Explanations with Examples (IFRS for SMEs)
Inventories
I'll be using a chair business. This business manufactures chairs, and it also buys and sells chairs.
Why a chair could be inventory
- It is a tangible asset that you can touch and see.
- It can be held for sale in the ordinary course of business.
- It can have a low value, and be held for future use in the business
Some chairs are non-current assets. What's the difference?
- If a chair is used (or kept to be used at a later date) in the business, has significant value (cost), and will probably be used for more than 12 months, then it is a non-current asset (classified as property, plant and equipment)
- Even if it has significant value, or could probably be used for more than 12 months (if it's used), if it is held for sale in the ordinary course of business, then it is inventory
- If it is kept in the business without being used (for future use), and it doesn't have significant value, or probably won't be used for more than 12 months, then it is inventory, even if it's not held for sale.
Manufacture of chairs
- Raw materials: materials such as wood, metal, plastic, fabric, leather, mesh.
- Work-in-progress: a chair that you've partly made, but not completed yet
- Finished goods: a chair that you have finished making
Cost of a chair
- It has to be the lower of the cost and net realisable value.
Cost of a purchased chair
- You have to include all the costs incurred (paid or payable) to bring the chair to it's intended final location and condition. This should be the costs after any discounts received are deducted. It should not include any refundable taxes that you paid (such as, refundable sales taxes like VAT/GST).
For example, let's say you purchased 3 types of chairs. 2 units of each. Total 6 chairs.
The amounts you paid to the supplier are:
Chair Type A MVR 20
Chair Type B MVR 25
Chair Type C MVR 30
The amounts you paid for transportation to bring them to your shop is MVR 500.
Note: You have to add this to the cost of inventory only if it is significant enough and it's practical for the cost to be added. For example, you may be renting many pick-up rides to transport materials to and from your shop. In this case, trying to figure out which pick-up ride was used to transport which items to your shop may not be worth it (the cost of keeping this record is greater than the benefits received from keeping the record). So, it doesn't need to be added to cost of inventory.
How to calculate:
2 x 20 = MVR 40
2 x 25 = MVR 50
2 x 30 = MVR 60
Total initial purchase cost is MVR 150
Find the percent of the transportation cost applicable to each kind of inventory. It's preferable to add this cost proportionately, based on the initial purchase costs, so that you can incorporate both the quantities and the initial purchase unit costs.
(40 / 150) x 500 = MVR 133.33
(50 / 150) x 500 = MVR 166.67
(60 / 150) x 500 = MVR 200
Add the transportation cost to the initial purchase costs, and divide by the number of units purchased to find the cost of each unit.
40 + 133.33 = MVR 173.33 / 2 = MVR 86.67
50 + 166.67 = MVR 216.67 / 2 = MVR 108.34
60 + 200 = MVR 260 / 2 = MVR 130
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Cost of a manufactured chair
Raw materials:
The cost of raw materials should be calculated the same way that the cost of a purchased chair is calculated. It should include its initial purchase cost, and any other cost incurred to bring the raw materials to bring them to its intended location and condition. This is excluding any discounts received and any refundable taxes paid.
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Work-In-Progress:
The cost is based on the percentage of completion. Find the average cost of recently finished chairs, and consider it as the estimated cost of finished chairs. Then, estimate what percent of the chair has been completed. Multiply the estimated cost with this percent. You will get the cost of work-in-progress.
This isn't a calculation you have to do so frequently. You can do this calculation only when you're doing a stock count and finding the value of all inventories to make financial statements. You might have a software that keeps track of the progress of manufacturing a chair. If you do, it will be easier to find the cost of work-in-progress, because you can easily find out the percent of completion of each unit.
If finding the cost of work-in-progress isn't practical, you don't need to do it. For example, restaurants are manufacturing businesses. You don't need to find the percentage of a pizza that has been completed as of 11:59pm of 31st December of a year to find the year-end inventory value.
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Finished goods:
The cost is consists of cost of direct materials (raw materials) and direct labour, cost of indirect variable and fixed production overheads, and costs of other items used in production process.
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How to calculate cost of a finished chair
1. Find a typical list of quantities of raw materials needed to make a chair in your business. I don't know the exact materials, so just assume that the following list is correct (even if it doesn't make sense).
10 square inches of Fabric
15 pcs of screws
4 blocks of wood
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2. Find the total cost and quantity of each of the raw materials you purchased in the previous month (for this example, I'll say 'in the previous month', but you can use any other recent time period, such as the last 60-days or the previous quarter).
60 square inches of Fabric (Total Cost: MVR 5,000)
450 pcs of Screws (Total Cost: MVR 600)
30 blocks of Wood (Toatl Cost: MVR 3,000)
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3. Find the cost of raw materials needed to make a chair.
