Inventoriable Cost

An inventoriable cost is a cost that is recorded as part of the cost of inventory when it is incurred, rather than being expensed immediately. Inventoriable costs sit on the balance sheet as an asset, among current assets, for as long as the goods remain unsold. When the goods are sold, the costs move to the income statement as cost of goods sold. Inventoriable costs are also called product costs, in contrast to period costs, which are expensed in the period they are incurred regardless of when products are sold.

The distinction matters because it affects when costs reduce profit. A cost charged to inventory in December for goods sold in February will reduce profit in February, not December. Which costs are inventoriable is governed by ASC 330 in US GAAP and IAS 2 under IFRS, and for US tax purposes by the uniform capitalization (UNICAP) rules of section 263A of the Internal Revenue Code.

For a manufacturer, inventoriable costs are all the costs of producing goods, which are classified into three elements:

• Direct materials, the raw materials and components that become part of the product and can be traced to it.
• Direct labor, the wages of workers who make the product.
• Manufacturing overhead, the indirect production costs such as factory rent, equipment depreciation, utilities, supervision and indirect materials, allocated to products through an overhead rate.

Direct labor and overhead together are called conversion costs. This approach, which includes fixed as well as variable production overhead in inventory, is known as absorption costing and is required for external financial statements.

For a merchandising business, inventoriable costs are the costs of acquiring goods for resale and bringing them to their current location and condition. They include the purchase price less trade discounts and rebates, import duties and non-refundable taxes, and freight-in and handling costs. Together they form the cost of goods purchased. Costs of selling the goods, such as advertising, sales salaries and freight-out, are not inventoriable.

A bakery that supplies supermarkets incurs the following costs in March: flour, sugar and other ingredients of $40,000, wages for bakers of $30,000, oven depreciation, factory rent and utilities of $20,000, delivery van costs of $8,000 and office salaries of $12,000. Its inventoriable costs are the $40,000 of materials, $30,000 of direct labor and $20,000 of manufacturing overhead, a total of $90,000. The $8,000 of delivery and $12,000 of office salaries are period costs, expensed in March.

If the bakery produced 60,000 loaves and sold 54,000 by month end, each loaf carries $1.50 of cost. Cost of goods sold for March is $81,000, and the remaining 6,000 loaves, $9,000, stay in finished goods inventory. If instead the bakery had treated all $110,000 as inventoriable, it would have overstated its inventory and its March profit.

Accounting standards specifically exclude several costs from inventory, even when they relate to production. These include abnormal amounts of wasted materials, labor or overhead, such as abnormal spoilage; storage costs after goods are finished, unless storage is necessary in the production process, as with ageing wine; administrative overheads that do not contribute to bringing inventories to their present location and condition; and selling costs. Unallocated fixed overhead caused by abnormally low production is also expensed. Interest on inventories is generally not capitalized, except in limited cases for goods that take a long time to produce. These rules prevent companies from inflating profit by loading period expenses into inventory, a practice that auditors look for when inventory balances rise faster than sales, and they tie inventory valuation to the cost principle.