Dissecting Normal Capacity for allocation of Fixed Overheads and Assay the treatment of various costs

[2013] 36 taxmann.com 66 (Article)Dissecting Normal Capacity for allocation of Fixed Overheads and Assay the treatment of various costs
VARUN KUMAR
CA
Introduction
1. Accounting Standard (AS) 2 - Valuation of Inventories lays down the principles and policies to be used for the inventory valuation. Inventories consist of Costs of Purchase, Costs of Conversion and other costs incurred in bringing the inventories to their present location and condition. Inventories consist of material cost, labour cost and production overheads (variable and fixed).
The fixed production overheads are indirect costs of production that remain relatively constant, irrespective of the volume of production.
There is no fixed rule which can be applied in each and every situation for inclusion of various costs in production overheads in order to value inventories as per AS 2.
A case study
2. A big Indian company dealing in the manufacture of compressors used in refrigerators, air conditioners, etc., was established in 1990 with a production capacity of 4 million units. For its steel requirements the company was importing it till 1998. In 1999, the company opened a steel plant to meet its demands and also enhanced its production capacity from 4 million to 6 million. But this steel plant was closed in 2004 due to some legal issues. As a result of it, the company restricted its production on account of its dependency for steel on imports. But the company is planning to open it again in F.Y. 2014-15. The company was using the underlying accounting policy for the valuation of the closing stock at the end of financial year 2011-12:
"Stock of finished goods, namely, Compressors is valued at lower of cost and net realizable value. Cost comprises of expenditure incurred in the normal course of business in bringing such inventories to their location and includes wherever applicable, appropriate overheads, based on normal level of activity. However, when the actual production is abnormally lower as compared to normal level, the expenditure of fixed nature is reduced in proportion to the shortfall."
On the basis of the accounting policy followed by the company, the following were considered for valuation of closing stock of finished goods:
(A) Fixed cost was allocated, based on actual production of the financial year 2011-12 adjusted to the average production of the last three years;
(B) Expenses such as general expenses, interest, advertisement and publicity expenses, opportunity costs of loans and other income (interest recovered from employees on their loans), etc., were considered for valuation.
2.1 Contentions of company for treatments mentioned in points (A) and (B) above - As per the company for point (A)mentioned above, it relied on the Paragraph 9 of Accounting Standard 2 – Valuation of Inventories. The relevant extract of Paragraph 9 of AS 2 is stated below:
"The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity...."
The contention behind considering the average production during the past 3 years prior to F.Y. 2011-12, as normal capacity for allocation of fixed overheads was that the company had to close its steel producing plant in 2004 due to which the company depended on imported steel for manufacturing of compressors. Hence, the period from 2004 depicted the normal capacity of the manufacturing unit, considering the reliance placed upon Paragraph 9 of AS 2.
As per the company for point (B) mentioned above, the nature of the expenses was as follows:
(i) General expenses - It included expenses of routine nature related to operation of plant and also related to the production of finished goods, whether directly or indirectly. The major general expenses were Travel and Conveyance, Legal charges, Printing and Stationery, Repair and Maintenance, etc.
(ii) Advertisement expenses - For publishing tender notices in print media and to advertise in electronic media in order to obtain requisite services and raw materials.
(iii) Other Income (Interest recovered from employees on their loans) - The loans and advances were given to the production related employees for purchasing houses in nearby location, vehicles and Laptops. Interest so recovered was recognized as "other income" in books of account. While the opportunity cost as per normal interest rates in the market was added to the cost of inventories. As the company was a manufacturing entity, its employees were its major resources and the loans and advances were for betterment of employees to derive better results from them.
The company had supported it's view by referring to Paragraph 11 of the Accounting Standard 2 – Valuation of Inventories, which is stated below:
"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."
2.2 Related issues - In context to the valuation of closing stock of finished goods, the following issues came into the picture:
(1) Whether the average production for the last three years was to be taken as normal production or the budgeted production was to be taken as normal production for the purpose of valuation of inventory?
(2) Whether the company was justified in the treatment of general expenses, advertisement cost and other income (Interest recovered from employees on their loans) for the purpose of valuation of inventory?
2.2.1 Dissecting the issues
2.2.1.1 NORMAL CAPACITY FOR FIXED OVERHEAD ALLOCATION - One can say that the Company should have taken budgeted production plan targets into account, rather than considering the average of last 3 years prior to the F.Y. under audit, as normal capacity for allocation of fixed overheads in the valuation of closing stock of finished goods. Would it be correct to say so or was the management justified?
