

ELEMENTS OF COSTS

Prime Cost = Direct Materials + Direct Labour+ Direct Expenses

Works Cost (Factory) = Prime Cost+ Factory Overhead

Cost of Production = Factory Cost + Administration Overhead

Total Cost (Cost of Sales) =Cost of Production + Selling and Distribution Overhead

Direct materials: All those materials which can be easily identified as chargeable to a particular product, job or process, are known as direct materials. Examples: Timber used in furniture’s, paper used in note books etc.

Direct Labour: All those laborers who can be easily identified as attributable to a particular job, production process are known as direct labour. The wages given to them are known as direct wages. Example: Workers directly engaged on production.

Direct or chargeable expenses: All those expenses which are incurred specifically for a particular job, product or process are known as direct expenses. Examples: Expenses on drawings, models, design, excise duty, royalty etc.

Overhead: Indirect materials, indirect labour and indirect expenses are collectively know a “Overhead”

6 .PREPARATION OF COST SHEET

SPECIMEN OF A COST SHEET

Cost sheet for the period________________



Particulars Total Cost

(Rs)

Cost Per unit

(Rs)

Direct material Consumed:

Opening stock of raw materials

Add Purchases

Less Closing stock

Cost of Drawings

Direct Expenses

Primary Packing Materials

PRIME COST

Add Works /Factory overheads:

Indirect Materials

Indirect wages

Factory Rent and Rates

Factory Lighting and Heating

Power and fuel

Repairs and Maintenance

Drawing Office Expenses

Research and Experiment Cost

Depreciation of Factory Plant

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****



Works Stationery

Insurance of Factory

Works Manager’s Salary

FACTORY COST/WORK COST/

MANUFACTURING COST

Add Office and Administrative Overheads:

Office Salaries

Office Rent and Rates

Lighting and Heating

Cleaning

Telephone and Postages

Printing and Stationery

Depreciation of Office Furniture

Insurance

Legal Expenses

COST OF PRODUCTION

Add Selling and Distribution Overheads:

Advertising

Salesmen Salaries

Samples and Free gifts

Sales office Rent

Sales promotion Expenses

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****

****



Packaging and Demonstration

Showroom Rent and Rates

Repair of Delivery vans

Carriage freight outwards etc

COST OF SALES

****

****

****

**** ****

7. INVENTORY SYSTEM

Meaning Inventory control means the safeguarding and maintaining of inventories at optimum

level by taking into consideration the production requirements and the financial resources of the business. The term inventory includes all materials in stock like raw materials finished and semi-finished goods, crap etc. the proper control over materials will reduce the cost of production since it forms major proportion of cost of a product. This control over materials is normally, exercised over purchases, storage and consumption of materials.

Objectives To ensure minimum utilization of financial resources without affecting the operational

needs. To avoid break down in production due to shortage of materials. To reduce the risk of loss through obsolescence, theft, fire and damage. To make purchases economically. To ensure prompt delivery of finished goods ordered. To submit accurate materials reports to the management in time.

8.METHODS OF PRICING MATERIAL ISSUES

There are different methods of pricing materials issue. The various methods used fall under the following main categories:

I. Cost Price Methods



(a) First in First out (FIFO)(b) Last in First out (LIFO)(c) Base StockII. Average Price Methods (a) Simple Average.(b) Weighted Average.

III. Notional Price Method (a) Standard Price.(b) Inflated Price.(c) Replacement price.As per the syllabus only F.I.F.O., L.I.F.O., Average and Base Stock methods are discussed below:

First in First out Method (FIFO)

Under this method materials are used in the order in which they are received. In other words, materials received first are issued first. This process is repeated throughout.The price of the earliest consignment is taken first and when that is exhausted, the price of the next consignment is adopted and so on. This method is most suitable for use where the material is slow moving and has comparatively high unit cost This method is also useful in times of falling prices because the issue price of material to the job will be high while the replacement cost of material will be below.The following are the advantages of FIFO method:(i) It is simple to understand and easy to calculate.(ii) FIFO method is based on sound principle that materials are issued in order of purchase. Thus materials received first are issued first.(iii) The value of closing stock will reflect current market price.(iv) This method is suitable when prices are falling.(v) This method is also useful if transactions are few and prices of material remain stable.(vi) Unrealized profit or loss does not arise as materials are issued at actual cost but not on estimate.(vii) Deterioration and obsolescence can be avoided by exhausting oldest materials at the time of issue.

