Revise Materials and labour for Cambridge 9706 (2.1.1)

Material costs are a fundamental component of manufacturing accounts. They are classified as either direct or indirect. Direct materials are raw materials that can be physically and directly traced to each unit of a finished product, such as the wood used to make a chair. Indirect materials are necessary for the production process but are not directly traceable to a specific unit, like glue or sandpaper. The cost of materials recorded in the accounts should include all expenses incurred to bring them to their present location and condition. This includes the purchase price, delivery charges (carriage inwards), and any non-refundable taxes or import duties. Crucially, trade discounts are deducted from the purchase price, whereas settlement (cash) discounts for prompt payment are treated as financial income, not a reduction in material cost. These movements of materials are meticulously tracked in a stores ledger card, which forms the basis of a perpetual inventory system.

A stores ledger card is a crucial document in a perpetual inventory system. It provides a detailed, continuous record of the quantity and value of inventory on hand. For each type of material, the card has columns for 'Receipts' (purchases), 'Issues' (to production), and 'Balance'. Each entry records the date, quantity, unit price, and total value. This allows for tight control over inventory levels and provides the data needed to value both issues (cost of materials used) and closing inventory using either the FIFO or AVCO method. Mastery of preparing a stores ledger card is essential for exam success.

The First-In, First-Out (FIFO) method operates on the assumption that the first units of inventory purchased are the first ones to be issued to production or sold. This means that any inventory remaining at the end of a period (closing inventory) is assumed to be from the most recent purchases. When preparing a stores ledger card using FIFO, issues are priced using the cost of the oldest batch of inventory on hand. Once that batch is exhausted, the cost of the next oldest batch is used. In a period of rising prices (inflation), this method results in the cost of sales being based on older, lower costs, and closing inventory being valued at recent, higher costs. Consequently, reported profit and the inventory value on the statement of financial position will be higher than under other methods.

The Weighted Average Cost (AVCO) method smooths out the effect of price fluctuations by calculating a new average cost for all units in inventory after each purchase. This new weighted average cost is calculated by dividing the total cost of inventory on hand (including the new purchase) by the total quantity on hand. All subsequent issues are then priced at this new average cost until another purchase is made. This method is particularly useful when inventory items are identical and intermingled, making it impractical to identify specific batches. Unlike FIFO, AVCO does not attempt to match a specific cost flow to the physical flow of goods, instead providing a blended cost that moderates the impact of price changes on both cost of sales and closing inventory valuation.

Labour costs, like material costs, are categorised as either direct or indirect. Direct labour refers to the wages of employees directly involved in the manufacturing process, whose time can be traced to specific units of production (e.g., a factory machine operator). This cost is a component of the prime cost. Indirect labour is the cost of employees who support the production process but are not directly involved in making the product (e.g., factory supervisors, maintenance staff, cleaners). This is treated as a production overhead. Remuneration can be time-based (e.g., hourly wage), which is simple but may not incentivise efficiency, or output-based (piecework), which links pay to productivity but can compromise quality. Bonus schemes are often used to motivate workers by offering extra pay for achieving specific targets. A key component of labour cost is overtime, which is work done outside normal working hours. The extra amount paid above the basic rate is known as the overtime premium. Unless overtime is worked for a specific customer's job, the basic pay element is treated as a direct cost, while the premium element is treated as an indirect production overhead. Another consideration is idle time, which is non-productive paid time due to issues like machine breakdowns. The cost of normal idle time is also typically charged as a production overhead.