1.17 Query
Valuation of components manufactured for internal use as well as for sale to outsiders
1.One of the units of a public sector company is engaged in the manufacture of electronic components. The accounting policy followed by the company with regard to valuation of inventories is as below:
(a) at actual/estimated factory cost or realisable value whichever is lower, in case of sale orders from customers;
(b) at agreed price or estimated factory cost whichever is lower in the case of orders from other sister units.
2.One of the products---say ‘X’---has different ratings (types)—each rating having a different sale price (catalogue indicating trade discount on slab basis) as well as cost. This product is sold directly to outsiders as well as used internally in the manufacture of main product—say ‘Y’—which is made to customer’s specifications. ‘X’ is manufactured in optimum batch quantity which is generally more than the order on hand. The sale price of ‘X’ in the total sale price of ‘Y’ can also be determined.
3.At a point of time, product ‘X’ is at various stages as described below:
(a) as a finished product in plant, meant both for issue to inhouse manufacture as well as to customers—at this stage it is difficult to segregate the quantities applicable to the said two purposes;
(b) as stock in hand with the shipping department for despatch to customers against specific orders for this product;
(c) as stores in the course of final consumption in the manufacture of ‘Y’—separately identified and stored exclusively for this purpose;
(d) as work-in-progress under several manufacturing orders for product ‘Y’.
(e) as a part of finished goods against several manufacturing orders for product ‘Y’ i.e., ‘X’ as a part of finished product ‘Y’.
4. In the above circumstances, the company has been valuing the product ‘X’ on the following bases;
(a) Finished stock in plant, which is not identified either for direct sales or to be used in the manufacture of ‘Y’ is valued at the lower of factory cost or sale price (allowing for the highest rate of discount).
(b) To the extent ‘X’ is identified to sale orders, it is valued at sale price (less discount as applicable) or the factory cost whichever is lower.
(c) To the extent the product ‘X’ is identified to be used in product ‘Y’—whether already issued to the manufacturing orders of product ‘Y’ or not but is identified and earmarked for use therein by issue to a separate store for this purpose, it is valued at factory cost.
5.The querist has supplied the following additional information for the consideration of the Expert Advisory Committee:
(a) It is possible that due to storage product ‘X’ may lose its functional utility and may have to be sold as ‘second’ for which price will have to be determined.
(b) Where product ‘X’ is identified to sale orders from other units of the company, the price is as per catalogue which includes profit margin/loss.
(c) At the year end closing inventories of ‘X’ comprise items from opening stock and current production which may have different factory cost/sale price.
6.The querist has sought the opinion of the Expert Advisory Committee as to whether the valuation policy followed by the Company with regard to product ‘X’ is proper.
Opinion 10th July, 1985
1.The Committee notes that Accounting Standard-2 (AS-2) on ‘Valuation of Inventories’ issued by the Institute of Chartered Accountants of India recommends that “inventories should be valued at lower of historical cost and net realisable value” (para 24). The term ‘net realisable value’ has been defined in para 6.9 of the Standard as “the actual/estimated selling price in the ordinary course of business, less cost of completion and cost necessarily to be incurred in order to make the sale.” The Committee is therefore of the view that inventories of product ‘X’ meant for sale to customers should be valued at lower of cost and net realisable value calculated on the basis of actual/estimated selling price in the ordinary course of business. Similarly, inventories of ‘X’ meant for transfer to sister units should be valued at lower of cost and net realisable value calculated on the basis of actual/estimated transfer price in the ordinary course of business.
2.With regard to inventory of ‘X’ lying as finished product in plant the Committee is of the view that this may be segregated between the items meant for (i) sale to customers (ii) internal consumption in the manufacture of ‘Y’ and (iii) transfers to other sister units, for their proper valuation. In this context, the Committee notes the difficulty expressed by the querist in making such segregation. However, in the view of the Committee, events occurring between the balance sheet date and the date of finalisation of accounts may provide evidence of allocation of some of the items of ‘X’ to the aforesaid categories e.g. through actual sales or identification with individual categories. With regard to the remaining items, i.e., the ones which are not so allocated, an estimate may be made on reasonable basis, e.g., past experience, future commitments, budgeted production of ‘Y’ etc., to arrive at an allocation formula which may be revised from year to year, if necessary. The Committee is however of the view that the valuation policy being followed by the company with regard to such inventory items would be proper provided the selling price, after allowing for the highest rate of discount, is obtained or expected to be obtained in the ordinary course of business.
3.The Committee further notes that para 19 of the above-mentioned Standard (AS-2) states: “Normal quantity of materials and other supplies held for use in production are not written down below historical cost if the finished goods are expected to be sold at or above historical cost. The Committee is therefore of the view that part of product ‘X’ which is meant for the manufacture of product ‘Y’ should be valued at cost unless it is expected that product ‘Y’ would be sold at below cost.
4.With regard to the fact that closing inventories of ‘X’ are from its opening stock and production made during the year and that the two may have different costs should not be a problem since the cost of closing inventories can be ascertained on the basis of the method of costing followed by the company, e.g., FIFO, average cost etc.
5. With regard to deterioration in the quality of product ‘X’ and its subsequent sale as ‘seconds’, it would be necessary to make a provision to bring it down to its ‘net realisable value’. Such a provision may be made by the use of formulae based on predetermined criteria which “normally take account of the age, movements during the past, expected future movements and estimated scrap value of the stock, as appropriate. Whilst the use of such formulae establishes a basis for making a provision which can be consistently applied, it is still necessary for the results to be reviewed in the light of any special circumstances which cannot be anticipated in the formulae, such as changes in the state of the order book.”[1]
6.On the basis of the above, the opinion of the Committee on the valuation of inventories of ‘X’ is as below:
(i) The valuation policy followed by the company regarding finished product ‘X’ in plant would be correct if the sale price (allowing for the highest rate of discount) is being obtained or expected to be obtained in the ordinary course of business. In case it is not so then such inventory items should be segregated as suggested in para 2 above, and valued as suggested below with regard to the other categories.
(ii) Inventory of product ‘X’ for sale to the customers and for transfers to sister units should be valued at the lower of cost and net realisable value (as defined in para 6.9 of AS-2, which is reproduced in para 1 above).
(iii) Inventory of product ‘X’ meant for the manufacture of product ‘Y’ should be valued at cost unless it is expected that product ‘Y’ would be sold at below cost. _____________________________________ [1] Para 16 of Appendix of SSAP-9 issued by the ASC in the U.K.
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