Disadvantages

This method suffers from the following disadvantages:(i) The calculation becomes difficult and cumbersome when purchases are made very frequently at different prices.(ii) Issue price does not reflect current market price and so does cost of production.(iii) For pricing one requisition, more than one price has often to be taken.(iv) Cost of production tends to be high during the period of falling prices.(v) Two similar jobs cannot be compared as the issue price of one lot differs from that of other.



Last in First Out Method: (LIFO)

This method is exactly the opposite of FIFO method. Under this me materials received last are issued first. The price of the material to be issued would the cost price of the last lot of materials purchased.This method is useful during t period of rising prices because materials will be issued from the latest consignment a price which is closely related to the current price levels. Under this method product' cost is calculated on a basis which approximates to replacement cost.Illustration

The followings transactions took place in respect of material in during the month of January, 2008. You are required to write up the Stores Ledger under LIFO methThe following are the advantages of LIFO method:(i) This method is very simple to operate and quite useful where transactions are not too many and prices are fairly steady.(ii) Production is charged at the most recent prices so that it is based on the principle that costing should be related to current price levels.(iii) During the period of rising prices there is no windfall profit as in case of FIFO method.(iv) Closing stock will be valued at earlier price and will not, therefore, show unrealised profit.(v) This method reduces burden of income tax during the period of price rise DisadvantagesThis method suffers from the following disadvantages:(i) Like FIFO system, calculations become complicated and cumbersome when transactions are many with frequent price fluctuations.(ii) Two similar jobs cannot be compared because of charging different rates of materials to different jobs.(iii) Under this system, closing stocks are not shown at current market price.(iv) Sometimes more than one price has to be adopted for pricing a single requisition.(v) When prices are falling it will lead to low charge to production, whereas materials in the stock purchased at higher rate need adjustment for valuation of closing stock.(vi) This system of material issue is not accepted by Income Tax Authorities.

Base Stock Price

This is not a distinct method of pricing materials issue. This method is based o^ the principle that a certain minimum quantity of material is always maintained in to ensure continuous production.This minimum stock is treated as fixed asset and is called as base stock. Since minimum stock is created out of first lot of material purchased, it is always valued at cost price of first lot of materials. The quantity in excess of this base stock is issued at a price similar to FIFO or LIFO method.This bad stock method operates in conjunction with some other methods like FIFO or LIFO and is called Base Stock - FIFO method or Base Stock - LIFO method. The advantages of FIFO and LIFO are applicable in this method.



Simple Average Price Method

Under this method, materials issued are valued at average price. This is calculated by dividing the total of the price of the materials on the stock from which the material to be priced could be drawn by the number of prices used in that total.Unit pieces of material in stock Issue Price - Number of purchases.A new simple average price is to be determined when a fresh receipt is made. The rate is also revised when an earlier consignment is exhausted.The following example will illustrate this. Suppose, following are three different lots of materials in stock when materials is to be priced:100 units purchased @ Rs.4.00 200 units purchased @ Rs.5.00 300 units purchased @ Rs.6.00The simple average price will be =--- = Rs.5.00The following are the advantages of simple average method:(1) It is easy to calculate and simple to operate.(2) A particular purchase at higher or lower rate cannot disturb the price to a great extent. .(3) Issue rate remains the same until a fresh purchase is made. Disadvantages:(1) It is not a logical method as it takes into account purchase price but not quantity.(2) The value of closing stock becomes absurd.(3) The issue price does not relate to the current market price. METHODS OF INVENTORY CONTROL

Inventory consists of stock of raw materials, work-in-progress, spare pa consumables for production and finished goods for sale. Thus, inventory com includes control over raw materials, spare parts, consumables, partly finished goods, and finished goods. The following are the common techniques of inventory control:1. Determination of various levels of materials2. Economic Order Quantity3. ABC Analysis4. Perpetual Inventory System1. Determination of Various Levels of MaterialsThe store-keeper plays an important role in deciding upon the various levels materials. In order to ensure that the optimum quantity of materials is purchased stocked neither less nor more, the store keeper applies scientific techniques of material management. Fixing of certain levels for each item of materials in one of techniques.These levels are not permanent but require revision according to the change in the factors which determine these levels. The following levels are generally fixed.(a) Re-order Level(b) Maximum Level(c) Minimum Level(d) Average Level(e) Danger Level



(a) Re-order Level:This level is that level of material at which it is necessary to initiate purchase requisition for fresh supplies. This is normally the point lying between the maximum and the minimum levels. Fresh orders must be placed before the actual stocks touch the minimum level.This level is fixed in such a manner that the quantity of materials represented by the difference between the re-order level and the minimum level will be sufficient to meet the requirement of production till such time as the order materializes and materials are delivered. The following factors are taken into account for fixing the Re-order level:(i) Rate of consumption of material(ii) Lead time, i.e., time required to receive the delivery of fresh purchase.(iii) Re-order quantity(iv) Minimum levelRe-order level can be calculated by applying the following formula:Re-order level = Minimum level + consumption during period required to get fresh delivery

