Accounting Standard 2

Valuation of Inventories

Objective:
Objective is to formulate the method of computation of cost of inventories/ stock, determining the value of closing stock/ inventory at which, the inventory is to be shown in the balance sheet till it is not sold.

Definition of Inventory:
Consists of following:
1. Anything held for sale in ordinary course of business 2. Materials in the process of production of such sale 3. Materials or supplies to be consumed in production process or rendering of services (M/c not included)

Except:
1. Work-in-progress arising out of construction contracts. 2. Work-in-progress arising in ordinary course of business for service providers 3. Financial instruments held as stock-intrade (e.g. shares, debentures etc.) 4. Producers inventories like live stock, agricultural, forest products, Mineral oils, gases and ore.

How to measure:
Inventories are to be valued at cost or net realizable value whichever is

less.

Important Points:
Determining cost of Inventories Determining realisable value of inventory Comparison between cost or realisable value

Cost of Inventories:
Cost includes:
1. Cost of Purchase 2. Cost of Conversion 3. Other costs incurred in bringing in inventories to their present location and condition

Cost of Purchase:
Cost includes:
1. Purchase Price 2. Duties and Taxes 3. Freight and purchase expenses

Less:
1. Tax rebate 2. Trade Discount 3. Duty Drawback

Conversion Costs:
Conversion costs largely constitutes two types of costs:
Direct costs: Cost directly related to the units (mainly Materials, Labour and Direct Expenses) Indirect cost: (Overheads) Systematic allocation of fixed and variable Production overheads incurred for conversion

Fixed Production Overheads:

Indirect cost of production that largely remains fixed irrespective of the output. For eg. Rent of factory, depreciation of machinery, rent of godown. Allocation of Fixed overhead is to be done on the basis of NORMAL CAPACITY,

Variable Production Overheads:

Indirect cost of production that varies with the output, like indirect materials, indirect wages etc. Allocation of Variable overhead is to be done on the basis of ACTUAL PRODUCTION.

Example:1
A Compact Disc manufacturer Sony Ltd. manufactures a CD which includes materials worth Rs. 5, wages worth Rs. 2, and other direct cost like packing box etc.. Cost Rs. 1 per unit. Rent of the factory, depreciation and other fixed costs amounts to Rs. 2,00,000 p.a. The company if working at 100% capacity can produce 1 million CDs a year. On 31.3.2005 the company had 50,000 CDs in stock. You are required to value the stock of finished goods at the end of the year.

Joint Products:
Joint product represent tow or more product separated in the course of same processing operation, e.g.. Petrol, kerosene, diesel etc. are joint product processing the crude oil. When total conversion cost of each product is not separately identifiable then, total cost of conversion is allocated between the products on the rational and consistent basis.

By- Products:
Any saleable or usable value incidentally produced in addition to the main product. E.g. in making ground nut oil the waste/reminder after crushing the ground nut. By-products are valued at Net Realisable Value, then the net realisable value is deducted from the cost of conversion of main product.

Not included in cost of inventories:

Abnormal Amount of wasted material or labour or overheads. Storage Costs. Administrative Overheads. Selling and distribution costs. Interest and Borrowing costs

Cost Formula:
Specific Identification Method: Other Methods:
FIFO Weighted Avg. Cost

Specific Identification Method:

Directly linking the cost with the specific item of inventory:
In case of purchase of item specifically segregated for specific project and is not ordinarily interchangeable In case of goods or services produced and segregated for specific purpose.

Other Methods:
Where specific identification method doesnt apply other method applies:
FIFO (First In First Out) Weighted Average Cost

Cost of inventories in certain conditions:

When it is impracticable to calculate cost, the following methods can be adopted:
Standard Cost Retail Method

Standard Cost:
It takes into account normal level of consumtion of material and supplies, labour, efficiency and capacity utilisation. It must be regularly revies and revised taking into account current conditions.

Retail Method:
Generally used in retailing business;
when it is difficult to ascertain the cost of individual item, Inventories are rapidly changing items and have similar margins for which it is impracticable to use other costing methods

Cost is determined by reducing approximate gross profit margin from the original selling price.

Net Realizable Value:

The estimated selling price in ordinary course of business less:
Estimated cost of completion Estimated cost necessary to make the sale

Estimation of NRV is done on the basis of most reliable evidence at the time of valuation

Estimation of NRV:
The NRV of the materials and other supplies held for use in producion of finished goods
If finished product in which rawmaterial and supplies used is sold at cost or above the cost, then the estimated realisable value of rawmaterial and supplies is considered more than its cost. If finished product in which raw material and supplies used is sold below the cost. Then the estimated realisable value of rawmaterial or suppoies is equal to the repalcement cost.

Example 2:
Raw material XGwas purchased at Rs. 250 Kg. for making Product C. The price of XG goes down in the market. Because of this Product C would also be sold below the cost. At the end of the year there are 1500 kgs. of XG was in the stock. The replacement cost is Rs. 200 per kg. Determine the value of inventory.

Example 3:
In a production process normal wastage is 10% of the input. Actually 10000mtrs. was put into process resulting a wastage of 1200 mtrs. The input cost per mtr. is Rs. 100. The waste realises Nil. Calculate the cost of inventory.

Example 4:
In an inventory of finished goods the cost consists of Rs. 10 for materials, Rs. 4 for wages and Rs. 2 for variable overheads. The comapany has a normal capacity of maiking 1,00,000 units p.a. A fixed overhead is incurred at Rs. 50,000 p.a. At the end of the year 1750 units are in the stock detemaine the value of stock.

Thank you