(MVR 5,000 / 60) x 10 = MVR 833.33
(MVR 600 / 450) x 15 = MVR 20
(MVR 3,000 / 30) 4 = MVR 400
Total cost of raw materials needed to make one chair is MVR 400.
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4. Find the number of finished chairs produced in the previous month, assuming that the operations were done in normal conditions (which means, nothing significantly different that affected production rate happened).
100 chairs were produced (finished)
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5. Find the total cost of all tools purchased for the production of chairs in the last month, and find the cost to be allocated to each chair.
2 hammers for MVR 50 each were purchased
3 screw drivers for MVR 20 each were purchased
(2 x 50) + (3 x 20) = MVR 160
MVR 160 / 100 chairs = MVR 1.6 per chair.
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6. Find the total depreciation of all fixed assets used in production of chairs for the year, and find the depreciation to be allocated to each chair.
Total depreciation for the year = MVR 20,000
Total depreciation for a month = MVR 20,000 / 12 = MVR 1,666.67
Depreciation allocated for each chair = MVR 1,666.67 / 100 = MVR 16.67
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7. Find other production overheads (general expenses incurred on the place at which production of chairs take place), and find the overhead amount to be allocated to each chair.
Electricity bill for the production site for the month: MVR 3,000
Water bill for the production for the month: MVR 2,000
MVR 2,000 + 3,000 = MVR 5,000
MVR 5,000 / 100 = MVR 50 per chair
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8. Find the salaries and wages paid for production labour (staff working on production of chairs). Exclude any salaries given on paid leaves. Find the amount allocated to each chair.
Total salaries of production site employees (excluding salaries given for paid leaves) for a month: MVR 30,000
MVR 30,000 / 100 = MVR 300 per chair.
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9. Find the total cost of a chair by adding figures from Points 3, 5, 6, 7 and 8.
400 + 1.6 + 16.67 + 50 + 300 = MVR 768.27 is the cost per chair.
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Note: Remember to keep updating the values used as "figures from the previous month".
In this example, I assumed that chairs were produced in normal capacity in the 'previous month', and there were no unusual situations where production was significantly higher or lower than usual. Fixed production overheads need to be divided by the number of chairs produced in normal capacity. Otherwise, an unfairly high cost will be allocated to each chair. In a period where production is unusually lower, charge the difference between the actual fixed cost and the allocated fixed costs, as an expense in the income statement. In the case where production is unusually higher, allocate the full fixed production overheads to the chairs, even if the cost allocated to each chair will be unusually low.
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Fixed overheads are overheads that do not change with the level of production (number of chairs produced).
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Direct labour charges
If you're able to tell by physical observation, the amount of time a labourer/staff spends in the production of an item of inventory, then you have to keep records of the time spent on by the staff on that item. This is done by keeping time sheets in which time spent by an employee on each item is recorded regularly. Then, the salaries or wages paid to the staff is allocated to each item, based on the amount of time spent by the staff on each item. You have to find the salary per minute, and multiply it by the number of minutes spent on each item. If there are any minutes on the staff's work schedule that he hasn't worked on production of any item, then the salary which relates to those minutes should be expensed.
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For example, in a construction business, you can reliably measure the time spent by each construction worker on each construction project. A building is construction is part of inventory for a construction business, because it is held to be sold in the ordinary course of business.
If the monthly salary of an employee is MVR 10,000, then the daily salary for a 30-day month would be MVR 333.33. If the employee is working 8 hours per day, the salary per minute would be MVR 0.69444. This is assuming that he is required to work 8 hours on all days of the month.
On one day of the month, the employee spent 3 hours of Project A, 3 hours on Project B, 1 hour on tasks not directly attributable to a single project, and 1 hour on lunch break. This means, his labour cost for Project A is MVR 125, and for Project B is also MVR 125. These have to be added to the costs of the project. The remaining salary for the day, which is MVR 83.33 (333.33 - 125 - 125) has to be expensed as Salary.
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Inventory held for future use
If you buy stationery or any other tangible assets to be used in the business, and if you haven't started using it, then it's inventory. You can expense them when you start using it. However, for these type of items to be recorded as inventory, it needs to be held in high enough quantity. Otherwise, you can just expense it.
For example, if your business purchased 30 boxes A4 papers for MVR 350 each, you can record MVR 10,500 as inventory. If you're using 2 boxes per month, you can expense the value of 2 every month, which is MVR 700, to an expense account like Stationery Expense.
Net realisable value and impairment
Net realisable value is the estimated selling price of an item minus estimated costs that would be incurred to sell the item. Impairment loss is the reduction in the value of an asset to ensure that the asset is not recorded at a value which is higher than the amount of money which can be received by selling it (recoverable amount).
For example, if the normal selling price of a chair that you have in your inventory is MVR 2,000, and if in order to sell the chair, you have to transport it to the customer's house by renting a pick-up for MVR 100, then the net realisable value is 2,000 - 100 = MVR 1,900.
