Use of cost formulas – general

Cost may be assigned to individual items of inventory, depending on their nature, either by the specific identification method or by the use of a cost formula. When the use of the specific identification method is inappropriate, IAS 2 allows a choice between two cost formulas: the weighted average formula and the first-in, first-out (FIFO) formula. The use of the last-in, first-out (LIFO) formula is prohibited under IAS 2.

Cost formula to be consistent for similar inventories

Although IAS 2 permits a choice between the weighted average formula and FIFO for those inventories not measured by specific identification, it requires that the same cost formula is used for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, a different cost formula may be justified. IAS 2: Differences in geographical location or tax rules will not, by themselves, justify the use of different cost formulas.

Specific identification

IAS 2 requires that the cost of inventories of items that are not ordinarily interchangeable, and of goods or services produced and segregated for specific projects, should be assigned by using specific identification of their costs. The specific identification method entails assigning specific costs to identified items of inventory. Thus, this method is appropriate when items of inventory are produced for specific projects or when other items of inventory held cannot be substituted for those items (e.g., antique cars or works of art).

The specific identification method is not appropriate for the routine production of inventories that are ordinarily interchangeable, because it would allow an entity to influence its reported profits by choosing which specific units to sell – and, hence, which otherwise identical products remain in inventory at the end of the reporting period – based on those products having higher or lower specific costs.

Some entities may nevertheless have set up computer systems that allocate specific costs to inventories that are ordinarily interchangeable. Whether the valuations produced by such systems will be acceptable will depend on whether they reasonably approximate those that would have resulted from the use of cost formulas.

Weighted average cost

The weighted average cost formula assigns a value to each item of inventory based on the weighted average of items in inventories at the beginning of the period and the weighted average of items of inventories purchased or produced during the period. Depending on the inventory system of the reporting entity, the weighted average cost is calculated either periodically or on a perpetual basis as the inventories are received.

Weighted average cost formula – example An entity had opening inventories of 15,000 units at a weighted average cost of CU4 per unit, and made the following purchases during the year. Date of purchases Number of units Cost per unit Total cost     CU CU 1 January 15,000 4.20 63,000 1 April 20,000 4.50 90,000 1 May 25,000 4.10 102,500 1 July 10,000 4.40 44,000 1 October  5,000 4.50  22,500 Total 75,000 322,000 Closing inventories are 20,000 units. Under the weighted average formula, the number of units in closing inventories is multiplied by the weighted average cost per unit for the year.   Number of units Cost per unit Total cost     CU CU Opening inventories 15,000 4.00 60,000 Date of purchase: 1 January 15,000 4.20 63,000 1 April 20,000 4.50 90,000 1 May 25,000 4.10 102,500 1 July 10,000 4.40 44,000 1 October  5,000 4.50  22,500 Total 90,000 382,000 The weighted average cost per unit for the year is calculated as follows. CU382,000 / 90,000 = CU4.24 The value of closing inventories is CU4.24 × 20,000 = CU84,800.

FIFO

The FIFO cost formula assumes that the items of inventory that were purchased or produced first are sold first. Therefore, at the end of the period, the items in inventory are valued using the prices for the most recent purchases.

FIFO cost formula – example Under the FIFO formula, the first units held are the first units sold. Therefore, closing inventories are valued at the cost per unit of the latest purchases. If 20,000 units are on hand at year end, the value of closing inventories is calculated as follows. Date of purchases Number of units Cost per unit Total cost CU CU October 5,000 4.50 22,500 July 10,000 4.40 44,000 May  5,000 4.10 20,500 Total 20,000 87,000 Thus, closing inventories are valued at CU87,000.

Changing from one cost formula to another

Changing from one cost formula to another A reporting entity may decide to change from one cost formula to another (e.g., from the weighted average formula to FIFO) on the basis that the latter is more widely used in its particular industry and will, therefore, enhance comparability. A common question is whether such a change constitutes a change in accounting policy or a change in estimate. It is sometimes argued that it merely represents a change in estimate, in that it is a revision of the method of estimating cost. On balance, however, it seems appropriate to treat this as a change of accounting policy, for the following reasons. For inventories that are ordinarily interchangeable, states that a specific identification approach is inappropriate. Accordingly, the use of cost formulas is not merely a method of estimating the aggregate actual cost of individual items, because otherwise a specific identification approach would not be inappropriate, but would instead give the best possible estimate. Rather, cost formulas are used to arrive at a different figure that avoids the unacceptable distortions that would occur if a specific identification approach were adopted. IAS 2 requires disclosure of the accounting policies used for measuring inventories “including the cost formula used“, which reinforces the view that the cost formula selected is a matter of accounting policy. Other changes to the way in which inventories are measured (e.g., any changes to the basis for allocation of overheads or other costs of conversion to inventories) are likely to be changes of estimate rather than matters of accounting policy. Under IAS 8, the effect of a change in estimate should be separately disclosed, when material.

