Intermediate Accounting — Inventories: Cost, Allocation of Fixed Production Overheads and the Retail Method

Principles of Accounting chapter 8 covered the basics of cost flow assumptions and the lower of cost and NRV. This chapter takes up the detailed issues of K-IFRS 1002 Inventories (IAS 2): what goes into cost, how manufacturers allocate fixed costs, and how retailers estimate cost.

1. The scope of the cost of inventories

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

What is included in cost and what is excluded
Included	Excluded (expensed as incurred)
Purchase price, import duties, non-recoverable taxes	Abnormal amounts of wasted materials, labour or other production costs
Freight-in, handling	Storage costs, unless necessary before a further production stage
Direct labour, variable and (allocated) fixed production overheads	Administrative overheads that do not contribute to bringing inventories to their present location and condition
Non-production overheads and design costs for specific customers	Selling costs

Trade discounts and rebates are deducted from purchase cost. Where a purchase effectively contains a financing element, such as terms deferring payment for more than a year, the difference between the price for normal credit terms and the amount paid is recognized separately as interest expense.

2. Fixed production overheads are allocated on normal capacity

Variable production overheads are allocated on actual production. Fixed production overheads are allocated on the basis of normal capacity: the production expected to be achieved on average over a number of periods under normal circumstances.

Fixed overhead allocation rate

\text{Allocation rate} = \frac{\text{Fixed production overheads}}{\max(\text{Normal capacity},\ \text{Actual production})}

If actual production is below normal capacity, divide by normal capacity; unallocated overheads are expensed in the period. If production is abnormally high, divide by actual production so that inventory is not measured above cost.

Company K has annual fixed production overheads of ₩50 million and normal capacity of 10,000 units. This year a downturn cut production to 8,000 units. The allocation rate is ₩50 million / 10,000 = ₩5,000. $8{,}000 \times 5{,}000 =$ ₩40 million is allocated to production, and the unallocated ₩10 million is an expense of the period. Dividing by actual production of 8,000 would give ₩6,250 per unit, piling the cost of idle capacity into inventory and deferring profit by the same amount. The standard prevents this.

3. The retail method

Retailers with many fast-moving items find it hard to track cost item by item. The retail method estimates the cost of closing inventory by applying a cost ratio to inventory managed at selling prices. It may be used only if the result approximates actual cost.

A. Data

L Mart's data for the year (unit: ₩10,000)
Item	Cost	Retail
Opening inventory	400	600
Purchases	2,000	3,000
Net markups		200
Net markdowns		(100)
Goods available for sale	2,400	3,700
Sales (at retail)		(2,800)
Closing inventory (at retail)		900

B. Closing inventory depends on the cost ratio

Closing inventory cost by method (unit: ₩10,000)
Method	Cost ratio working	Cost ratio	Closing inventory at cost
Average-cost retail method	2,400 ÷ 3,700	64.86%	583.8
Lower-of-cost (conventional) retail method	2,400 ÷ (3,700 + net markdowns 100)	63.16%	568.4

The conventional retail method does not deduct net markdowns in the denominator of the cost ratio, so the ratio is lower and closing inventory is estimated conservatively. Since the markdowns already reflect price declines, this builds the lower-of-cost effect into the ratio. The FIFO retail method excludes opening inventory and computes the ratio from current purchases only.

4. Detailed rules for the lower of cost and NRV

Raw materials: even if the NRV of raw materials is below cost, they are not written down if the finished products in which they will be incorporated are expected to sell at or above cost. They are written down only when the products are expected to sell below cost, and then the replacement cost of the materials may be the best available measure of NRV.
Firm sales contracts: NRV for the quantity under contract is based on the contract price. Inventory in excess of contracted quantities uses general selling prices.
Reversal: when the circumstances that caused a write-down no longer exist, the write-down is reversed up to the original carrying amount and deducted from cost of sales.

5. Inventory errors that counterbalance

If closing inventory for 20X1 is overstated by ₩1 million, 20X1 cost of sales is understated and profit overstated by ₩1 million. Because that inventory is the opening inventory of 20X2, 20X2 cost of sales is overstated and profit understated by ₩1 million, and retained earnings at the end of 20X2 are correct. Such errors are called counterbalancing errors. If one is discovered before the 20X2 financial statements are issued, the 20X1 comparative statements must be restated (chapter 16).

Check your understanding

Company M has fixed production overheads of ₩36 million a year and normal capacity of 12,000 units. Actual production is 9,000 units and sales 7,000 units, with no opening inventory. Variable production cost is ₩8,000 per unit. What is the cost of closing inventory, and how much fixed production overhead is expensed in the period?

The allocation rate is ₩36 million / 12,000 = ₩3,000, so product cost per unit is $8{,}000 + 3{,}000 = 11{,}000$ . Fixed cost allocated to production is $9{,}000 \times 3{,}000 =$ ₩27 million, and the unallocated ₩9 million is expensed. Closing inventory of 2,000 units costs $2{,}000 \times 11{,}000 =$ ₩22 million. Fixed production overhead expensed in the period is the $7{,}000 \times 3{,}000 =$ ₩21 million in cost of sales plus the unallocated ₩9 million, ₩30 million in all. The remaining ₩6 million stays in closing inventory.

References

Korea Accounting Standards Board, K-IFRS 1002 Inventories
Donald Kieso, Jerry Weygandt and Terry Warfield, Intermediate Accounting: IFRS Edition, ch. 8–9
IASB, IAS 2 Inventories