Net realisable value can go down if a chair gets damaged. In this case, you have to find the market price at which you could sell the chair. It can also go down in mobile phone businesses. The selling prices of iPhone and Samsung mobile phones tend to be very high when they are first released into the market, and the market price drop significantly (even below the cost of purchase) within a few years. In this case, you have to lower the recorded cost of the phones to their estimated selling price every year.
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For example, if the cost of a chair in your inventory if MVR 1,500, and the net realisable value of value drops to MVR 1,300 due to it being damaged, you can to make the following double-entry.
DR IMPAIRMENT LOSS 200
CR INVENTORY 200
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After this, if the demand for this type of chair later increased a lot for some reason, and people were willing to buy even a damaged chair for MVR 1,400, then the net realisable value has gone up. So, you can increase the recorded value of the damaged chair by making the following double-entry
DR INVENTORY 100
CR IMPAIRMENT GAIN 100
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Impairment loss can be reversed like this, but it can only go up to the initial cost of the chair, which is MVR 1,500 maximum.
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Refundable taxes
This is one example. Some governments refund sales taxes. If a government wants to promote the export of certain products that are being sold in the country, the foreign importer can first pay the full purchase price with the sales tax amount to the supplier of that country, for purchase of those products. Then, the foreign importer can submit forms to that government and get back the sales tax you paid. These sales taxes cannot be included in cost of inventory.
Foreign exchange gain/loss
When inventory is purchased in a foreign currency, you're required to use the spot exchange rate (the market exchange rate at the time of transaction) to make payment. However, this is for countries with a floating exchange rate system. If a country has a fixed exchange rate system where the monetary authority sets an official exchange rate, then that rate should be used.
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In Maldives, we import goods from other countries by making payments in USD. The official fixed exchange rate set by Maldives Monetary Authority is around 1 USD = 15.42 MVR. However, we purchase USD at higher exchange rates than this. When USD is purchased at higher rates, there is a loss in the value of money (loss in purchasing power), and it leads to a foreign exchange loss. The following double entry is made at the time of USD purchase (USD 100 being purchased for the rate of 1 USD = 17 MVR)
DR CASH-USD 1,542
DR FOREIGN EXCHANGE LOSS 158
CR CASH-MVR 1,700
This loss happens at the time of USD purchase, not at the time of inventory purchase. So, the 17.00 exchange rate cannot be used to find the cost of inventory in MVR. The 15.42 exchange rate has to be used. Foreign exchange gain/loss won't affect cost of inventory to be recorded.
If inventory is purchased using that USD 100, the following double entry has to be made.
DR INVENTORY 1,542
CR CASH-USD 1,542
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Costs to be excluded from inventories
Abnormal waste:
When a chair, or anything else is being produced, some ordinary loss is expected. For example, producing a chair involves cutting fabric. Cutting fabric will lead to some pieces of fabric to be lost here and there. You cannot use absolutely 100% of the fabric. This type of waste is normal waste. It doesn't have to be expensed separately as a loss of inventory. It can be considered as just part of the item which is being produced.
However, if some significant amount of raw materials get damaged or lost, and it's not a normal expected loss to occur, then the cost of that raw material has to be expensed. For example, this is when you lose a box of screws.
Storage cost:
This is the cost of keeping inventory stored somewhere. As long as storage cost isn't required to bring an inventory item to its final intended condition, then it shouldn't be added to cost of inventory.
For example, if you're selling cupcakes, and you keep your each cupcake inside a small box until it is sold, then the cost of the box can be added to the cost of the cupcake. If you're putting the cupcake inside a box only when a customer has decided to buy a cupcake, then the cost of the box cannot be added to the cost of the cup cake.
As another example, if you're selling clothes, and you have rented a storage space (room) to keep your inventory of clothes until they are sold, you cannot add the rent of the room to the cost of the clothes.
Selling costs:
These are costs incurred to make a sale. They are usually incurred after a customer has decided to make a purchase.
For example, if a person decides to buy a burger which is on display at a cafe, and the cafe staff wrapped up the burger for the person before giving it, the cost of the wrapping paper is a selling cost.
As another example, if a customer decides to buy a chair, and chair is transported to the customer's house, the transportation charge is a selling cost.
Administrative overhead costs:
These are costs that aren't incurred directly on the production site, or directly on the items being produced in a manufacturing business.
For example, the salaries paid to sales staff, and rent paid for office space aren't related to the place where production of items take place. So, it cannot be added to cost of inventory. However, the salary paid to an administrative staff working at the production site can be added to the cost of inventory.
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Flow of Cost
When you buy a certain type of item at different costs at different times, it may not be practical to identify which unit of the item cost how much. So, cost flow assumptions should be used. There are two common types of cost flow assumptions, First-in First-out (FIFO) and Weighted Average Cost (AVCO). Last-in First-out (LIFO) is not allowed.
