Enquiry:

Entity 1: ABC Ltd. is a trading company which imports Product A in bulk at Karachi port,
which is then distributed to various of its warehouses throughout Pakistan, from where it is sold to its customers. ABC Ltd. incurs a substantial freight cost in transporting Product A from port to warehouses (Primary Freight) and also in transporting it from warehouses to the customers (Secondary Freight).

Entity 2: DEF Ltd., a sister concern of ABC Ltd., manufactures Product A at Karachi, which is then distributed to various of its warehouses throughout Pakistan, from where it is sold to its customers. DEF Ltd. also incurs a substantial freight cost in transporting Product A from port to warehouses (Primary Freight) and also in transporting it from warehouses to customers (Secondary Freight).

Both the entities expense out the entire secondary freight costs and that part of the primary freight costs which is relevant to the inventory sold, out of the total inventory transported, under Selling and Distribution expenses. For example:
Total inventory transported (Primary Freight)= 1 million units
Total inventory sold = 0.6 million
Total primary freight cost = Rs. 10 million
Primary freight cost expenses under Selling and Distribution = Rs. 6 million (0.6/1 X 10)

The remaining Rs. 4 million is shown as an asset under “Loans, advances, deposits, prepayments and other receivables” and expensed out when the related inventory is sold.

The following are some relevant paragraphs from IAS 2:

Para 10:

Cost of inventories:
“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.”

Para 15:
“Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories.”

In light of the above and any other relevant technical references, the following questions arise:
1. Should the primary freight cost be included in the cost of inventories and consequently in the Cost of Goods sold?

If the answer to question 1 is yes:
2. Would this be an optional or a necessary treatment?
3. Would this apply to both the manufacturing as well as the trading entity? (considering that there is a general belief among accountants that costs should only be included in inventory if they are necessary to bring it in “saleable condition”, a term not used anywhere in IAS 2)

4. Where then would secondary freight be classified in case:
a) The risk remains with the selling entity during transport to the customer, and passes onto him when the Product reaches his premises?
b) The risk passes onto the customer during transport to him, but the transport cost is borne by the seller?

5. If the entities, in addition to the warehouses, had retail units, would it then be appropriate to include the cost of transportation from the warehouse to the retails unit in inventory?

6. In a scenario where inventory is moved from Karachi to Peshawar, for planned sales there, but due to low demand or any other extraordinary circumstances, has to be moved back to Karachi again, under which head would the cost of this return trip of inventory be classified?
If the answer to question 1 is no or the answer to question 2 is optional:

7. Is it appropriate to defer the primary freight expenses under the Head “Loans, advances, deposits, prepayments and other receivables” till the time of sale of related inventory?

8.Would the entity’s pricing at different locations affect where primary freight cost is classified? If yes, where would it be classified under the following scenarios?
a) The entities charge the same price at all locations
b) The entities charge a price varying in line with primary freight costs at all locations
c) The entities charge a price directly dependent on primary freight cost at most locations, but charge lower prices at locations where they face stiff competition.

9. If the primary freight cost is to be classified under Cost of Goods Sold because the relevant revenue (the increase in price due to the freight cost incurred) is included in sales revenue, would it then be appropriate to classify secondary freight under Cost of Goods Sold if the entity charges additionally for delivery to the customer, which is part of sales revenue?

Opinion:

The Committee would like to refer following paragraphs of IAS 2 ‘Inventories’:

11 The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase.

16 Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which they are incurred are:
(a) abnormal amounts of wasted materials, labour or other production costs;
(b) storage costs, unless those costs are necessary in the production process before a further production stage;
(c) administrative overheads that do not contribute to bringing inventories to their present location and condition; and
(d) selling costs.

The cost of inventory includes all necessary expenditures in bringing the inventory to its desired condition and location for sale or for use in the manufacturing process. For raw material and inventory that are purchased outright and not intended for further conversion, cost identification is straight forward. The cost of these inventories will include all expenditures incurred in bringing the goods to the point of sale and capable of being sold. These costs include purchase price, transportation (freight), insurance and handling cost.

Freight-in costs are part of the cost of goods purchased. The cost of goods includes all costs necessary to get an asset in place and ready for use. Freight-in costs are allocated to the products purchased and will cling to the products. Those products in inventory (items not yet sold) will include their share of the freight-in costs (as part of the inventory cost). The products that have been sold will include their share of the freight-in costs (as part of the cost of goods sold).

Freight-out i.e. Distribution costs and the costs of transporting goods to customers are not product costs and are not to be included in the cost of the inventories. However, transport and distribution costs that are necessary to get the inventory to its present location or condition for sale form part of the cost of inventory. The following are examples of costs that are allocated to inventory:
o the cost of transporting goods from the supplier;
o transport or distribution costs that are incurred at an intermediate stage in the production process; and
o transport or distribution costs to get the inventory from a central warehouse to the point of sale.

Similarly, packaging costs incurred to prepare inventory for sale are part of the cost of inventory.

(February 11, 2015)