Both the IFRS (IAS 2) and ASPE (ASPE 3031) accounting frameworks define, measure and classify Inventory using more or less the same criteria. In this article we review the definition of Inventory, how it is classified and measured.
Definition
IAS 2 (paragraph 6) and ASPE 3031.07 define Inventory as assets that are:
Being held for sale as part of the entity’s normal business activities (Finished Goods Inventory), OR
In the production process so that they can later be held for sale (Work In Process Inventory), OR
Raw materials and/or supplies that will be used in the production process so that they can later be held for sale (Raw Material Inventory).
This definition means that items held for sale that are not part of the entity’s business model/normal business activities should not be considered Inventory. For example, an entity that exclusively manufactures and sells crayons, would not consider a piece of used machinery that is being held for sale, as “Inventory.”
Classification
Inventory is classified as a Current Asset, regardless of whether or not the asset is to be sold within a year. For example, aged alcohol, cheeses, etc.. inventories would still be considered “Current Assets,” despite that they might be sold after 12 months.
Inventory assets are classified and grouped into their major categories. These major categories are presented on the Financial Statements, with inventory grouped under each term:
Raw Materials Inventory,
Work in Process (WIP) Inventory, and
Finished Goods Inventory.
Measurement
IAS 2 (Paragraph 9) and ASPE 3031.10 state that Inventories should be measured at the lower of:
Cost, AND
Net Realizable Value (NRV)
All inventory cost and NRV calculations are done on a per-unit basis.
Cost
The majority of cost associated with Inventory are fairly self-explanatory, except perhaps, Production Overheads. These are discussed in more detail below.
The Cost of Inventory includes:
ADD: Cost of Purchase
Purchase Price
Import Duties
Cost of Transportation to Current Location
Handling Costs
Other direct costs
ADD: Cost of Conversion: (only for WIP and Finished Goods Inventory)
Direct Labor
Direct Materials
Allocation of fixed and variable production overhead
Design Costs related to specific inventory
Production Specific Administrative Costs
Interest on loans to pay for inventory purchases (only on “qualifying” assets - those that must be held for a long period of time to be made ready. E.g.: wine)
ADD: Other costs required to bring the inventory to current location and condition
LESS:
Trade Discounts
Rebates and Subsidies
Other similar items
Items NOT included in the Cost of Inventory:
General Administrative costs and overheads
Selling costs
Abnormal waste (materials, labor, etc…)
Storage costs (unless required as part of the production process: e.g.: cheese may need to be aged and stored in a particular manner as part of the production process)
Allocation of Fixed and Variable Production Overheads:
Production Overheads are costs (other than Direct Labour and Direct Materials) used in the conversion of Raw Materials into WIP or Finished Goods. Examples of Production Overheads include: leasing costs of equipment, manufacturing facility rent, electricity, water, heating, depreciation on equipment, etc…
When determining the cost of either WIP or Finished Goods Inventory, we need to determine how to measure the production overheads associated with the Inventory. There are a variety of different methods which can be used to allocate the costs of Production Overhead. The main categories of costing approaches include: Variable Costing and Absorption Costing. Within these categories, there are sub-categories such as: Actual Absorption Costing, Normal Absorption Costing, Standard Absorption Costing, Normal Variable Costing, and Standard Variable Costing. Many of these costing methods are useful for internal purposes, and will be discussed in detail in a later article. They are especially relevant for those interested in management accounting.
The good news is that, despite all of the different costing approaches, only one approach is acceptable for external reporting purposes (for both IFRS and ASPE). This approach is called Full Absorption Costing. In full absorption cost, we include both variable and fixed manufacturing overhead into the cost of Inventory for the period.
How do we determine Manufacturing overhead (MOH)?
One method would be to simply take all of the costs incurred in the manufacturing facility for the period, and divide this by the number of units in inventory, resulting in an MOH/unit.
