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Chapter 4
Inventories
Reference: IAS 2
Contents: Page
- Introduction 137
- Definitions 137
- Different classes of inventories 137
- Recording inventory movement: periodic versus perpetual 4.1 Overview Example 1: perpetual versus periodic system 4.2 Stock counts, inventory balances and stock theft 4.2.1 The perpetual system and the use of stock counts 4.2.2 The periodic system and the use of stock counts Example 2: perpetual versus periodic system and stock theft 4.3 Gross profit and the trading account Example 3: perpetual and periodic system: stock theft and profits
- Measurement: cost 5.1 Overview 5.2 Cost of purchase 5.2.1 Transport costs 5.2.1.1 Transport/ carriage inwards 5.2.1.2 Transport/ carriage outwards Example 4: transport costs 5.2.2 Transaction taxes Example 5: transaction taxes 5.2.3 Rebates Example 6: rebates 5.2.4 Discount received Example 7: discounts 5.2.5 Finance costs due to extended settlement terms Example 8: extended settlement terms 5.2.6 Imported inventory Example 9: exchange rates – a basic understanding Example 10: foreign exchange 5.3 Cost of conversion 5.3.1 Variable manufacturing costs Example 11: variable manufacturing costs 5.3.2 Fixed manufacturing costs 5.3.2.1 Under-production and under-absorption Example 12: fixed manufacturing costs – under-absorption 5.3.2.2 Over-production and over-absorption Example 13: fixed manufacturing costs – over-absorption 5.3.2.3 Budgeted versus actual overheads summarised Example 14: fixed manufacturing costs – over-absorption Example 15: fixed manufacturing costs – under-absorption
Contents continued …
- Measurement: cost formulas (inventory movements) 6.1 Overview 6.2 First-in-first-out method (FIFOM) Example 16: FIFOM purchases Example 17: FIFOM sales Example 18: FIFOM sales 6.3 Weighted average method (WAM) Example 19: WAM purchases Example 20: WAM sales 6.4 Specific identification method (SIM) Example 21: SIM purchases and sales
Page
- Measurement of inventories at year-end 7.1 Overview Example 22: lower of cost or net realisable value Example 23: lower of cost or net realisable value Example 24: lower of cost or net realisable value 7.2 Testing for possible write-downs: practical applications Example 25: lower of cost or net realisable value – with disclosure
- Disclosure 8.1 Accounting policies 8.2 Statement of financial position and supporting notes 8.3 Statement of comprehensive income and supporting notes Example 26: disclosure of cost of sales and depreciation 8.4 Sample disclosure involving inventories 8.4.1 Sample statement of financial position and related notes 8.4.2 Sample statement of comprehensive income and related notes 8.4.2.1 Costs analysed by nature in the statement of comprehensive income 8.4.2.2 Costs analysed by function in the statement of comprehensive income 8.4.2.3 Costs analysed by function in the notes to the statement of comprehensive income
- Summary 175
4. Recording inventory movements: periodic versus perpetual
4.1 Overview
Inventory movements may be recognised using either the perpetual or periodic system.
The perpetual system refers to the constant updating of both the inventory and cost of sales accounts for each purchase and sale of inventory. The balancing figure will represent the value of inventory on hand at the end of the period. This balance is checked by performing a stock count at the end of the period (normally at year-end).
The periodic system simply accumulates the total cost of the purchases of inventory in one account, (the purchases account), and updates the inventory account on a periodic basis (often once a year) through the use of a physical stock count. The balancing figure, in this case, is the cost of sales.
Example 1: perpetual versus periodic system C Opening inventory balance 55 000 Purchases during the year (cash) 100 000
A stock count at year-end reflected 18 000 units on hand (cost per unit: C5).
Required: Show the t-accounts using A. the perpetual system assuming that 13 000 units were sold during the year; and B. the periodic system.
Solution to example 1A: using the perpetual system
Inventory (Asset) Cost of Sales (Expense) O/ balance 55 000 Cost of sales (2) 65 000 Inventory (2) 65 000 Bank (1) 100 000 C/ balance c/f 90 000 155 000 155 000 C/ balance (3) 90 000
(1) The cost of the purchases is debited directly to the inventory (asset) account.
