Expert Advisory Committee
ICAI-Expert Advisory Committee
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1.24   Query:  

Types of factory administration costs for inclusion in the

production overheads for inventory valuation.

 

1. A public sector company is engaged in the manufacture of earthmoving equipments for supply to various core sectors of the economy. The manufacturing operations are carried out at various divisions located in Karnataka State at Kolar Gold Fields, Mysore, and Bangalore. Each division is independent for its manufacturing activity and has its own functional departments like factory management and administration including factory personnel, administration and accounts. The overall policy making superintendence and control are provided by the corporate office located in Bangalore, where the top management team comprising chairman, functional directors and the central marketing set up, corporate personnel and administration, accounts department etc., are located.

 

2. As part of the manufacturing process, the company has huge inventory of work-in-progress and finished goods at any point of time, and these inventories, at the end of the financial year, for purposes of preparation of statement of accounts, are valued at cost or estimated realisable value, whichever is lower. The cost for this purpose includes all the overheads incurred at the division level, including factory management and administration. These overheads include expenditure on ‘Factory – Direct departments’; ‘Factory—Indirect departments’; ‘Factory-Social Overheads’; but does not include the share of expenditure of corporate office, corporate marketing offices located in Pantalone and corporate R & D offices (which undertake design and development work also) located at the KGF division. The above practice has been consistently followed and accepted by statutory auditor as well as the government auditors for purpose of review under section 619(4).

 

3. A list showing the department at factory level, the expenditure on which hitherto was treated as administrative overheads at the various divisions has been submitted by the querist for the perusal of the Committee. However, this list has been revised in 1992-93 to include only the Department of Executive Director/Chief General Manager’s Office. The expenditure on all other departments relate to manufacturing activity and is classifiable under factory overheads.

 

4. However, while reviewing the accounts for 1991-92, under section 619(4), the government auditors have pointed out that the inclusion of the administration overheads of the factory in the valuation of finished goods inventory needs review. Their opinion has emanated out of a directive issued by Comptroller and Auditor General of India on strict adherence to Accounting Standard (AS) 2, issued by the Institute of Chartered Accountants of India, by all the PSUs for purposes of uniformity as different practices were adopted by various PSUs in determination of the cost for purposes of valuation of inventories. The view of the government auditors on the valuation and replies given by the company justifying the method of valuation are also submitted by the querist for the information of the Committee. In the replies, inclusion of administration overheads for the purpose of valuation of finished goods was justified on the ground that these overheads are incurred in putting the inventories into the present state of readiness for sales and should therefore include all overheads other than selling overheads incurred only for effecting the sales. Further, the common expenditure incurred by corporate office which is common to all the divisions was not included in factory overheads as a principle of conservatism.

 

5. The querist feels that the government auditor’s point appears to be based on an opinion given by the Expert Advisory Committee earlier in the case of a machine tool manufacturing company (which included the financing charges and expenditure on the centralised service departments like finance and accounts, purchase, personnel, stores etc., i.e., corporate office expenses, in the costs for purpose of valuation of inventories). The opinion of the Committee, as per the querist, is as below:

 

a)         The procedure followed by the company for valuation of inventories is not correct.

 

b)         The recommendations contained in Accounting Standard (AS) 2 are expected to be followed in all cases, except in respect of the inventories mentioned in para 5 of the Accounting Standard reproduced above.

 

c)         The financing charges, including the financing charges on long term loans for capital expenditure, are not to be taken into account for the valuation of inventories.

 

d)       Administrative overheads and share of head office expenses, (presumably the administrative expenses), should not be included in the overheads for the purposes of valuation of inventories.

 

6. While the querist is in agreement with non-inclusion of financing charges and administrative overheads common to all divisions in costs for purposes of valuation of finished goods, the Committee has not clearly spelt out what administration overheads constitute and whether the expenditure on factory management and administration comes under the purview of the administrative overheads. The querist therefore feels that the above opinion needs to be further clarified (emphasis supplied by the querist).

 

7. In order to appreciate the problem in all its intricacies the querist has brought the following points for the consideration of the Committee:

 

(i)       Accounting Standard (AS) 2, issued by the Institute of Chartered Accountants of India, on ‘Valuation of Inventories’, has identified different types of inventory and the method of valuing each type of inventory, i.e., purchased inventory (like raw materials, components, stores and spares), processed inventory like work-in-progress and finished goods. AS 2 has indicated that inventories are normally stated at the lower of historical cost and net realisable value. The historical cost  has been defined (para 6.2) as an appropriate combination of:

 

a)         cost of purchase,

 

b)         cost of conversion, and

 

c)       other costs incurred in the normal course of business in bringing the inventories upto their present location and condition.

 

Cost of conversion indicated in the above definition has been defined (para 6.4) as consisting of:

 

i)      costs which are specifically attributable to units of production, i.e., direct labour, direct expenses and sub- contracted work; and

 

ii)         production overheads, ascertained in accordance with either the direct costing or absorption costing methods.

 

Production overheads, exclude expenses which relate to general administration, finance, selling and distribution.

 

While explaining the computation of cost of conversion, para 16 of the Standard states that:

 

“Cost other than production overheads are sometime incurred in bringing inventories to their present location and condition, for example, expenditure incurred in designing products for specific customers. On the other hand, selling and distribution expenses, general administration overheads, research and development costs and interest are usually considered not to relate to putting the inventories in their present location and condition. They are, therefore, excluded from determining the valuation of inventories”.

