Query No. 8

Subject: 

A. Facts of the Case

1. A public sector company is engaged in refining, transportation and sale of petroleum products.  The company has various function-based divisions such as refineries, pipelines, marketing, etc.  In respect of refineries, the company has a headquarter at Delhi to coordinate and control the operations of various refineries.  The refineries headquarter functions are basically in the nature of production planning, working out crude oil requirements, monitoring of performance of the refineries on day-to-day basis, etc.  The headquarter also acts as a coordinator for crude procurement, monthly production plans, monthly dispatch plans, etc., with other divisions such as pipelines, marketing, etc.

2.  The querist has stated that these functions essentially relate to the manufacturing and refining of the products and are only an extension of the functions at the refineries.  Since the company has seven refineries, such functions have to be coordinated at a centralised place and hence the need for the headquarter.  The querist has stated that the expenditure essentially pertains to manpower cost and overheads relating to manpower.

B. Query

3. The querist has sought the opinion of the Expert Advisory Committee on the issue whether the expenses of the refineries headquarter should be included for determination of the cost of inventory of finished products.

C.  Points Considered by the Committee

4.  Paragraph 6 of AS 2 states that “the cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.”

5.  Paragraphs 8 and 11 of  AS 2 provide as under:

“8. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour.”

“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.”

6.  Paragraph 13(c) of AS 2 provides that in determining the cost of inventories, it is appropriate to exclude “administrative overheads that do not contribute to bringing the inventories to their present location and condition”.

7.  From the above, the Committee notes that as per AS 2, the cost of inventories would include such costs as are incurred in bringing the inventories to their present location and condition.  Further, overheads other than production overheads may in certain situations contribute to bringing the inventories to their present location and condition and may thus qualify for inclusion in the cost of inventories in such situations.

8.  The querist has made a reference to the activities carried out at the refineries headquarter.  In this regard, the Committee is of the view that the test for determining whether or not the cost of carrying out a particular activity should be included in the cost of inventories is whether the activity contributes to bringing the inventories to their present location and condition; the nomenclature of the activity or the place where the activity is carried out is not relevant.

9.  The Committee is of the view that the company should carry out an exercise to segregate those activities carried out at the refineries headquarter that contribute directly and clearly to the functions carried out at refineries.  The costs attributable to such activities should be included in the cost of inventories.  For example, personnel engaged in production planning, working out crude oil requirements and similar activities can be considered as contributing directly and clearly to bringing the inventories to their present location and condition.  On the other hand, general administrative functions cannot be considered as relating to bringing the inventories to their present location and condition. Accordingly, general administration overheads such as salaries of general administrative staff should not be included in the cost of inventories.  Wherever necessary, apportionment of costs between those to be included in the cost of inventories and those not to be so included should be made; such apportionment should be made on a reasonable basis.

D. Opinion

10. On the basis of the above, the Committee is of the opinion that the expenditure incurred at the refineries headquarter should be included in the cost of inventories to the extent that such expenditure relates directly and clearly to bringing the inventories to their present location and condition.  However, the general administrative overheads incurred at the refineries headquarter should not be included in the cost of inventories as they cannot be considered as relating to bringing the inventories to their present location and condition.  Such overheads should be expensed in the year of incurrence.

1Opinion finalised by the Committee on 22.4.2000.