Cost of Inventory Determination

The cost of inventory includes all the costs necessary to bring the goods to their present location and condition ready for sale. The costs have three main components.

  1. Costs of purchase
  2. Costs of conversion
  3. Other costs

The cost of purchase is the cost of buying products and services for use in production, the cost of conversion is the cost of converting those purchases into a finished product, and other costs are all additional costs of bringing the inventory to its present location and condition ready for sale.

Cost of inventory = Cost of purchase + Cost of conversion + Other costs

Cost of Purchase

The costs of purchase are the costs directly related to the acquisition of finished goods, materials and services, they include

  • Product purchase price
  • Direct materials
  • Import duties
  • Non recoverable taxes
  • Freight-in
  • Handling costs
  • Insurance
  • Other acquisition costs
  • less: Trade discounts
  • less: Purchase discounts
  • less: Rebates

Cost of Conversion

The costs of conversion are costs directly related to the conversion of the purchased materials (costs of purchase) into a finished product. Costs of conversion include direct labor and allocated variable and fixed overheads.

Direct costs

  • Direct labor
  • Normal spoilage

Variable overheads

  • Indirect materials
  • indirect labor

Variable overhead is allocated to units of production based on usage.

Fixed overheads relating to production facilities

  • Depreciation
  • Maintenance
  • Management labor costs
  • Administration labor costs

Fixed overhead is allocated to units of production based on normal production capacity.

Other Costs

Other costs include any cost which is incurred in bringing the inventory to its present location and condition.

Costs Excluded from Cost of Inventory

The followings costs are excluded from the cost of inventory.

  • Selling costs
  • Warehousing and storage costs, unless the storage is needed as part of the production process.
  • Administrative overheads that are not a cost of bringing the inventory to its present location and condition.
  • Interest and finance costs
  • Abnormal costs for items such as of from freight-in, spoilage, and handling costs.

Having determined which costs are included in the cost of inventory, the next step is to decide the cost flow assumption (FIFO, LIFO, average etc) to be used to allocate the costs between inventory and cost of goods sold at the end of an accounting period.

Last modified July 16th, 2019 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.

You May Also Like