Chapter 5

Inventories

TECHNICAL COMPETENCIES

1.2.2 Evaluates treatment for routine transactions

This chapter will discuss financial reporting for inventories.

Inventories include material or supplies waiting to be used, products in the process of being manufactured, and finished goods (purchased or
manufactured) that are ready to be sold.
Financial reporting for costs included in inventory will also be discussed. This chapter will explore the application of overhead to the cost of the
inventory in a manufacturing environment as well as the ongoing measurement of inventory and considerations for impairment.
0 Summary
OR0294E_FR_Inventories_SUM
1 Costs included in inventory
The general rule is that any cost incurred to move inventory from its purchased state to a point where it may be sold should be included in the
cost of inventory.
1.1 Merchandise inventory
For merchandise inventory purchased for resale, the costing of inventory is relatively straightforward. Basically, any costs incurred to bring the
inventory to its present location and condition should be added to inventory. Costs that are recovered, such as vendor rebates, would be netted
against the cost of the inventory.
Once the inventory is in a condition where it can be sold, no additional costs can be added. Storage and shipping costs to the customer are
explicitly excluded from inventory.
Examples of costs added to inventory include:
• cost of purchase
• shipping costs to receive the merchandise
• import duties and any other unrecoverable taxes
1.2 Manufacturing inventory
Where an entity turns raw materials into a new product, the process of costing the inventory is more complicated.
Examples of costs added to inventory in a manufacturing environment include:
• raw material
• direct labour
• manufacturing overhead
The amount of direct labour and manufacturing overhead costs that are required to turn raw materials into a product are known as conversion
costs.
Raw material is similar to merchandise inventory, and the same inclusions and exclusions are made to its cost.
Direct labour is added to the cost of inventory as incurred. Direct labour is straightforward and is recorded to the cost of inventory when time is
traceable to a product during the manufacturing process.
The application of manufacturing overhead costs can be more complicated and is discussed in the following sections of this chapter.
1.3 Manufacturing overhead
Overhead is composed of both variable and fixed overhead costs. Total variable overhead costs change based on the volume of production.
Total fixed overhead costs stay consistent, regardless of the volume of production.
The differences in variable and fixed overhead costs make the allocation of manufacturing overhead challenging. Both IFRS and ASPE require
the use of absorption costing to allocate overhead costs to inventory. This simply means that the overhead costs are "absorbed" by the inventory
and included in its cost.
Overhead costs include costs to operate the manufacturing facility, such as heat, electricity, depreciation of the facility, insurance, and indirect
factory labour. These costs are allocated to inventory using a predetermined overhead rate (POHR) based on a cost driver, such as units
produced or machine hours.
The POHR is determined at the beginning of the period, before manufacturing occurs. Total period overhead costs for allocation are estimated
and then divided by the normal volume of the cost driver at normal capacity. Note that an entity may use expected volume of production,
provided that this approximates normal capacity. The amount of overhead allocated to a product should not be increased as a result of low
production or an idle plant.
In an ideal situation, the allocation of the overhead costs will be close to the actual costs incurred. However, when estimates vary significantly
from the actuals, there will be an over-allocation or under-allocation of overhead.
When overhead is over- or under-allocated as a result of actuals or estimates varying, or as a result of a plant not operating at capacity, any
variance should be adjusted through cost of goods sold.
1.3.1 Test your knowledge
Green Box Inc. manufactures packaging materials for takeout meals from restaurants. At the beginning of the period, the company estimates
that there will be manufacturing overhead of $150,000. This overhead includes rent for the factory buildings, insurance, heat, and electricity. The
direct material costs include cardboard paper at $0.07 per unit and direct labour at $0.12 per unit. During the period, Green Box estimates that it
will manufacture 1,000,000 takeout boxes, which is normal capacity.
Required
What is the direct cost per unit? What is the overhead allocation cost per unit?
Answer
The direct cost per unit = $0.19 ($0.07 / unit for cardboard paper + $0.12 / unit for direct labour).
The overhead allocation cost per unit = total overhead costs divided by the expected volume of production ($150,000 / 1,000,000 units) =
$0.15/unit.
 As each takeout box is manufactured, $0.15 of overhead costs will be added to the direct costs of $0.19. The total cost of each takeout box is
$0.34 per unit.
1.3.2 Test your knowledge
Continuing with Green Box Inc., recall that the estimated overhead allocation is $0.15 / unit, based on a production of 1,000,000 units at the
beginning of the period.
Scenario 1: At the end of the year, assume that annual production was 1,000,000 units and the actual overhead cost was $175,000.
Scenario 2: At the end of the year, assume that annual production was 1,000,000 units and the actual overhead cost was $140,000.
Required
For each scenario, determine the following:
• Has overhead been over- or under-allocated?
• How can this over- or under-allocation be accounted for?
Answer
Scenario 1: Overhead of $150,000 was allocated ($0.15/unit × 1,000,000 units), but $175,000 of overhead was incurred. Overhead has been
under-allocated by $25,000. To adjust for this under-allocation, recognize that the goods sold were costed at a value lower than they should
have been. The following entry increases the cost of goods sold:

Dr. Cost of goods sold (expense account) $25,000

Cr. Manufacturing overhead (temporary

account) $25,000

Scenario 2: Overhead of $150,000 was allocated ($0.15/unit × 1,000,000 units), but $140,000 of overhead was incurred. Overhead has been
over-allocated by $10,000. To adjust for this over-allocation, recognize that the goods sold were costed at a value higher than they should have
been. The following entry decreases the cost of goods sold:

Dr. Manufacturing overhead (temporary

account) $10,000

Cr. Cost of goods sold (expense account) $10,000

Note that in both scenarios, it is assumed that all inventory has been sold in the year. If this is not the case, the over- or under-allocated
overhead should be divided between cost of goods sold and inventory.
For example, of the 1,000,000 units produced in the year, assume that 10,000 units are still in inventory at the end of the year. In Scenario 2, the
goods sold and produced were costed at a value higher than they should have been by $0.01/unit ($10,000 overhead over-allocation/1,000,000
units).
If 990,000 units are sold throughout the year and 10,000 units remain in inventory at the end of the year, then the adjusting entry is as follows:

Dr. Manufacturing overhead (temporary

account) $10,000

Cr. Cost of goods sold (expense account) $9,900

Cr. Inventory (asset account) $100

Note that many entities make the full adjustment to cost of goods sold, provided that the error in inventory is not material. Similarly, if costs are
accumulated in overhead and not allocated due to lower production from not operating at capacity, the manufacturing overhead account is
cleared out to cost of goods sold in the year incurred.
2 Inventory cost flow assumptions
When companies have a low volume of transactions of uniquely identifiable products in inventory (such as automobiles), it is easy to determine
which unit was sold. When a unit of inventory is sold, it is moved to cost of sales. This is referred to as specific identification.
However, when companies have large volumes of non-distinguishable products, they must adopt a cost flow assumption. There are two
accepted cost flow assumptions:
• first-in, first-out (FIFO) cost
• weighted average cost
When a sale is made under the FIFO cost flow assumption, the oldest inventory items are moved to cost of sales first. What remains in
inventory at the end of the year are the newest purchases of inventory. As a result, the cost of the older inventory is assigned to the cost of
goods sold, and the cost of the newer inventory is assigned to ending inventory.
Under the weighted average cost method, the weighted average cost per unit is calculated as follows: [(Beginning inventory cost + Cost of
purchases to date) / (Quantity of inventory in beginning inventory + Quantity of purchases to date)]. The weighted average cost per unit is
applied to the units in ending inventory and cost of goods sold.
3 Lower of cost or net realizable value
Inventory is carried on the balance sheet at the lower of cost or net realizable value (NRV). NRV is the value that the company could realize
through an ordinary sale of the inventory. It equals proceeds less selling costs.
Write downs of inventory to NRV are typically done on an item to item basis, but grouping similar or related product lines is permissible.
Estimates of NRV are based on the best available measure of the amount the inventories are expected to realize. This estimate is typically
based on the proceeds from a recent sale less selling costs. In some circumstances, such as for materials held for use in production, this
estimate may be based on a recent purchase price from a supplier (ie. the replacement cost).
3.1 Test your knowledge
A company has 500 units of inventory on hand with an average cost of $45 each. The most recent units sold for $40 each. Is an adjustment to
inventory necessary?
Answer
Yes, an adjustment to inventory is necessary. In this case, the cost of the inventory is $45 and the NRV is $40. As the NRV is less than the cost,
there is a write-down of $5 per unit and a total write-down of $2,500 (500 units × $5).
The journal entry to record the write-down is as follows:

Dr. Cost of goods sold $2,500

Cr. Inventory $2,500

4 ASPE differences
IFRS requires the capitalization of borrowing costs, as directed under IAS 23 Borrowing Costs. ASPE does not require borrowing costs to be
capitalized; rather, it allows companies to either capitalize borrowing costs or expense them.
5 Practice problem 1
Bonobo Chemical Limited manufactures a cleaning product called CleanTek that is used in hospitals. The company produces three batches of
CleanTek per day, 350 days per year, under normal circumstances. The standard costs per batch, based on 1,050 batches produced per year,
are as follows:

Raw material — chemicals $1,000

Wages 400

Fixed overhead 400

Total production cost per batch $1,800

At the beginning of the year, there wasn't an opening inventory of finished goods, but at the end of the year, there were 30 batches of CleanTek
on hand.
Required
1. During 20X6, Bonobo received an unusually large order of CleanTek for a hospital. To complete this order, Bonobo had to temporarily
increase output of CleanTek to 1,250 batches for the year. Determine the value of the ending inventory at the end of the year.
2. Independent of requirement 1, Bonobo experienced some equipment downtime and actual production of CleanTek was only 500
batches during the year. Determine the value of the ending inventory at the end of the year.
Answer
1. The company produced more CleanTek than it does at normal capacity, so the overhead rate must be adjusted to reflect this.
The original estimate of overhead of $400 per batch was based on normal capacity of 1,050 batches. Total overhead for the year would,
therefore, equal $420,000 ($400 × 1,050 batches).
Overhead of $500,000 was applied to 1,250 batches ($400 × 1,250 batches). Overhead has been over-allocated by $80,000 ($500,000 –
$420,000), or $64 per batch ($80,000 / 1,250 units).
The cost of the ending inventory equals $52,080 ($1,736 × 30 batches).

Raw material — chemicals $1,000

Wages 400

Fixed overhead ($400 – $64) 336

Total production cost per batch $1,736

2. The company produced fewer units during the year than expected, so the overhead cost per batch would remain the same as
calculated at the beginning of the year, as product cost does not increase for excess capacity. The cost per batch would be as follows:

Raw material — chemicals $1,000

Wages 400

Fixed overhead 400

 Total cost per batch $1,800

The cost of the ending inventory equals $54,000 ($1,800 × 30). Any unallocated overhead at the end of the year will be expensed.
6 Practice problem 2
The December 31, 20X6, inventory of Alexandra Toy Company consists of four products. At year end, the following information is provided:

Product Original Replacement Estimated Expected Normal

cost cost selling cost selling price profit on
sales

Aquaball $ 26.00 $ 22.00 $ 6.50 $ 40.00 15%

Baby guitar 42.00 40.00 8.00 48.00 25%

Computer 130.00 125.00 25.00 190.00 30%

Drum 19.00 15.80 3.00 28.00 20%

Required
What is the inventory value that should be reported for each product on December 31, 20X6?
Answer

Product NRV Cost Lower of cost

and NRV

Aquaball $40.00 – $6.50 = $33.50 $ 26.00 $ 26.00

Baby guitar $48.00 – $8.00 = $40.00 42.00 40.00

Computer $190.00 – $25.00 = $165.00 130.00 130.00

Drum $28.00 – $3.00 = $25.00 19.00 19.00

7 Supplemental Resources
There are no supplemental resources available for this chapter
8 Practice Multiple Choice Questions (MCQ) Quizzes
Log into the Knotia course in D2L, in the Content section, navigate to the volume of the eBook to find the MCQ quizzes for this chapter.

Document ID: FinRep - Chapter 5 – Inventories

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