“Can you please give us the examples of allocation of cost of conversion to the cost of inventories under normal circumstances, when low production and if abnormally high production?

I don’t understand what it means that you cannot do higher allocation if low production and reduce allocation if abnormally high production.”
 

Answer: Understand allocation

This question seems rather elementary, but it is very important and it requires clarification.

I’ve seen it many times: the companies simply made a calculation of how much cost should be allocated to one unit of inventories and at the end, they sometimes over-allocated or under-allocated due to different production levels and produced mess in their system.

So let me explain what the allocation is.
 

What is the allocation of cost of conversion?

IAS 2 Inventories says that you should also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.

Variable overheads are clear, because they vary directly with the volume of production, such as indirect materials and indirect labor.

For example, let’s say that you need one production supervisor to produce 2 ships.

If you produce 4 ships, you need 2 supervisors. The cost of this supervisor is variable overhead because the number of supervisors needed varies with the number of ships produced.

This is easy to allocate – you simply add ½ of supervisor’s cost to the cost of the ship.

Allocating fixed production overheads is more difficult.

For example, salary of a factory production manager who supervises supervisors: his salary will be the same regardless the number of ships produced.

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How to allocate it?

IAS 2 says that you should allocate the fixed production overheads to the cost of inventories based on normal capacity of the production facilities .

What is the normal capacity?

It is the production expected to be achieved on average over some period under normal circumstances.
 

How to allocate fixed overheads

The elementary question here is: What is the actual level of production?

  • If your actual level of production is about the same as normal production, then you can allocate your cost of conversion based on actual level.
  • If your actual level is much lower than the normal capacity is, then you cannot allocate the costs based on actual level, but still based on the normal capacity . The remaining unallocated amount is expensed in profit or loss.
  • If your actual level is higher than the normal capacity, then allocating based on normal capacity could mean that you allocated more costs than you really incurred – you cannot do it. So, you would simply allocate less per unit, based on actual production.

 

Illustration: Allocating costs based on different production levels

Imagine you produce sports boats. Your normal capacity is 1 000 boats per year and total cost of production is CU 2 000 per one boat, before fixed overhead.

Except for other costs, you pay employee benefits to the factory production manager amounting to CU 100 000 per year.

Hence, normally, you can allocate CU 100 000/1 000 = CU 100 as a fixed overhead to the cost of one boat.
 

Allocating at normal production level

If you actually produce 990 boats in a year and you allocated 99 000 CU in total, that’s fine (unless the unallocated difference of CU 1 000 is material).

The reason is that your actual production of 990 comes close to the normal capacity of 1 000.

Thus the total cost of one boat is CU 2 000 + CU 100 = CU 2 100.
 

Allocating at low production level

However, imagine you have a low production.

Let’s say you produced just 800 boats per year and the real incurred cost for factory production manager was CU 100 000.

You cannot allocate CU 100 000/800 = CU 125 as a cost of conversion to 1 boat, because this allocation is NOT based on normal capacity.

Instead, you should allocate CU 100 to one boat, as based on normal capacity of 1 000 boats per year.

So, you allocate only 800*100 = CU 80 000, and the remaining unallocated salary of Cu 20 000 is expensed in profit or loss.

The journal entry is then:

  • Debit Inventories: CU 80 000;
  • Debit P/L Employee benefits: CU 20 000;
  • Credit Cash 100 000.

The total cost of one boat is still CU 2 000 plus CU 100 = CU 2 100.
 

Allocating at abnormally high production level

Let’s say you produced 1 200 boats instead of 1 000 because of huge one-off order from your customer.

In this case, based on normal capacity, you would allocate CU 100 * 1 200 = CU 120 000 to the cost of inventories.

But, your actual incurred cost for the salary of your production manager was just CU 100 000.

Therefore, you can allocate only CU 100 000/1 200 = CU 83 to one boat.

So, the total cost of one boat is now CU 2 000 + CU 83 = CU 2 083.

Any questions or comments? Please share them below – thank you!