(2) The cost of the sale is calculated: 13 000 x C5 = C65 000 (since the cost per unit was constant at C5 throughout the year, the cost of sales would have been the same irrespective of whether the FIFO, WA or SI method was used).
(3) The final inventory on hand at year-end is calculated as the balancing figure by taking the opening balance plus the increase in inventory (i.e. purchases) less the decrease in inventory (i.e. the cost of the sales): 55 000 + 100 000 – 65 000 = 90 000. This is then compared to the physical stock count that reflected that the balance should be 90 000. No adjustment was therefore necessary.
Solution to example 1B using the periodic system
Purchases Trading Account Bank (2)^ 100 000 T/ account(5)^000 Inventory o/b(3)^55 Inventory c/b 000
Purchases (5)^000 Total c/f(6)^65 000 155 000 155 000 Total b/f (6)^ 65 000
Inventory (Asset) O/ balance(1)^ 55 000 T/ account(3)^000 T/ account(4)^ 90 000
This balance will remain as C55 000 for the entire period until such time as the stock count is performed.
(1) The purchases are recorded in the purchases account during the period (this account will be closed off at the end of the period to the trading account).
(2) The closing balance of the inventory account is determined at the end of the period by physically counting the inventory on hand and valuing it (C90 000). In order for the closing balance to be recorded, the opening balance of C55 000 needs to first be removed from the asset account by transferring it to the trading account.
(3) The inventory is counted and valued via a physical stock count (which is typically performed on the last day of the period, being the end of the reporting period). This figure is debited to the inventory account with the credit-entry posted to the trading account: given as C90 000
(4) The total of the purchases during the period is transferred to the trading account.
(5) Notice how the trading account effectively records the cost of sales and that the cost of sales is the same as if the perpetual system had been used instead: 65 000. Incidentally, the inventory balance is also the same, irrespective of the method used: 90 000.
4.2 Stock counts, inventory balances and stock theft
In example 1, the cost of sales and inventory balances are not affected by whether the periodic or perpetual system is used (i.e. cost of sales was C65 000 and inventory was C90 000 in part A and part B). This may not always be the case however, since a disadvantage of the periodic system is that any stock thefts will remain undetected. The periodic system is, however, still useful to small businesses due to its practical simplicity.
4.2.1 The perpetual system and the use of stock counts
When using the perpetual system, the accountant is able to calculate the balance on the inventory account without the use of a stock count. This balance, however, reflects what the balance should be – not necessarily what the actual balance is. A sad truth of our society is that it is plagued by theft. Therefore, even though the accountant is not reliant on the stock count, a stock count is performed as a control measure. In other words, the balance calculated by the accountant is checked by performing a stock count at the end of the period (normally at year-end).
If the physical count reveals a lower stock level than is reflected by the balance on the inventory account, the difference will be accounted for as a stock theft (expense) (if the physical count reflects more stock than appears in the inventory account, then this suggests that an error may have occurred in recording the purchases or sales during the period).
4.2.2 The periodic system and the use of stock counts
When using the periodic system, the accountant does not have any idea of what his cost of sales are until the stock count is performed. Since we are using the stock count to calculate the cost of sales, the accountant will also not have an idea of what the inventory balance should be (if we had the cost of sales figure, we could have calculated the closing balance as: opening balance + purchases – cost of sales). In short: when using the periodic system, the accountant is unable to calculate the balance on the inventory account without the use of a stock count. If the accountant does not know what the balance should be, the stock count will not be able to highlight any stock thefts.
Solution to example 2B using the periodic system and stock theft
Purchases Trading Account Bank (2)^ 100 000 T/account(5)^ 100 000 Inventory o/b(3)^55 Inventory c/b 000
Purchases (5)^000 Total c/f(6)^75 000 155 000 155 000 Total b/f (6)^ 75 000
Inventory (Asset) O/ balance(1)^ 55 000 Trade a/c(3)^000 Trade a/c(4)^ 80 000
(1) This balance will remain as C55 000 for the entire period until such time as the stock count is performed.
