Manufacturing: work in progress and overhead

Ironvale Fixtures makes steel shelving for warehouses. A retailer buys finished goods; a manufacturer builds them, so its inventory has three stages and its costs move through them:

• Raw materials — steel coil, bolts and paint not yet issued to the factory floor.
• Work in progress (WIP) — partly finished shelving. It collects direct materials, direct labour and manufacturing overhead (indirect materials, supervisors, factory depreciation, power, rent).
• Finished goods — completed units waiting to be sold. On sale their cost moves to cost of sales.

IAS 2 says inventory cost includes the costs of conversion, including a systematic allocation of fixed and variable production overheads (IAS 2.12). Actual overhead isn't known until month end, and much of it is fixed, so manufacturers absorb overhead with a predetermined rate: budgeted overhead ÷ budgeted activity. Ironvale's machines drive its costs, so it uses machine hours: 540,000 ÷ 45,000 hours = 12 per hour.

Actual overhead is collected in a manufacturing overhead control account (debits); overhead applied to jobs is credited out of it into WIP. At month end the balance left is under-absorbed (debit: actual exceeded applied) or over-absorbed (credit). Small balances go to cost of sales; large ones are allocated across WIP, finished goods and cost of sales.

Two traps. First, fixed overhead is allocated on normal capacity (IAS 2.13): if the factory runs well below normal, the unabsorbed fixed cost is expensed, not loaded onto fewer units. Second, abnormal waste, storage, administration and selling costs are never inventory (IAS 2.16) — they are period expenses.