Cost formulas

The cost of inventories of items that are not ordinarily interchangeable, and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their costs.

Specific identification of cost means that specific costs are attributed to identify items of inventory. This is the appropriate treatment for items that are segregated for a specific project, regardless of whether they have been bought or produced. However, specific identification of costs is inappropriate when there are large numbers of items in inventory that are ordinarily interchangeable.

In such circumstances, the method of selecting those items that remain in inventories could be used to obtain predetermined effects on profit or loss.

The cost of inventories shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula. An entity shall use the same cost formula for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may be justified.

For example, inventories used in one operating segment may have a use to the entity different from the same type of inventories used in another operating segment. However, a difference in the geographical location of inventories (or in the respective tax rules), by itself, is not sufficient to justify the use of different cost formulas.

The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently, the items remaining in inventory at the end of the period are those most recently purchased or produced.

Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated periodically, or as each additional shipment is received, depending upon the circumstances of the entity.

Cost of inventories

The cost of inventories shall comprise all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

Costs of purchase

The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), transport, handling, and other costs directly attributable to the acquisition of finished goods, materials, and services. Trade discounts, rebates, and other similar items are deducted in determining the costs of purchase.

Costs of conversion

The costs of conversion of inventories include costs directly related to the units of production, such as direct labor. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.

Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and equipment, and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labor.

The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on average over several periods or seasons 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 normal capacity. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognized as an expense 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 above cost.

Variable production overheads are allocated to each unit of production based on the actual use of the production facilities.

A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or when there is a main product and a by-product. When the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis.

The allocation may be based, for example, on the relative sales value of each product either at the stage in the production process when the products become separately identifiable, or after production. Most by-products, by their nature, are immaterial. When this is the case, they are often measured at net realizable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost.

Other costs

Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories.

Examples of costs excluded from the cost of inventories and recognized as expenses in the period in which they are incurred are:

1. Abnormal amounts of wasted materials, labor, or other production costs;
2. Storage costs, unless those costs are necessary in the production process before a further production stage;
3. Administrative overheads that do not contribute to bringing inventories to their present location and condition; and
4. Selling costs.

IAS 23 Borrowing Costs identifies limited circumstances where borrowing costs are included in the cost of inventories.

An entity may purchase inventories on deferred settlement terms. When the arrangement effectively contains a financing element, that element, for example, a difference between the purchase prices for normal credit terms and the amount paid, is recognized as interest expense throughout the financing.

Cost of agricultural produce harvested from biological assets

By IAS 41 Agriculture inventories comprising agricultural produce that an entity has harvested from its biological assets are measured on initial recognition at their fair value less costs to sell at the point of harvest. This is the cost of the inventories at that date for application of this Standard.

Techniques for the measurement of cost

Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate cost. Standard costs take into account normal levels of materials and supplies, labor, efficiency, and capacity utilization. They are regularly reviewed and, if necessary, revised in light of current conditions.

The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins for which it is impracticable to use other costing methods. The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross margin. The percentage used takes into consideration inventory that has been marked down to below its original selling price. An average percentage for each retail department is often used.

Measurement of inventories

Inventories to be measured at the lower of cost and net realizable value

Inventories are measured at the lower cost and net realizable value. IAS 2 The comparison of cost with net realizable value should, in principle, be carried out on an item-by-item basis but, if this is impracticable, groups of similar items may be considered together. It is unacceptable to compare the total net realizable value of all inventories with their total purchase price or production cost.

The introduction to IAS 2 makes clear that, with the limited exception of the classes of inventory listed (i.e., those outside the scope of the Standard and those exempt from its measurement rules), it is not acceptable to adopt an accounting policy of carrying inventories at a current value.

Measurement of cost

Components of cost

specifies that the cost of inventories comprises:

• all costs of purchase;
• costs of conversion; and
• other costs incurred in bringing the inventories to their present location and condition.

Costs of purchase

Items included in the cost of purchase

The costs of purchase of inventories include:

• purchase price;
• import duties and other taxes that are not recoverable by the entity (e.g., associated VAT paid to the extent that an entity cannot reclaim it);
• transport and handling costs; and
• other costs directly attributable to the acquisition of finished goods, materials, and services.

