Inventory Valuation & Costing

1. Profit Markup vs Profit Margin

Idea: gross profit can be worked out in two ways — as a % of cost or as a % of sales.

Name	% applied on	Pairs with
Markup	Cost of sales	Cost ✓   (Sales ✗)
Margin	Sales	Sales ✓   (Cost ✗)

Conversion formulas — learn by heart!

Put a markup in → you get a margin out. Put a margin in → you get a markup out.

Cost given + margin given ⇒ convert margin → markup.   Sales given + markup given ⇒ convert markup → margin.

Example 1 — Cost $1,000, margin 20%. Find profit & selling price

Can 20% margin be applied to cost? No (margin is on sales) ⇒ convert to markup.

Example 2 — Sales $3,000, markup 25%. Find profit & cost

Can a markup be applied to sales? No ⇒ convert markup → margin.

2. IAS 2 — Inventory Valuation

IAS = International Accounting Standards, now called IFRS (International Financial Reporting Standards). “Inventories” is the IAS word for what used to be called stock / goods.

① What are inventories?

Definition (IAS 2): inventories are assets —

• held for sale in the ordinary course of business — goods bought for sale (shoes in a shoe shop like Bata);
• in the process of production for such sale — we make the goods ourselves (Unilever making shampoo);
• in the form of materials or supplies to be consumed in production or in rendering services — school stationery (markers, dusters, pens); oil, lubricants, detergents used in the factory.

② Two key definitions

③ Measurement — the most important rule of IAS 2

This is the prudence concept in action: never overstate assets or profit. A loss expected in future is recorded immediately; a profit is not booked until the sale actually happens.

④ Cost of inventories = purchase + conversion + other costs

Part	What it contains (IAS 2 list)
Costs of purchase	Purchase price plus import duties & other taxes plus transport, handling and any other cost directly attributable to acquiring finished goods, services & materials, less trade discounts, rebates & similar amounts
Costs of conversion	(a) costs directly related to units of production — direct materials, direct labour; (b) fixed & variable production overheads incurred converting materials into finished goods, allocated on a systematic basis
Other costs	any cost needed to bring inventory to its present location (e.g. carriage inwards, freight) and condition

• Carriage inwards is part of inventory — that is why the income statement runs “opening + purchases + carriage in …”. Buy inventory $100,000 + carriage $5,000 ⇒ inventory cost $105,000.
• Import duty is added: car imported from Japan $10,000 + customs duty $5,000 ⇒ cost $15,000. Freight / shipping cost is added too.
• Discounts are deducted (trade discount, rebates) — total the costs first, then take off discounts.
• Conversion example: furniture maker buys wood and converts it into chairs/desks — labour + factory overheads (indirect labour, indirect material, rent, electricity, depreciation) all form part of cost.

⑤ When is NRV likely to fall below cost?

Assets must not be carried above what we expect to recover from sale or use. Inventory can fall below cost when items are damaged or obsolete, or costs to completion have increased. The five situations:

#	Situation	Teacher’s explanation
(a)	Increase in costs or fall in selling price	bought a large quantity at high prices, market falls, forced to sell cheaper
(b)	Physical deterioration in the condition of inventory	physically damaged goods
(c)	Obsolescence of products	out of fashion / technology goods like phones & laptops
(d)	Marketing-strategy decision to make & sell at a loss	deliberately selling at a loss to gain market share or drive a competitor out
(e)	Errors in production or purchasing	—

3. Marginal Costing & Break-even (CVP) Analysis

Marginal cost = variable (incremental) cost — the extra cost of making one more unit. Break-even analysis is part of marginal costing, also called CVP analysis = Cost – Volume – Profit.

Break-even point (BEP): the point where there is no profit and no loss. A new owner first wants to stand on his own feet (not pump money in every month); profit comes next.

