What goes into the cost of manufactured inventory
Which purchase, labour and overhead costs belong in a manufacturing client's inventory under IAS 2, which stay as expenses, and how to adjust at year end.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A furniture workshop counts its closing stock: finished tables and chairs in the showroom, half-built cabinets on the floor, timber and fittings in the store. The count sheet lists quantities, and someone multiplies them by the cost of the timber. The labour that turned planks into a table, and the power and machine wear that went with it, are nowhere in the figure. The closing inventory is understated, and so is the year's profit.
Other workshops make the opposite mistake and load closing stock with every cost in sight, from the owner's car to the accountant's fee. Both errors come from the same place: no clear view of what IAS 2 counts as the cost of inventory. This article sets out the categories, the costs that belong outside them, and how to correct the figure at year end.
Costs of purchase, costs of conversion and other costs
Under IAS 2, the cost of inventories includes all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Conversion costs, in the standard's words, are direct labour and production overhead.
For the furniture workshop, that gives three buckets:
| Bucket | Workshop example |
|---|---|
| Costs of purchase | Timber, board, hinges, varnish, plus freight to bring them to the workshop |
| Costs of conversion | Wages of the carpenters and finishers; production overhead such as workshop power and machine depreciation |
| Other costs to reach present location and condition | Costs specific to getting particular goods to where they are, such as moving finished pieces to the showroom |
Investopedia's description of cost of goods sold runs along the same lines: direct materials, direct labour, manufacturing overhead, freight and shipping costs, though not the cost of shipping products to customers, and other direct production costs. The exclusion matters. Delivering a finished table to a buyer is a cost of selling it, not of making it.
Direct labour and production overhead
Direct labour is the easier half. The people who physically make the product, and their employment costs, belong in conversion cost. Timesheets or production records should show which wages relate to production and which to sales or administration; a workshop where the owner both builds and sells will need a reasonable split.
Production overhead is where judgement comes in. It covers the costs of running the place where things are made: the workshop's power and water, depreciation of saws and sanders, maintenance of the production equipment, the supervisor's wages, the rent of the production floor. The test is the one in IAS 2's definition: is the cost part of converting materials into finished goods?
Spreading overhead across the goods produced needs a basis. Labour hours or machine hours are common, but the basis should reflect how the overhead is actually consumed and should be applied the same way each year. Keep the calculation, its basis and the period's production records together in the working papers, because a reviewer will want to recompute it.
Costs that stay in the income statement
Investopedia explains that operating expenses such as rent, utilities, office supplies, legal costs, sales and marketing, payroll and insurance are not directly tied to production and are reported separately from cost of goods sold. Read that list with its qualifier in mind: these are expenses that are not tied to production. The rent of the showroom and the office is such an expense; the rent of the workshop floor is production overhead. The bookkeeper's salary is administration; the carpenter's is direct labour.
Costs that typically stay in the income statement as period expenses include:
- selling costs: advertising, sales commission, delivery to customers;
- administration: office rent, accounting and legal fees, office staff;
- general insurance not specific to production;
- finance costs on general borrowings.
Overheads parked in inventory: the risk to profit
Investopedia also makes the point that costs incurred on goods not sold during the year are not included in that year's cost of goods sold. That is the mechanism behind both errors at the start of this article. Every cost placed in closing inventory is held back from this year's expenses and released next year when the goods are sold.
Understating conversion costs understates closing inventory and profit. Loading non-production overheads into inventory does the reverse: it defers ordinary expenses into next year and flatters this year's result. A client under pressure from a lender's covenant, or a director whose bonus depends on profit, has an obvious incentive to lean that way. Compare the overhead included in closing inventory with last year's, and ask for an explanation of any significant increase in the proportion absorbed.
Adjusting entries and the inventory policy
A worked example in words. The workshop's closing stock was recorded at timber cost only. The preparer calculates direct labour and production overhead for the finished and part-finished items, using the year's wage and overhead records and the chosen basis, and finds that conversion costs of a material amount are missing. The adjusting entry increases closing inventory and reduces cost of sales by that amount. Half-built cabinets need the same treatment; the extra considerations for partly completed goods are covered in valuing work in progress.
In Achekam, the correction is posted as a year-end adjusting entry in the Studio. If it turns out to be wrong, it is reversed with a record of who reversed it and why, not deleted. Note that Achekam does not calculate depreciation; it presents what is in the trial balance and flags when the charge does not agree with the accumulated depreciation movement. Production equipment depreciation used in the overhead calculation should therefore be the figure the client's trial balance holds, after that flag is cleared.
The Studio's standard policy wording is based on IFRS for SMEs and is labelled for review before issue, and staff can write the client's own. The inventory policy for a manufacturer should state that cost includes materials, direct labour and an appropriate share of production overhead, describe the basis of allocation, and name the cost formula used. Notes take their figures from the mapped trial balance.
The IFRS Foundation's IAS 2 page explains how the standard determines the cost of inventories. Once cost is settled, test it against selling prices too, as described in writing inventory down to net realisable value.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
