Valuation of Inventory

AS 2 and its implications
Before going into any discussion regarding any method of inventory valuation the epitome
of Indian Accounting Standard 2 (AS 2) should be understood. It says that—
(1) Inventory should normally be valued at historical cost or net realisable value whichever
is lower.
(2) Historical Cost is the combination of (a) cost of purchase; (b) cost of conversion; and (c)
any other cost incurred in the normal course of a business to bring the inventories up
to their present location and condition.
(3) Net realisable value represents the actual or the estimated selling price less cost of
completion and sale.
(4) By Products should be valued as the lower of cost and net realisable value. Consumable
stores and maintenance supplies should generally be valued at cost.
Re-usable wastes should be valued at net realisable value, if reprocessing is possible.
Goods which are not interchangeable and which are manufactured for a specific purpose
should be valued at specific costs.
Where there is a scope of analysing the difference between the Standard Cost and Actual
Cost (that is, Variance Analysis) direct costing or absorption Costing may be applied.
(5) Cost of Purchase = Purchase Price + Duties and Taxes (unless recoverable from taxing
authorities like CENVAT credit) + Other expenses directly related to the acquisition of
goods (-) Trade Discounts, Rebates, etc.
(6) Cost of Conversion includes any cost related to, production including any overhead
cost.
(7) For retail businesses, adjusted selling price (that is, selling price less gross margin of
profit) may be applied.
(8) Production Overheads should be included only to the extent which has brought the inventory
to the present condition or location. It may be illustrated as—
(a) Production Overheads may be Fixed or Variable by nature.
(b) Fixed Overheads should normally be spread over units produced on the basis of
normal capacity.
For example, if the normal capacity is 10,000 units, actual production is 6,000 units, units sold
is 5,000 units and Fixed Overhead is Rs. 30,000—
Normal Recovery Rate should be Rs.30,000 /10,000 or Rs. 3 per unit. In the case of actual production
overhead recovered becomes 6,000 × Rs. 3 or Rs. 18,000 (at normal rate). The under
recovery of Rs. 30,000 — Rs. 18,000 or Rs. 12,000 is treated as an expense of the year. For valuation
of Stock (in this case 6,000 — 5,000 = 1,000 units), Fixed Production Cost is
1,000 × Rs. 3 = Rs. 3,000.
BUT if actual production is abnormally high say 20,000 units, the overhead rate applicable for
stock valuation should be based on the actual production. It should be Rs. 30,000 / 20,000 or
Rs. 1.50 per unit.
(c) Variable Overheads should be based on the actual units produced.
(3) Inventory carried at net realisable value should be separately disclosed.