Chapter 2: Material Costing and Control
Materials typically constitute 50-70% of total production cost in manufacturing. Effective material costing and control is therefore critical for profitability. This chapter covers material procurement, inventory valuation methods, stock control techniques, and material cost accounting — all essential for managing costs in Nepali manufacturing businesses.
2.1 Material Cost Components
| Type | Definition | Example (Garment Factory) |
|---|---|---|
| Direct Materials | Materials that can be directly identified with product | Fabric, buttons, zippers, thread |
| Indirect Materials | Materials that cannot be directly traced to product | Machine oil, cleaning supplies, needles |
2.2 Inventory Valuation Methods
When materials are purchased at different prices over time, we need a method to determine which cost is assigned to units issued and which to closing stock.
FIFO (First In, First Out)
Assumes materials purchased first are issued first. Closing stock valued at most recent prices. During rising prices: lower cost of goods sold, higher closing stock, higher profit.
LIFO (Last In, First Out)
Assumes most recently purchased materials are issued first. Closing stock valued at oldest prices. During rising prices: higher cost of goods sold, lower closing stock, lower profit (tax advantage).
Weighted Average
Each issue is valued at the weighted average cost of all units in stock. Average recalculated after each new purchase.
Comparison of Methods
| Basis | FIFO | LIFO | Weighted Average |
|---|---|---|---|
| Issue Price | Oldest purchase price | Latest purchase price | Average of all stock |
| Closing Stock | Latest prices (realistic) | Oldest prices (understated) | Average prices |
| Profit (rising prices) | Higher | Lower | Moderate |
| Tax Impact | Higher tax | Lower tax | Moderate tax |
| NAS/NFRS | Allowed | Not allowed under NFRS | Allowed |
Worked Example: FIFO
Data: Jan 1: Opening stock 100 units @ NPR 10 = 1,000 | Jan 5: Purchased 200 units @ NPR 12 = 2,400 | Jan 10: Issued 150 units | Jan 15: Purchased 100 units @ NPR 15 = 1,500 | Jan 20: Issued 200 units
FIFO Issues:
Jan 10: 100 units @ 10 + 50 units @ 12 = 1,000 + 600 = NPR 1,600
Jan 20: 150 units @ 12 + 50 units @ 15 = 1,800 + 750 = NPR 2,550
Total issues = 1,600 + 2,550 = NPR 4,150
Closing stock = 50 units @ 15 = NPR 750
Check: 1,000 + 2,400 + 1,500 = 4,900 = 4,150 + 750 ✓
2.3 Inventory Control Techniques
Economic Order Quantity (EOQ)
EOQ = √(2DO/C) where D = Annual demand, O = Ordering cost per order, C = Carrying/holding cost per unit per year
Example: Annual demand = 10,000 units, Ordering cost = NPR 200/order, Carrying cost = NPR 5/unit/year
EOQ = √(2 × 10,000 × 200 / 5) = √(800,000) = 894 units
Number of orders = 10,000/894 = 11.2 ≈ 12 orders/year
Stock Levels
| Level | Formula | Purpose |
|---|---|---|
| Reorder Level | Maximum Usage × Maximum Lead Time | When to place new order |
| Minimum Level | Reorder Level - (Normal Usage × Normal Lead Time) | Safety stock; buffer against stockout |
| Maximum Level | Reorder Level + EOQ - (Minimum Usage × Minimum Lead Time) | Avoid overstocking |
| Average Stock | (Minimum Level + Maximum Level) / 2 | For carrying cost calculations |
ABC Analysis
| Category | % of Items | % of Value | Control Level |
|---|---|---|---|
| A (High Value) | 10-20% | 70-80% | Tight control, frequent review, EOQ application |
| B (Medium) | 20-30% | 15-20% | Moderate control, periodic review |
| C (Low Value) | 50-70% | 5-10% | Simple controls, bulk ordering |
2.4 Weighted Average Method — Complete Worked Example
Same data as FIFO example: Jan 1: 100 units @ NPR 10 | Jan 5: 200 units @ NPR 12 | Jan 10: Issued 150 units | Jan 15: 100 units @ NPR 15 | Jan 20: Issued 200 units
Weighted Average Stores Ledger:
| Date | Receipts | Issues | Balance | ||||||
|---|---|---|---|---|---|---|---|---|---|
| Qty | Rate | Amt | Qty | Rate | Amt | Qty | Rate | Amt | |
| Jan 1 | 100 | 10 | 1,000 | 100 | 10.00 | 1,000 | |||
| Jan 5 | 200 | 12 | 2,400 | 300 | 11.33 | 3,400 | |||
| Jan 10 | 150 | 11.33 | 1,700 | 150 | 11.33 | 1,700 | |||
| Jan 15 | 100 | 15 | 1,500 | 250 | 12.80 | 3,200 | |||
| Jan 20 | 200 | 12.80 | 2,560 | 50 | 12.80 | 640 | |||
Weighted Average Calculation after Jan 5: (100×10 + 200×12) / 300 = 3,400/300 = NPR 11.33
After Jan 15: (150×11.33 + 100×15) / 250 = (1,700+1,500)/250 = 3,200/250 = NPR 12.80
Comparison Summary:
| Method | Total Issues Cost | Closing Stock Value |
|---|---|---|
| FIFO | NPR 4,150 | NPR 750 |
| Weighted Average | NPR 4,260 | NPR 640 |
Total = 4,150 + 750 = 4,900 = 4,260 + 640 = 4,900 ✓ (Both methods account for same total cost)
2.5 Just-In-Time (JIT) Inventory Management
JIT is a system where materials arrive exactly when needed in production, eliminating the need for large inventories. Pioneered by Toyota, it reduces carrying costs but requires reliable suppliers and efficient logistics.
