Query No. 14 Subject: Normal capacity for the purpose of allocation of fixed overheads to cost of inventory.1 A. Facts of the Case 1. A company is engaged in transmission, processing and marketing of natural gas. Besides sale to different customers, natural gas is also used internally by the company as a major raw material for the manufacture of LPG, polymers and other value added products and also as a fuel.
2. In the context of valuation of inventories by the company, the querist has drawn the attention of the Committee to paragraph 9 of revised Accounting Standard (AS) 2, ‘Valuation of Inventories’ which provides that the allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion should be based on the normal capacity of the production facilities.
B. Query
3. The querist has sought the opinion of the Expert Advisory Committee on the issue whether the designed capacity should be considered as the normal capacity or the capacity utilisation as specified in the feasibility report of a particular project for different years should be considered for determining normal capacity. In case the answer to both is in the negative, how should the normal capacity be worked out?
C. Points Considered by the Committee
4. Paragraph 9 of revised AS 2 states, inter alia, the following:
“The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognised as an expense in the period in which they are incurred.”
5. As per paragraph 9 of AS 2, normal capacity is the level of production that an enterprise expects to achieve over a period of time under normal circumstances. The Committee is of the view that designed capacity or the capacity utilisation stated in the feasibility report may not necessarily reflect the production that is expected to be achieved over a number of years/seasons, assuming normal circumstances. The Committee is further of the view that normal capacity may be assessed taking into account the designed capacity, normal level of efficiency that is expected to be achieved considering the actual working conditions (as distinct from efficiency level based on ideal conditions) in normal circumstances, and estimated loss of production due to planned maintenance. Further, in the case of a newly commissioned plant, the normal capacity should be determined with reference to the period when the plant would reach the stage of stability. The normal capacity so determined should form the basis of allocation of fixed production overheads even during the initial years of working of the plant when the actual capacity utilisation may be lower than the normal capacity.
D. Opinion
6. Based on the above, the Committee is of the opinion that the normal capacity should be determined taking into account the designed capacity, normal level of efficiency that is expected to be achieved considering the actual working conditions in normal circumstances, and estimated loss of production due to planned maintenance. Designed capacity or capacity utilisation for different years as stated in the feasibility report of a particular project can be used for the purpose of allocation of fixed production overheads only if it approximates the normal capacity estimated in the manner specified above.
1Opinion finalised by the Committee on 22.4.2000. ________ |