Chapter 5: Costs of conversion

Items included in the cost of purchase

The costs of conversion of inventories include costs directly related to the units of production such as: IAS 2

• direct labor, including all related employment taxes, benefits, and any share-based payment costs; and

• a systematic allocation of the fixed and variable production overheads incurred in converting materials into finished goods.

Is it acceptable to omit overheads from the cost of inventories on the basis of prudence? It is sometimes argued that overheads should be excluded from the cost of inventories on the grounds of prudence. Such an approach (sometimes called ‘direct costing‘) is not acceptable under IAS 2, which requires a systematic allocation of production overheads.

‘Marginal costing’ approaches to inventory valuation ‘Marginal costing’ approaches, under which only costs that vary directly with volume of output are included in the measurement of inventories and costs that accrue on a time basis (such as some overheads) are excluded, are not acceptable under IAS 2 because they do not result in the allocation of fixed production overheads as required under IAS 2.

Direct labor

The cost of wages of employees directly engaged in production should be allocated to production activities based on normal operating conditions. Labor costs that are the result of operating inefficiencies, such as abnormal idle capacity or abnormal rectification work, should not be included in inventory valuation.

How are overheads classified for the allocation?

Classifying overheads for the allocation takes the function of the overhead as its distinguishing characteristic (for example, whether it is a function of production, marketing, selling, or administration), rather than whether the overhead varies with time or volume. The costs of general management, as distinct from functional management, are not directly related to current production and are, therefore, excluded from the cost of conversion.

A company should not include external distribution costs, such as those relating to the transfer of goods from a sales depot to an external customer. It could, however, include a proportion of the costs that a company incurs in distributing goods from its factory to its sales depot because these are costs incurred in bringing the inventory to its present location. Furthermore, distribution costs are to be taken into account when assessing the net realizable value.

How is overhead cost allocated to inventory at normal capacity and at less than normal production?

The following example illustrates how to allocate overhead costs to inventory at normal capacity.

The following is relevant information for entity A:

• Full capacity is 10,000 labor hours in a year.
• Normal capacity is 7,500 labor hours in a year.
• Actual labor hours for the current period are 6,500 hours.
• The total fixed production overhead is C1,500.
• Total variable production overhead is C2, 600.
• The total opening inventory is 2,500 units.
• Total units produced in a year are 6,500 units.
• Total units sold in a year are 6,700 units.
• The total ending inventory is 2,300 units.
• The cost of inventories is assigned by using the FIFO cost formula.

Management should allocate fixed overhead costs and variable overhead costs to units produced at a rate of C0.2 per hour and C0.4 per hour respectively.

Fixed production overhead absorption rate: = fixed production overhead/labour hours for normal capacity

= C1, 500/7,500 = C0.2 per hour

Therefore, fixed production overhead allocated to 6,500 units produced during the year (one unit per hour) = 6,500 × C0.2 = C1, 300.

The remaining C200 of overhead incurred that remains unallocated is recognized as an expense. The amount of fixed overhead allocated to inventory is not increased as a result of low production by using normal capacity to allocate fixed overhead.

Variable production overhead absorption rate:

= variable production overhead/actual hours for the current period

= C2, 600/6,500

= C0.4 per hour

The above rate results in the allocation of all variable overheads to units produced during the year. As each unit has taken one hour to produce (6,500 hours/6,500 units produced), total fixed and variable production overhead recognized as part of the cost of inventory: = number of units of closing inventory × number of hours to produce each unit × (fixed production overhead absorption rate + variable production overhead absorption rate)

= 2,300 × 1 × (C0.2 +C 0.4)

= C1,380

The remaining C2,720 ((C1,500 + C2,600) – C1,380) is recognized as an expense in the income statement as follows:

Absorbed in cost of goods sold (FIFO basis) (6,500 – 2,300) = 4,200 × C0.6              2,520

Unabsorbed fixed overheads are also included in the cost of goods sold                                       200

Total                                                                                                                                                2,720

How is overhead cost allocated to inventory where an entity is not allowed to operate during the whole year?

A particular situation occurs in some industries that, due to the nature of their activities, entities are not allowed to operate during the whole year. For example, fishing industry activities in most countries are regulated in terms of allowed periods of extraction of natural resources, to ensure that resources are conserved.

Accordingly, governments establish periods in which fishing companies are allowed to extract these natural resources while establishing periods in which fishing is forbidden. During these periods, entities continue to incur maintenance and other expenses relating to their vessels and plants. The question that arises is whether these expenses should be expensed as incurred or whether they can be capitalized as production overheads of the finished goods produced during the year.

In this case, the expenses incurred during the non-fishing periods correspond to unused capacity. The entity might have a fully operating fleet of vessels during the fishing season. As stated above, to determine ‘normal capacity’, entities should consider the volume of production that the production facilities are intended to produce under the working conditions prevailing during the year.

