Calderbank Foods Ltd: normal capacity, idle time and net realisable value
Calderbank Foods Ltd produces one product line at a plant with a normal capacity of 60,000 cases a year, a figure that already reflects the annual four-week maintenance refit. In the year to 31 December 20X5 it produced 48,000 cases and sold 45,000; three of the shortfall weeks were lost to an unplanned breakdown. Fixed production overhead was £600,000 and variable production cost £11 per case. Closing inventory is 8,000 cases. In December a supermarket chain cut its retail price and the market price fell to £19 per case, with costs to sell of £1.50. Calderbank has separately contracted to sell 5,000 cases to one customer in February 20X6 at £12 per case. The finance director values inventory at variable cost only, has recalculated normal capacity as 48,000 cases to avoid any unallocated overhead, and has included £80,000 of finished-goods storage costs and £45,000 of breakdown wastage in the inventory valuation.
1. Calculate the correct cost per case and the amount of fixed overhead to be expensed. Address the finance director's revised normal capacity.
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Absorption rate. IAS 2 requires fixed production overhead to be allocated on the basis of normal capacity, not actual output:
- Rate = £600,000 ÷ 60,000 cases = £10 per case
- Absorbed into production = 48,000 × £10 = £480,000
- Unallocated overhead = 60,000 × £10 − £480,000 = £120,000, expensed immediately
- Cost per case = £11 variable + £10 fixed = £21
The FD's £11 figure omits fixed overhead altogether and would defer cost into an asset that has no future benefit.
Why his 48,000 capacity is wrong. Normal capacity is the production achievable under normal circumstances and already reflects planned maintenance - the four-week refit is in the 60,000. Setting capacity equal to whatever output was actually achieved destroys the purpose of the test: nothing would ever be unallocated, and the cost of idle plant would be carried forward in inventory. The unplanned breakdown is not a reason to lower capacity either, though it is a reason to exclude the abnormal wastage (see below).
2. Value the closing inventory and respond to the argument that the fixed-price contract removes the need for a write-down.
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Inventories are measured at the lower of cost and net realisable value, and NRV is assessed item by item using the most reliable evidence of what the goods will realise.
| Group | Cases | Cost (£21) | NRV | Lower | Write-down |
|---|---|---|---|---|---|
| Contract stock | 5,000 | 105,000 | 5,000 × £12 = 60,000 | 60,000 | 45,000 |
| Remainder | 3,000 | 63,000 | 3,000 × (£19 − £1.50) = 52,500 | 52,500 | 10,500 |
| Total | 8,000 | 168,000 | 112,500 | 55,500 |
Closing inventory = £112,500.
The contract argument fails. A contract price of £12 against a cost of £21 does not protect the inventory from write-down - it proves the loss. The contract is the best available evidence of the amount those 5,000 cases will realise, so it is used in preference to the £19 market price. What the FD is really proposing is offsetting the good news on some stock against the bad news on other stock, which IAS 2 does not permit: NRV is tested on groups of similar items, and losses are not netted against unrealised gains.
3. Explain the treatment of the storage costs, the breakdown wastage and the idle capacity, and quantify the effect of the errors.
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Storage costs - £80,000 expensed. IAS 2 excludes storage costs from the cost of inventory unless storage is necessary in the production process before a further production stage. Finished-goods warehousing is a distribution cost, so it is expensed as incurred.
Abnormal wastage - £45,000 expensed. The cost of abnormal amounts of wasted materials, labour or other production costs is excluded from inventory cost. The breakdown was unplanned, so the wasted output is not a normal cost of production and cannot be carried forward.
Idle capacity - £120,000 expensed. The unallocated overhead is a period cost. The FD's adjustment of normal capacity to 48,000 would have raised the absorption rate to £12.50 per case and lifted cost per case to £23.50, inflating inventory and improving profit by deferring a real loss.
Overall effect of the FD's valuation: he would carry storage and wastage forward (£125,000), absorb all £600,000 of overhead into stock, and ignore the net realisable value test, overstating both inventory and profit by well over £200,000. Note that the inventory write-down of £55,500 and the expensed costs above are separate adjustments and must not be double-counted.