B. Query

5. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

        (i) Whether rent, electricity and salary of the personnel working for footwear distribution centres (DCs) where merchandise are branded, packed and stored primarily before despatch towards retail point of sales, should be considered in determining cost of footwear inventory at DC level. (Emphasis supplied by the querist.)

       (ii) As the company is operating through ‘Hub ‘n Spoke’ module, whether, carriage inwards cost and loading and unloading costs incurred at footwear retail outlet points in bringing the inventories to their present condition and location, on being despatched from distribution centers, should be included in determining cost of inventory at footwear retail level. (Emphasis supplied by the querist.)

        (iii) Whether rent and part of electricity charges that is directly relatable to footwear storage, paid for footwear retail outlets where merchandise has to be stored, as per retail industry business practices, irrespective of merchandise type/nature, time of sale, quantum of sale, should be considered in determining cost of inventory at footwear retail level. It is also to be considered that goods have to be kept and maintained at retail store for a considerable time before sale. (Emphasis supplied by the querist.)

        (iv) Whether rent, electricity charges and salary of procurement and merchandising staff should be considered in arriving at landed cost of merchandise held at LFR–DC. [At LFR - DC major activities are (a) branding, (b) tagging, (c) packing (d) storing and (e) despatch to LFR retail store.] (Emphasis supplied by the querist.)

       (v) Whether rent, salary of logistics staff and portion of electricity charges that is directly relatable to merchandise storage at LFR store should be considered in arriving at landed cost of merchandise held at LFR store. [At LFR store major activities are (a) merchandise supply chain management at store level, (b) storing, (c) merchandise display and (d) sale. In LFR business, numerous and variety of merchandise, backed by intelligent logistics support, has to be maintained and carried at store level as per industry demand.] (Emphasis supplied by the querist.)

C. Points considered by the Committee

6. The Committee notes that the basic issue raised by the querist relates to inclusion of certain items as costs of inventories in distribution centres (hereinafter referred to as ‘DCs’) and retail outlets of Footwear and LFR businesses. Therefore, the Committee has examined only this issue and has not examined any other issue that may be contained in the Facts of the Case, such as, valuation of inventories, cost formula, etc. Further, the Committee restricts itself to the specific activities mentioned by the querist in the issues raised. The Committee also notes that the querist has used the expression ‘landed cost of merchandise’ in the Facts of the Case without explaining its meaning. The Committee, in its opinion given hereinafter, has considered the expenses referred to in this regard from the point of view of whether the same should be included in the cost of inventories concerned.

7. The Committee notes that the Institute of Chartered Accountants of India has issued Accounting Standard (AS) 2, ‘Valuation of Inventories’, which has also been notified by the Central Government under the Companies (Accounting Standards) Rules, 2006. The Committee notes the following paragraphs from AS 2:

       “6. 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.

        Costs of Purchase

        7. The costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.

       Costs of Conversion

        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…”

       “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.”

8. From the above, the Committee notes that as per AS 2, the cost of inventories would include costs other than cost of purchase and cost of conversion as are incurred in bringing the inventories to their present location and condition. 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 term ‘distribution costs’ referred to in paragraph 13(d) of AS 2 reproduced above read with paragraph 6 of AS 2, should be construed as distribution costs which are incurred by the seller in making the goods available to the buyer from the point of sale. In other words, distribution costs used in the expression ‘selling and distribution costs’ would include only those costs which are incurred for moving the goods from the premises of the seller, whether from the factory or DCs or retail outlets to the premises of the buyer. It does not include the cost of moving the goods from the factory to DCs or from DCs to seller’s retail outlets before sale.

10. The querist refers to the activities of the Footwear DCs as branding (seems to be for purchased items), packing and storing before despatch to retail outlets. The Committee is of the view that rent, electricity and salary of the personnel working for Footwear DCs are, in effect, product costs to the extent they are related to branding because these are incurred in changing the condition of the product from unbranded to branded. Since these expenses are incurred in bringing the inventory to a saleable condition, i.e., branded condition as intended by the management, the same should be included in the cost of footwear inventory in accordance with paragraph 6 of AS 2. The Committee also notes that the above-mentioned expenses are storage cost to the extent these are related to storage activity. Since the footwear merchandise at the DCs are already finished goods requiring no further processing, the storage cost incurred at the DCs is not of the type which is necessary in the production process prior to a further production stage. Hence, inclusion of such storage cost in the cost of footwear inventory at DC level is prohibited by paragraph 13(b) of AS 2. As regards packing, the treatment of the aforesaid expenses related to packing depends on whether packing material cost itself is includible in the cost of inventories or not, which, in turn, depends on the nature of packing.

11. As regards carriage inwards cost and loading and unloading costs incurred at footwear retail outlet points in bringing the inventories to their present condition and location, on being despatched from DCs, the Committee is of the view that the same should be included in the cost of inventories at retail footwear level as required by paragraph 11 read with paragraph 6 of AS 2, whether or not ‘Hub ‘n Spoke’ module is operated. For the reasons stated in paragraph 9 above, the Committee is of the view that these are not ‘distribution costs’ mentioned in paragraph 13(d) of AS 2.