Going by Paragraph 9 of AS 2, it explicitly describes that the normal capacity is the volume of production that the entity expects to achieve on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.
For the ease of understanding, we can divide production capacities into two types:
(i) Installed Capacity (Theoretical Capacity) - It does not consider the impact of decrease in production due to normalplanned maintenance and other normal interruptions/loss of time and aims at producing at full efficiency at all the times without any failures.
(ii) Practical Capacity - Practical capacity can be calculated by reducing from the installed capacity, the impact of decrease in production due to normal planned maintenance and other normal interruptions/loss of time, seasonal production fluctuations, etc.
Abiding by Paragraph 9 of AS 2, the normal capacity should also consider the idle capacity on account of normal reasons, but excluding abnormal reasons like short supply of raw material, etc.
AS 2 is very clear that the normal capacity should be expected/future production requiring adjustment for normal planned maintenance but does not talk about the past years actual production average. While as Paragraph 7.1 of Cost Accounting Standard 2 (CAS 2)gives the flexibility to consider the past years average for estimating normal capacity, but the Financial Statements as per the Companies Act, 1956 needs to comply with Accounting Standard issued by the Institute of Chartered Accountants of India and, hence, Paragraph 7.1of Cost Accounting Standard 2 (CAS 2) will be superseded by Paragraph 9 of AS 2 issued bythe ICAI.
Though there can be a situation in which the average production of past years can be considered as normal production capacity, when the same approximates the expected future production in normal circumstances but as the company is expecting to reopen the steel plant in F.Y.14-15, it will increase the production as compared to production achieved between the years F.Ys. 2004-05 to 2011-12. Hence, the normal capacity calculated on the basis of last three years does not seem to be appropriate. The company should consider budgeted production for determining normal capacity.
2.2.1.2 TREATMENT OF VARIOUS COSTS FOR VALUATION OF INVENTORY - If we move with the essence of Paragraph 11 of AS 2, the litmus test for inclusion or the exclusion of expenses in cost of inventories can be whether the activity to which expenses relate to is contributing in any manner to bring it to its present location and condition. We can pinpoint it by saying that the cost is includible, if the same is so important to be incurred, that non-incurrence of it will hinder the production of finished goods.
2.2.1.2.1 GENERAL EXPENSES - As mentioned above, in the contentions of company for point (B), the general expenses are of routine nature related to"operation of plant" and, thus, it can be concluded that these are vital for production. Hence, the company is correct by not considering these as administrative overheads, which are not includible.
2.2.1.2.2 ADVERTISEMENT EXPENSES - As mentioned above, in the contentions of company for point (B), the advertisement expenses mainly pertain to tender notices in print media and electronic media for obtaining requisite services and raw materials for production of finished goods, these if passed through litmus test (as mentioned above) will fail to qualify for inclusion in inventory cost. The reason for it is that the company can get the suppliers and service providers, even if it does not advertise. Though the company may not get that much competent suppliers/service providers, which it could have through advertisement, yet this should not be included in cost of purchase, as treated by the company.
2.2.1.2.3 OTHER INCOME (INTEREST RECOVERED FROM EMPLOYEES ON THEIR LOANS) - As mentioned above, in the contentions of company for point (B), the company is recognizing interest recovered as "other income" and adding the opportunity cost (as per normal interest rates in the market) to the value of inventories. In case of recognizing interest recovered from employees as "other income", the company is correct while considering the "opportunity cost" for inventory valuation is not in sync with AS 2. As the "opportunity cost" is a hypothetical cost and AS 2 does neither mention directly nor indirectly, for its inclusion in inventory valuation.
2.3 Essence of the study - The management of the company does not seem to have correctly considered the normal capacity as average of last three years for the simple reason that these may not represent the production in future years succeeding F.Y.2011-12. As is evident from the case details the company is foreseeing to open the steel plant again in F.Y. 2014-15. This will increase production of compressors. Hence, the normal production capacity on the basis of last three years average is not what the company is expecting to produce in a near future and, thus, is violating Accounting Standard 2. The company should consider budgeted production for determining normal capacity, to be used in overhead allocation for inventory valuation.
For treatment of other cost to be included in value of inventory, the above mentioned litmus test can be used as a guiding factor. The management of the company has correctly treated the general expenses, but needs to rectify the treatment of advertisement expenses and other income (Interest recovered from employees on their loans).