## Learning Outcomes

After reading this article, you will be able to apply the requirements of IAS 2 for inventory valuation in a manufacturing context. You will know how to determine which production overheads are included in the cost of conversion, allocate them appropriately, distinguish between normal and abnormal costs, and identify overhead treatment pitfalls. This will help you prepare accurately for inventory calculations in the ACCA FR exam.

## ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand how inventories are valued under IAS 2, especially in manufacturing entities. Focus your revision on the following points:

- Distinguishing between direct and indirect manufacturing costs for inventory
- Allocating production overheads to costs of conversion
- Determining normal versus abnormal production costs
- Applying IAS 2 rules to inventory valuation in the financial statements
- Excluding non-allowable costs from inventory valuation
- Recognising exam warning areas in overheads and cost calculations

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. Under IAS 2, which of the following costs may be capitalised as part of inventory?
   a) Direct material
   b) Normal indirect production overheads
   c) Abnormal spoilage
   d) Selling and distribution costs
   _(Select all that apply)_

2. What is the correct basis for allocating manufacturing overheads to each unit of output?

3. True or false? General administrative expenses that do not contribute to bringing inventories to their present condition must be excluded from the cost of inventories.

4. Briefly explain how abnormal waste is treated under IAS 2 Inventories.

## Introduction

Correct inventory valuation ensures profit is not overstated or understated. IAS 2 Inventories requires manufacturing businesses to include the costs directly related to production and an appropriate allocation of fixed and variable production overheads in inventory. Understanding the distinction between what must be included and what must be excluded—and how to allocate overheads fairly to inventories—is essential for the FR exam.

> **Key Term: cost of conversion**
> The costs incurred to convert raw materials into finished goods. This includes direct labour and a systematic allocation of fixed and variable production overheads.
> **Key Term: production overheads**
> Indirect costs of production that cannot be traced directly to a specific inventory unit, such as factory rent, factory manager salaries, or depreciation of factory equipment.
> **Key Term: normal level of activity**
> The average production volume expected to be achieved over several periods under normal circumstances, used as the basis for allocating fixed overheads.

### COST OF INVENTORY IN MANUFACTURING

IAS 2 states that cost includes costs of purchase (materials), costs of conversion (labour and production overheads), and other costs to bring inventory to its intended location and condition.

### Components of Manufacturing Inventory Cost

1. **Direct costs**:
   - Direct material (raw materials)
   - Direct labour (factory workers directly manufacturing goods)

2. **Production overheads**:
   - Fixed production overheads (e.g., factory rent, equipment depreciation)
   - Variable production overheads (e.g., indirect materials like screws, indirect labour such as factory cleaners)

### Systematic Allocation of Overheads

Fixed production overheads must be allocated based on the normal capacity of production facilities. This means if a factory normally makes 10,000 units but only produces 8,000 this period (due to abnormally low output), the total fixed overhead is allocated as if 10,000 were produced.

Variable production overheads are allocated based on actual production for the period.

> **Exam Warning:**
> Do not allocate more fixed overhead per unit just because the factory operated below normal capacity. Over-allocating increases inventory value incorrectly and overstates profit.

### Normal vs Abnormal Costs

- **Normal costs:** Include in inventory. For example, usual rates of breakage, wastage, or machine running costs.
- **Abnormal costs:** Exclude. Abnormal wastage, excess spoilage, and overheads incurred during idle capacity due to strikes or breakdowns must be written off to profit or loss immediately.

### Non-allowable Costs

IAS 2 specifically requires the following to be excluded:

- Abnormal wastage
- Storage costs not necessary for production
- General administrative overheads
- Selling and distribution costs

### ALLOCATING FIXED PRODUCTION OVERHEADS

Fixed overhead per unit is calculated as:

![Manufacturing overhead allocation under IAS 2, from normal-capacity fixed overhead rates to inventory inclusion and expensing under-absorbed overhead.](https://static.pastpaperhero.com/images/acca-fr-inventories-ias-2-manufacturing-overheads-and-cost-of-conversion_00.png)

_IAS 2 cost of conversion shows fixed overhead allocation using normal capacity, variable overhead on actual output, and idle-capacity write-off._

**Fixed production overhead to be allocated per unit = Total budgeted fixed production overhead for the period / Normal level of production**.

If actual output is lower than normal due to abnormal causes, the under-absorbed overhead (the difference between actual and allocated) is expensed, not capitalised.

### Worked Example 1.1

> **Question:**
> A manufacturer expects to produce 20,000 units but only produces 16,000 due to a fire. Fixed overheads for the year total \$180,000. What fixed overhead per unit is allocated to cost of conversion? How is the difference treated?
>
> **Answer:**
> Fixed overhead per unit = \$180,000 / 20,000 = \$9 per unit.
> The \$9 is included per unit for all inventory produced.
> Under-absorbed overhead = (\$180,000 – (16,000 × \$9)) = \$36,000.
> The \$36,000 is written off as an expense in the statement of profit or loss.

### COSTS TO BE EXCLUDED FROM INVENTORY

IAS 2 prohibits including:

- Storage costs incurred after production unless needed for production
- Administrative overheads not contributing to production
- Selling and distribution costs, even if related to inventory

### Worked Example 1.2

> **Question:**
> A factory incurs \$40,000 in selling costs, \$15,000 in warehouse storage (for finished goods), and \$80,000 in indirect factory wages. Which can be included in inventory?
>
> **Answer:**
> Only the \$80,000 indirect factory wages (if normal and related to production) can be allocated to inventory cost. Selling costs and post-production storage costs are excluded.

### ABNORMAL COSTS AND WASTE

Abnormal losses—such as spoilage outside normal expectations—are recognised immediately as an expense. Only costs up to the normal level of wastage are included in the cost of inventories.

### Worked Example 1.3

> **Question:**
> A batch of 3,000 units is produced. Normally, 3% are spoiled; in one period, 200 units are spoiled. The batch cost \$30,000 to make. How is spoilage treated in inventory valuation?
>
> **Answer:**
> Normal spoilage = 3% of 3,000 = 90 units. Cost per unit = \$30,000/3,000 = \$10.
> Only the cost of 90 spoilt units is included in inventory cost. The remaining 110 units (abnormal spoilage) cost \$1,100 (\$10 × 110), which is expensed immediately.

### OVERHEAD ALLOCATION METHODS

Manufacturers may use job costing, process costing, or activity-based costing. The key requirement is that overhead allocation methods must be systematic and consistent each period.

> **Revision Tip:**
> For FR exam questions, clearly show the calculation of normal capacity, fixed overhead rates, and any adjustments for abnormal costs. Always state assumptions.

## Summary

Inventory in manufacturing must be valued at the lower of cost and net realisable value. Cost includes material, direct labour, and production overheads allocated systematically. Only normal costs are included; abnormal costs, non-production overheads, and post-production costs are expensed when incurred. Incorrect overhead allocation is a frequent exam pitfall.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Define “cost of conversion” and “production overheads” under IAS 2
- Identify costs to include/exclude in manufacturing inventory
- Allocate fixed production overheads based on normal activity
- Recognise and exclude abnormal costs and waste from inventory
- Treat indirect and support costs appropriately in inventory valuation

## Key Terms and Concepts

- cost of conversion
- production overheads
- normal level of activity


Inventories (IAS 2) - Manufacturing overheads and cost of conversion