① Contribution — the starting idea

Per unit ($)	Scenario 1 (FC ÷ units = 100)	Scenario 2 (FC ÷ units = 200)	Scenario 3 (FC ÷ units = 150)
Selling price	500	500	500
less Variable cost	(350)	(350)	(350)
Contribution / unit	150	150	150
less Fixed cost / unit	(100)	(200)	(150)
Profit / (loss) per unit	50 profit	(50) loss	NIL = break-even

Fixed cost per unit = Total FC ÷ total units: $100,000 ÷ 1,000 = 100; $100,000 ÷ 500 = 200; at break-even it equals 150.

② Break-even units

Verify (not needed in the exam — just to understand):

$	667 shirts	668 shirts
Sales revenue (units × $500)	333,500	334,000
less Variable costs (units × $350)	(233,500)	(233,850)
Contribution	100,000	100,150
less Fixed costs	(100,000)	(100,000)
Profit / (loss)	NIL	150

③ Break-even revenue (two ways)

• Per unit contribution ⇒ use selling price per unit below the line. Total contribution ⇒ use total sales revenue.
• 30% means: out of each $500 sale, 30% (= $150) is contribution — 30 cents per $1 of sales.
• The higher the C/S ratio the better — more contribution ⇒ more profit.
• Why 333,500 vs 333,333? Because 667 was rounded up. With unrounded 666.67 units both give 333,333.

④ Reverse working — find contribution or selling price

Owner thinks 667 units is a high break-even (higher BEP ⇒ longer to reach profit) and relaxes the target to 500 units. What must the selling price be? (FC $100,000, VC $350/unit.) Rearrange the formula:

Fewer shirts to break even ⇒ each shirt must contribute more ($200 not $150) ⇒ raise price to $550 (from $500).

⑤ Target profit

Once the business breaks even, the next aim is profit (“we are not an NGO”). Add target profit (TP) to the fixed costs — BE units become target units.

Think: 100,000 to cover fixed costs + 50,000 profit to take home = 150,000 contribution needed ÷ 150 per shirt = 1,000 shirts.

C/S ratio = contribution ÷ sales = 150 ÷ 500 = 0.3 (use total ÷ total, or per unit ÷ per unit). Method ② needs no units first.

⑥ Margin of safety (MOS)

Meaning: tells us how safe the business is from incurring a loss — how far sales can fall below plan before we reach break-even. Below that we make a loss. Bigger MOS = safer.

Version	Formula	Working
MOS units	Budgeted units − BE units	1,000 − 667 = 333 units
MOS revenue	Budgeted revenue − BE revenue	(1,000 × $500) − 333,333 = 500,000 − 333,333 = $166,667
MOS % (units)	Bud. units − BE unitsBudgeted units × 100	1,000 − 6671,000 × 100 = 33.3% (⅓)
MOS % (revenue)	Bud. rev. − BE rev.Budgeted revenue × 100	500,000 − 333,333500,000 × 100 = 33.3% (⅓)

• 333 units ⇒ if budgeted sales of 1,000 fall by 333 we are exactly at break-even (667); a fall of more than 333 ⇒ loss.
• In revenue terms: sales can drop by $166,667 from $500,000 before break-even.
• As a percentage, units or revenue give the same answer (33.3%) — budgeted sales can fall by ⅓ before a loss.

4. Overheads & Absorption Costing

① Direct vs indirect costs → overheads

• Direct costs are easily traced to a product/service: direct material, direct labour, direct expenses (e.g. royalty). Easy to charge.
• Indirect costs cannot be easily traced to a product: indirect material (IM), indirect labour (IL), indirect expenses (IE).

Problem: how do we charge a factory’s rent, a supervisor’s salary, machine depreciation to each unit (e.g. each iPhone)? Use absorption costing (= full costing): the method of charging overheads to the products manufactured / services provided.

② Step 1 — Overhead allocation

Allocation = charging the whole cost item to the cost centre / department that is responsible for it. Nothing is divided.

• Indirect material used by the finishing dept ⇒ the whole bill goes to finishing.
• Supervisor’s salary for the cutting dept (or assembly) ⇒ borne wholly by that department.

