Advanced Accounting · AS 2 Valuation of Inventory

Cost of Inventories under AS 2: Purchase, Conversion and Other Costs

Updated 4 October 2026 · Fact-checked

Under AS 2, cost of inventory is the sum of purchase costs, conversion costs and other costs needed to bring inventory to its present location and condition. Add each included cost, deduct trade discounts and rebates, allocate fixed overheads on normal capacity, and expense the excluded items.

Understand Cost of Inventories: Purchase, Conversion and Other Costs

AS 2 says inventory is valued at the lower of cost and net realisable value. This page deals only with the first part: what goes into cost. The test is simple. Include a cost if it was incurred to bring the item to its present location and condition. Exclude it if it is wasteful, or does not relate to getting the item there.

There are three groups of cost. Cost of purchase is the purchase price plus import duties and other taxes (other than those later recoverable from tax authorities, such as credit-eligible GST), plus freight inward, handling and other costs directly attributable to acquisition. Trade discounts, rebates and similar items are deducted.

Cost of conversion applies to manufactured goods. It has direct costs such as direct labour, and systematic allocation of production overheads. Fixed production overheads (factory rent, depreciation of factory plant, factory management) do not change with volume. They are allocated on the basis of the normal capacity of the production facilities. Variable production overheads (indirect materials, indirect labour) change with volume. They are allocated on actual production.

Normal capacity is the average production expected over several periods under normal conditions, allowing for planned maintenance. Actual output may be used if it is close to normal. If production is low, you do not load the unabsorbed fixed overhead into inventory. You charge it to the profit and loss statement of that period. If production is abnormally high, you reduce the fixed overhead per unit so that inventory is not stated above cost.

Other costs are included only if incurred to bring inventory to its present location and condition, for example design costs for specific customers. Joint products come from one process. If the cost of each product is not separately identifiable, allocate the total cost on a rational and consistent basis, such as relative sales value. By-products are often immaterial. They may be measured at net realisable value, and that value is deducted from the cost of the main product.

Key rules to remember

Cost of inventory: Cost = Cost of purchase + Cost of conversion + Other costs to bring to present location and condition; Use this as the master list for every question.
Cost of purchase: Purchase price + Duties and non-recoverable taxes + Freight inward + Handling and other direct costs − Trade discounts, rebates; Recoverable taxes such as credit-eligible GST are not part of cost.
Fixed overhead absorption rate: Fixed production overhead per unit = Total fixed production overhead ÷ Normal capacity (units); Use normal capacity, not actual output, unless actual output is close to normal.
Fixed overhead included in inventory: Fixed overhead in inventory = Fixed overhead per unit (normal capacity) × Units in inventory; Unabsorbed overhead from low production is expensed in the period.
Variable overhead rate: Variable overhead per unit = Total variable overhead ÷ Actual production (units); Variable overheads follow actual use of the facilities.
Excluded costs: Exclude: abnormal wastage, storage costs (unless needed before a further production stage), administrative overheads not related to production, selling and distribution costs; These are charged to expense when incurred. Interest follows AS 16 and is not covered by this formula.
Joint cost allocation: Share of joint cost = Total joint cost × (Sales value of product ÷ Total sales value); Relative sales value is one rational basis. Apply it consistently.

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

Use this order for any cost-of-inventory question. It keeps you from missing included items and from adding excluded ones.

1List every cost given in the question in a column, with its amount.
2Tick the purchase items: price, duties, non-recoverable taxes, freight inward, handling. Deduct trade discounts and rebates. Leave out recoverable taxes.
3For manufactured goods, add direct material, direct labour and direct expenses. Then handle overheads.
4Split overheads into variable and fixed. Absorb variable overheads on actual production.
5Absorb fixed overheads on normal capacity. If actual output is below normal, the unabsorbed fixed overhead goes to profit and loss. If actual output is above normal, use actual output as the base.
6Strike out excluded items: abnormal losses, selling and distribution costs, general administration, and storage not needed for production. State why in one line.
7Compute cost per unit and multiply by closing units. For joint products, allocate joint cost first on the stated basis.
8Compare with NRV only if the question gives it. State the final value at the lower of the two.

Quickest way: Include-Exclude Sweep

When to use it: Use this when a question lists many costs and asks for the value of inventory or cost per unit, and time is short.

MCQs: spot the trap word. Selling, administration, abnormal, storage, recoverable tax and wasted all point to exclusion. Freight inward, import duty, direct labour and factory overhead point to inclusion.
For fixed overhead, divide by normal capacity first. Do not divide by actual output unless the question says actual is close to normal or higher than normal.
Write a two-column list headed Include and Exclude. Total only the Include column. This shows the examiner your logic even if arithmetic slips.
In written answers, give one line of reason for each excluded item, quoting AS 2. Step marks are given for the reason as well as the figure.
Close with the final answer in a clear sentence: cost per unit and total value of closing stock.

