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Accounting · Inventories

Cost of Inventories: Purchase and Conversion Costs (AS 2)

Updated 1 October 2026 · Fact-checked

Under AS 2, the cost of inventories includes the cost of purchase, the cost of conversion and other costs needed to bring inventory to its present location and condition. Add costs in that order. Allocate fixed overheads on normal capacity, variable overheads on actual use, and exclude abnormal wastage, storage, admin and selling costs.

Understand Cost of Inventories: Purchase and Conversion Costs

AS 2 says inventories are valued at the lower of cost and net realisable value. This page covers only the first half: how to find cost. Cost means every expense needed to bring the item to where it is and to the state it is in.

There are three building blocks. Cost of purchase is what you pay to buy the goods. Cost of conversion is what you spend to turn raw material into finished goods. Other costs are added only if they bring the inventory to its present location and condition.

Cost of purchase includes the purchase price, import duties, non-refundable taxes and freight inwards. Add any other expense directly attributable to the purchase. Then deduct trade discounts, rebates and similar items. Taxes that the enterprise can later recover from tax authorities, such as credit for GST, are not part of cost.

Cost of conversion has two parts. Direct costs are direct labour and similar items. Production overheads are split into fixed and variable. Fixed overheads (factory rent, depreciation of factory machinery, factory management) stay about the same whatever the output. You absorb them on the basis of normal capacity. Variable overheads (indirect materials, indirect labour) change with output. You absorb them on actual production.

Sometimes one process makes more than one product. Joint products are main products of similar importance. If their costs cannot be separated, you allocate the total cost on a rational and consistent basis, such as relative sales value. By-products are minor and are often measured at net realisable value. That value is deducted from the cost of the main product.

Key rules to remember

Cost of inventories
Cost = Cost of purchase + Cost of conversion + Other costs to bring to present location and condition
Then compare with NRV and take the lower.
Cost of purchase
Purchase price + Duties and non-recoverable taxes + Freight inwards + Other directly attributable costs − Trade discounts, rebates
Do not deduct cash discount unless the question treats it as a trade discount. Exclude recoverable taxes.
Fixed overhead absorption rate
Fixed overhead per unit = Total fixed production overheads ÷ Normal capacity (units)
Use normal capacity, not actual output, when output is below normal.
Fixed overhead when output is above normal
Fixed overhead per unit = Total fixed production overheads ÷ Actual production
Applies when actual production is higher than normal capacity. This avoids valuing inventory above cost.
Variable overhead per unit
Variable overhead per unit = Variable overheads ÷ Actual production
Always on actual use of production facilities.
Joint cost allocation (relative sales value)
Share of joint cost = Joint cost × (Sales value of product ÷ Total sales value)
One common rational basis. Use it when the question gives no other basis.
Main product cost after by-product
Cost of main product = Total cost of production − NRV of by-product
Used when by-product value is small.
Costs excluded
Exclude: abnormal wastage, storage costs (unless needed in production), administrative overheads not related to production, selling and distribution costs
These are expensed in the period they are incurred.

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

Use this order for any cost of inventory question. It keeps your working clear and earns step marks.

  1. 1List all items given in the question in a column. Tick each as purchase, conversion, excluded, or recoverable tax.
  2. 2Compute cost of purchase: price + duty + freight + other direct costs − trade discount. Leave out recoverable taxes.
  3. 3Find the cost of conversion: direct labour and other direct costs plus production overheads.
  4. 4Split overheads into fixed and variable. Absorb variable on actual production.
  5. 5Absorb fixed overheads on normal capacity. If actual output is higher than normal, use actual output instead.
  6. 6Remove abnormal losses and excluded costs. Show them separately as charged to Profit and Loss.
  7. 7If there are joint or by-products, allocate joint cost on a rational basis, or deduct by-product NRV from main product cost.
  8. 8Total the cost, divide by units if needed, and write the final answer with the unit cost or total value clearly stated.

Quickest way: Tick-and-total method

When to use it: Use when the question lists many costs and you have limited time.

  1. Write the letters P, C or X beside each item: P = purchase, C = conversion, X = excluded.
  2. Strike out X items at once: selling, admin, storage, abnormal loss, recoverable tax.
  3. Check the capacity data. Decide the fixed overhead rate before touching other numbers.
  4. Add P items, deduct trade discounts, then add C items.
  5. Write a one-line note on each excluded item. This shows the examiner your reasoning.

Common mistakes in Cost of Inventories: Purchase and Conversion Costs

  • Including recoverable GST or similar credit in cost of purchase.