(b) Maximum Level:

The maximum level is that level of stock which can be held at any time. In other words, it is the level beyond which stock should not be maintained. The purpose is to avoid over-stocking and thereby using working capital in a proper way. This level is fixed after taking into account the following factors:(i) Rate of consumption(ii) Lead time(iii) Availability of capital(iv) Storage capacity(v) Cost of maintaining stores including insurance cost(vi) Nature of commodity(vii) Possibility of price fluctuation(viii) Possibility of change in fashion, habit, etc.(ix) Restrictions imposed by Govt., local authority or trade associations(x) Re-order level it(xi) Re-order quantityMaximum level can be calculated by applying the following formula:Maximum Level = Re-order level + Re-order Quantity - (Minimum consumption x Minimum Re-order period)

(c) Minimum Level:

This is the level below which the stock of an item should not fall. This is known as safety or buffer stock. An enterprise must maintain minimum quantity of stock so that the production is not hampered due to non-availability of materials. This level is fixed after considering the following factors:(i) Re-order level(ii) Lead time



(iii) Rate of consumptionThe formula for calculating minimum level is:Minimum level = Re-order level - (Normal consumption x Normal Re-order period)

(d) Average Level: Average level can be calculated by applying the following formula:Maximum level + Minimum level Average level = Average level Or Average level = Minimum level + of Re-order Quantity.

(e) Danger Level: Usually stock should not be lower than the minimum level. But if for any reason, stock comes down below the minimum level, it is called danger level. When the stock reaches danger level, it is necessary to take urgent action on the part of the management for immediate replenishment of stock to prevent stock-out situation. The danger level can be calculated by applying the following formula:Danger Level = Average consumption x Maximum Re-order period for emergency purchasesFrom the following particulars, calculate the maximum level, minimum level, re-order level and average level:Normal consumption - 300 units per day Maximum consumption - 420 units per day Minimum consumption - 240 units per day Re-order quantity - 3,600 unitsRe-order period - 10-12 days

10. Economic Order Quantity (EOQ)

The economic order quantity, known as EOQ, represents the most favorable quantity to be ordered each time fresh orders are placed.The quantity to be ordered is called economic order quantity because the purchase of this size of material is most economical. It is helpful to determine in advance as to how much should one buy when the stock level reaches the re-order level. If large quantities arc purchased, the carrying costs would be large.On the other hand, if small quantities are purchased at frequent intervals the ordering costs would be high. The economic order quantity is fixed at such a level as to minimise the cost of ordering and carrying the stock. It is the size of the order which produces the lowest cost of material ordered.While determining the economic order quantity, the following three cost factors are taken into consideration:(i) The cost of the material(ii) The inventory carrying cost(iii) The ordering costCarrying costs are the costs of holding the inventory in the stores. These are:(i) Rent for the storage space.(ii) Salaries and wages of the employees engaged in store keeping department.(iii) Loss due to pilferage and deterioration.(iv) Insurance charges.



(v) Stationery used in the stores.(vi) Loss of interest on the capital locked up in materials.Ordering costs are the costs of placing orders for the purchase of materials. These are:(i) Salaries and wages of the employees engaged in purchasing department.(ii) Stationary, postage, telephone expenses, etc. of the purchasing department.(iii) Depreciation on equipments and furniture used by the purchasing department.(iv) Rent for the space used by the purchasing department.While placing orders for purchasing materials, the total cost to be incurred is kept in view. As discussed earlier, if an order is placed for a large quantity at a time, the ordering cost is less but the carrying cost would be more.On the other hand, if orders are placed for small quantities, the ordering cost is more but the carrying cost would be less; thus the economic order quantity is determined at a point when the ordering costs and the carrying costs are equal. Only at this stage the total of ordering cost and carrying cost is minimum.Determination of Economic Order Quantity: The economic order quantity is determined by using the following formula:Where, EOQ = Economic order quantity.C = Annual consumption or usage of material in units.0 = Cost of placing one feeder including the cost of receiving the goods.1 = Cost of carrying one unit of inventory for one year.

Assumptions in the Calculation of Economic Order Quantity: The economic order quantity is based on the following assumptions:Quantity of the item to be consumed during a particular period is known with certainty.The pattern of consumption of material is constant and uniform throughout the period.Cost per unit is constant and known and quantity discount is not involved.Ordering cost and carrying cost are known and they are fixed per unit and will remain constant throughout the period.


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