IAS 2 — Cost of Inventory:
What Actually Goes Into
Your Inventory Valuation
Most finance teams know the textbook line: "inventory is valued at the lower of cost and net realisable value." But ask them to define cost precisely — purchase price plus what, exactly? — and the answers start to diverge. This lesson walks through exactly what IAS 2 requires you to include when measuring the cost of inventory, with the normal capacity rule that trips up almost every finance team the first time they apply it.
Cost of Inventory — What IAS 2 Requires You to Capitalise
Taught by Dr. Hesham MokhiemerThis is a free preview lesson from the IAS 2 module inside DipIFR Masterclass and the IFRS CERT Course. Watch the full clip above, then read the companion notes below — this is exactly the depth and teaching style you get across all 30+ IFRS standards in the full programme.
What Is "Cost of Inventory"? — IAS 2.10
IAS 2 paragraph 10 sets the core principle in one sentence: the cost of inventories shall comprise all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Three categories. Every cost you capitalise into inventory has to fit into one of them — and just as importantly, every cost that doesn't fit gets expensed immediately (which is exactly what Part 2 of this module covers).
Costs of Purchase — IAS 2.11
This is the most intuitive category, but it has more components than most people initially list. Costs of purchase comprise:
Purchase price
The invoiced amount for the goods or raw materials themselves.
Import duties and other non-recoverable taxes
Customs duties, and any tax that the entity cannot reclaim from the tax authority. VAT that is recoverable is NOT included — only non-recoverable taxes.
Transport, handling, and other directly attributable costs
Freight-in, insurance during transit, and handling costs incurred to get the goods to the entity's premises.
LESS: Trade discounts, rebates, and similar items
Trade discounts and rebates are deducted in arriving at the cost of purchase — they reduce the cost, they are not income.
Costs of Conversion — IAS 2.12
For manufactured inventory, you also have to capitalise the cost of turning raw materials into finished goods. This has two components:
Direct labour
Costs directly related to the units of production — the wages of the people physically converting raw materials into finished goods.
Production overheads — fixed AND variable
A systematic allocation of both fixed and variable production overheads incurred in converting materials into finished goods. This is where most of the complexity — and most of the exam questions — live.
The Normal Capacity Rule — IAS 2.13
This is the single most important — and most frequently misapplied — rule in this entire module. Fixed production overheads must be allocated to units of production based on the normal capacity of the production facilities — not on actual output.
| Scenario | Normal Capacity | Actual Output | Total Fixed OH | OH Allocated to Inventory | OH Expensed Immediately |
|---|---|---|---|---|---|
| Low production month | 100,000 units | 60,000 units | SAR 500,000 | SAR 300,000 (60,000 × SAR 5/unit) | SAR 200,000 — expensed |
| Normal production month | 100,000 units | 100,000 units | SAR 500,000 | SAR 500,000 (full amount) | SAR 0 |
| High production month | 100,000 units | 130,000 units | SAR 500,000 | SAR 500,000 (rate decreases to SAR 3.85/unit) | SAR 0 — rate adjusts down |
Notice what happens in the high-production scenario: the actual fixed overhead rate per unit decreases (because the same fixed cost is spread over more units) — IAS 2.13 explicitly permits this. The rule exists specifically to prevent abnormally low production periods from inflating inventory values above their real cost.
Other Costs Includable — IAS 2.15
The third bucket is deliberately narrow. Other costs are only included in the cost of inventories to the extent that they are incurred in bringing the inventories to their present location and condition. IAS 2 gives one example: costs of designing products for specific customers can be included if directly attributable. Beyond that narrow test, most "other" overhead-type costs are explicitly excluded — which is exactly what Part 2 of this module covers in full.
Worked Example — Al-Sahra Manufacturing Co.
Al-Sahra Manufacturing imports raw plastic resin from South Korea to produce packaging components at its Jeddah facility.
| Cost Element | Amount (SAR) | Category |
|---|---|---|
| Purchase price of resin (10,000 kg) | 180,000 | Cost of purchase |
| Customs duty (non-recoverable) | 9,000 | Cost of purchase |
| Sea freight + marine insurance | 14,500 | Cost of purchase |
| Less: trade discount from supplier (5%) | (9,000) | Cost of purchase (deduction) |
| Direct labour — production line | 42,000 | Cost of conversion |
| Fixed production overhead (normal capacity basis) | 38,000 | Cost of conversion |
| Variable production overhead | 16,500 | Cost of conversion |
| Total Cost of Inventory — this batch | 291,000 |
Continue Your IFRS Journey
This lesson is one part of a structured, 30+ standard IFRS curriculum. If the teaching style and depth here is what you're looking for, here's where to go next:
DipIFR Masterclass
The complete IFRS curriculum mapped to the ACCA DipIFR syllabus — every standard taught with full worked examples and Excel models, exactly like this lesson.
- 30+ Excel models, one per standard
- Full video library — all modules, all parts
- Mock exams + marking guidance
- Certificate of completion
IFRS CERT Course
A practitioner-focused IFRS certification for finance professionals applying these standards in real GCC company accounts — not exam-focused, job-focused.
- GCC case studies in every module
- Real company worked examples
- Downloadable application checklists
- Certificate of completion
Frequently Asked Questions
Is this the complete IAS 2 Module 2 lesson, or an excerpt?
This is the complete Part 1 lesson on Cost of Inventory — taught exactly as it appears inside the DipIFR Masterclass and IFRS CERT Course curricula. Part 2 (Costs Excluded from Inventory) continues directly from where this lesson ends, and is also available as a free preview — look for it in the related lessons section as it's published.
Do I need to watch this in order with other IAS 2 lessons, or can I start anywhere?
Within the full course, IAS 2 is structured as: Module 1 (Scope and Definitions), Module 2 (Measurement — this lesson is Part 1 of 2), Module 3 (Net Realisable Value and Write-Downs), and Module 4 (Disclosures). Each module builds on the prior one, so we recommend following the sequence if you're working toward a full understanding of the standard — though every module is also designed to stand alone if you need a specific topic refresher.
Does the full course include an Excel model for cost of inventory calculations?
Yes — DipIFR Masterclass includes a complete IAS 2 Excel workbook covering cost of purchase build-up, the normal capacity fixed overhead allocation calculator (exactly like the worked example in this lesson), NRV write-down testing, and full disclosure templates. This is part of the 30+ Excel model library included with enrolment.
Dr. Hesham Mokhiemer
Dr. Hesham Mokhiemer is the founder of The Financeer Academy. He has 25+ years of experience delivering IFRS, financial modelling, and exam preparation training to finance professionals across Saudi Arabia and the GCC — and personally teaches every module in the DipIFR Masterclass and IFRS CERT Course curricula.
Comments (2)
The normal capacity allocation example finally made this click for me. I had been allocating fixed overhead based on actual output every month — which meant our inventory cost per unit was swinging wildly between high and low season. This is exactly the fix we needed.
Watched this before deciding whether to enrol in the full masterclass. The teaching pace and the worked example format is exactly what convinced me — clear, practical, no wasted time. Signed up for DipIFR Masterclass right after.
Leave a Comment
Have a question about this lesson? Register or log in to comment.