Any trade discounts or rebates received are deducted in determining the costs of purchase of inventory.

Discounts and rebates

Discounts and rebates – example Entity A is a retailer that acquires products from manufacturers, which are sold to end users. The manufacturers grant incentives to Entity A on one of two bases: a 10 per cent prompt settlement discount on all purchases of inventories settled within 30 days of purchase; or rebates based on the volume of merchandise purchased or sold. Scenario 1 – Entity A acts as principal If Entity A acts as principal in the purchase of products from manufacturers and the sale of products to end users then, in accordance with IAS 2 rebates and discounts that have been received as a reduction in the purchase price of inventories should be taken into consideration in the measurement of the cost of those inventories. Prompt settlement (cash) discount Entity A should deduct prompt settlement discounts from the cost of the inventories. When measuring the cost of the inventories, Entity A should estimate the expected settlement discount to be received from the supplier. Volume rebates Similarly, volume rebates should be deducted from the cost of inventories. Scenario 2 – Entity A acts as agent If Entity A is not purchasing the products as principal, and is instead acting as an agent of the manufacturers in making sales to end users, any rebate received will form part of the net commission revenue earned.

Cash refund based on volume of purchases – example On 1 July 20X1, in a binding arrangement, a vendor offers a cash refund of CU1,000 to a customer if during the 12 months to 30 June 20X2 the customer purchases 1,000 units of a particular product. Historically, on average, the customer has purchased 1,700 units each year and there have been no significant changes in the trading relationship in the current period. The customer is preparing its financial statements for the year ending 31 December 20X1 and the 1,000-unit threshold has not yet been reached. Volume rebate to be accounted for as a reduction in the cost of inventories The cash refund constitutes a volume rebate, to be accounted for as a reduction in the cost of inventories. IAS 2 does not, however, specify the treatment of refunds or rebates that are anticipated but have not yet been ‘earned’ or the allocation of refunds or rebates to items of inventory. Anticipation of refunds not yet earned At 31 December 20X1, the customer has not yet reached the threshold for the volume rebate, but it anticipates that it will do so before 30 June 20X2. The topic of refunds or rebates that are anticipated but that have not yet been earned in full is addressed in IAS 34 in the context of the preparation of interim financial statements, and it is appropriate to apply the principle established in IAS 34 to the preparation of annual financial statements in the circumstances described. IAS 34 states as follows. “Volume rebates or discounts and other contractual changes in the prices of raw materials, labour, or other purchased goods and services are anticipated in interim periods, by both the payer and the recipient, if it is probable that they have been earned or will take effect. Thus, contractual rebates and discounts are anticipated but discretionary rebates and discounts are not anticipated because the resulting asset or liability would not satisfy the conditions in the Conceptual Framework that an asset must be a resource controlled by the entity as a result of a past event and that a liability must be a present obligation whose settlement is expected to result in an outflow of resources.” Therefore, in the circumstances described, if it is probable that the customer will purchase at least 1,000 units in the specified period (e.g., forecast purchase levels are in line with historical volumes), the refund (which is contractual) should be accrued as the units are purchased. Units to which the refund should be allocated The refund should be allocated to the units of inventory purchased on a systematic and rational basis. If the vendor’s offer of a cash refund is a one-off incentive, and not expected to be repeated, it may be appropriate to account for the refund as a reduction in the cost of the first 1,000 units purchased, because the customer’s entitlement to the refund is based only on the purchase of 1,000 units of inventory. Conversely, if the vendor routinely offers such a refund on an annual basis but on the condition that the customer purchases all inventories of this type from the vendor (i.e., an exclusive supply arrangement), it may be more appropriate to regard the refund as relating to all purchases in the year and account for it as a reduction in the cost of all units purchased. This assessment should be made on the basis of the specific facts and circumstances, including all relevant contractual terms. Note that IAS 34 quoted above refers to the definition of an asset in the Conceptual Framework. In this instance, the reference is to the Conceptual Framework for Financial Reporting issued in 2010.

Direct materials and waste

Direct materials and wastage When raw material is unavoidably subject to wastage and spoilage during production, it is generally appropriate to include the cost of such normal scrapping and wastage as part of the direct material cost of the product. Alternatively, if more practicable, the cost of direct materials unavoidably wasted or spoiled may be included in overheads as part of the costs of conversion. It is not appropriate, however, to include abnormal wastage in the carrying number of inventories.

Measurement of inventories

Inventories shall be measured at the lower of cost and net realizable value.