(2) The purchases are recorded in the purchases account during the year (this account will be closed off at the end of the period to the trading account).
(3) The closing balance of the inventory account is determined at the end of the period by physically counting the inventory on hand and valuing it (C90 000). In order for the closing balance to be recorded, the opening balance of C55 000 needs to first be removed from the asset account by transferring it to the trading account.
(4) The inventory is counted and valued via a physical stock count (which is typically performed at the end of the reporting period). This figure is debited to the inventory account with the credit-entry posted to the trading account: C80 000 (16 000 x C5).
(5) The total of the purchases during the period is transferred to the trading account.
(6) The trading account effectively records the cost of sales. Whereas the perpetual system in Part A indicated that cost of sales was 65 000 and that there was a cost of theft of 10 000, this periodic system indicates that cost of sales is 75 000. In other words, the periodic system assumed that all missing stock was sold. It is therefore less precise in describing its expense but it should be noted that the total expense is the same under both systems (periodic: 75 000 and perpetual: 65 000 + 10 000). Incidentally, the inventory balance is the same under both methods: 80 000.
4.3 Gross profit and the trading account
If one uses the periodic system, the trading account is first used to calculate cost of sales. The sales account is then also closed off to the trading account, at which point the total on the trading account (sales – cost of sales) equals the gross profit (or gross loss). This total is then transferred to (closed off to) the profit and loss account together with all other income and expense accounts. The total on the profit and loss account will therefore equal the final profit or loss for the year.
If the perpetual system is used, the trading account is only used to calculate gross profit: it is not used to calculate cost of sales. The cost of sales account and sales account are transferred to (closed off to) the trading account. The total on this trading account (sales – cost of sales) represents the gross profit. This total will be transferred to (closed off to) the profit and loss account together with all other income and expense accounts. The total on the profit and loss account will therefore equal the final profit or loss for the year.
The gross profit calculated according to the perpetual system may differ from that calculated under the periodic system if, for example, stock theft went undetected. The final profit or loss calculated in the profit and loss account will, however, be the same.
The use of the trading account to calculate gross profit and how gross profits can differ is shown in this next example.
Example 3: perpetual and periodic system: stock theft and profits C Units Opening inventory balance 55 000 11 000 Purchases during the year (cash) 100 000 20 000 A stock count at year-end reflected 16 000 units on hand (cost per unit: C5). Revenue from sales totalled C95 000 for the period (cash).
Required: Show the ledger accounts and extracts of the statement of comprehensive income using: A. the perpetual system assuming that the company sold 13 000 units during the year; and B. the periodic system assuming that sales totalled C95 000.
Solution to example 3A: perpetual system: stock theft and profits
Inventory (Asset) Cost of sales (Expense) O/ balance 55 000 Cost of S 65 000 Inventory 65 000 TA (1) 65 000 Bank 100 000
Subtotal c/f
Subtotal b/f
90 000 Cost of T 10 000
C/ bal c/f 80 000 90 000 90 000 C/ balance 80 000
Cost of theft (Expense) Inventory 10 000 P&L (3) 10 000
Sales (Income) Trade Acc 95 000 (1)
Bank 95 000
Trading account (Closing account) Profit and loss account (Closing account) CoS 65 000
(1) Sales 95 000
(1) Cost: theft 10 000 (3) Trade A/c (GP)
(2)
P&L 30 000
(2) Total c/f 20 000
95 000
Total b/f 20 000 (4)
(1) Sales and cost of sales are transferred to the trading account.
(2) The total on the trading account (gross profit) is transferred to the profit and loss account.
(3) All other income and expenses are closed off at the end of the year to the profit and loss account.
C C
Revenue from sales 95 000 x Cost of sales (75 000) (x) Gross profit (4) 20 000 x
(4) Notice how the gross profit in the statement of comprehensive income is 20 000 under the periodic system but is 30 000 under the perpetual system. The final profit in both cases is, however, 20 000.