Common mistakes in Cost of Inventories: Purchase, Conversion and Other Costs

Dividing fixed overhead by actual production when output is low
Students treat all overhead like variable overhead and want cost per unit to cover every rupee spent.
Fix: Divide fixed overhead by normal capacity. Charge the unabsorbed amount to profit and loss for the period.
Including GST input credit in purchase cost
Students see tax on the invoice and assume it is a cost of purchase.
Fix: Include only taxes that are not recoverable from tax authorities. Credit-eligible GST is left out.
Adding selling expenses, administration costs or abnormal wastage to cost
They seem like genuine costs of the business.
Fix: AS 2 includes only costs to bring inventory to its present location and condition. Expense selling, distribution, unrelated administration and abnormal losses.
Not deducting trade discounts and rebates from purchase price
Students start from the invoice gross price, or confuse trade discount with cash discount.
Fix: Deduct trade discounts and rebates. Check what the question calls the discount before treating it differently.
Splitting joint cost equally between products
It is easy, and students forget that a rational basis is needed.
Fix: Use relative sales value or the basis stated in the question. Treat a minor by-product at NRV and deduct it from the main product cost.
Including all storage costs
Storage sounds like a cost of holding goods.
Fix: Include storage only if it is necessary in the production process before a further production stage. Otherwise expense it.

Worked examples

Example 1

A trader buys 2,000 units of raw material at ₹100 per unit. A trade discount of 5% is allowed on the list price. Other items: freight inward ₹8,000; non-refundable import duty ₹12,000; GST of ₹36,000 eligible for input credit; unloading and handling ₹4,000; storage costs after delivery that are not needed for production ₹5,000; and administration overhead allocated ₹6,000. Find the cost of purchase and cost per unit.

Show the solution

List price = 2,000 × ₹100 = ₹2,00,000.
Trade discount = 5% × ₹2,00,000 = ₹10,000. Net price = ₹1,90,000.
Add freight inward ₹8,000, non-refundable import duty ₹12,000 and handling ₹4,000. These are directly attributable.
Exclude GST of ₹36,000 because it is recoverable as input credit.
Exclude storage ₹5,000 (not needed before a further production stage) and administration overhead ₹6,000 (not related to bringing the goods to their location and condition).
Cost of purchase = ₹1,90,000 + ₹8,000 + ₹12,000 + ₹4,000 = ₹2,14,000.
Cost per unit = ₹2,14,000 ÷ 2,000 = ₹107.

Answer: Cost of purchase is ₹2,14,000 and cost per unit is ₹107.

Example 2

A company has normal capacity of 10,000 units per year. In the year it produced 8,000 units and sold 6,000 units. Costs: direct material ₹16,00,000; direct labour ₹8,00,000; variable production overhead ₹4,00,000; fixed production overhead ₹5,00,000; selling and distribution cost ₹3,00,000. There was no opening stock and no abnormal loss. Find the value of closing stock and the amount of fixed overhead charged to profit and loss as unabsorbed.

Show the solution

Production is 8,000 units. Closing stock = 8,000 − 6,000 = 2,000 units.
Direct material per unit = ₹16,00,000 ÷ 8,000 = ₹200.
Direct labour per unit = ₹8,00,000 ÷ 8,000 = ₹100.
Variable overhead per unit (actual production) = ₹4,00,000 ÷ 8,000 = ₹50.
Fixed overhead per unit (normal capacity) = ₹5,00,000 ÷ 10,000 = ₹50.
Cost per unit = ₹200 + ₹100 + ₹50 + ₹50 = ₹400. Selling and distribution cost is excluded.
Closing stock = 2,000 × ₹400 = ₹8,00,000.
Fixed overhead absorbed in production = 8,000 × ₹50 = ₹4,00,000. Unabsorbed = ₹5,00,000 − ₹4,00,000 = ₹1,00,000, charged to profit and loss.

Answer: Closing stock is valued at ₹8,00,000 (₹400 per unit). Unabsorbed fixed overhead of ₹1,00,000 is charged to the profit and loss of the year.

Exam tips

Always show the include and exclude lists. Many questions give 8 to 10 cost items and test whether you can sort them. Marks follow the sorting.
When you see normal capacity and actual output in the same question, check which is lower. If actual is lower, absorb fixed overhead on normal capacity. If actual is higher, use actual.
Never include selling and distribution cost, even if the question says it relates to the stock. This is a common one-mark MCQ trap.
For joint products, read the question for the basis. If none is given, use relative sales value and say so in your answer.
Give a one-line reason against each exclusion. Write the exact cost amount you removed, so the examiner can follow your working.

Practice questions from AS 2 Valuation of Inventory

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

Which costs are included in the cost of inventory under AS 2?

Cost of purchase, cost of conversion and other costs incurred to bring the inventory to its present location and condition. Purchase cost includes duties, non-recoverable taxes and freight inward, net of trade discounts and rebates. Conversion cost includes direct labour and production overheads.

Why are fixed overheads allocated on normal capacity?

Fixed overheads do not change with output. If you spread them over a low actual output, each unit would carry too much cost, and inventory could be overstated. Using normal capacity avoids this, and the unabsorbed amount is expensed in that period.

How are joint products and by-products valued under AS 2?

If the costs of each joint product cannot be identified separately, allocate the total cost on a rational and consistent basis, such as relative sales value. By-products that are immaterial are often measured at net realisable value, and that value is deducted from the cost of the main product.

Are storage costs part of inventory cost?

Only if they are necessary in the production process before a further production stage. Other storage costs are expensed when incurred.