What types of costs can be included in inventories?

The following table gives examples of the types of costs that can be included in the cost of inventories:

Description of costs	Include in inventory	Expense
	Direct	Indirect	Selling and Administration
Production materials	✓
Production labour	✓
Employment costs of direct labour (for example, pension costs)	✓
Normal amounts of materials wastage	✓
Supervisor salaries and employment costs		✓
Other indirect labour		✓
Maintenance, heat, light, some taxes (excluding income taxes) and other indirect costs of running factory		✓
Depreciation of production equipment and related facilities and property		✓
Amortization of related acquired intangibles		✓
Product research			✓
Abnormal amounts of wastage, labour and other costs			✓
Selling costs			✓
Storage costs			✓
General management costs
Borrowing costs on inventories that are manufactured in large quantities and on a repetitive basis, that can be either included in inventory or expensed (policy choice)		✓	✓
Borrowing costs on other qualifying categories under IAS 23			✓

Can storage costs be included in the cost of inventory?

The production of whisky involves the aging of whisky in a cask before bottling. Can storage costs be included in the cost of inventory?

Capitalization of storage costs is allowed only if the storage is necessary for the production process before a further production stage. Therefore, in this situation, the storage costs that the entity incurs during the aging process should be capitalized, because aging is integral to making the finished product saleable.

Can the editing and translation costs be included in the cost of inventory held by a publisher?

A publisher prepares travel guides. Part of the costs of preparing the guides include the costs of editing, translating, and collecting the data for the travel guides.

Can the editing and translation costs be included in the cost of inventory held by a publisher?

The costs incurred in editing, translating, and collecting the data should be included in the cost of inventories, as they are direct costs related to preparing the travel guides for use. The cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

How should spare parts used in connection with property, plant, and equipment be accounted for?

A car manufacturer keeps spare parts on hand. Some of the spare parts will be used in the production of vehicles in less than one period in the normal course of business; others will be used in connection with repairs and servicing of property, plant, and equipment used in the manufacturing of vehicles.

The spare parts to be used in the production of vehicles do not meet the definition of property, plant, and equipment because they are consumed in less than one period. Therefore, they are accounted for as inventory. Conversely, the spare parts that will be used to repair and service property, plant, and equipment used in the manufacturing of vehicles meet the definition of property, plant, and equipment, because they are consumed over more than one period.

How are rebates that refund selling expenses accounted for?

The IFRS IC has confirmed, in its rejections, that cash discounts received and settlement discounts should be deducted from the cost of inventories. However, rebates that specifically and genuinely refund selling expenses should not be deducted from the cost of inventories.

At what point are import duties included in inventory valuation?

A car dealer imports cars, bringing them initially into a customs-free zone. The cars remain there until they are sold and delivered to customers, at which point import duties will become payable by the importer.

Should the estimated import duties on inventory held in a customs-free zone be included in the cost of inventories?

No, import duties are not included in the inventory valuation for inventory held in a customs-free zone. Import duties do not arise from shipping the cars to the customs-free zone. Therefore, they are not included in the inventory valuation at that point. Import duties payable are included in the cost of inventory when the cars leave that zone.

When is a bonus related to the sale of inventory recognized?

A car dealer receives bonuses from car manufacturers when it reaches certain sales targets for motor vehicles. The sales-related bonuses are received only after the cars have been sold (that is when they are no longer in inventory).

The bonus from the manufacturers is a contingent asset and should be recognized only when it becomes virtually certain. As it is a sales-related bonus in respect of inventory that has been sold, it is appropriate to take the credit to income as a reduction in the cost of sales.

What are the costs incurred in bringing inventories to their present location and condition?

An entity has development land on which it intends to build houses for sale. It is to pay the local authority to build an access road from A to B, where A is on local authority land and B is on the edge of the land owned by the entity.

The entity will not own the access road or have exclusive rights to use it. However, the entity considers that there is an economic benefit from the cost of building the access road because the homes that it builds on the development site will be more attractive to customers if there is a good access road.

Can the cost of building the access road be capitalized?

If so, is it a separate asset or is it added to the cost of the development?

Cost should include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. The cost of paying the local council to build an access road should be capitalized as part of the development, provided that the entity will gain economic benefits from the access road.

This would be so, for example, if the entity needs the access road built to obtain planning permission for the development, or if the entity can sell the houses more easily or for a higher value.

If, however, the money paid to the local authority resulted in no future economic benefits to the entity (for example, if the access road did not lead to the development site) and was more like a gift or goodwill gesture, it should be written off to the income statement.