23 October 2011
The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the capital is raised in substantial amount in practice marginal cost is referred to as the cost incurred in raising new funds. Marginal cost of capital is derived, when the average cost of capital is calculated using the marginal weights. The marginal weights represent the proportion of funds the firm intends to employ. To calculate the marginal cost of capital, the intended/proposed financing proportion should be applied as weights to marginal component costs. The marginal cost of capital should, therefore, be calculated in the composite sense. When a firm raises funds in proportional manner and the component.s cost remains unchanged, there will be no difference between average cost of capital (of the total funds) and the marginal cost of capital. The component costs may remain constant upto certain level of funds raised and then start increasing with amount of funds raised. For example, the cost of debt may remain 7% (after tax) till Rs. 10 lakhs of debt is raised, between Rs. 10 lakhs and Rs. 15 lakhs, the cost may be 8% and so on. Same is the case with equity capital. When the components cost start rising, the average cost of capital will rise and the marginal cost of
25 October 2011
AS – 2 VALUATION OF INVENTORY Inventories are assets: (a) held for sale in ordinary course of business;
(b) in the process of production fro such sale (WIP);
(c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.
However, this standard does not apply to the valuation of following inventories: (a) WIP arising under construction contract (Refer AS – 7); (b) WIP arising in the ordinary course of business of service providers; (c) Shares, debentures and other financial instruments held as stock in trade; and (d) Producers’ inventories of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realizable value in accordance with well established practices in those industries. Inventories should be valued at the lower of cost and net realizable value. The cost of inventories should comprise (a) all costs of purchase (b) costs of conversion (c) other costs incurred in bringing the inventories to their present location and condition. The costs of purchase consist of (a) the purchase price (b) duties and taxes ( other than those subsequently recoverable by the enterprise from the taxing authorities like CENVAT credit) (c) freight inwards and other expenditure directly attributable to the acquisition. Trade discounts (but not cash discounts), rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase. The costs of conversion include direct costs and systematic allocation of fixed and variable production overhead. Allocation of fixed overheads 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. Under Recovery: Unallocated overheads are recognized as an expense in the period in which they are incurred. Example: Normal capacity = 20000 units Production = 18000 units Sales = 16000 units Closing Stock = 2000 units Fixed Overheads = Rs. 60000 Then, Recovery rate = Rs60000/20000 = Rs 3 per unit Fixed Overheads will be bifurcated into three parts: Cost of sales : 16000*3 = 48000 Closing stock : 2000 *3 = 6000 Under recovery : Rs 6000 ( to be charged to P/L) (Apparently it seems that fixed cost element in closing stock should be 60000/18000*2000 =Rs 6666.67. but this is wrong as per AS-2) Over Recovery: In period of high production, the amount of fixed production overheads is allocated to each unit of production is decreased so that inventories. Example: Normal capacity = 20000 units Production = 25000 units Sales = 23000 units Closing Stock = 2000 units Fixed Overheads = Rs 60000 Recovery Rate = Rs 60000/20000 = Rs 3 per unit But, Revised Recovery rate = Rs 60000/25000 = Rs. 2.40 per unit Cost of sales : 23000*2.4 = Rs 55200 Closing Stock : 2000 *2.4 = Rs. 4800 Joint or by products: In case of joint or by products, the costs incurred up to the stage of split off should be allocated on a rational and consistent basis. The basis of allocation may be sale value at split off point or sale value at the completion of production. In case of the by products of negligible value or wastes, valuation may be taken at net realizable value. The cost of main product is then joint cost minus net realizable value of by product or waste. The other costs are also included in the cost of inventory to the extent they contribute in bringing the inventory to its present location and condition. Interest and other borrowing costs are usually not included in cost of inventory. However, AS-16 recommends the areas where borrowing costs are taken as cost of inventory. Certain costs are strictly not taken as cost of inventory. (a) Abnormal amounts of wasted materials, labour, or other production costs; (b) Storage costs, unless those costs are necessary in the production process prior to a further production stage; (c) Administrative overheads that do not contribute to bringing the inventories to their present location and condition; and (d) Selling and Distribution costs. Cost Formula: Specific identification method for determining cost of inventories Specific identification method means directly linking the cost with specific item of inventories. This method has application in following conditions: In case of purchase of item specifically segregated for specific project and is not ordinarily interchangeable. In case of goods of services produced and segregated for specific project. Where Specific Identification method is not applicable The cost of inventories is valued by the following methods; FIFO ( First In First Out) Method Weighted Average Cost Cost of inventories in certain conditions: The following methods may be used for convenience if the results approximate actual cost. Standard Cost: It takes into account normal level of consumption of material and supplies, labour, efficiency and capacity utilization. It must be regularly reviewed taking into consideration the current condition. Retail Method: Normally applicable for retail trade Cost of inventory is determined by reducing the gross margin from the sale value of inventory. Net Realisable Value means the estimated selling price in ordinary course of business, at the time of valuation, less estimated cost of completion and estimated cost necessary to make the sale. Comparison between net realizable value and cost of inventory The comparison between cost and net realizable value should be made on item-by-item basis. (In some cases, group of items-by-group of item basis) For Example:
Raw material valuation If the finished goods to which raw material is applied, is sold at profit, RAW MATERIAL is valued at cost irrespective of its NRV level being lower to its costs.