How to allocate cost of conversion to inventories at abnormal levels of production?
“Can you please give us the examples of allocation of cost of conversion to the cost of inventories under normal circumstances, when low production and if abnormally high production?
I don’t understand what it means that you cannot do higher allocation if low production and reduce allocation if abnormally high production.”
Answer: Understand allocation
This question seems rather elementary, but it is very important and it requires clarification.
I’ve seen it many times: the companies simply made a calculation of how much cost should be allocated to one unit of inventories and at the end, they sometimes over-allocated or under-allocated due to different production levels and produced mess in their system.
So let me explain what the allocation is.
What is the allocation of cost of conversion?
IAS 2 Inventories says that you should also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.
Variable overheads are clear, because they vary directly with the volume of production, such as indirect materials and indirect labor.
For example, let’s say that you need one production supervisor to produce 2 ships.
If you produce 4 ships, you need 2 supervisors. The cost of this supervisor is variable overhead because the number of supervisors needed varies with the number of ships produced.
This is easy to allocate – you simply add ½ of supervisor’s cost to the cost of the ship.
Allocating fixed production overheads is more difficult.
For example, salary of a factory production manager who supervises supervisors: his salary will be the same regardless the number of ships produced.
How to allocate it?
IAS 2 says that you should allocate the fixed production overheads to the cost of inventories based on normal capacity of the production facilities .
What is the normal capacity?
It is the production expected to be achieved on average over some period under normal circumstances.
How to allocate fixed overheads
The elementary question here is: What is the actual level of production?
- If your actual level of production is about the same as normal production, then you can allocate your cost of conversion based on actual level.
- If your actual level is much lower than the normal capacity is, then you cannot allocate the costs based on actual level, but still based on the normal capacity . The remaining unallocated amount is expensed in profit or loss.
- If your actual level is higher than the normal capacity, then allocating based on normal capacity could mean that you allocated more costs than you really incurred – you cannot do it. So, you would simply allocate less per unit, based on actual production.
Illustration: Allocating costs based on different production levels
Imagine you produce sports boats. Your normal capacity is 1 000 boats per year and total cost of production is CU 2 000 per one boat, before fixed overhead.
Except for other costs, you pay employee benefits to the factory production manager amounting to CU 100 000 per year.
Hence, normally, you can allocate CU 100 000/1 000 = CU 100 as a fixed overhead to the cost of one boat.
Allocating at normal production level
If you actually produce 990 boats in a year and you allocated 99 000 CU in total, that’s fine (unless the unallocated difference of CU 1 000 is material).
The reason is that your actual production of 990 comes close to the normal capacity of 1 000.
Thus the total cost of one boat is CU 2 000 + CU 100 = CU 2 100.
Allocating at low production level
However, imagine you have a low production.
Let’s say you produced just 800 boats per year and the real incurred cost for factory production manager was CU 100 000.
You cannot allocate CU 100 000/800 = CU 125 as a cost of conversion to 1 boat, because this allocation is NOT based on normal capacity.
Instead, you should allocate CU 100 to one boat, as based on normal capacity of 1 000 boats per year.
So, you allocate only 800*100 = CU 80 000, and the remaining unallocated salary of Cu 20 000 is expensed in profit or loss.
The journal entry is then:
- Debit Inventories: CU 80 000;
- Debit P/L Employee benefits: CU 20 000;
- Credit Cash 100 000.
The total cost of one boat is still CU 2 000 plus CU 100 = CU 2 100.
Allocating at abnormally high production level
Let’s say you produced 1 200 boats instead of 1 000 because of huge one-off order from your customer.
In this case, based on normal capacity, you would allocate CU 100 * 1 200 = CU 120 000 to the cost of inventories.
But, your actual incurred cost for the salary of your production manager was just CU 100 000.
Therefore, you can allocate only CU 100 000/1 200 = CU 83 to one boat.
So, the total cost of one boat is now CU 2 000 + CU 83 = CU 2 083.
Any questions or comments? Please share them below – thank you!
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Dear madam, pls suggest :
should we allocate under or overapplied overhead proportionately on CLOSING WIP AND FG when all produced FG are not sold and some are in WIP
SHOULD WE CHARGE UNDER OR OVER APPLIED OVERHEAD TO CLOSING FG AND WIP IN Proportion
Hi Not sure if you will receive this message. We have a warehouse/distribution facility in the same facility as our manufacturing facility. The warehouse stock is mostly made up of imported or locally sourced finished goods. The company i the past allocated all these warehouse costs including store manager and stores staff to the Overheads cost of the BOM. What are your feelings on this? Does it make a difference if we do or dont?
My query is as i seen in manufacturing industry BILL OF MATERIAL (BOM) is created at initial stage only and at that time we dont know if production will exceed the normal production or not, in that scanrio how would we take fixed o/h rate at actual production nymbers(when actual production is higher than normal capacity).
Vinay, this is the matter of your system set-up. Yes, of course – BOM, or “cost cards” are often used for practical reasons because you need to account for inventories as you go. Many companies revise this at the year-end during the closing works. They revise the actual production, compare to normal capacity and make adjustment to cost of inventories/cost of sales to reflect the reality.
In this ever changing world, I wonder whether we still have the sanctity of normal production. The normal production need not be a factor of a normal business cycle. Now, business cycle can be a quarter, half year or full year. It used to be considered as one year earlier, but, now with the changing economic conditions, the normal operating cycle has undergone a change. I guess it would be fair to allocate fixed costs based on production in a normal business operating cycle rather than normal capacity. In case of the scenario that you have envisaged wherein the actual production is less, the unallocated portion is taken to the P&L a/c , whereas these are in fact these indirect production costs would have an impact on the normal operating business cycle and hence should ideally form part of the inventory cost so that comparison of ratios are accurate over different operating business cycles. Please let me know. Thanks.
thanks a lot for your comment.
I don’t think that the IAS 2 rules contradict what you wrote.
In fact, IAS 2 defines normal capacity as the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance (please see IAS 2 par. 13).
Therefore, it is not necessary to take 1 year as I did in the above examples – I did it for the sake of simplicity and illustration.
But, you can select your own normal operating cycle with planned maintenance – this is required by IAS 2, I would say. Best, S.
Which section of the P&L (COGS or G&A) are we referring to when we say that “un-allocated portion” will be taken to P&L?
*I believe we are referring to COGS, because production costs cannot go to G&A (even if they are un-allocated)
Great article as usual