The IAS 2 Game-Changer: How Smart Inventory Costing Drives Better Margins

A manufacturing giant just restated five years of profits. The damage? $22 million. The cause? They’d been calculating inventory costs wrong this entire time. And they’re not alone.

The Overhead Allocation Disaster

Here’s the rule everyone thinks they understand: Include production overheads in inventory based on “normal capacity.” Simple, right? Wrong.

The trap: What’s “normal capacity”? Last year’s production? This year’s budget? The machine’s maximum output?

IAS 2 says it’s the average production expected over several periods under normal circumstances. Not your actual production. Not your budget. Your realistic long-term average.

Why this matters: A factory can produce 100,000 units. This year they made 60,000 due to slow sales. Many accountants spread all fixed costs over 60,000 units.

IAS 2 says: “No! Use normal capacity—maybe 80,000 units. The unallocated overhead? Straight to expense.”

The Hidden Costs Nobody Includes

Which costs belong in inventory? Most accountants miss these:

• Quality control salaries (if part of production)
• Depreciation on factory equipment
• Factory management bonuses
• Even some IT costs for production systems

But here’s what doesn’t belong (and where people mess up):

• Storage costs (unless part of production process)
• Selling costs (even if incurred before sale)
• Head office allocations
• Abnormal waste

Costly example: A food manufacturer included warehouse costs because “we can’t sell without storing.” Auditors disagreed. Impact? $3 million of costs moved from inventory to immediate expense.

The Write-Down Shock

Net realizable value (NRV) seems straightforward—compare cost to selling price minus selling costs. But when do you test? How often? What about raw materials?

The gotcha: Raw materials aren’t tested against their selling price—test against the finished goods they’ll become. That copper you bought at peak prices? If the final product is profitable, no write-down needed.

One electronics manufacturer wrote down $5 million in components when prices dropped. Problem? Those components were for products with locked-in sales contracts at profitable prices. Unnecessary write-down reversed, credibility damaged.

Your Takeaway as an Accountant

Create a detailed inventory cost build-up and review it annually. Document your “normal capacity” calculation with data, not guesses. Set up quarterly NRV testing—but test the right thing. Most importantly, when production levels swing wildly, remember: fixed costs per unit should stay stable, not bounce around.

The companies that survive downturns aren’t lucky—they’re the ones who got their inventory accounting right when times were good.

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