A. Facts of the case

1. A company has three independent production units located at different places.  Each unit has  finance, administration, personnel, purchase and other departments.  Besides the production units, there are registered/head office, marketing division, engineering and design division and fabrication division.  The company has included in the cost of inventories the expenses incurred for the finance, administration, personnel, purchase and other departments related to production of units.  However, the expenses of the registered/head office and marketing division have not been included.

2. The company has given the following reasons for including finance, administration, purchase costs as costs of inventories.  The company has three production divisions, one marketing division, one head office/corporate office, one engineering and design division and one fabrication division.  It has separate accounts for each activity/division.  The finance, administration, and purchase, referred to in paragraph 1 above, are functions attached to the manufacturing activity. A production division is headed by a General Manager who is actually the Works Manager, supervising the activity of manufacture of the product.  The finance, administration and personnel are all located at the manufacturing site and are directly related to the production of the particular product in that manufacturing division and, therefore, contribute to bringing the inventories to their present location and condition as stated in paragraph 13(c) of Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India.  Activities such as secretarial, legal, public relations and general administration are managed by the head office/corporate office and all expenses incurred by such departments are excluded in the valuation of inventories.  Hence, the practice of the company of excluding only general administration overheads for valuation of inventories is in order.

3. The statutory auditors of the company disagreed with the method of valuation of inventories adopted by the company.  According to the auditors, the administration and other indirect expenses incurred at the production sites for the production only can be treated as cost of inventory. The expenses incurred for the finance/administration/ purchase/personnel and other departments of the unit are all indirect expenses and general in nature and, therefore, do not contribute to bringing the inventory to their present location and condition as stated in paragraph 13(c) of AS 2.

B. Query

4. The querist has sought the opinion of the Expert Advisory Committee as to whether the inclusion of cost related to finance/administration/ purchase/personnel departments incurred at the unit where the production facilities are located in the cost of inventories is appropriate for the purpose of valuation thereof.

C. Points Considered by the Committee

5. The Committee notes that paragraphs 11 and 13 of AS 2 state as below:

“11. Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific customers in the cost of inventories.”

“13. In determining the cost of inventories in accordance with paragraph 6, it is appropriate to exclude certain costs and recognise them as expenses in the period in which they are incurred.  Examples of such costs are:

(a)   abnormal amounts of wasted materials, labour, or other production costs;

 

(b)   storage costs, unless those costs are necessary in the production process prior to a further production stage;

 

(c)   administrative overheads that do not contribute to bringing the inventories to their present location and condition; and

 

(d)   selling and distribution costs.”

6. Generally, organisations having various production sites, have a head office/corporate office which takes care of the finance, personnel, general administration, etc., of the organisation as a whole.  Such production sites may also be having their own finance and personnel divisions whose activities might be restricted only to the particular factory/production site concerned.  For example, the personnel division at the production site might be involved only in recruitment of workers locally as per the overall company policy laid down by the head office.  In such a case, the cost of activities being carried out at the factory site relating to personnel would amount to expenses incurred in bringing the inventories to their present location and condition and, therefore, would form part of cost of inventories, whereas the corporate finance, personnel and general administration for the company as a whole being carried out by the head office would not be directly related to bringing the inventories to their present location and condition and thus would not form part of cost of inventories.  On the other hand, there may be an organisation whose production sites act as if they are independent units in respect of performance of functions such as finance, personnel, etc.  In other words, there could be units having finance, personnel and other divisions that carry out the activities which are normally carried out by a head office.  Such activities at the units cannot be said to be directly related to bringing the inventories to their present location and condition and their related costs should not form part of cost of inventories.  Thus, the cost incurred by finance, personnel and purchase divisions to the extent they are directly related to the production unit would be the cost which could form part of the cost of inventory. In this given case, the Committee presumes that the production sites of the company in question do not perform finance, personnel, etc., functions as if they are independent units.

D. Opinion

7. On the basis of the above, the Committee is of the opinion that keeping in view the presumption stated in paragraph 6 above, the cost of activities carried out at the production sites of the company should form part of the cost of inventories.

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1Opinion finalised by the Committee on 17.1.2001.