COVID-19: How to allocate fixed indirect production costs in the manufacturing cost of inventory?
How to allocate fixed indirect production costs
Companies need to allocate the fixed indirect production costs to each unit of production based on the normal capacity of the production facilities even when the production capacity is temporarily reduced as a consequence of COVID-19
What’s the issue?
For manufacturing entities the average normal production may significantly be affected as a result of COVID-19 (e.g. temporary closure of business, adaption of production process or shortages of labour and/or materials). Fixed indirect production costs are allocated to each unit of production based on the normal capacity of the production facilities. The question arises: How to account for a temporary change in the normal capacity under Dutch GAAP?
Getting into more detail
Normal capacity is the average production expected to be achieved under normal conditions for a number of periods or seasons, taking into account the loss of capacity due to planned maintenance. The fixed indirect production costs must be allocated to inventory in a systematic and consistent manner. Generally, the normal capacity is not adjusted for temporary changes. Therefore, the amount of fixed indirect costs that can be allocated to each unit of production is not increased as a consequence of temporary low production due to COVID-19. The unallocated fixed indirect production costs are recognised as an expense in the period in which they incurred.
However, circumstances may arise under which a reduced level of capacity becomes the ‘new normal’. The fixed indirect production costs (such as depreciation, maintenance of factory buildings and installations, the costs of management and administration of the factory) will be allocated prospectively to reflect this new reality.
Regardless of the allocation of fixed indirect production costs, companies must not forget that inventories are measured at cost or lower net realisable value and that the net realisable value is estimated at each reporting date. So careful consideration should be given to any indication that, due to COVID-19, the net realisable value of the inventory is lower than its cost. For example, as a consequence of a decline in selling prices, higher production costs or obsolescence of inventory.
Actions for management to take now
- Review the allocation of the fixed indirect production costs.
- Determine if inventory should be written down to the net realisable value.
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