Financial Reporting · Ind AS 2 Inventories

Ind AS 2: Cost of Inventories – Purchase and Conversion Costs

Updated 5 October 2026 · Fact-checked

Under Ind AS 2, cost of inventories = cost of purchase + cost of conversion + other costs to bring inventory to its present location and condition. Purchase cost includes duties and freight, net of trade discounts and rebates. Fixed overheads are absorbed on normal capacity. Joint costs are split on a rational basis; by-products are measured at net realisable value.

Understand Cost of Inventories: Purchase and Conversion Costs

Ind AS 2 says inventories are measured at the lower of cost and net realisable value. This page covers the first half: how to build cost. Cost has three parts: cost of purchase, cost of conversion, and other costs incurred to bring the inventory to its present location and condition.

Cost of purchase is the purchase price plus import duties and other taxes that are not later recoverable from tax authorities (for example, GST credit you can claim is not part of cost), plus transport, handling and similar costs directly attributable to acquiring goods. Trade discounts, rebates and other similar items are deducted. The logic: cost is what you truly spent, net of what you got back.

Cost of conversion applies to manufactured goods. It has direct costs (direct labour, and other costs directly linked to units produced) and a systematic allocation of production overheads. Overheads split into two kinds. Variable production overheads change almost directly with output (indirect materials, indirect labour). They are allocated on actual use of production facilities. Fixed production overheads stay broadly constant (factory rent, depreciation of factory plant, factory management). They are allocated on the basis of normal capacity, the production expected on average over several periods under normal circumstances, allowing for planned maintenance.

The normal capacity rule protects against inflating inventory. If actual production is lower than normal, the fixed overhead per unit is NOT increased; the unallocated amount is expensed in the period. If actual production is higher than normal, the fixed overhead per unit is decreased, so inventory is not carried above cost. Actual output may be used as normal capacity if it approximates normal capacity.

When one process produces more than one product at the same time, you have joint products or a by-product. The joint cost of conversion is allocated between products on a rational and consistent basis, for example relative sales value at the point of separation. Most by-products are immaterial and are measured at net realisable value; that value is deducted from the cost of the main product, so the main product's carrying amount is not materially different from its cost.

Key rules to remember

Cost of inventories: Cost = Cost of purchase + Cost of conversion + Other costs to bring to present location and condition; Lower of this and NRV is the carrying amount.
Cost of purchase: Purchase price + import duties + non-recoverable taxes + freight, handling and other directly attributable costs − trade discounts, rebates and similar items; Recoverable taxes such as GST input credit are excluded. Settlement (cash) discount is treated as a deduction only if it is similar to a trade discount or rebate; otherwise it is a financing item.
Fixed overhead absorption rate: Fixed overhead per unit = Total fixed production overheads ÷ Normal capacity (units); Use normal capacity, not actual output, unless actual approximates normal.
Fixed overhead absorbed in inventory: Absorbed = Fixed overhead rate × Actual units produced (when actual ≤ normal); Unabsorbed fixed overhead is an expense of the period.
Higher-than-normal production: Fixed overhead per unit = Total fixed production overheads ÷ Actual units produced (when actual > normal); Rate is reduced so that inventory is not measured above cost.
Variable overhead: Allocated on the basis of actual use of production facilities; No normal-capacity adjustment.
Joint cost allocation (relative sales value method): Share of joint cost = Joint cost × (Sales value of product at split-off ÷ Total sales value of all products at split-off); Any rational and consistent basis is allowed. This is the common exam basis.
By-product: Main product cost = Total joint cost − NRV of by-product; Applies when the by-product is immaterial in value.

How to solve Cost of Inventories: Purchase and Conversion Costs questions

Use this order for any cost-of-inventory question. It stops you adding items that do not belong and missing items that do.