5. Measurement: cost (IAS 2.10)
5.1 Overview
The costs that one should include in (i.e. capitalise to) inventory include the (IAS 2.10):
- costs to purchase the inventory,
- costs to convert the inventory into a saleable or consumable condition; and
- other costs to bring the inventory to its present location and condition.
5.2 Cost of purchase (IAS 2.11)
The cost of inventory would include all costs directly associated with the acquisition, such as:
- purchase price,
- transport costs (inwards),
- import duties and transaction taxes that are not reclaimable * by the business, and
- other direct costs.
The following costs would be excluded from the cost of inventory:
- import duties and transaction taxes that are reclaimable * by the business,
- financing costs due to extended payment terms.
*: The acquisition of inventory very often involves the payment of transaction taxes and import duties. Sometimes these taxes or import duties (which are either paid over to the supplier or directly to the tax authority) and are able to be reclaimed at a later date from the tax authorities. If they can be reclaimed (recovered), then there is no net cost to the business. A typical example is the transaction tax levied by many countries: VAT. See chapter 3 for more information in this regard.
The following would be set-off against the cost of inventory:
- rebates received,
- trade, bulk and cash discounts received,
- settlement discounts received or expected to be received.
Only those costs that are incurred in bringing the inventory to its present location and condition may be capitalised. The following costs should therefore always be expensed:
- abnormal amounts of wastage;
- storage costs (unless these are directly attributable to the production process, e.g. the cost of storage in-between processes that is considered to be unavoidable and normal); and
- selling costs.
5.2.1 Transport Costs
There are two types of transport costs (carriage costs): transport inwards and transport outwards, each of which being accounted for differently.
5.2.1.1 Transport/ carriage inwards
The cost of transport inwards refers to the cost of transporting the purchased inventory from the supplier to the purchaser’s business premises. It is a cost that was incurred in ‘bringing the inventory to its present location’ and should therefore be included in the cost of inventory.
5.2.1.2 Transport/ carriage outwards
Frequently, when a business sells its inventory, it offers to deliver the goods to the customer’s premises. The cost of this delivery is referred to as ‘transport outwards’. It is a cost that is incurred in order to complete the sale of the inventory rather than to purchase it and may therefore not be capitalised (since it is not a cost that was incurred in ‘bringing the inventory to its present location’). Transport outwards should, therefore, be recorded as a selling expense in the statement of comprehensive income instead of capitalising it to the cost of the inventory.
Example 4: transport costs
A company purchases inventory for C100 from a supplier. No VAT was charged. The following additional information is provided: Cost of transport inwards C Cost of transport outwards C All amounts were on credit and all amounts owing were later paid in cash.
Required: Calculate the cost of the inventory and show all related journal entries.
Solution to example 4: transport costs
Calculation Cost of inventory purchased: 100 + 25 = C
Journals Debit Credit Inventory (A) 125 Trade payable (L) 125 Cost of inventory purchased on credit: 100 + 25 (transport inwards)
Transport outwards (E) 15 Trade payable (L) 15 Cost of delivering inventory to the customer
Trade payable (L) 100 Bank 100 Payment of supplier
Trade payable (L) 25 Bank 25 Payment of the transport company that transported goods from supplier
Trade payable (L) 15 Bank 15 Payment of the transport company that transported goods to the customer
5.2.2 Transaction taxes
The only time that transaction taxes (e.g. VAT) or import duties will form part of the cost of inventory is if they may not be claimed back from the tax authorities. This happens, for
(3) Notice that the inventory account reflects a balance of C14 120 and that this equals the amount paid per the bank account: 9 120 + 5 000.
5.2.3 Rebates
The entity that is purchasing inventory may receive a rebate that is somehow related to the inventory. There are many different types of rebates possible. The rule is, however, that if the rebate is received as a reduction in the purchase price, then the cost of the inventory must be reduced by the rebate. Some rebates, although connected to the inventory, are not really a direct reduction in the purchase price but a refund of certain of the entity’s costs. In this case, the rebate received should be recognised as income instead.