| Feature | Traditional System | JIT System |
|---|---|---|
| Inventory Level | Large buffer stocks | Minimal/zero inventory |
| Order Size | Large, infrequent orders (EOQ) | Small, frequent deliveries |
| Supplier Relationship | Multiple suppliers, competitive bidding | Few trusted suppliers, long-term partnerships |
| Quality | Inspection after receipt | Zero defects expected at source |
| Nepal Feasibility | More practical given supply chain uncertainty | Challenging due to unreliable supply chains, transport disruptions |
2.6 Perpetual vs Periodic Inventory Systems
| Basis | Perpetual System | Periodic System |
|---|---|---|
| Recording | Every transaction recorded immediately | Counted periodically (monthly, quarterly, annually) |
| Accuracy | Real-time inventory knowledge | Only accurate at count date |
| Cost | Higher (requires HRIS/software) | Lower (less record-keeping) |
| Best For | High-value items, automated warehouses | Low-value items, small businesses |
| Nepal Practice | Supermarkets (Bhatbhateni), banks | Small shops, traditional retailers |
2.7 Stock Level Comprehensive Example
Data: Normal usage = 100 units/day, Maximum = 150, Minimum = 60. Lead time: Normal = 10 days, Max = 15, Min = 6. EOQ = 1,500 units.
Reorder Level = Max usage × Max lead time = 150 × 15 = 2,250 units
Minimum Level = ROL - (Normal usage × Normal lead time) = 2,250 - (100×10) = 1,250 units
Maximum Level = ROL + EOQ - (Min usage × Min lead time) = 2,250 + 1,500 - (60×6) = 3,750 - 360 = 3,390 units
Average Stock = (1,250 + 3,390) / 2 = 2,320 units
Danger Level = Normal usage × Emergency lead time = 100 × 3 = 300 units (if emergency delivery takes 3 days)
Practice Questions
Short Answer:
1. Differentiate between direct and indirect materials.
2. Compare FIFO, LIFO, and Weighted Average methods.
3. What is EOQ? Derive the formula.
4. Explain Reorder Level, Minimum Level, and Maximum Level.
5. What is ABC Analysis? How does it help in material control?
Long Answer:
6. From the following data, prepare stores ledger using FIFO and Weighted Average: Opening stock 500 units @ NPR 20; Purchases: Mar 5: 300 @ 22, Mar 12: 400 @ 25; Issues: Mar 8: 400, Mar 15: 500. (15 marks)
7. Calculate EOQ and related costs: Annual demand 24,000 units, ordering cost NPR 150, carrying cost NPR 2/unit/year, price NPR 50. Also find number of orders and total inventory cost. (15 marks)
8. Explain inventory valuation methods and their impact on profit and taxation. Which method is recommended under NFRS? (15 marks)
9. Discuss techniques of material cost control suitable for a Nepali manufacturing company. (15 marks)
10. Calculate stock levels: Normal usage 100 units/day, Maximum usage 150, Minimum usage 60, Lead time: Normal 10 days, Max 15, Min 6, EOQ 1,500 units. (15 marks)
Exam Tips: ✓ FIFO/Weighted Average numericals are always asked ✓ Show complete stores ledger with columns for receipts, issues, balance ✓ EOQ formula and calculation frequently tested ✓ Stock level formulas must be memorized ✓ ABC Analysis is a popular short answer topic