1List every cost given and tag each as purchase, conversion, other cost, or excluded (abnormal waste, storage not needed for production, selling and admin costs, and so on).
2Build cost of purchase: price + non-recoverable duties and taxes + freight and handling − trade discounts and rebates. Remove recoverable GST.
3Split overheads into variable and fixed. Variable is taken at actual. Fixed is absorbed on normal capacity.
4Compare actual production with normal capacity. If lower, use the normal-capacity rate and expense the unabsorbed amount. If higher, spread fixed overheads over actual units.
5Add direct labour and direct costs to get conversion cost, then total cost per unit and total cost of closing inventory.
6For joint products, allocate joint cost on the stated basis, usually relative sales value at split-off. Deduct by-product NRV from the main cost.
7Write the answer with the Ind AS 2 principle for each judgement (normal capacity, rebates, abnormal waste), then state the final figure.

Quickest way: Tag, rate, multiply

When to use it: Use in numerical questions with many cost items and limited time.

Tick or cross each item in the margin: include or exclude. Cross out recoverable taxes, abnormal losses, selling and admin costs.
Compute fixed overhead rate = fixed overhead ÷ normal capacity (or actual if actual is higher).
Cost per unit = materials net of discount + freight and duty + direct labour + variable overhead + fixed rate.
Closing inventory = cost per unit × units unsold. Unabsorbed fixed overhead goes straight to profit or loss.
Do a one-line sense check: unit cost should not rise just because output fell.

Common mistakes in Cost of Inventories: Purchase and Conversion Costs

Dividing fixed overheads by actual production when output is below normal capacity.
Students follow cost-accounting habit of absorbing all overhead into units.
Fix: Use normal capacity as the denominator. Expense the unabsorbed fixed overhead in the period.
Including GST paid on purchases in cost even though input credit is available.
Invoice total looks like the cost.
Fix: Include only taxes that are not recoverable from the tax authorities. Exclude recoverable GST.
Ignoring trade discounts and rebates, or deducting them only when received in cash.
Students focus on the invoice price.
Fix: Deduct trade discounts, rebates and similar items from purchase cost. Check whether a discount is for volume (reduce cost) or for early payment (generally a financing item).
Including abnormal wastage, selling costs or general administration in cost.
All factory-related costs feel like product costs.
Fix: Abnormal waste of materials, labour or other production costs is expensed. Selling costs and admin overheads not related to production are also expensed. Normal wastage stays in cost.
Allocating joint cost equally or on units without justification, and costing the by-product at full share.
Students apply a convenient basis.
Fix: Use a rational and consistent basis such as relative sales value at split-off. Measure an immaterial by-product at NRV and deduct it from the main product's cost.
Raising the unit fixed overhead when production is above normal.
Students apply the normal-capacity rate mechanically.
Fix: When actual exceeds normal, spread fixed overhead over actual units so inventory is not above cost.

Worked examples

Example 1

Alpha Ltd manufactures a component. In March it bought 10,000 kg of raw material at ₹50 per kg. A 4% trade discount was allowed on the list price. Import duty paid was ₹20,000 (not recoverable), freight inwards ₹30,000, and GST of ₹90,000 was recoverable as input credit. Direct labour was ₹1,40,000. Variable production overhead was ₹60,000. Fixed production overheads for the year are ₹12,00,000 and normal capacity is 1,20,000 units a year (10,000 units a month). In March actual output was 8,000 units, and all raw material was used in this output. Compute the cost of the 8,000 units and state the treatment of the unabsorbed fixed overhead for March.

Show the solution

Raw material list price = 10,000 × ₹50 = ₹5,00,000. Trade discount 4% = ₹20,000. Net price = ₹4,80,000.
Add non-recoverable import duty ₹20,000 and freight ₹30,000. Cost of purchase = ₹5,30,000. Recoverable GST of ₹90,000 is excluded.
Direct labour = ₹1,40,000. Variable overhead = ₹60,000, taken at actual.
Fixed overhead rate on normal capacity = ₹12,00,000 ÷ 1,20,000 = ₹10 per unit. Monthly normal output is 10,000 units, so monthly fixed overhead is ₹1,00,000.
Actual output 8,000 is below normal, so absorbed fixed overhead = 8,000 × ₹10 = ₹80,000. Unabsorbed = ₹1,00,000 − ₹80,000 = ₹20,000.
Total cost of 8,000 units = 5,30,000 + 1,40,000 + 60,000 + 80,000 = ₹8,10,000. Per unit = ₹101.25.