Example 6: rebates
An entity purchased inventory for cash. The details thereof were as follows:
C
- Invoice price (no VAT is charged on these goods) 9 000
- Rebate offered to the entity by the supplier 1 000
Required: Show the ledger accounts assuming that the terms of the agreement made it clear that the rebate: A. Was a reduction to the invoice price of the inventory; and B. Was a refund of the entity’s expected selling costs.
Solution to example 6A: rebate reducing cost of inventory
Inventory (Asset) Bank Bank 8 000 (1) Inv 8 000 (1)
(1) The rebate reduces the cost of inventory: 9 000 – 1 000
Solution to example 6B: rebate not reducing cost of inventory
Inventory (Asset) Bank Bank (1)^ 9 000 Inv (1) 8 000
Rebate received (Income) Bank 1 000 (1)
(1) The cost of inventory is shown at 9 000 even though only 8 000 is paid. This is because the rebate of C1 000 is not connected to the cost of the inventory but the entity’s future expected selling costs. The rebate is recognised as income instead because by recognising it as income, it enables the rebate income to be matched with the related selling expenses.
5.2.4 Discount received
There are a variety of discounts that you could receive on the purchase of goods:
- trade discount or bulk discount : this is usually received after successfully negotiating the invoice price down, because you are a regular customer or you are buying in bulk; and
- cash discount : this is sometimes received as a ‘reward’ for paying in cash;
- settlement discount: this is sometimes received as a ‘reward’ for paying promptly. All these discounts are deducted from the cost of the inventory. Trade discounts, bulk discounts and cash discounts are generally agreed to on the transaction date. Settlement discounts, however, will have to be estimated on the transaction date based on when the entity expects to settle its account with the creditor.
Example 7 : discounts
An entity purchased inventory. The costs thereof were as follows: C
- Marked price (no VAT is charged on these goods) 9 000
- Trade discount 1 000
Required: Show the ledger accounts assuming: A. The entity pays in cash on transaction date and receives a cash discount of C500; and B. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the entity pays within the required period of 20 days. C. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the entity pays after a period of 20 days.
Solution to example 7 A: discounts including a cash discount
Inventory (Asset) Bank Bank (1)^ 7 500 Inventory 7 500 (1)
- The marked price is reduced by the trade discount and the cash discount: 9 000 – 1 000 – 500
Solution to example 7 B: discounts including a settlement discount
Inventory (Asset) Trade payables (Liability) Bank (1)^ 7 600 Bank (2)^ 7 600 Inventory 8 000 (1) Sett Disc All
(3)
Bank Settlement discount allowance (negative liability) Tr Payable 7 (2) 600
Inventory 400 (1)
Tr Payable 400 (3)
(1) The marked price is reduced by the trade discount and the estimated settlement discount: 9 000 – 1 000 – 400 = 7 600. The settlement discount is an estimated discount until the payment is made within the required period, at which point the discount becomes an actual discount received. Until then, the creditor’s account is credited with the full amount payable and an allowance for possible settlement discount of C400 is debited (this reduces the carrying amount of the creditors presented in the statement of financial position).
(2) The entity pays within 20 days and the settlement discount becomes a reality (i.e. the estimated discount becomes an actual discount). The payment is therefore only C7 600.
Inventory (A) 6 050 Trade payable (L) 6 050 Cost of inventory purchased on credit (time value ignored because effects immaterial to the company)
31 December 20X Trade payable (L) 6 050 Bank 6 050 Payment for inventory purchased from X on 1 January 20X1 ( years ago)
Solution to example 8B: extended settlement terms: material effect
The cost of the inventory must be measured at the present value of the future payment (thereby removing the finance costs from the cost of the purchase, which must be recognised as an expense).
