5
lOMoAR cPSD|
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After discussions with one of her colleagues, Judy realised that it might be cheaper to manufacture some
of the handbags herself. A friend of hersis a designer, and soon Judy started manufacturing her own range
of handbags with the assistance of her...
1. Introduction
2. The manufacturing process and inventory type classification
3. Measurement of inventory
3.1. Costs incurred to bring the inventory to a condition and location ready for sale
3.2. Net realisable value (NRV)
4. Determining the cost of manufactured products
4.1. Direct materials and conversion costs
4.1.1. Classification of costs
4.2. The allocation of indirect costs
5. Classification of operating costs in the statement of comprehensive income
5.1. Classification of operating costs according to the function basis
5.2. Classification of operating costs according to the nature basis
6. Comprehensive example
7. Questions
Learning objectives
By the end of this chapter, you will be able to:
• Know the different types of inventory and classify items accordingly
• Measure the various types of inventory, and:
o Determine whether costs should be expensed or capitalised
o Know how abnormal and normal wastage/losses should be treated
o Calculate the inventory cost using the first-in-first-out (FIFO) and weighted average costing
formula
o Calculate the net realisable value (NRV) of a product and be able to explain the concept
• Understand the difference between direct materials and conversion costs
• Explain the difference between direct and indirect costs and variable and fixed costs
• Determine whether costs should be traced to inventory units (direct costs) or need to be
allocated to products (indirect costs)
• Allocate indirect costs to manufactured inventory, using the absorption costing method
• Prepare a statement of comprehensive income on the nature basis and on the function basis
After discussions with one of her colleagues, Judy realised that it might be cheaper to manufacture some
of the handbags herself. A friend of hers is a designer, and soon Judy started manufacturing her own range
of handbags with the assistance of her friend. It did not take long before Judy realised that she did not
know how to account for the production expenses. Should she capitalise them as assets? Or expense them
immediately? She approached her accountant to find out more.
1 What do we already know about inventory
Inventory controlled at financial year-end is included in the statement of financial position. It is measured
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, lOMoAR cPSD| 40099155
by taking into account the number of units on hand and the cost or, if lower, the net realisable value of
each unit. IAS2 states that the cost of inventory includes all costs of purchases, costs of conversion (we
will look at what this is later in this chapter), and other costs incurred to bring the inventory to its current
condition and location, ready for sale.
The cost of inventory units is determined in accordance with the accounting policy selected by the entity:
the first-in first-out basis or the weighted-average basis.
1.1 Costs incurred to bring the inventory to a condition and location ready for sale
cost = purchase price + conversion costs + costs to get inventory to its place of sale
+ costs to get inventory into a saleable condition
What is included in and excluded from the cost of inventory
The cost of inventory includes: The cost of inventory excludes the following
• The cost of purchases costs that are expensed immediately:
• Import duties and handling fees • Storage costs
• Conversion costs • Agents’ commissions
• Transport costs to the place of • Selling and marketing costs
sale. • Transportation costs after sale, and
• Administration costs.
The cost is determined after deducting
trade and cash discounts. The cost of inventory also excludes any VAT
charged (assuming the business is a VAT
vendor)
The table above summarises which costs can be capitalised as inventory costs and which costs are
expensed immediately.
The cost of the different inventory types is measured according to the following principles:
• Raw materials and consumables on hand at the date of the statement of financial position should
be recorded and measured separately. Raw materials should be measured at the lower of cost or
net realisable value, and their cost should be calculated by multiplying the quantity on hand by
the cost determined using the selected costing formula (for example, the FIFO formula) or net
realisable value.
• When incomplete products (WIP) are still on hand at the date of the statement of financial
position, the costs incurred to get them to their stage of completion are capitalised. It is important
for the costs incurred up to the date of the statement of financial position to be allocated to the
products on hand based on their stage of completion. This should include a portion of labour and
material costs, as well as a portion of manufacturing overhead costs.
• The cost of finished goods on hand at the date of the statement of financial position includes all
direct and indirect production costs.
1.2 Net realisable value (NRV)
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, lOMoAR cPSD| 40099155
IAS2 requires inventory to be shown at the lower of cost and net realisable value (NRV). Therefore, the
NRV of each inventory item needs to be determined and must be compared to the inventory cost.
2. The manufacturing process and inventory type classification
Manufacturing businesses produce goods that they sell to their customers. These could be other
manufacturers, wholesalers, retailers, or even the final consumer. Judy’s decision to make her own bags
instead of buying them makes her a manufacturer. Manufacturers purchase raw materials, such as
leather, that they convert (through the production process) into a finished product, in Judy’s case,
handbags. If the business has products that are not complete at year-end, these products are referred to
as work-in-progress.
In order to convert the raw material into the finished products (the handbags), the business will need to
incur costs. These include, for example:
• Labour cost paid to workers making the handbags
• Depreciation of the machinery used in the manufacturing process
• Water and electricity used, and/or
• Cleaning materials.
These costs are referred to as conversion costs, and a portion of these costs will need to be allocated to
all work-in-progress and finished goods at year-end.
It is important to note that in most manufacturing businesses a lot of effort is spent in recording and
monitoring costs accurately. It is important that the accounting records are updated continuously to
ensure that wastage and inefficiency is kept to a minimum.
Wastage refers to raw materials and other conversion costs that are lost. As an example, if one of the
completed handbags in Judy’s manufacturing process is of poor quality and has to be thrown away the
leather, consumables and labour used to manufacture that item is wasted. Inefficiency refers to
conversion costs not being applied as well as it can be to produce the products. As an example, if the
leather for the handbags is not cut to maximise the usage of the leather the leather is being used
inefficiently.
Wastage is a normal part of any manufacturing process. A manufacturer would set a level of wastage that
they consider Normal Waste/Loss. They may say for example that 5% of units introduced into the
manufacturing process is expected to be unsuitable for sale. Therefore, if 100 units were produced the
first 5 units lost is seen as part of the normal manufacturing process.
In contrast Abnormal wastage/losses during the manufacturing process is not considered a cost incurred
to bring the inventory to a condition and location ready for sale. In the above example if 7 of units were
unsuitable for sale 5 would be classified as normal losses and 2 as abnormal losses. The related costs
therefore need to be expensed and not included in the value of inventory.
Finally, if we produced 100 units but only lost 3 in the manufacturing process we would consider 2 units
an Abnormal Gain. Abnormal gains are shown as income in the accounting records.
We say that normal losses are capitalised as they are added to the cost of inventory whilst abnormal losses
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