COGS/ Inventory Costs


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Background: Currently working at a small manufacturing company that makes machines

I have a question regarding IAS 2, specifically how the costs of inventories and COGS should be reported. Currently, the company puts all of its overheads related to production (100% of direct labour/ overheads/ materials) into COGS every month.

The company is currently not selling at 100% of it's capacity, i.e. the number of machines made and sold has not fully utilised all the labour/ rental overheads capacity etc. To me, the income statement is thus reporting only 20% (for example) capacity of sales, but matching said sales with 100% of its manufacturing overheads.

IAS 2 states that inventory costs should include a "systematic allocation of fixed and variable overheads" where "unallocated overheads are recognised as an expense in the period in which they are incurred".

My understanding of this is that overheads should be somehow allocated to the costs of inventories i.e. if only 20% of products are solds, only 20% of manufacturing overheads should be recognised in COGS, with the remainder expensed below the GP line. My thinking is that the top part of the I/S, up till the GP line is representative of the primary business activities of the company, and therefore the remainder of the overhead expenses should not be there. It would also grossly inflate the costs of inventories if only a portion of overheads went into making them, and instead we put all overhead expenses into their costs.

Anyone's opinions on this would be greatly appreciated!
 
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Werner Reisacher

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The company you are dealing with is using the "full absorption costing" under IAS 2. (under the umbrella of IFRS)
Contrary to the direct costing system, all costs that are related to the purchase and handling and conversion of materials (fixed and variables) direct labor and services, and manufacturing-related fixed and variable overhead costs are capitalized as Finished Products. Contrary to GAAP.
During times of declining productivity in a factory, the unit cost of the items produced is increasing. As an instant measure to handle this issue, you have to look at following items:

- make sure that you are not capitalizing unit costs above the net realizable value.
If this should be the case, you must, as an initial measure, start setting up "inventory reserves" to counterbalance the overstated unit costs in the inventory until you have time to correct the value of the capitalized cost on a unit by unit basis.
- you could also consider a change in the way you handle your COGS valuation by switching to an average cost system to spread the financial impact over a longer period. The LIFO method is not allowed under IFRS.

Depending on the stability of the economy in the months to come, you might consider switching to a "direct costing" method. In particular in view of the fact that all of your competitors in your business segment are faced with the same inventory problems. Overstocked inventories in a market usually lead to aggressive sales tactics and often result in price wars.

I do not quite understand the last part of your posting. When it comes to the definition "overhead cost" related to manufacturing, it only includes those costs that are directly related to the "production of products" Any items that are defined as "operating expenses" below the GP level are not involved in the valuation of product costs. I understand that you feel that your inventory valuation is a serious problem, but to correct this, you still have to stick to the rules under IFRS. Setting up Inventory Reserves being the fastest way to counteract.
 

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