 

(ii)        According to the querist, the explanation given in para 16 above gives an impression that whenever the finished goods are valued at cost, the cost should not include overheads other than production overheads, as such overheads are considered not to relate to putting the inventories in their present location and condition. If such interpretation is considered as valid, it may lead to a situation where the work–in-progress and finished goods are valued at same level of costs and the general cost accounting practice of adding administration overheads in cost of production which is taken for valuation of finished goods is not recognised. The standard text books on costing indicate cost build-up step by step, i.e., factory cost (prime cost consisting of direct materials, labour and expenses + factory overheads), cost of production (factory cost +administration overheads), cost of sales (cost of production + selling overheads). The cost accounting records rules also are framed on these lines and state that the finished inventory is to be valued at the cost of production which includes production overheads. Production overheads for this purpose include all expenses relating to factory management and administration. The querist has quoted the extracts of “Guide to Cost Audit” by Sri. A. R. Ramanathan as below:

 

“Normally the valuation of the work in progress should include a share of works overheads also. The work in progress figure as reflected in the cost statements should be supported by a detailed calculation-sheet. While valuing the finished stocks, a share of administration overheads should be included preferably to the extent such overheads can be attributed to bringing the goods to such state.”

 

The querist has also quoted from International Accounting Standard (IAS) 2 on the subject, which, according to the querist, was incorporated in AS 2. According to the querist, the said standard has also accepted the inclusion of factory management and administration overheads under production overheads as below:

 

“7.      Production overhead is comprised of costs incurred for production other than direct materials and labour. Examples are indirect materials and labour, depreciation and maintenance of factory buildings and equipment and the cost of factory management and administration.”

 

(iii)       According to the querist, while the International Accounting Standard on inventory valuation and the cost accounting records rules are very clear in accepting the inclusion of the cost of factory management and administration in the costs for valuation of finished goods, the general cost accounting principal go a step further in including all the administration overheads for determining the cost of production. AS 2, however, is not clear about the acceptability of inclusion of overheads relating to factory management and administration, thereby leading to controversies in valuation of finished goods. The company in question is a little conservative in including only the factory management and administration overheads but not all administration overheads like corporate office share allocated to the divisions.

 

9. In view of the above, the querist has requested the Expert Advisory Committee of the Institute of Chartered Accountants of India to examine the matter in all its aspects and issue suitable guidelines on the valuation of inventories, more specifically to define what constitutes production overheads, to avoid the problems of interpretation by various institutions like statutory auditors, government auditors and tax authorities.

 

                                                         Opinion                                        May 4, 1993

 

1. The Committee notes that the basic issue raised by the querist relates to the inclusion of administration overheads in the historical cost for inventory valuation purposes in financial accounts. The Committee therefore restricts its opinion on this issue only.

 

2. The Committee is of the view that if different bases of inventory valuation are adopted in cost accounts and financial accounts, a statement for reconciling the value of stock as per financial books and as per cost records may have to be prepared.

 

3. The Committee notes from para 6.4 of Accounting Standard (AS) 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, that “Production overheads exclude expenses which relates to general administration, finance, selling and distribution”.

 

4. The Committee also notes para 28 of AS 2 which states as follows:

 

“Overheads other than production overheads should be included as part of the inventory cost only to the extent that they clearly relate to putting the inventories in their present location and condition”.

 

5. The Committee notes that the general principle of inclusion of overheads in determination of historical cost for inventory valuation purposes has been laid down in para 28 of AS 2, read with para 16 of the Standard (reproduced at para 7 (i) of the query). Thus, only those overheads should be considered for inventory valuation purposes, that are clearly incurred and directly related in effecting change in the location and condition of inventory items.

 

6. The Committee is of the view that in order to decide costs related to which functions/activities are clearly incurred for effecting change in the location and condition of inventories, one should go by the function or activity which is performed, rather than by the nomenclature or the place where the function/activity takes place. In other words, in case a particular function/activity is clearly related to production activity, it can be considered as part of production overheads. For example, in a highly volatile fashion industry, if the central EDP department of a company is also regularly involved in making designs and drawing of products produced in its factories, an appropriate portion of the EDP department costs should be included in the production overheads. In similar cases, appropriate portions of costs of other service departments can be considered as production overheads. The Committee is of the view that it is not feasible to lay down hard and fast rules applicable in all situations for inclusion of various elements of cost in production overheads for the purpose of inventory valuation. Thus, it is a matter of judgment, taking into account the relevant facts and circumstances of each case. However, broadly, on the basis of the above principles, various types of administration overheads should be treated in the following manner in the opinion of the Committee:

 

(i)         General administration overheads, e.g., general manager’s salary, rent of the general administration building, printing and stationery used by general administration offices etc., are not clearly incurred and directly related in effecting change in the location and condition of inventory items. Thus, these are generally not included in the historical cost for the purpose of inventory valuation.

 

(ii)        Cost of factory management and factory administration, such as, factory manager’s salary, cost of stationery, (e.g., used for preparing job cards, time sheets, plant utilisation report etc.) incurred in factory, are costs that are clearly related to production activities. These are considered part of production overheads and therefore included in historical cost for the purpose of inventory valuation.

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