Business Processes & Accounting Systems · Week 08

Material Costing & LKAS 2 Inventories

Inventory types, the cost of inventory and NRV (LKAS 2), the purchase function (centralised vs decentralised, purchase procedure, material cost), storing materials (stock levels, EOQ), and pricing issues with FIFO and weighted average — with every lecture example solved.

ITE36221 video · 45 min📄 Material costing session 8.pdf📄 LKAS 02 - Inventory.pdf📄 Practice – Material costing & LKAS 2.pdf

▶Lecture videos

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Inventory Costing

Lecture on inventory and material costing.

00:48Learning outcomes: what inventories are and why systems matter 03:13Key features of an inventory system 05:01Why hold inventory: independence of operations 06:34Flexibility in production scheduling 07:46Economic purchase orders and discounts 09:50Inventory costs: ordering cost 11:09Set-up costs (e.g. switching car models)12:41Stock-out costs (e.g. a phone launch)14:03Objectives of stock control 17:04Stock levels 19:34Reorder level formula 20:53Minimum stock level (buffer stock)24:01Maximum stock level 25:42Worked example: stock levels 27:14EOQ: minimising total cost 28:31Holding cost per unit per year 29:58FIFO valuation 31:37Example: FIFO and weighted average cost (WAC)41:16FIFO in inflation: higher profit and stock value 42:39WAC smooths out price changes 44:21Summary: FIFO vs WAC

1Inventory & LKAS 2

Definition

Inventory is the raw materials, work-in-progress and finished goods that are the part of a business's assets ready, or that will be ready, for sale.

Raw materialsWork in progress (WIP)Finished goods

LKAS 2 objective: prescribe the accounting for inventories:

determining cost
recognising the expense, including any write-down to NRV
the cost formulas used

The fundamental principle of LKAS 2

Inventories are stated at the LOWER of cost and net realisable value (NRV).

What goes into the cost of inventory

Include	Exclude
Purchase costs: price + non-refundable taxes, transport and handling, net of trade discounts and subsidies	Abnormal waste
Conversion costs: direct labour + fixed and variable production overheads	Storage costs
Other costs to bring inventory to its present location and condition	Administrative overheads not related to production
	Selling costs
	Foreign-exchange differences on recent foreign-currency purchases
	Interest on deferred-settlement purchases

Purchase-cost layout:

	Rs
Purchase price	xxxx
Less: trade discounts	(xxx)
Less: subsidies	(xxx)
Carriage inwards	xxxx
Direct taxes	xxxx
Non-refundable taxes	xxxx
Other direct costs	xxxx
Total purchase cost	xxxx

Net realisable value

NRV = Estimated selling price − Estimated costs of completion − Estimated costs to sell

Write-downs to NRV are an expense in the period they happen. Reversals are recognised in the income statement when they happen.
NRV can be compared item by item (the item method) or by groups of similar items (the batch method).
Cost formulas for interchangeable items: FIFO or weighted average (LIFO is not allowed).
Expense recognition: when inventory is sold, its carrying amount becomes cost of goods sold. Write-downs and losses are expensed when they occur.

Lower of cost and NRV

Item	Cost	NRV	Value used
A	1,000	1,300	1,000
B	800	650	650
C	500	500	500
Item-by-item total			2,150

Comparing the totals instead (cost 2,300 vs NRV 2,450) would give 2,300. That hides B's loss, which is why the item method is preferred.

2Function 1: managing purchases

Centralised vs decentralised buying

	Centralised buying	Decentralised buying
Advantages	Consistent buying policy · better control · expert buying staff · avoids excess stock	Lower transport cost · rejections, shortages and excess receipts settled quickly · local purchase benefits (low or seasonal prices)
Disadvantages	Less flexible · high initial cost · high transport cost	High stock-holding cost

The purchase procedure

Purchase requisition (when?)

Determine quantity (how much?)

Select supplier (where?)

Purchase order & follow-up

Receive & inspect (GRN)

Check invoice & pass for payment

Step	Details
1. Purchase requisition (PR)	Request to buy, usually in triplicate: to purchasing, to production control, and kept by the initiating department
2. Quantity	In line with production and sales plans. Optimum quantity, no overstocking (EOQ)
3. Supplier	Inquiries and tenders or quotations → analyse tenders → select the best source
4. Purchase order	A large firm may make 5 copies: supplier, receiving department, accounts, the requisitioning department, and one kept by purchasing
5. Receive and inspect	Unload, unpack, mark; check quality and quantity; move into the factory. Prepare the goods received note (GRN), the basis of entries in the stores ledger
6. Invoice	Check against the PO and GRN, then pass for payment

Material cost

Invoice price + freight + excise duty + non-returnable containers (as LKAS 2's purchase cost).

Cash discount is a financial item, not deducted from material cost.
Returnable containers: only the net cost (charge − credit on return) is included.

