Inventory and production cost
What the domain tests
You must prepare a manufacturing account to find cost of production, apportion production overheads, and value inventory using the lower of cost and net realisable value. The exam also tests the link between the manufacturing and trading accounts.
Manufacturing account structure
- Direct materials consumed = opening raw materials + purchases + carriage inwards on materials − closing raw materials.
- Prime cost = direct materials consumed + direct labour + direct expenses.
- Cost of production = prime cost + production overheads + opening work in progress − closing work in progress.
Production overheads include factory rent, factory depreciation, factory power and factory supervision. Administration, selling and distribution costs are not production costs; they are charged in the profit and loss account. The cost of production is transferred to the trading account, where it is treated like purchases and adjusted for opening and closing finished goods inventory.
Inventory valuation
The inventory teaching model here uses the lower of cost and net realisable value, consistent with the general IAS 2 overview; the target syllabus may prescribe its own detailed reporting framework. Cost includes purchase price, import duties, transport and directly attributable production overheads. Net realisable value is estimated selling price less costs to complete and sell. FIFO and weighted average cost are acceptable cost formulas; LIFO is not permitted under IFRS.
Worked example
Raw materials: opening 100,000; purchases 500,000; closing 150,000. Direct labour 300,000; factory overheads 200,000; work in progress: opening 40,000, closing 60,000.
- Materials consumed = 100,000 + 500,000 − 150,000 = 450,000.
- Prime cost = 450,000 + 300,000 = 750,000.
- Cost of production = 750,000 + 200,000 + 40,000 − 60,000 = 930,000. If 500 units cost 2,000 each but can be sold for 2,100 with selling costs of 300 per unit, NRV is 1,800, so inventory is valued at 900,000 and the loss of 100,000 is recognised.
Traps
Do not include selling and administration costs in production overheads. Closing work in progress is deducted, not added. Do not value inventory at selling price when NRV is lower than cost. Opening finished goods inventory belongs in the trading account, not the manufacturing account.