IAS 2 Cost of Inventories — Core Rule

Under IAS 2, the cost of inventories must include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition (IAS 2.10). This three-part framework is the foundation for every inventory costing decision your entity makes.

How IAS 2 Cost of Inventories Works

Costs of purchase are the first building block. These comprise the purchase price, import duties and other non-recoverable taxes, and transport, handling and other costs directly attributable to acquiring finished goods, materials and services. Trade discounts, rebates and similar items are deducted when arriving at the final figure (IAS 2.11).

Costs of conversion are the second building block. These include direct labour and a systematic allocation of fixed and variable production overheads — costs that are directly linked to transforming raw materials into finished goods.

Other costs form the third category, but they carry a strict gatekeeping test: they are included only to the extent they are incurred in bringing the inventories to their present location and condition. For example, non-production overheads or costs of designing products for specific customers may qualify where this test is met (IAS 2.15).

Special case — agricultural produce. Where inventories comprise agricultural produce harvested from biological assets, IAS 2 accepts fair value less costs to sell at the point of harvest as the deemed cost on initial recognition (IAS 2.20). This is the carrying amount used as the starting point for all subsequent IAS 2 measurement.

IAS 2 Cost of Inventories — Common Pitfalls

Certain costs are explicitly excluded from inventory and must be expensed in the period incurred (IAS 2.16):

• Abnormal amounts of wasted materials, labour or other production costs
• Storage costs, unless necessary before a further production stage
• Administrative overheads that do not contribute to bringing inventories to their present location and condition
• Selling costs

Two additional traps catch preparers regularly:

• Borrowing costs. These are generally excluded. Inclusion is permitted only in the limited circumstances set out in IAS 23, and those situations are narrow (IAS 2.17 footnote reference to IAS 23).
• By-products. When a process produces a main product and one or more by-products, the by-product is often measured at net realisable value, and that value is deducted from the cost of the main product. The result is that the carrying amount of the main product is not materially different from its cost (IAS 2.14 context).

A further point on cost formulas: once you have determined what costs to include, you must assign them using FIFO or weighted average cost. The same formula must be applied to all inventories of a similar nature and use — you cannot mix formulas arbitrarily across comparable stock lines (IAS 2.25).

IAS 2 Cost of Inventories — Key Paragraphs

• IAS 2.10 — Core definition: cost of inventories = costs of purchase + costs of conversion + other costs to bring to present location and condition.
• IAS 2.11 — Components of costs of purchase, including the deduction of trade discounts and rebates.
• IAS 2.15 — Other costs included only when the "present location and condition" test is met; examples include non-production overheads and customer-specific design costs.
• IAS 2.16 — Explicit list of costs excluded from inventories and recognised as period expenses (abnormal waste, storage, admin overheads, selling costs).
• IAS 2.20 — Agricultural produce: fair value less costs to sell at harvest is treated as deemed cost under IAS 2.
• IAS 2.25 — FIFO or weighted average cost formulas; same formula required for inventories of similar nature and use.