Furthermore, normal capacity is the production expected to be achieved, on average, over several periods or ‘seasons’ under normal circumstances.

Accordingly, we consider that an entity operating under a similar regime to the fishing industry should establish its normal capacity taking into account the loss of capacity resulting from the periods when its operations are restricted. Expenses incurred during these periods should be capitalized as production overheads of the goods produced during the year.

Overhead costs

The allocation of fixed production overheads to inventories should be based on the normal capacity of the production facilities, which is the production expected to be achieved on average over several periods under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.

The actual level of production may be used if it approximates to normal capacity.

Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production. They may include:

• depreciation and maintenance of factory buildings, equipment and, for entities that have adopted IFRS 16, right-of-use assets used in the production process; and
• factory management and administration costs.

When an entity adopts the revaluation model for items of property, plant, and equipment, it should consider, for inventory valuation, depreciation based on the revalued amounts of those items.

When production levels are abnormally low, unallocated fixed overheads are recognized in profit or loss in the period in which they are incurred. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured at above cost.

Allocation of fixed overheads based on normal capacity – example Entity A manufactures televisions. Under normal operating conditions, it expects to manufacture 2,000 televisions each year. Total fixed production overheads for 20X1 are CU16,000. On the basis of normal production, fixed production overheads will be allocated to televisions produced at a rate of CU8 (CU16,000/2,000) per television. During 20X1, because of lower-than-expected customer demand for televisions and problems with production machinery, Entity A only manufactures 1,500 televisions. In accordance with IAS 2, the fixed production overheads are still allocated based on normal capacity of 2,000 televisions. Therefore CU12,000 (CU8 × 1,500 televisions manufactured) of the fixed overheads are allocated to the televisions manufactured. The remaining unallocated fixed overheads of CU4,000 are recognised immediately in profit or loss. In contrast, if Entity A experienced increased demand for its products and actually manufactured 4,000 televisions in 20X1, the amount of fixed overheads allocated to each television would decrease and would be limited to the amount of actual expenditure. Therefore, fixed overheads would be allocated to each television produced at a rate of CU4 (CU16,000/4,000) per television.

Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production. Variable overheads may include indirect materials and indirect labor. They are allocated to each unit of production based on the actual use of the production facilities.

Allocation of overheads to the cost of inventories Overheads that are properly classified as selling costs should not be included in the cost of inventories. Other non-production overheads should only be included when this is justified by exceptional circumstances. When firm sales contracts have been entered into for the provision of goods or services to customer specification, overheads (other than selling costs) relating to design, incurred before manufacture, may be included in arriving at cost. The process for determining the amount of overheads to be carried forward in inventories can be considered under two headings: (1) identifying the overheads to be included, and (2) allocating those overheads to production in a logical manner. It is necessary first to analyse overheads by function between production, marketing and distribution, and administration. There are practical problems in performing this analysis. For example, management salaries may include an element of supervision of production as well as of administration, and pension costs are likely to cover employees in the production function as well as those in sales and general administration departments. Central services departments, such as accounts, may provide identifiable services for production. Costs should be allocated over the functions on a reasonable basis, which should be applied consistently and reviewed regularly. The method for allocating overheads to production should be one that is appropriate to the nature of the product and the method of production. The most popular methods for allocating overheads are: by way of a labour-hour or machine-hour rate; in proportion to direct labour costs; in proportion to material costs; in proportion to prime costs; and equally to each unit of production. (This is only appropriate when a single product is being produced in a given cost centre.) Whichever method for allocating overheads is adopted, the overheads should be allocated on the basis of the entity’s normal level of activity. Overhead costs that are the result of operating inefficiencies, such as abnormal idle capacity or abnormal rectification work, should not be included in the inventory carrying amount.

Depreciation of the right-of-use asset on leasehold land during the development of a property for sale An entity develops properties for sale which qualify as inventory within the scope of IAS 2. When those properties are located on leasehold land, the depreciation of the leasehold land right-of-use asset during the construction period should be incorporated in the cost of the property inventories based on a reasonable allocation of such depreciation. This is consistent with the requirement in IAS 2 that depreciation of right-of-use assets that are used in the production process is a fixed production overhead, which would be allocated and included as part of the cost of the inventory.

Allocation of cost to joint products and by-products

Sometimes two products may result from the production process when joint products are produced or when a product and a by-product are produced. In such cases, when it is difficult to allocate costs between the two, a rational and consistent allocation method is chosen. For example, the cost of joint products may be allocated based on relative sales values either at the stage in production when each product becomes identifiable or when production is complete.

If an immaterial by-product results from the production of the main product, the net realizable value of the by-product is often deducted from the cost of the main product. Because the value of the by-product is immaterial, this deduction does not result in the cost of the main product being understated.