Packaging batch: NRV, unabsorbed overhead and a firm order
Nuqta Packaging (Pvt) Ltd makes laminated film. At 30 June 20X5 its finished-goods ledger carries one batch of 50,000 units at a total cost of Rs 3,975,000: materials Rs 2,400,000, direct labour Rs 900,000, variable overhead Rs 300,000 and fixed production overhead Rs 375,000. Fixed overhead was absorbed at a normal capacity of 80,000 units, but the plant produced only 50,000 units; the remaining Rs 225,000 of unabsorbed fixed overhead sits in a suspense account pending the audit. The market price of the film has fallen to Rs 62 per unit because an imported substitute entered the market, and selling and distribution costs are Rs 9 per unit. Separately, the sales manager holds a signed, non-cancellable order from a distributor for 20,000 of these units at Rs 70 each. He argues that those units should not be written down at all because Rs 70 is well above the batch cost figure he has in his own working paper. The accounts for the year are being finalised.
1. Compute the carrying amount of the batch at 30 June 20X5 and explain the treatment of the Rs 225,000 unabsorbed overhead.
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Step 1 - establish cost per unit. The batch cost of Rs 3,975,000 excludes the Rs 225,000 unabsorbed fixed overhead, which is correct: overhead is absorbed on the basis of normal capacity, and the cost of abnormal idle capacity is not an inventory cost. It is expensed in the period. Cost per unit = Rs 3,975,000 ÷ 50,000 = Rs 79.50.
Step 2 - establish net realisable value (NRV). NRV is estimated selling price less costs to complete and sell. For the uncommitted units: Rs 62 − Rs 9 = Rs 53.00 per unit.
Step 3 - apply the lower of cost and NRV rule. Because Rs 53.00 < Rs 79.50, the batch is written down to NRV. Write-down = (79.50 − 53.00) × 50,000 = Rs 1,325,000, charged to profit or loss.
Step 4 - the firm order. NRV is assessed on the most reliable evidence available for the specific units. A signed, non-cancellable order at Rs 70 is better evidence than the general market price for those 20,000 units, so NRV for them is Rs 70 − Rs 9 = Rs 61.00. That is still below cost of Rs 79.50, so a write-down of Rs 18.50 × 20,000 = Rs 370,000 is still required. The sales manager's error is comparing Rs 70 with a cost figure that ignored the unabsorbed overhead; even on his own comparison the correct test is against the properly computed cost, and the answer does not change the direction of the write-down.
Total carrying amount = 20,000 × 61 + 30,000 × 53 = Rs 1,220,000 + Rs 1,590,000 = Rs 2,810,000. Disclose the write-down and the accounting policy for NRV.
2. The market price recovers to Rs 75 per unit before the financial statements are approved. May Nuqta reverse the write-down, and how much?
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A reversal is permitted, but it is not automatic and it is capped. Under the inventory standard, a new assessment of NRV must be made at each reporting date, and a reversal is recognised only if the circumstances that caused the write-down have ceased to exist. A price recovery caused by a genuine change in market conditions qualifies; a recovery caused merely by a later retail promotion or by a firm order obtained after the year end is a non-adjusting event and does not change the year-end NRV.
If the recovery is genuine and occurs before the year-end (or is an adjusting event providing evidence of conditions at the year-end), the reversal is limited to the original write-down so that the carrying amount does not exceed original cost of Rs 79.50 per unit.
For the 30,000 uncommitted units, new NRV = Rs 75 − Rs 9 = Rs 66.00. Carrying amount rises from Rs 53.00 to Rs 66.00, a reversal of Rs 13.00 × 30,000 = Rs 390,000. For the 20,000 committed units, the contract price of Rs 70 still governs NRV of Rs 61.00, so no reversal arises. Maximum possible reversal is therefore Rs 390,000, recognised in profit or loss in the period of reversal, with disclosure of the nature of the event. The remaining Rs 1,325,000 − Rs 390,000 = Rs 935,000 write-down stands.
3. The auditor proposes that the Rs 225,000 unabsorbed overhead be included in inventory “to match cost with the batch”. Assess this proposal.
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The proposal should be rejected. Inventory cost may include fixed production overhead only on the basis of normal capacity. When actual production is below normal capacity, the unabsorbed portion is not a cost of the units produced; it is a cost of under-utilisation and belongs in profit or loss. Capitalising it would defer a known loss into a future period and overstate both inventory and profit for the current year, which is precisely the treatment the standard prohibits.
There is also a presentation issue: the amount is sitting in a suspense account, which means it is currently presented as neither inventory nor expense. That is not an acceptable presentation. Before the accounts are signed, the suspense account must be cleared: Rs 225,000 transferred to cost of sales as an abnormal cost, and the reason (production of 50,000 units against normal capacity of 80,000) disclosed if material.
The auditor's language of “matching” is a useful reminder of why absorption exists, but it cannot override the capacity rule. A correct absorption calculation would have absorbed Rs 12.00 per unit (Rs 600,000 ÷ 50,000) only if 50,000 units were normal capacity. Because normal capacity is 80,000, the per-unit absorption rate is Rs 7.50 (Rs 600,000 ÷ 80,000), giving Rs 375,000 absorbed into the 50,000 units and Rs 225,000 unabsorbed - which is exactly the split already in the ledger.