③ Step 2 — Overhead apportionment

Apportionment = dividing / sharing joint (shared) overheads among departments that are jointly responsible (no single department caused it). e.g. electricity bill, rent, depreciation of non-current assets, insurance.

Dept	Base (sq ft)	Working	Rent
Maths	300	300800 × 60,000	$22,500
Accounts	200	200800 × 60,000	$15,000
Chemistry	200	200800 × 60,000	$15,000
Others	100	100800 × 60,000	$7,500
Total	800		$60,000 ✓

The board shows rupees (Rs.) — the teacher says use any currency;uses the US dollar. Always check the total equals the original overhead.

④ Step 3 — Overhead re-apportionment

A factory has two kinds of departments:

Order: canteen first (it serves maintenance too), then maintenance (carrying the canteen’s share). Bases (given in the question): canteen — number of meals / employees; maintenance — maintenance hours (or number of calls).

$	Prod. A	Prod. B	Canteen	Maint.
Allocation	100,000	50,000	30,000	20,000
Apportionment	50,000	75,000	20,000	10,000
Allocated & apportioned	150,000	125,000	50,000	30,000
Re-apport. (Canteen)	25,000	15,000	(50,000)	10,000
Re-apport. (Maint.)	26,667	13,333	NIL	(40,000)
Total OH	201,667	153,333	NIL	NIL

Check: 201,667 + 153,333 = 355,000 = 150,000 + 125,000 + 50,000 + 30,000 ✓

⑤ Step 4 — Overhead absorption & the OAR

Absorption refers to charging overheads to the products manufactured or services provided. We use the overhead absorption rate (OAR), also called overhead recovery rate.

Budgeted overhead = estimated overhead — sometimes given, sometimes it is the total overhead left in the production department after allocation, apportionment and re-apportionment (all of which were estimates, not actual costs).

Which activity base? (units / labour hrs / machine hrs / % of cost)

As a % of cost (if only costs are given): denominator can be direct material cost, direct labour cost (recommended), prime cost, production cost… Numerator and denominator both in $ ⇒ multiply by 100.

⑥ Unit cost card — absorbing overhead into one unit

Prime cost = sum of all direct costs. Production (factory / manufacturing) cost = prime cost + production overhead. Total cost = production cost + non-production overhead (selling, marketing, distribution, advertising).

Absorbed overhead per unit = hours (or units) per product × OAR. Unit cost changes with the denominator chosen!

Unit cost card ($/unit)	OAR per unit ($10/unit)	Labour hrs (2 hrs × $10)	Machine hrs (3 hrs × $10)
Direct material	10	10	10
Direct labour	10	10	10
Direct expenses	10	10	10
Prime cost	30	30	30
Add: production overhead (absorbed)	10	20	30
Production cost	40	50	60
Add: non-production OH (selling, marketing…)	10	10	10
Total cost per unit	50	60	70

• Basic case: OAR per unit = $10 ⇒ overhead $10 ⇒ production cost 40 ⇒ total 50.
• Labour-hour base: unit takes 2 labour hrs × $10 = $20 ⇒ production 50 ⇒ total 60.
• Machine-hour base: unit takes 3 machine hrs × $10 = $30 ⇒ production 60 ⇒ total 70.

5. Over & Under Absorbed Overheads

The OAR uses budgeted (estimated) figures, but at year-end the actual overhead and activity are different — so the amount absorbed into products is usually not equal to the overhead actually incurred.

• Over-absorbed = more overhead charged to products than should have been (overcharged).
• Under-absorbed = less overhead charged to products than should have been.

Which is better — over or under? Neither!

	Problem
Over-absorbed	costs charged to products are too high ⇒ production cost (and a markup-based price) too high ⇒ in a competitive market selling price above rivals ⇒ demand falls
Under-absorbed	fixed overheads are not fully recovered ⇒ we sell below the price we could have charged ⇒ we earn less profit than we could

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