The present value can be calculated using a financial calculator by inputting the repayment period (2 years), the future amount (6 050) and the market related interest rate (10%) and requesting it to calculate the present value. (FV = 6 050, i = 10, n = 2, COMP PV)
This can also be done without a financial calculator, by following these steps:
Step 1: calculate the present value factors Present value factor on due date 1. Present value factor one year before payment is due
Present value factor two years before payment is due
0.90909 / (1 + 10%) or 1 / (1 + 10%) / (1 + 10%)
Step 2: calculate the present values Present value on transaction date
6 050 x 0.82645 (2 years before payment is due)
Present value one year later 6 050 x 0.90909 (1 year before payment is due)
Present value on due date Given: future value (or 6 050 x 1) 6 050
The interest and balance owing each year can be calculated using an effective interest rate table:
Year Opening balance Interest expense Payments Closing balance 20X1 5 000 Opening PV 500 5 000 x 10% (0) 5 500 5 000 + 500 20X2 5 500 550 5 500 x 10% (6 050) 0 5 500 + 550 – 6050 1 050 (6 050)
Notice that the present value is 5 000 and yet the amount paid is 6 050. The difference between these two amounts is 1 050, which is recognised as interest expense over the two years.
1 January 20X1 Debit Credit Inventory (A) 5 000 Trade payable (L) * 5 000
Cost of inventory purchased on credit (invoice price is 6 050, but recognised at present value of future amount). 10% used to discount the future amount to the present value: 6 050 / 1.1 / 1.1 or 6 050 x 0.
31 December 20X Interest expense 500 Trade payable (L) * 500 Effective interest incurred on present value of creditor: 5 000 x 10%
31 December 20X2 Debit Credit Interest expense 550 Trade payable (L) * 550 Effective interest incurred on present value of creditor: 5 500 x 10%
Trade payable (L) 6 050 Bank 6 050 Payment of creditor: 5 000 + 500 + 550
- Notice that the trade payable balance:
- At 1 January 20X1 (2 years before payment is due) is 5 000. This is calculated using the ‘present value factor for two years’: 6 050 x 0.82645 = 5 000,
- At 31 December 20X1 (1 year before payment is due) is 5 500 (5 000 + 500). This can be checked by using the ‘present value factor after 1 year’ of 0.90909: 6 050 x 0.90909 = 5 500.
- At 31 December 20X2 (immediately before payment) is 6 050 (5 000 + 500 + 550). This can be checked using the ‘present value factor for now’ of 1: 6 050 x 1 = 6 050
5.2.6 Imported inventory
When inventory is purchased from a foreign supplier the goods are referred to as being ‘imported’. A complication of an imported item is that the cost of the goods purchased is generally denominated in a foreign currency on the invoice. This foreign currency amount must be converted into the local currency using the currency exchange rate ruling on transaction date.
Example 9: exchange rates – a basic understanding
Mr. X has $1 000 (USD) that he wants to exchange into South African Rands (R).
Required: Calculate the number of Rands he will receive if the exchange rate ruling on the date he wants to exchange his dollars for Rands is: A. R5: $1 (direct method); and B. $0.20: R1 (indirect method).
Solution to example 9A: exchange rates – dollar is the base
$1 000 x R5 / $1 = R5 000 (divide by the currency you’ve got and multiply by the currency you want)
Solution to example 9B: exchange rates – Rand is the base
$1 000 x R1 / $0.20 = R5 000 (divide by the currency you’ve got and multiply by the currency you want) Since currency exchange rates vary daily, it is very important to identify the correct transaction date since this will determine both when to recognise the purchase and what exchange rate to use when measuring the cost of the inventory.
Inventory (A) $100 000 x 7,30 = R730 000 730 000 Creditor (foreign) 730 000 Purchase of inventory from New York
15 March 20X Foreign exchange loss ($100 000 x 7,50) – 730 000 20 000 Creditor (foreign) 20 000 Translation of foreign creditor on payment date
Creditor (foreign) 730 000 + 20 000 or $100 000 x 7.
Bank 750 000 Payment of foreign creditor Notice: The amount paid under both situations is R750 000 (using the spot rate on payment date). The inventory is, however, measured at the spot rate on transaction date: the transaction dates differed between part A (FOB) and part B (CIF) and therefore the cost of inventory differs in part A and part B. The movement in the spot rate between transaction date and payment date is recognised in profit and loss (i.e. not as an adjustment to the inventory asset account).