Answer: Cost of 8,000 units = ₹8,10,000 (₹101.25 per unit). The unabsorbed fixed overhead of ₹20,000 is recognised as an expense in March, not added to inventory.

Example 2

Beta Ltd runs a joint process costing ₹9,00,000 for the month (materials, labour and overheads, all to the point of separation). It yields 3,000 kg of Product X (sold at ₹200 per kg), 2,000 kg of Product Y (sold at ₹150 per kg) and a by-product Z, which is immaterial and has an NRV of ₹30,000 for the month. No further processing is needed. At month end, 500 kg of X and 400 kg of Y remain unsold. Compute the cost allocated to X and Y and the value of closing inventory of each.

Show the solution

By-product Z is immaterial, so it is measured at NRV of ₹30,000. Deduct from joint cost: ₹9,00,000 − ₹30,000 = ₹8,70,000 to allocate to X and Y.
Sales value at split-off: X = 3,000 × ₹200 = ₹6,00,000. Y = 2,000 × ₹150 = ₹3,00,000. Total = ₹9,00,000.
Cost allocated to X = 8,70,000 × 6,00,000 ÷ 9,00,000 = ₹5,80,000. Cost allocated to Y = 8,70,000 × 3,00,000 ÷ 9,00,000 = ₹2,90,000.
Cost per kg: X = 5,80,000 ÷ 3,000 = ₹193.33 approx. Y = 2,90,000 ÷ 2,000 = ₹145.
Closing inventory: X = 500 × 5,80,000 ÷ 3,000 = ₹96,667 approx. Y = 400 × ₹145 = ₹58,000.
Check against NRV: both costs are below selling prices, so cost is the carrying amount.

Answer: Cost allocated: X ₹5,80,000 and Y ₹2,90,000. Closing inventory: X ₹96,667 (approx.) and Y ₹58,000. By-product Z is carried at its NRV of ₹30,000 and deducted from joint cost.

Exam tips

In case-scenario MCQs, scan for traps: recoverable GST, abnormal wastage, storage costs, and settlement discounts. Each is usually the one item that changes the answer.
Always show the normal-capacity rate as a separate line. Examiners award marks for the rate and for expensing the unabsorbed overhead.
For written answers, quote the principle first, then apply it to the facts, then conclude with the figure.
State your basis for joint cost allocation in one line. If the question names a basis, use it; if not, use relative sales value at split-off and say so.
Check units carefully when production is monthly but normal capacity is given annually.

Practice questions from Ind AS 2 Inventories

Cost of Inventories: Purchase and Conversion Costs in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Inventories: Purchase and Conversion Costs: frequently asked questions

What costs are included in cost of purchase under Ind AS 2?

Purchase price, import duties and other non-recoverable taxes, and transport, handling and other directly attributable costs. Trade discounts, rebates and similar items are deducted. Taxes that you can recover from tax authorities, such as GST input credit, are excluded.

What is normal capacity in Ind AS 2?

It is the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account planned maintenance. Fixed production overheads are absorbed on this base. Actual output may be used if it approximates normal capacity.

What happens to fixed overheads if production is below normal capacity?

Fixed overhead per unit is not increased. You absorb only the normal-capacity rate on the units actually produced. The remaining unabsorbed fixed overhead is recognised as an expense in the period.

How are joint products and by-products costed?

The total cost of conversion of joint products is allocated on a rational and consistent basis, such as relative sales value at the point of separation. Most by-products are immaterial, so they are measured at net realisable value and that amount is deducted from the cost of the main product.