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

Understand Cost of Inventories: Purchase, Conversion and Other Costs

Key rules to remember

Cost of inventories

Cost = Purchase cost + Conversion cost + Other costs to bring to present location and condition

Cost of purchase is net of trade discounts and rebates, and excludes recoverable taxes.

Fixed overhead absorption rate

Fixed overhead per unit = Total fixed production overheads ÷ Normal capacity (units)

When production is abnormally low, use normal capacity. Unallocated overhead is an expense of the period.

Fixed overhead when production exceeds normal

Fixed overhead per unit = Total fixed production overheads ÷ Actual production

Applies when actual production is higher than normal capacity, so that inventory is not measured above cost.

Variable overhead

Variable overhead per unit = Total variable production overheads ÷ Actual production

Always allocated on actual use of the production facilities.

Unabsorbed fixed overhead

Expense = Fixed overheads − (Actual units × Rate on normal capacity)

Charged to profit or loss. It is not added to closing inventory.

Joint cost allocation (relative sales value)

Share of product = Joint cost × Sales value of product at split-off ÷ Total sales value at split-off

One acceptable basis. The by-product is usually carried at net realisable value and deducted from joint cost.

Excluded costs

Abnormal waste, storage (unless necessary in production), administrative overheads unrelated to production, selling costs

These are expensed in the period incurred.

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

1. 1List every cost given and tag it as purchase, conversion, other cost or excluded.
2. 2Compute the purchase cost: invoice price less trade discount, plus duty, non-recoverable taxes, freight inward and handling. Leave out recoverable GST.
3. 3Check for abnormal losses. Separate normal loss, which stays in cost, from abnormal loss, which is charged to profit or loss.
4. 4Split production overheads into fixed and variable. Absorb variable on actual output.
5. 5Absorb fixed overheads on normal capacity, or on actual output if that is higher. Compute the unabsorbed amount if output is below normal.
6. 6Check borrowing costs. Include them only if the inventory is a qualifying asset.
7. 7Add up the cost, divide by good units where needed, and state the closing inventory value.
8. 8Write what was excluded and why, because that earns marks.

Quickest way: Include-or-expense scan

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

• Including recoverable GST in the purchase cost.

  Students copy the invoice total.

  Fix: Include only non-recoverable taxes. If input credit is available, exclude the GST.

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

  Students think actual output is always the base.

  Fix: Use normal capacity when actual output is lower. Charge the unabsorbed fixed overhead to profit or loss.

• Adding abnormal wastage to inventory cost.

  All losses look like part of production cost.

  Fix: Normal loss stays in cost. Abnormal loss is expensed separately.

• Including storage and selling costs in cost.

  These costs are incurred while goods are held, so they look relevant.

  Fix: Include storage only if it is necessary in the production process before a further stage. Always exclude selling and general administration.

• Capitalising borrowing costs on every inventory item.

  Interest looks like a financing cost of any stock.

  Fix: Capitalise only for qualifying assets under Ind AS 23, which need a substantial period to be ready for sale.

• Allocating joint cost on units when the question gives sales values.

  Physical units are easier to use.

  Fix: Follow the basis the question states. If it gives sales values at split-off and asks for a rational basis, use relative sales value.

Worked examples