Measuring Cost of Inventory

For inventory to be reported in the financial statements of entity, they need to be measured in monetary terms. Inventory may be measured at:

  1. cost that entity has incurred on acquiring or producing; or
  2. net realizable value which is simply entity may receive on selling the item

The choice of measurement basis is usually governed by:

  • applicable rules and regulations e.g. International Accounting Standards (IAS) 2 requires inventory to be measured at lower of cost and net realizable value; or
  • entity’s policy or
  • nature of reporting e.g. for internal reporting management may consider costing basis to be more suitable.

But before we even make a selection of basis, we must learn how to measure the cost of inventory. Concepts and discussion on net realizable value (NRV) and other important aspects like cost flow assumptions will be discussed later.

1 Measuring cost of inventory

Cost of inventory includes:

  1. purchase cost
  2. conversion cost
  3. any other cost specifically incurred to bring the inventory in its current state and location

1.1 Purchase cost

Purchase cost includes all such costs entity incurred usually until possession is obtained. It comprises of:

  1. the purchase price,
  2. import duties
  3. irrecoverable taxes
  4. transportation costs; e.g. carriage inwards, freight etc
  5. handling costs e.g. insurance cost
  6. any other cost that is directly attributable to the acquisition of finished goods, materials and services.

However following are deducted while calculating purchase cost of inventory:

  1. Trade discounts i.e. deduction in price given by the supplier at the time of sale and mentioned on the invoice.
  2. Recoverable taxes and rebates; as entity will get them reimbursed or take credit against liabilities therefore they must be deducted
  3. Any other item that require adjustment e.g. government grant or subsidy for specific inventory.

1.2 Conversion cost

Conversion cost is simply the expenditures incurred to process raw material into finished goods. These expenditures include:

  1. direct labour cost i.e. wages of workforce that is directly involved in conversion process e.g. personnel working on cutting machine and polishing frames in furniture manufacturing unit.
  2. variable production overheads; costs that change with change in activity level but are of indirect nature e.g. wages of inspection personnel.
  3. fixed production overheads; costs that do not change with the change in activity level and tend to remain same for a particular range of activity e.g. rent of warehouse, salaries of labour supervisors.

However, administrative and selling overheads are not added as cost of inventory unless and until they are incurred specifically for inventory that are necessary to make sales and can be traced back.

1.3 Other costs

Entity may incur costs other than purchase cost and conversion cost that form part of product cost e.g. royalties that are paid on per unit basis or cost of packing that is done on customers’ request or delivery cost incurred to bring the inventory to a location where customer was ready to buy etc.

Rule is that any cost specifically incurred to bring the inventory to a ready for sale state is added as cost of inventory.

However, under special circumstances entity may have to incur certain costs that are to be included as cost of inventory. Borrowing cost is one of such special examples

1.3.1 Borrowing costs

Under certain circumstances if inventory fulfills the condition of qualifying asset then borrowing cost can be included as cost of inventory. It may be a little hard for students to understand but some entities have inventories that take considerable time to get ready. For example for construction company, houses built are its inventory.

However, care should be taken while applying this principle as inventory has to fulfill the criteria of qualifying asset. Ready for sale inventory or inventory that can be produced in short periods of time does not qualify as qualifying asset.

Another important aspect is interest paid under deferred payment contracts. If entity has agreed to pay for inventory on delayed basis and compensates for such delay then such interest cost is treated as an expense in the income statement and is not included as cost of inventory.

Costs to be Excluded from Inventory
Above we discussed the costs that are included as cost of inventory, however, there are certain costs that we DO NOT add up as cost of inventory. Following are the examples of costs that are excluded from cost of inventory and are recognized as expense separately in the income statement in the relevant period:

  1. abnormal losses i.e. wasted materials, labour or other production costs;
  2. storage costs also known as holding costs incurred to store inventory 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 and distribution costs
  5. Other general overheads that are not incurred specifically
  6. Interest expense incurred on inventories acquired under deferred payment contract. These should be expensed out.

2 Other methods to determine cost of inventory

In some cases it may be difficult to determine cost of inventory as discussed above. In such situations entity may choose to determine cost of inventory using a different method that gives approximate figure that is as reliable as determined using method discussed above.

Two known methods are:

  1. Standard costing method
  2. Retail costing method

2.1 Standard costing method

Standard costing involves setting costs in advance considering the normal production output. Management usually derive standards on the basis of past experience and use this method if cost remains fairly consistent and update the standards if situation changes.

Usually such method is used for such material or labour which is hard to trace or measure its consumption or the benefits of such measurement are not much as compared to cost of conducting such measurement. For example cost of glue or nails consumed in production and entity still hold at the end of the period can be done standard costing basis.

2.2 Retail costing method

Retail method is an easy approach to determine cost by deducting profit from the sales price. This method is employed in situations where inventory has a fairly fast turnover rate. In such situations managing the records of costs incurred is not easy. So this retrograde approach help ease the pressure.

This method is useful for inventories that have fairly consistent sales price as we all profit margins and thus help determine reliable cost estimates. However, care should be taken while establishing the profit margin to be deducted as it is connected with sales price which may change making estimates unreliable.