In this series so far we have reviewed, the theory behind inventory valuation, considered the characteristics of the three common methods available methods, FIFO, LIFO and AVCO and used each of them to calculate the cost of issues and the value of closing inventory.
If you have missed part one or part two then click on the links to re-cap, as this article is going to conclude by looking at how the valuation of raw materials fits into the bigger picture of cost accounting and is used to calculate the total costs of products and their cost per unit.
In part one, we alluded to the relationship that exists between the costing and financial accounting systems within organisations.
Inventory management and valuation
Inventory management and valuation is an area where it is clear to see because the process of buying raw materials throughout the year includes cross over between the financial accounting tasks, regarding purchases, and the cost accounting tasks, regarding inventory records.
Then at year-end the closing inventory is valued* and the overall figure included in the financial statements. Both systems use the same costs but in different ways and for different purposes. Ultimately the two systems work together and one way of illustrating that, is by looking at how the cost of issues of raw materials, is included in the cost of production of products.
Calculating the total cost of raw materials
We have used the example of manufacturing a toaster and the inventory records of two raw materials, stainless steel and some plastic trim, to give context to this series.
In reality, a toaster is made from a long list of parts that includes “a heating element, spring, bread rack, heat sensor, trip plate, level, timing mechanism, electromagnet, catch, and browning control.”
These parts are manufactured from metals and moulded plastics and are held together by screws, nuts, bolts, and washers.**
Each of these inventory lines will have a separate physical location in stores and a separate inventory record showing the value of issues that have been made to production. This information can be used to calculate the total cost of raw materials that have been used in the production process.
Analysing timesheets to calculate the direct labour costs
Let’s suppose that once we add up all the total costs of issues, for all the raw materials needed to make 50,000 toasters in April, we calculate a figure of £230,000.
We could also analysis timesheets to calculate the direct labour costs attributable to the same product in the same month and retrieve appropriate data about the manufacturing overheads. These are the three main elements of cost and are combined to calculate the total cost of the 50,000 toaster produced:
The cost of each toaster is calculated as the total cost divided by the quantity (£763,400 ÷ 50,000).
It is essential for organisations to know how much it has cost to produce products because this helps inform decisions about selling prices or control costs to achieve a fixed sales price.
For example, if these toasters sell for £25.99 each, then the £10.722 difference between the selling price and the cost per unit, is gross profit.
Predicting costs at different levels
Another use of this information is to help predict costs at different levels of production. Let’s say that next month a marketing campaign is running and increased sales of toasters are expected as a result.
The information we have about the three elements of cost can be used along with our knowledge and understanding about how costs behave, to predict the costs for the manufacture of an additional 10,000 toasters.
The fixed manufacturing overheads will remain the same regardless of the level of output. Whereas the variable costs will change in direct proportion to production.
Therefore, the direct materials figure is divided by the 50,000 unit of production to calculate the cost per unit of direct materials (£230,000 ÷ 50,000 = £4.60), which is then multiplied by the new level of production (£4.60 x 60,000 = £276,000).
This process is repeated for the direct labour and then the total cost and cost per unit is calculated as before:
Whilst we have moved away from methods of inventory valuation a little to more strategic planning and budgeting, it is important to recognise that higher level uses of costing information are only possible if the initially management and valuation of inventory is accurate.
In the same way that financial statement can only be accurate if they are based on high quality bookkeeping, the accurate application of an organisation’s chosen inventory valuation method, underpins many further cost accounting functions and should not be underestimated.
* in accordance with IAS2 using either FIFO or AVCO
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Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.