Fabric That Nobody Wants and Overheads Left Out
Nova Furnishings makes made-to-order sofas. At 31 March 2025 its fabric inventory ledger shows a single line of 4,200 metres, made up of 2,700 metres bought at Rs 1,700 per metre, 900 metres bought at Rs 2,400 per metre on special terms, and 600 metres bought at Rs 1,850 per metre for a cancelled order. The 600 metres can now be sold only as scrap at Rs 300 per metre and would cost Rs 40 per metre to deliver. Fabric prices fell sharply in March; replacement cost at year end is Rs 1,500 per metre. The company uses FIFO. Also in the closing count are 40 completed sofas at a unit cost of Rs 28,000. Twelve of these were sold on 5 April under a contract signed on 20 March at Rs 34,000 each; the remaining 28 are expected to sell at Rs 31,000 each, incurring selling costs of Rs 1,200 each. Fixed production overheads of Rs 640,000 for the year have been excluded from the cost of the sofas, and the accountant proposes to write them off in full.
1. Value the fabric inventory at 31 March 2025, showing the treatment of each layer and explaining why replacement cost is not used.
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Rule applied. IAS 2 requires inventory to be measured at the lower of cost and net realisable value (NRV). NRV is estimated selling price less costs of completion and costs necessary to make the sale. Replacement cost is not the measurement basis; it is at most evidence about NRV.
| Layer | Cost | NRV | Carrying amount |
|---|---|---|---|
| 2,700 m at Rs 1,700 | 4,590,000 | No evidence NRV is below cost | 4,590,000 |
| 900 m at Rs 2,400 | 2,160,000 | No evidence NRV is below cost | 2,160,000 |
| 600 m at Rs 1,850 | 1,110,000 | 600 x (300 - 40) = 156,000 | 156,000 |
| Total | 7,860,000 | 6,906,000 |
Write-down. The 600 metres were bought for a cancelled order; there is no prospect of using them in normal production, so NRV is scrap value less delivery cost. Write-down = 1,110,000 - 156,000 = 954,000, charged to cost of sales.
Why not Rs 1,500 replacement cost? Using replacement cost would write the whole 4,200 metres down and overstate the loss. The fall in fabric prices is not by itself evidence that NRV is below cost for the 3,600 metres, because the finished sofas made from that fabric are expected to sell above their cost. The write-down must be supported by evidence about realisable value of the specific inventory, layer by layer.
FIFO note. The physical identification of the 600 metres with the cancelled order is acceptable because the metres are identifiable; FIFO does not force the newest layer to be valued at cost when it is separately identified as impaired. Where identification is impossible, apply the cost formula first and then test the resulting carrying amount against NRV.
2. Value the 40 finished sofas and justify the selling price used for the contracted and uncontracted units.
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Cost. 40 sofas x Rs 28,000 = Rs 1,120,000 (ignoring the overhead issue in the next task).
NRV, 12 contracted sofas. NRV = 34,000 - 1,200 = Rs 32,800 each, which exceeds the Rs 28,000 cost, so no write-down: carrying amount Rs 336,000 (12 x 28,000).
NRV, 28 uncontracted sofas. NRV = 31,000 - 1,200 = Rs 29,800 each, again above cost, so no write-down: carrying amount Rs 784,000.
Total: Rs 1,120,000 – no write-down is required.
Reasoning on the contract. The contract signed on 20 March fixes the price for the 12 units before the year end, so it is strong evidence of NRV at 31 March even though delivery took place on 5 April. The sale is not a post-balance-sheet event that changes the measurement; it confirms a condition that already existed. Using the contract price is also prudent and verifiable.
Consistency point. The same Rs 1,200 selling cost must be deducted from both groups; deducting it only from the uncontracted units (a common shortcut) would flatter the NRV of the contracted units. Students should also check whether the sales price is a genuine arm's-length price; if the contract price were below cost, the 12 units would be written down despite the sale being secured.
3. Evaluate the accountant's proposal to write off the Rs 640,000 fixed production overheads in full. What information would you need before finalising the figure?
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Standard. IAS 2 states that the cost of conversion includes costs directly related to the units of production, including a systematic allocation of fixed production overheads based on the normal capacity of the production facilities. Fixed overheads are absorbed into inventory, not written off just because the sofas are unsold.
Effect of the proposal. Writing off Rs 640,000 in full understates closing inventory and overstates cost of sales, understating profit and net assets. It also creates an inconsistency: the same sofas in a different month would carry a different cost, so gross margin becomes meaningless. The proposal is therefore not acceptable as a general policy.
The exception. If production was abnormally low (for example, a plant shutdown or a demand collapse), the unabsorbed overhead caused by the idle capacity is expensed and not carried into inventory. That is an exception for abnormal conditions, not a routine year-end choice.
Information needed before finalising. (1) Normal capacity in sofas or machine hours and actual production for the year; (2) the overhead absorption rate used during the year and whether it was based on budgeted activity; (3) the split of the Rs 640,000 between fixed production overheads and non-production or abnormal items; (4) whether any overheads relate to the cancelled order, which should be expensed; (5) whether the cost sheet of Rs 28,000 per sofa already includes any absorbed overhead, to avoid double counting.