    Students see tax on the invoice and add it automatically.

    Fix: Add only taxes that cannot be recovered from tax authorities. Exclude credit-eligible taxes.

  • Absorbing fixed overheads on actual output when output is below normal capacity.

    Actual output feels more natural, and it is simpler.

    Fix: When output is lower than normal, use normal capacity for the rate. The unallocated fixed overhead is an expense of the period.

  • Including abnormal wastage in inventory cost.

    Students treat all lost material as part of production cost.

    Fix: Normal loss is part of cost. Abnormal loss is charged to Profit and Loss.

  • Adding selling and administration costs to inventory.

    They are part of total business expense, so they seem to belong in cost.

    Fix: Include admin cost only if it relates to production. Selling and distribution costs are always excluded.

  • Forgetting to deduct trade discounts and rebates.

    Students start from the list price and move on to freight.

    Fix: Deduct trade discounts and rebates from the price before adding other costs.

  • Allocating by-product cost like a joint product.

    Both come out of the same process, so students split cost for both.

    Fix: For by-products, deduct their NRV from the cost of the main product. Split joint cost only among joint products.

Worked examples

Example 1

A company bought 1,000 units of raw material at ₹200 per unit. Trade discount was 5% on the price. Freight inwards was ₹6,000. Non-refundable import duty was ₹10,000. GST of ₹30,000 is recoverable. Insurance for storing goods in the godown before use was ₹4,000, which is not needed for production. Find the cost of purchase.

Show the solution
  1. Purchase price = 1,000 × ₹200 = ₹2,00,000.
  2. Trade discount = 5% × ₹2,00,000 = ₹10,000. Net price = ₹1,90,000.
  3. Add freight inwards ₹6,000. Total = ₹1,96,000.
  4. Add non-refundable import duty ₹10,000. Total = ₹2,06,000.
  5. Exclude recoverable GST ₹30,000 and storage insurance ₹4,000.

Answer: Cost of purchase = ₹2,06,000, which is ₹206 per unit.

Example 2

A factory has normal capacity of 10,000 units. Actual production is 8,000 units. Costs: raw materials ₹4,00,000, direct labour ₹2,00,000, variable overheads ₹80,000, fixed production overheads ₹1,00,000. Selling costs were ₹50,000. Find the cost per unit and the fixed overhead not absorbed.

Show the solution
  1. Variable overhead per unit = ₹80,000 ÷ 8,000 = ₹10.
  2. Fixed overhead rate on normal capacity = ₹1,00,000 ÷ 10,000 = ₹10 per unit.
  3. Fixed overhead absorbed = 8,000 × ₹10 = ₹80,000.
  4. Unabsorbed fixed overhead = ₹1,00,000 − ₹80,000 = ₹20,000. Charge it to Profit and Loss.
  5. Cost of conversion = ₹2,00,000 + ₹80,000 + ₹80,000 = ₹3,60,000.
  6. Total cost = ₹4,00,000 + ₹3,60,000 = ₹7,60,000.
  7. Cost per unit = ₹7,60,000 ÷ 8,000 = ₹95.
  8. Selling costs of ₹50,000 are excluded.

Answer: Cost per unit = ₹95. Total cost of inventory = ₹7,60,000. Unabsorbed fixed overhead of ₹20,000 and selling costs of ₹50,000 are expensed.

Exam tips

  • Read the capacity data first. Many questions test whether you use normal or actual capacity for fixed overheads.
  • Write a short reason beside each excluded item. This earns marks even if your total is off.
  • Show trade discount, freight and duty on separate lines. Examiners give step marks for each.
  • For joint products, state the basis you used. If the question gives none, say you used relative sales value.
  • Keep cost and NRV separate. This topic is about cost only, so do not compare with NRV unless asked.

Practice questions from Inventories

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

What is included in the cost of inventories under AS 2?

Cost of purchase, cost of conversion and other costs to bring the inventory to its present location and condition. Excluded items include abnormal wastage, selling costs and unrelated administrative costs.

How are fixed production overheads allocated under AS 2?

They are absorbed based on the normal capacity of the production facilities. If actual production is higher than normal, use actual production instead. Unabsorbed overhead is an expense of the period.

How are by-products treated under AS 2?

By-products are usually minor and are measured at net realisable value. That value is deducted from the cost of the main product. Joint products are different and share the joint cost on a rational basis.

Is storage cost part of inventory cost?

No, storage costs are excluded unless they are necessary in the production process before a further stage. Normal warehouse storage after production is an expense of the period.