Valuation of Inventories

Accounting Standard – 2 (Revised) provides that inventories should be valued at the lower of the cost and net realizable value. It is thus clear that the basis for valuation of inventories in good or sealable condition is the cost or historical cost. “The cost of inventories comprises all costs of purchases, costs of conversion and other costs incurred in bringing the inventories to their present location and condition”. Thus costs of inventories comprise of: (i) costs of purchase (ii) costs of conversion and (iii) other costs.

Cost of purchase:

The costs of purchase consist of the purchase of the purchase price including duties and taxes, freight inwards and other expenditure directly connected with purchase such as costs of packaging, insurance, transportation, inspection, storage and so on. Trade discount, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchases. It may be noted that cash discounts are allowed for prompt payments and should be regarded as source of revenue rather than as a reduction in cost; hence cash discount has no role in inventory valuation. Cost of purchase refers to the value of resources required to obtain the inventory in its present condition and location. If some expenditure can not be directly related to the purchase of goods for resale, such as general administrative and selling and distribution costs, they are entirely excluded for the calculation of inventory cost and are therefore treated as operating expenses for the accounting period.

Cost of conversion:

When applied to production, the costs of conversion of inventories include costs directly related to the units of production such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. The allocation of fixed production overheads such as depreciation, maintenance of factory building etc., are allocated on the basis of normal capacity of the production facilities. Variables production overheads such as indirect materials and indirect labour are assigned to each unit of production on the basis of the actual use of the production facilities. Unallocated overheads are recognized as an expense n the period in which they are incurred.

Other costs

are included in the cost of inventories to the extent that they are incurred in bringing inventories to their present location and condition e.g. costs of designing products for specific customer.

However the following costs are excluded: abnormal amounts of wasted materials, labour or other production process prior to a further production stage and administrative overheads that do not contribute to bringing the inventories to their present location and conditions. Similarly interests and other borrowing costs are excluded for inventory valuations.

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