12. The Committee notes that at the footwear retail outlets, the footwear merchandise are already finished goods requiring no further processing. Hence, the cost of storing such goods in the retail outlets is not of the type which is necessary in the production process prior to further production stage. Hence, rent and part of electricity charges, whether or not directly relatable to footwear storage, paid for footwear retail outlets should not be included in the cost of footwear inventory at the retail level as the inclusion of the same is prohibited by paragraph 13(b) of AS 2.

13. The querist states that at the LFR – DC (which is the central warehouse), major activities are (a) branding, (b) tagging, (c) packing (d) storing and (e) despatch to LFR retail store. All merchandise at LFR-DC are meant for despatch to retail outlets. The Committee is of the view that to the extent the activities of the procurement and merchandising staff are related to branding, the salary of staff would be product costs for the reasons stated in paragraph 10 above and, hence, should be considered in arriving at the cost of inventories held at LFR-DC. Further, the Committee is of the view that to the extent their activities are related to tagging, their salary would also be product costs. In reaching this conclusion, the Committee presumes that ‘tagging’ refers to attaching a tag containing price and dimension details etc., to the product as required under various laws, such as the Standards of Weights and Measures Act, 1976 and, therefore, the Committee is of the view that to attach a tag is a legal requirement to bring the product to a saleable condition and is not an activity to promote sales. To the extent the activities of the procurement and merchandising staff are related to packing, the treatment of their salary depends on whether the packing material cost itself is includible in cost of inventories or not, which, in turn, depends on the nature of packing. Since no further processing activity takes place in LFR-DC, storage costs incurred at LFR-DC are not of the type which is necessary in the production process prior to further production stage. Inclusion of the same in the cost of inventories is prohibited by paragraph 13(b) of AS 2. Hence, to the extent, the activities of the procurement and merchandising staff are related to storage activities at LFR-DC, their salary should not be considered in arriving at the cost of inventories held at LFR-DC. For the reasons stated in paragraph 9 above, despatch to retail outlets is not a distribution activity. To the extent the activities of the procurement and merchandising staff are related to despatch to retail stores, their salary should not be considered in arriving at the cost of inventories held at LFR-DC which are meant for despatch to retail stores. However, such cost should be considered in arriving at the cost of inventories held at retail outlets as required by paragraph 11 read with paragraph 6 of AS 2 since this expenditure is incurred in changing the location of the merchandise, i.e., bringing the inventories to the intended point of sale. The above principles in respect of salary of procurement and merchandising staff are equally applicable for rent and electricity charges incurred at LFR-DC.

14. The Committee notes that at LFR stores, the merchandise are already finished goods, not requiring any further processing. Therefore, the storage cost is not a cost of the type which is necessary in the production process prior to further production stage. Inclusion of the same in the cost of inventory is prohibited by paragraph 13(b) of AS 2. Consequently, rent, salary of logistics staff and portion of electricity charges, whether or not directly relatable to merchandise storage at LFR store, should not be considered to derive the cost of inventory held at LFR store.

D. Opinion

15. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 5 above:

       (i) Rent, electricity and salary of the personnel working for Footwear DCs related to the activities of branding should be considered in determining cost of footwear inventory at DC level. To the extent these expenses are related to storing, the same should not be considered in determining cost of footwear inventory at DC level. As regards packing, these expenses related to the same can be included in the cost of the said inventory, if the packing material cost itself is includible, which, in turn, depends on the nature of packing.

       (ii) Carriage inwards cost and loading and unloading costs incurred at footwear retail outlet point in bringing the inventories to their present condition and location, on being despatched from distribution centres, should be included in determining cost of inventory at footwear retail level. This will be so whether or not ‘Hub ‘n Spoke’ module is operated.

       (iii) Rent and part of electricity charges, whether or not directly relatable to footwear storage, paid for footwear retail outlets where merchandise have to be stored, as per retail industry business practices, irrespective of merchandise type/nature, time of sale, quantum of sale, should not be considered in determining cost of inventory at footwear retail level.

       (iv) Rent, electricity charges and salary of procurement and merchandising staff related to branding and tagging activities should be considered in arriving at the cost of inventories at LFR–DC as discussed in paragraph 13 above. To the extent these expenses are related to storing, the same should not be considered in arriving at the cost of inventories held at LFR-DC. As regards packing, expenses related to the same can be considered in arriving at the cost of inventories, if the packing material cost itself is includible, which, in turn, depends on the nature of packing. As regards despatch to retail stores, to the extent the above expenses are related to the said activity, the same should not be considered in arriving at the cost of inventories held at LFR-DC meant for despatch to retail stores, rather the same should be considered in arriving at the cost of inventories held at retail outlets.

       (v) Rent, salary of logistics staff and portion of electricity charges, whether or not directly relatable to merchandise storage at LFR store, should not be considered in arriving at the cost of inventories held at LFR store.