Presenting both an in-depth and light hearted discussion on the fundamentals of inventory valuation. Including but not limited to overhead allocation, fifo vs weighted average and periodic vs perpetual inventory systems. Primarily intended for beginner to intermediate level.
IAS 2 Inventories
Inventories are trading assets of the business. When bought as complete or finished products, they
are normally bought for lower price and sold for a higher price in the case of a retailer for instance.
Sometimes businesses produce (manufacture) their own inventory. Their main inventory would be
raw materials, work in progress (refers to raw material entered into the production process but
incomplete at year end) and finished goods.
IAS 2 states that inventory is measured at lower of cost or net realizable value (NRV). NRV is used to
approximate market value. There are slight differences between market value and NRV.
Fair value vs NRV
Market value (fair value) is not adjusted for selling costs such as marketing costs or commissions. The
reason being that the amount has nothing to do with the price agreed between the buyer and seller.
Commissions are payments made to third parties and are hence dealt with separately.
NRV is an entity specific value which means it can be estimated by management of the company and
will differ from one entity to another. The selling price and “selling costs” are split to arrive at a net
amount. Selling costs are included in the calculation of NRV as in the definition to arrive at NRV, any
additional costs to complete the sale must be subtracted from the estimated selling price.
If NRV is less than cost, the company is required to measure inventory at NRV and recognize an
impairment write down for the difference
Let’s assume the inventory is damaged, then the entity would not be able to sell in their usual
market and fetch normal selling price (fair value). The entity may have to sell in a different market or
even a scrapyard. A selling price will have to be estimated together with selling costs. An impairment
will be recorded for the difference between the historical cost and NRV.
Fixed Overheads
Before going into a discussion about overheads, what exactly is the meaning of the term and what do
they consist of. The standard does not give a very clear explicit explanation.
Overheads are those necessary expenses for the continued existence of the business. Included are
items needed to ensure assets stay in good condition and that there is an adequate level of quality
attained. Therefore rent, maintenance and supervisor salaries are overheads as they allow for the
smooth efficient running of the business.
Overheads can be further divided into manufacturing and non-manufacturing overheads.
Manufacturing overheads are everything related to producing the product in the factory. Non-
manufacturing overheads may be general in nature relating mostly to the administration wing of the
business.
Only manufacturing overheads are applied to inventory units per IAS2.
IAS 2 states that manufacturing overheads must be allocated systematically. This means that there
must be an accurate relationship between the overhead cost and the allocation base (formula =
budgeted cost/cost driver). When wanting to track overhead costs accurately, it depends largely on
the nature of the business as to what type of cost driver is utilized. Normally a unit level cost driver
such as number of units produced or number of labour/machine hours is chosen as this is more
convenient and less costly.
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