The items that are considered as 'certain type of items' depends on the management judgement on what type of differences in items they believe should be tracked, and will impact decision making significantly enough, if tracked separately.
For example, a business selling furniture might have an item code in their software for "Chairs". They may be selling black, red and blue chairs under that item code, because to them, the color of the chairs being sold doesn't matter, since the difference in color doesn't significantly affect sales. Then maybe after a few years, they might notice that black colored chairs are selling a lot more than red and blue chairs. At this point, they might want to start tracking each color separately. They will make item codes for "black chair", "red chair" and "blue chair". Now, each color is treated as a different type of item. Cost flow assumption will consider the costs of the items related to each item code, separately.
First-in First-out (FIFO)
FIFO assumes that the cost of the item that comes in first is the cost of the item that goes out first.
Weighted Average Cost (AVCO)
AVCO assumes that the weighted average cost of the quantities of the same type of item that are currently in the business will be the cost of the next item that goes out.
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Weighted average calculation:
Currently, the below mentioned inventory are in the business
5 blue chairs costing MVR 30 each
15 blue chairs costing MVR 25 each
10 blue chairs costing MVR 35 each
Weighted Average = ((5x30) + (15x25) + (10x35)) / (5+15+10) = MVR 29.17 per chair.
Example of FIFO and AVCO cost flow calculation
Assume that the following transactions took place
01 Jan 2023: 10 red chairs purchased for MVR 50 each
05 Jan 2023: 10 red chairs purchased for MVR 55 each
06 Jan 2023: 15 red chairs sold
08 Jan 2023: 10 red chairs purchased for MVR 45 each
09 Jan 2023: 10 red chairs taken to be used in the new office
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Using FIFO,
a. Find the cost of goods sold
b. Find the cost of chairs taken to be used in office
c. Find the cost of remaining red chairs
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This table shows calculations in brackets
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Purchases Cost of Sales Expenses Closing
01 Jan 500 (10x50) 500
05 Jan 550 (10x55) 1050 (500+550)
06 Jan 775 ((10x50)+(5x55)) 275 (1050-775)
08 Jan 450 (10x45) 725 (275+450)
09 Jan 500 ((5x55)+(5x45)) 225 (725-500)
Totals: 1,500 775 500 225
a. Cost of goods sold is MVR 775
b. Cost of chairs taken to be used in office is MVR 500
c. Cost of remaining chairs in inventory is MVR 225 (5x45)
Using AVCO,
a. Find the cost of goods sold
b. Find the cost of chairs taken to be used in office
c. Find the cost of remaining red chairs
This table shows calculations in brackets
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Purchases Cost of Sales Expenses Closing
01 Jan 500 (10x50) 500
05 Jan 550 (10x55) 1050 (500+550)
06 Jan 787.50 ((1050/(10+10))x15) 262.50 (1050-787.50)
08 Jan 450 (10x45) 712.50 (262.50+450)
09 Jan 475 ((712.50/15)x10) 237.50 (712.50-475)
Totals: 1,500 787.50 475 237.50
a. Cost of goods sold is MVR 787.50
b. Cost of chairs taken to be used in office is MVR 475
c. Cost of remaining chairs in inventory is MVR 237.50
'Total cost of inventory that came in' is equal to 'total cost of inventory that went out plus closing inventory'.
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Valuation
If you're unable to accurately determine the actual cost of goods sold, there are methods you can use to estimate a figure. These include the standard cost method, the retail method and the most recent price method.
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Standard cost method
1. Find the total amount you spent on purchase of an inventory item, and the total quantity purchased within the last 30 days (or any proper number of recent days)
2. Divide the purchase amount by the total quantity. This will give you a standard cost for each unit of that inventory item.
3. Multiply the quantities of the item sold during this month, with the standard unit cost. This will give you the cost of goods sold for the current month.
Retail price method
1. Find the total amount paid to purchase all the quantities of an item during the period.
2. Divide this purchase amount by the quantity purchased. This will give you a general unit cost of the item.
3. Divide the unit cost by the average selling price you set for the item during the period, and multiply by 100. This will give the cost-to-retail percentage.
4. Find the total sales made during the period
5. Multiply the sales by the cost-to-retail percentage. This will give the cost of goods sold.
Basically, it's using the general profit mark-up placed on products sold during the year, to find the cost of goods sold.
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Most recent price method
1. Find the cost of the item most recently obtained
2. Multiply the cost with the number of units of that item sold during the period
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Negative or excess inventory
If you have a negative inventory balance value caused due to estimations made in calculating cost of goods sold or any other reason, find the difference between the negative balance and the value of inventory in physical stock, and pass it as an income on the income statement. If you find that you have an excess inventory balance when compared to the physical inventory, expense the excess.