The problem with this approach is the large variance in costs that can occur when the plant is not producing anything in one period, compared to when it is producing inventory in another period. The result would be that during periods where little inventory is produced, we would end up with an extremely high MOH per unit (since all MOH would be allocated to a very small number of units), while during periods where the facility produced an above normal number of units, we would end up with a very low MOH per unit (since MOH would be allocated amongst an unusually large number of units).
So what do we do?
1) Start by Separating Manufacturing Overhead into Variable and Fixed Components.
Variable Overhead (VOH) is overhead that can easily be attributed to each specific unit. If no production took place within the period, there should be no VOH. In other words - VOH include costs that are only incurred when units are produced. Examples could include a portion of electricity and water used within the manufacturing facility.
Fixed Overhead (FOH) is overhead that cannot easily be attributed to specific units, and is often incurred regardless of whether units are produced of not. Examples include: rent costs for the manufacturing facility and heating costs within the manufacturing facility.
Categorizing costs into VOH or FOH can be subjective, and will likely require historical data analysis. Costs such as depreciation on equipment and machinery may be considered either variable or fixed depending on what best models the depreciation of the equipment. For example, the most accurate way to represent depreciation for a piece of equipment may be on a per-unit basis (in which case, the cost would be considered VOH) or it could be the passage of time in the form of yearly depreciation (in which case, the cost would be considered FOH).
2) Determine both the VOH on a per unit basis and the FOH on a per unit basis. Production overheads are always allocated on a per unit basis.
3) Determine the FOH over the passage of time and use this to extrapolate an average “Normal Capacity” for the plant. The Normal Capacity is the average Fixed Overhead over a number of periods. We use this number to smooth out inefficiencies, overproduction and underproduction.
4) As a rule, when determining the FOH for the period we must always use the lower of:
the actual fixed cost per unit and
the budgeted (normal) fixed cost per unit.
We do this to ensure that Inventory is being valued at its lowest cost. As described in our earlier example, when output is below normal, the actual fixed costs per unit will be higher than normal. On the other hand, higher output will result in lower fixed costs per unit.
Trick:
When output is below normal -> Use the normal fixed production costs/unit
When output is above normal -> Use the actual fixed cost per unit.
Using the lower value will result in us reporting the lower production costs for our Inventory, at all times.
5) Add the VOH per unit and FOH per unit and multiply this by the number of inventory units to give us our total Production overhead.
Production Overhead for Inventory = Number of Inventory Units x (FOH/unit + VOH/unit)
Net Realizable Value (NRV)
NRV is the estimated price at which inventories could be sold less their selling costs and costs to complete the inventory.
Net Realizable Value = Selling Price - Cost to Complete - Selling Costs
Important: If there are extra costs required to complete an item (for example, custom rework), this should be deducted from the NRV and not from the “Cost”. This is because the cost has not yet been incurred.
Exceptions to the Rule
If NRV for Raw Materials is below their cost, and if these Raw Materials are intended to be used in the production process, then they should not be written down below their cost. In other words - if the Raw Material are going to be used for WIP or Finished Goods inventory - and this inventory is expected to be sold at above cost, then we record the Raw Materials at cost.
Multiple Items
Comparisons for Cost and NRV must be done on an item by item basis when the items are individualized, not as a group, unless the group holds the same items (e.g.: a commodity).
Helpful Formulas
Abbreviations:
COGS = Cost of Goods Sold
COGM = Cost of Goods Manufactured
WIP = Work in Process
General Inventory Equation:
Beginning Inventory + Purchases - COGS = Ending Inventory
Raw Material Inventory Equation:
Beginning Raw Materials + Purchases - Transferred to WIP = Closing Raw Materials
Work In Process Inventory Equation:
Beginning WIP + Manufacturing Costs (including Transferred in WIP) - COGM = Closing WIP
Finished Goods Inventory Equation:
Beginning Finished Goods Inventory + COGM - COGS = Closing Finished Goods Inventory
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