Which one of the following costs is generally not included in computing the cost of inventory ?

Correct — A, (a) Administration overheads. The booklet sets 'not' in bold italic, and the governing text is Accounting Standard 2, Valuation of Inventories.

AS 2 builds the cost of inventories from three components: the costs of purchase, the costs of conversion, and OTHER COSTS incurred in bringing the inventories to their PRESENT LOCATION AND CONDITION. That last phrase is the test everything else follows from. A cost enters inventory if it was necessary to get the goods to where and what they are; a cost that was incurred for some other purpose does not, however genuinely it was incurred.

The standard then names the exclusions expressly. Costs excluded from the cost of inventories and recognised as expenses of the period in which they are incurred are:

abnormal amounts of wasted materials, labour or other production costs; storage costs, UNLESS those costs are necessary in the production process prior to a further production stage; ADMINISTRATIVE OVERHEADS THAT DO NOT CONTRIBUTE TO BRINGING THE INVENTORIES TO THEIR PRESENT LOCATION AND CONDITION; selling and distribution costs.

Administration overheads are therefore the answer, and the word the stem uses — 'generally' — is exactly right, because the exclusion is not absolute. General office and management costs do not touch the goods and are period costs; an administrative cost that does contribute to bringing inventories to their present location and condition would be included. As a general rule, and as the paper's 'generally' signals, administration overheads stay out.

The other three options are each on the inclusion side of the same standard, and the notes below give the reasoning for each. Two of them are drafted to test the exact wording of an exclusion — normal against abnormal wastage, and storage that is part of the production process against storage that is not — which is why AS 2 has to be read in its own words rather than summarised as 'production costs in, other costs out'.

Why the others are wrong

• (b)All cost of purchase — All cost of purchase is INCLUDED, and it is the first component AS 2 names. The costs of purchase comprise the purchase price, duties and taxes other than those subsequently recoverable by the enterprise from the taxing authorities, freight inwards and other expenditure directly attributable to the acquisition — less trade discounts, rebates, duty drawbacks and other similar items, which are deducted in determining the cost. The two qualifications are worth carrying: recoverable taxes are excluded because they never become a cost to the enterprise, and trade discounts and rebates are netted off. Everything else that had to be paid to get the goods into the buyer's hands is part of their cost.
• (c)Normal wastage of materials — NORMAL wastage is included, and the word 'normal' is what decides it. Waste that is inherent in the process — evaporation, shrinkage, off-cuts, ordinary spoilage within accepted tolerances — is unavoidable if the good units are to be produced at all, so its cost is absorbed by the units that survive and the cost per good unit rises accordingly. What AS 2 excludes is 'abnormal amounts of wasted materials, labour or other production costs', which are charged to the profit and loss account of the period as a loss rather than buried in the value of stock. Capitalising an abnormal loss would carry a genuine loss forward into the next year disguised as an asset, which is why the standard singles it out. The option says normal, so it belongs inside the cost.
• (d)Storage cost assuming a special storage is required as part of production process — This is storage that IS included, and the option is worded to say so. AS 2 excludes storage costs 'unless those costs are necessary in the production process prior to a further production stage' — so storage that is a step in production is inside the cost of inventories, and storage of finished goods awaiting sale is outside it. The classic instances of the exception are goods that must mature or season before the next stage: whisky in cask, wine in barrel, timber left to dry, cheese ripening. In each the storage is not a delay but a process, and the cost of it is as much a part of making the product as the labour that put it there. The option's phrase 'assuming a special storage is required as part of production process' places it squarely within the exception.

AS 2, Valuation of Inventories, answers two questions: at what amount inventories are carried, and what goes into that amount. The first answer is the lower of cost and net realisable value, net realisable value being the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. The second answer is built in three parts. COSTS OF PURCHASE: purchase price, duties and taxes other than those recoverable from the taxing authorities, freight inwards and other directly attributable expenditure, less trade discounts, rebates and duty drawbacks. COSTS OF CONVERSION: direct labour, plus a systematic allocation of fixed and variable production overheads, the fixed overheads being allocated on the basis of the NORMAL CAPACITY of the production facilities so that idle capacity does not inflate the value of stock. OTHER COSTS: only to the extent they are incurred in bringing the inventories to their present location and condition. Against these stand the four express exclusions — abnormal waste, storage costs not required by the production process, administrative overheads that do not contribute to bringing inventories to their present location and condition, and selling and distribution costs. AS 2 also permits only two cost formulae for items ordinarily interchangeable: first-in first-out and weighted average cost. Specific identification is required where the items are not ordinarily interchangeable or are segregated for a specific project. The standard requires disclosure of the accounting policies adopted, including the cost formula used, and of the total carrying amount of inventories with the classifications appropriate to the enterprise.

Key facts

• AS 2 — the cost of inventories comprises the costs of purchase, the costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
• Costs expressly excluded and recognised as expenses of the period: abnormal amounts of wasted materials, labour or other production costs; storage costs unless necessary in the production process prior to a further production stage; administrative overheads that do not contribute to bringing inventories to their present location and condition; and selling and distribution costs.
• Costs of purchase include the purchase price, duties and taxes other than those recoverable from the taxing authorities, freight inwards and other directly attributable expenditure, less trade discounts, rebates and duty drawbacks.
• Costs of conversion include direct labour and a systematic allocation of fixed and variable production overheads.
• Fixed production overheads are allocated on the basis of the normal capacity of the production facilities, so that idle capacity does not inflate inventory.
• Normal wastage is absorbed by the good units produced; abnormal wastage is written off to the profit and loss account.
• Inventories are valued at the lower of cost and net realisable value.
• AS 2 permits first-in first-out and weighted average cost as formulae for interchangeable items; specific identification applies where items are not ordinarily interchangeable or are segregated for a specific project.

Common traps

• Answering the positive question. Three of the four options are includable costs.
• Reading past the qualifier. 'Normal' wastage is in, abnormal is out; storage that is part of production is in, storage of finished goods is out.
• Treating administrative overheads as an absolute exclusion. The standard excludes those that do not contribute to bringing inventories to their present location and condition.
• Forgetting that recoverable taxes are excluded from the cost of purchase and that trade discounts are deducted.

• practice — not a real PYQ

  Under AS 2, storage costs form part of the cost of inventories :

  • (a)In all cases, since the goods must be stored
  • (b)Never, since storage occurs after production
  • (c)Only where they are necessary in the production process prior to a further production stage
  • (d)Only where the goods are stored for more than one accounting period

  Answer(c) Only where they are necessary in the production process prior to a further production stage

• practice — not a real PYQ

  Under AS 2, fixed production overheads are allocated to the cost of conversion on the basis of :

  • (a)Actual production of the period
  • (b)Maximum theoretical capacity of the plant
  • (c)Normal capacity of the production facilities
  • (d)Budgeted sales for the period

  Answer(c) Normal capacity of the production facilities