Lecture example: material cost of 6,000 units from Mr. Naleen

Quotation: 2,000 units @ Rs 5.00; 4,000 @ Rs 4.75; 6,000 @ Rs 4.00
Trade discount 25%; cash discount 5% within 10 days
Freight Rs 200 per order
Containers Rs 0.50 each, one per 100 units, credit Rs 0.30 each if returned within two months

	Rs
6,000 × Rs 4.00	24,000
Less: trade discount 25%	(6,000)
	18,000
Freight	200
Containers: 60 × 0.50 = 30, less credit 60 × 0.30 = 18 → net	12
Total material cost	18,212
Cost per unit = 18,212 ÷ 6,000	≈ Rs 3.035

The cash discount is ignored: it's a financing decision, not a cost of the material.

3Function 2: storing materials & stock levels

Why efficient storing?

keep stores in proper custody
protect them from theft, deterioration, evaporation, pilferage
maintain a smooth, regular flow to production

Store locations: centralised, decentralised, or a combination.

Centralised stores: advantages	Disadvantages
Better layout, less equipment, better supervision, economy in cost, better stock forecasting	High transport cost, greater fire risk, delays to production

Stock control levels

Level	Formula	Meaning
Re-order level (ROL)	Max consumption × max lead time (or min stock + avg consumption × avg lead time)	When the storekeeper raises a purchase requisition
Maximum stock level	ROL + ROQ − (min consumption × min lead time)	Stock shouldn't rise above this (avoids blocking capital)
Minimum stock level (safety or buffer stock)	ROL − (avg consumption × avg lead time)	Stock shouldn't fall below this
Average stock level	(Max + Min) ÷ 2, or Min + ½ ROQ

Lecture example: stock levels

ROQ = 36,000 units
Lead time 2–4 months (average 3)
Max consumption 9,000 per month; normal consumption 6,000 per month
Assume minimum consumption = 2 × 6,000 − 9,000 = 3,000, since normal is the average of max and min

Level	Working	Units
Re-order level	9,000 × 4	36,000
Minimum level	36,000 − (6,000 × 3)	18,000
Maximum level	36,000 + 36,000 − (3,000 × 2)	66,000
Average level	(66,000 + 18,000) ÷ 2	42,000 (or 18,000 + ½ × 36,000 = 36,000)

Economic order quantity (EOQ)

EOQ = √( 2 × D × Co ÷ Ch )
D = annual demand · Co = cost of placing one order · Ch = holding cost per unit per year

EOQ assumptions:

perfectly forecastable, even demand
constant lead time
constant material price
constant holding cost per unit

Lecture example: EOQ

Monthly usage 250, so D = 3,000 a year
Co = Rs 30
Unit cost Rs 5, holding cost 10%, so Ch = Rs 0.50

EOQ = √(2 × 3,000 × 30 ÷ 0.5) = √360,000 = 600 units

🧪 Try it — EOQ & stock-level calculator

Annual demand D Order cost Co Unit price Holding %

4Function 3: pricing material issues — FIFO & weighted average

Method	Idea	Effect when prices rise
FIFO (first in, first out)	Issues are priced at the oldest batches first	Issues at older (lower) prices, so closing stock is at the latest (higher) prices and profit is higher
Weighted average cost (WAC)	After each receipt, compute average = total value ÷ total units; issue at that average	Smooths price changes

Lecture example: pillows, January 2019

1 Jan: balance 200 @ Rs 500
10 Jan: purchased 300 @ Rs 600
15 Jan: issued 250
20 Jan: purchased 100 @ Rs 650
24 Jan: issued 175

FIFO

Date	Issue	Issue value	Balance
15 Jan	200 @ 500 + 50 @ 600	130,000	250 @ 600 = 150,000
20 Jan	(receipt)		250 @ 600 + 100 @ 650 = 215,000
24 Jan	175 @ 600	105,000	75 @ 600 + 100 @ 650 = 110,000

Weighted average (perpetual)

Date	Working	Issue value	Balance
10 Jan	(100,000 + 180,000) ÷ 500 = Rs 560		500 @ 560 = 280,000
15 Jan	250 @ 560	140,000	250 @ 560 = 140,000
20 Jan	(140,000 + 65,000) ÷ 350 = Rs 585.71		350 = 205,000
24 Jan	175 @ 585.71	102,500	175 = 102,500

🧪 Try it — Stores ledger builder (FIFO vs weighted average)

One per line: R qty price for a receipt, I qty for an issue. The first line can be the opening balance as a receipt.