5.3 Cost of conversion (IAS 2.12 - .14)
Manufactured inventory on hand at the end of the financial period must be valued at the total cost of manufacture, being not only the cost of purchase of the raw materials but also the cost of converting the raw materials into a finished product, including:
- direct and indirect costs of manufacture; and
- any other costs necessarily incurred in order to bring the asset to its present location and condition (where even administrative overheads could be included if it can be argued that they contributed to bringing the asset to its present condition and location).
Apart from the need to know the total manufacturing cost to debit to the inventory account, it is also important to know what the manufacturing cost per unit is when quoting customers. Manufacturing costs (direct and indirect) may be divided into two main categories:
- variable costs: these are costs that vary directly or almost directly with the level of production e.g. raw materials (a direct cost that varies directly), labour and variable overheads (indirect costs that vary directly or almost directly); and
- fixed costs: these are indirect costs that do not vary with the level of production e.g. factory rental, depreciation and maintenance of factory buildings.
5.3.1 Variable manufacturing costs
Variable costs increase and decrease in direct proportion (or nearly in direct proportion) to the number of units produced (or level of production). By their very nature it is easy to calculate the variable cost per unit.
Example 11 : variable manufacturing costs
Assume that one unit of inventory manufactured uses:
- 3 labour hours (at C3 per hour) and
- 1 kilogram of raw material X (at C2 per kg excluding VAT).
Required: A. Calculate the variable manufacturing cost per unit of inventory. B. Show the journal entries for the manufacture of 10 such units assuming that the labour is paid for in cash and assuming that the raw materials were already in stock. Assume further that the 10 units were finished. Solution to example 11 : variable manufacturing costs
Calculation: variable manufacturing cost per unit C
Direct labour: 3 hours x C3 9 Direct materials: 1 kg x C2 2 Variable manufacturing cost per unit 11
Journals Debit Credit Inventory: work-in-progress 90 Bank 90 Cost of manufacture of 10 units: labour cost paid in cash (10 x C9)
Inventory: work-in-progress 20 Inventory: raw materials 20 Cost of manufacture of 10 units: raw materials used (10 x C2)
Journals continued … Debit Credit Inventory: finished goods 110 Inventory: work-in-progress 110 _Completed units transferred to finished goods ( 10 units x C11): 90
5.3.2 Fixed manufacturing costs
It is not as easy to calculate the fixed manufacturing cost per unit. The cost of inventory needs to be known during the year for quoting purposes as well as for any reports needing to be provided during the year. Since the standard requires that the cost of inventory includes fixed manufacturing overheads, we need to calculate a fixed cost per unit, which we call the fixed manufacturing overhead application rate (FOAR).
We won’t be able to calculate an accurate fixed cost per unit until the end of the year since we will only know the extent of the actual production at the end of the year. As mentioned above, however, a rate is needed at the beginning of the year for the purposes of quoting, budgeting and interim reporting. This means that a budgeted fixed overhead application rate (BFOAR) using budgeted normal production as the denominator, is calculated as an interim measure:
Fixed manufacturing overheads Normal production
The actual fixed overhead application rate (AFOAR), however, would depend on the actual level of inventory produced in any one period and can only be calculated at year-end.
Fixed manufacturing overheads Greater of: actual and normal production
5.3.2.1 Under-production and under-absorption
If the company produces at a level below budgeted production, a portion of the fixed overheads in the suspense account will not be allocated to the asset account. This unallocated overhead amount is termed an ‘under-absorption’ of fixed overheads and since it results from under-productivity, it refers to the cost of the inefficiency, which is quite obviously not an asset! This amount is expensed instead.
Example 12 : fixed manufacturing costs – under-absorption
Fixed manufacturing overheads C100 000 Normal expected production (units) 100 000 Actual production (units) 50 000
Required: A. Calculate the budgeted fixed manufacturing overhead application rate; B. Calculate the actual fixed manufacturing overhead application rate; and
