IAS 2 INVENTORIES : COST OF CONVERSION

5. COST OF CONVERSION

These are production costs, such as direct labour. They also include a systematic allocation of production overheads.

Example: allocating costs Your factory provides a packaging facility. 20.000 direct labour hours are used in each period. These are allocated to each product in proportion to the number of hours that each product uses in the packaging facility. Each direct labour hour costs $10. Product 1 uses 200 hours per batch. Product 2 uses 600 hours per batch. For each batch of Product 1, you will allocate 1% of the period’s packaging direct labour costs (200/20.000*$10). For each batch of product 2, you will allocate 3% of the period’s packaging direct labour costs (600/20.000*$10).
	I/B	DR	CR
Direct labour costs-packing	I		8.000
Inventory-product 1	B	2.000
Inventory-product 2	B	6.000
Allocation of packaging direct labour costs for each batch

Fixed production overheads are those indirect costs that remain virtually unchanged at different levels of production. Examples are factory rent, management and administration.

Variable production overheads are those indirect costs that vary directly with different levels of production, such as indirect labour and indirect materials.

The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. This is the average expected output over a number of periods, taking into account production reductions due to planned maintenance.

Example: planned maintenance

Each August, you close the factory for routine maintenance and cleaning. You take account of this by dividing the fixed production overheads by the number of actual production days over the year, rather than the calendar days. On Saturdays, you work only half a day.

You calculation of actual production days should count each working Saturday as only half a working day.

Low production levels, or idle plant are not taken into account in determining the allocation rate of fixed production overheads.

Example: fire in a factory There is a fire in your factory, which stops production for 6 weeks. The fixed production overheads incurred during that time should not be included in the costs of inventory.  They should be treated as an expense for the period.
	I/B	DR	CR
Depreciation	I		9.500
Rent of factory	I		17.000
General production overheads	I	26.500
Factory overheads being charged to general overheads, when no production occurs.

Unallocated overheads are recognised as an expense in the income statement, in the period that they are incurred. In periods of abnormally-high production, the overhead allocation rate is reduced, so that inventories are not measured above cost.

Example: normal overhead allocation

You factory works overtime every night and weekends for 2 months to complete a special order.

This order is a low margin order that has a sales value of $500 per unit.

Your direct costs are $400 per unit.

Your normal overhead allocation would be $250 per unit. For this order, this level of allocation would create a loss of $150 per unit ($500-$400-$150).

Normal output of the factory = 10.000 units per week. This recovers $2.5m per week (10.000 * $250) of fixed overheads.

The new level of output is 55.000 units per week.

To recover the $2.5m overhead, the overhead allocation can be reduced to

$45.455 per unit ($2.5m/55.000)

This lower overhead allocation allows a profit of ($500-445.455) = $54.

Variable production overheads are allocated to each unit of production, based on the actual usage of the facilities.

Example: variable production overheads Your firm has a centralised production quality control. It costs $300 per productive hour to run. Charge $300 per hour multiplied by the number of hours used, to each batch of products that uses the facility. For this batch, 50 hours were used.
	I/B	DR	CR
Expenses- centralised production quality control	I		15.000
Inventory	B	15.000
Transfer of centralised production quality control costs to inventory