Method

Exam focus

Expect:

LKAS 2: lower of cost and NRV; what's included in and excluded from cost; FIFO and WAC allowed
Material cost calculations (trade discount, freight, net container cost; ignore cash discount)
Centralised vs decentralised buying and stores
The purchase procedure and its documents (PR, PO, GRN)
ROL, maximum, minimum and average levels
EOQ with its assumptions
The stores ledger using FIFO and WAC

5Practice questions (course paper)

Q1: Cost of purchased materials

	Rs.
Purchase price 300,000 − trade discount 10%	270,000
Carriage inwards	50,000
Import tax	20,000
Clearing charges	15,000
Non-recoverable VAT: 60% × 10,000	6,000
Cost	361,000

Q2: Net realisable value (NRV = selling price − selling cost)

Item	Cost	Selling price	Selling cost	NRV	Value at (lower of cost and NRV)
A	100	120	30	90	90
B	120	150	20	130	120
C	300	305	15	290	290

Q3: Item method vs batch method

Batch	Item	Cost	NRV	Units	Item method (lower × units)
Soap	Lux	35	30	200	6,000
Soap	Rani	40	41	150	6,000
Toothpaste	Signal	120	110	100	11,000
Toothpaste	Supiriwiki	100	95	60	5,700
					28,700

Batch method:

Soap: cost 13,000 vs NRV 12,150 → 12,150
Toothpaste: cost 18,000 vs NRV 16,700 → 16,700
Total 28,850

The table columns are jumbled in the PDF; this is the reading that fits them.

Q4 to Q8: Multiple choice

Q	Answer	Why
4	(d) all of the above	Maximum, minimum and re-order levels all guide requisitioning
5	(b) re-order level	Safety stock depends on consumption, lead time and stock-out cost, not on the ROL
6	(c) EOQ	It balances ordering and holding costs
7	(b) 2,100	ROL = max usage × max lead time = 700 × 3
8	(a) LIFO	Issues are charged at the latest (higher) prices. LKAS 2 doesn't allow LIFO in financial statements, but it's the textbook answer

Q9: Stores ledger, FIFO vs weighted average

Opening 545 @ 35. Receipts: 444 @ 37.50 (Jan) · 500 @ 40 (Feb) · 750 @ 42 (Mar). Issues: 400 · 610 · 450.

Issue	FIFO	WAC (rate)
Jan 400	400 @ 35 = 14,000	@ 36.12 = 14,448.94
Feb 610	145 @ 35 + 444 @ 37.50 + 21 @ 40 = 22,565	@ 37.90 = 23,120.66
Mar 450	450 @ 40 = 18,000	@ 40.40 = 18,181.39
Closing 779 units	29 @ 40 + 750 @ 42 = 32,660	31,474.01

If a physical count differs from the card, adjust the card to the count, and write off the shortage at the issue rate as a material loss.

Q10 to Q15: EOQ and stock levels

Q10 (Swarnahansa):

EOQ = √(2 × 600 × 80 / 0.60) = 400 units
Orders a year = 600 / 400 = 1.5
Minimum yearly cost = 1.5 × 80 + (400 / 2) × 0.60 = 120 + 120 = Rs. 240
Supply period = 12 / 1.5 = 8 months

Q11 (Sachin Ltd): annual usage 1,200; carrying cost = 25% × 4 quarters × 40 = Rs. 40 per unit per year.

EOQ = √(2 × 1,200 × 600 / 40) ≈ 190 units
Orders ≈ 6.3 a year

Q12 (product X): annual usage 60 × 52 = 3,120.

Measure	Formula	Answer
Re-order quantity (EOQ)	√(2 × 3,120 × 120 / 12)	≈ 250
Re-order level	max usage × max lead time = 90 × 6	540
Minimum level	ROL − normal usage × normal lead time = 540 − 60 × 5	240
Maximum level	ROL + ROQ − min usage × min lead time = 540 + 250 − 30 × 4	670
Average level	(min + max) / 2	455

Q13 to Q15: annual usage 250 × 12 = 3,000.

Q13: EOQ = √(2 × 3,000 × 30 / 0.5) = 600 (c)
Q14: orders = 3,000 / 600 = 5 (a)
Q15: time between orders = 12 / 5 = 2.4 months (c)

🧪 Try it — EOQ calculator

Annual demand Cost per order Holding cost / unit / year

6Quick revision sheet

Concept	Remember it as
Inventory	Raw materials, WIP, finished goods
LKAS 2 rule	Lower of cost and NRV
Cost	Purchase + conversion + other costs (location and condition)
Excluded	Abnormal waste, storage, admin, selling, FX, deferred interest
NRV	Selling price − completion costs − selling costs
Formulas	FIFO or weighted average (no LIFO)
Buying	Centralised (control, expertise) vs decentralised (local, quick)
Documents	Purchase requisition → purchase order → GRN → invoice
Material cost	Price − trade discount + freight + net containers (6,000 units = 18,212)
ROL	Max use × max lead time (36,000)
Min	ROL − avg use × avg lead time (18,000)
Max	ROL + ROQ − min use × min lead time
EOQ	√(2DCo/Ch) = 600
FIFO / WAC example	Issues 130,000 + 105,000 vs 140,000 + 102,500

?Self-check quiz

11 questions on this week. Answer them all, then press Check my answers. Your best and latest scores are saved and shown on the subject page.

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