Notes on Ind AS 2: Inventories

Flow Chart of the contents of the Notes:

1. What are Inventories ?

Inventories include

Finished Goods: These are the items which are held for sale in the ordinary business of the entity. These items may be manufactured or purchased by the entity.

For Example for a soap manufacturing company soap is the finished good (it is manufactured), soap is also a finished good for distributors and retailers (for them it is finished good purchased). Depending upon the position in supply chain finished goods may be manufactured or purchased.

Work In Progress: These are item which are still in the process of manufacturing or in the middle of any other process.

For example, the raw materials are issued for the manufacturing of soap and some part of the labour work is done on them. Here some work has been applied on the raw materials and they were partly converted, they we neither raw materials nor finished goods, in this stage these are termed as work in progress.

Raw Materials: These are materials or supplies which are used in the process of manufacturing or providing services. Raw materials are essentials to bring finished goods into salable condition.

For example, core materials, primary materials and other consumables (like colour and other chemicals) are termed as raw materials. 

Note: Materials for secondary packing is not inventories because these are not required to bring finished goods into salable condition. The secondary packing is done upon the request of the customer or for some advertisement purposes but these not necessary to bring the goods to salable condition.

2. Measurement

Inventories are measured at lower of the following

2.1. Cost 

2.2. Net Realisable Value

 2.1. Cost

2.1.1. Components of the cost

Finished Goods: For finished goods cost include material cost and cost of conversion i.e. it include Direct Material + Direct Labour + Direct Expense + Overheads (Variable Overheads + Fixed Overheads). Overheads include only the overheads which are directly attributable to the manufacturing of finished goods. 

Note: If actual capacity > normal capacity then fixed overheads are allocated based on the actual capacity, otherwise allocated based on normal capacity i.e. if actual capacity < normal capacity.

Work in Progress: For work in progress cost include material cost and partly incurred cost of conversion.

For example, for manufacturing of soap we require 2 hours of labour and 2 hours of machine hours, if we already incurred 1 hour of labour cost and 1 hour of machine the cost of work in progress include cost of materials issued and partly conversion cost (i.e. 1 hour labour cost and cost associated with running of machine for 1 hour).

Raw Materials: For raw materials costs include purchase price, duties or non refundable taxes, other cost incurred to bring raw materials into usable condition.

Note: GST is not included in the cost of the raw materials because we can take refund of GST paid on purchase price in the form of ITC. Freight Inward is included in the cost of raw materials because it is necessary to transport the raw materials from supplier factory to our factory to use for the production. Other costs include insurance cost, loading and unloading cost, commission or brokerage etc.

2.1.2. Joint Product and By - Products:

Joint Products: If two or more products produced with the same process of manufacturing and all products have equal important or active market then they are termed as joint products. For joint products identifiable costs incurred can be allocated to the specific product directly but common costs incurred which are not separately identifiable is allocated based on reasonable basis decided by the management using professional judgement but basis employed must be followed consistently. Here management can use any method because Ind AS has not specified any method, it has given choice to select any method.

By-Products: In some manufacturing process one or more products with insignificant or immaterial value comes as an output of main product. These insignificant or immaterial value products are known as By-Products. In this situation cost of by-products is its realizable value and the cost of the main product is cost incurred deducted by the realizable value of by-product.

2.1.3. Agricultural Produce after the point of Harvest:

This standard does not applicable to the inventory held by forest and/or agricultural producer. From this we can understand that Ind AS 2 is not applicable only to pure agricultural producer or otherwise this standard is applicable to those who are manufactures, distributors, retailers or any other business person and also to those who are both agricultural producers and business persons.

Another important point is that for agricultural produce at the point of harvest falls under Ind AS 41 but not comes under Ind AS 2. Only the agricultural produce after the point of harvest comes under this standard. 

Agricultural produce after point of harvest is measured at Fair Value Less Costs to Sell.

2.1.4. Cost Formula:

If we have large quantity of inventory and each type has different costs we use cost formula or cost technique to value the inventory.

For example here is the retailer of soaps

Sl.No	Particulars	Date	Quantity	Price	Total
1	Purchase Soaps	03-01-2021	100	30	3000
2	Purchase Soaps	13-01-2021	100	32	3200
3	Closing stock	31-03-2021	50	?	??
Under FIFO, value of inventory is (Price per unit = 32)					1600
Under Weighted Average, value of inventory is (Price per unit = (3000+3200)/200 units = 31 per soup)					1550

The above methods cannot be used by a jewellery shop because each piece of jewelry has its own value, they are not interchangeable, and each should be valued separately. Therefor methods or techniques change based on the interchangeability of the inventory, so management should exercise proper judgement based on facts and circumstances.

2.1.4.1. Inventory ordinarily Interchangeable:

Interchangeable goods are like soaps, biscuits, etc.

• Historical cost methods: Under this Inventory can be measured either as per FIFO or Weighted Average.
• Non - Historical Cost methods:
• Retail method: For retailers who maintain huge variety of goods and it is very difficult to value the inventory based on cost of each product so for them it is very useful method. Under this method cost of inventory = Sale value of the inventory - appropriate gross margin.
• Standard cost method: This method is used by the manufacturer who can determine cost of each product accurately based on past experience or nature of business. For example handbag manufacturer can determine the standard cost of the each handbag manufactured.

2.1.4.2. Inventory not ordinarily Interchangeable:

Non Interchangeable goods are like jewelry (not two chains are same and each chain has its own value and is not interchangeable) or customized goods manufactured as per the request of customer.

For this type of goods specific identification method can be used to value the inventory allocating specific identifiable and attributable cost to that specific goods.

 2.2. Net Realizable Value

Note: Net realizable value (Net realizable value = Sale Price - Costs to sell) is different from Fair Value Less Cost to Sell. Because fair value is same throughout the industry and it is industry specific but the sale price is decided by the management of the entity and it is entity specific i.e. sale price may be above or below the fair value based on facts and circumstance.

2.2.1. NRV of Finished Goods

For finished goods NRV = Sale Price of the finished goods - Costs to Sell

2.2.2. NRV of Work in Progress

For Work in Progress NRV = Sale Price of the finished goods - Costs to be incurred to to turn work in progress to finished goods - Cost to sell the finished goods.

2.2.3. NRV of Raw materials

NRV of raw material is not determinable directly because entity does not sell the raw material in the normal course of business to fix the selling price of the raw materials. So we value the inventory indirectly based on the value of the finished goods. There are two situations as follows:

Situation I: If the finished goods are sold at above or equal to cost then the inventory of the raw materials is valued at cost.

Situation II: If the finished goods are sold at below the cost then the raw materials are valued at Replacement Cost.

Note: Replacement cost is the cost at which the entity can purchase the raw materials in the market on valuation date i.e. in simple cost at which the entity can replace the inventory at the valuation date.

3. Write - Down & Reversal of Write - Down

If the cost of the inventory is higher than net realizable value then the value of inventory is written down to NRV. This write down is done through or charged to Profit & Loss Account. 

If the situations indicate that the NRV of the inventory is increased and it is above cost then the previous write down can be reversed and this reversal cannot exceed the amount which was written down previously.