In this article we will discuss about the arguments for and against inclusion of overheads in valuation of stock.
Arguments for Inclusion:
1. Fixed overheads should form a part, of the cost of production as these are incurred during a period in order to manufacture products of that period.
2. Where the fixed costs are predominant over variable costs, their exclusion from the cost will understate the cost of production and cost calculated will also become unrealistic.
3. If the whole of the fixed costs are not included in the current cost of production, the valuation of stock will be less. This will understate the profit of the current year but the next year’s profit will be overstated. Thus, profit shown by Profit and Loss Account will be unrealistic and misleading.
4. According to International Accounting Standard Committee, cost should include prime cost, variable overheads and fixed overheads. Fixed production overhead should include a rate which is applicable to the normal capacity of the firm as, if the output changes, the fixed production overhead per unit may change.
Arguments against Inclusion:
1. Fixed costs, being period costs, are to be incurred irrespective of the level of activity attained during the period. Thus, such costs should be charged to Profit and Loss Account.
2. If fixed overhead costs are included in the cost of production, then stock of finished goods and work-in-progress (one of the main constituents of working capital) will consist of past unrecoverable expenditure.
3. When fixed overhead costs are included in the valuation of stock, it will affect the unit cost of the period. The high cost for low activity in the previous period will increase the unit cost of this period. Due to this, period’s cost efficiency cannot be reasonably measured.
Valuation of work-in-progress can be done at prime cost or at marginal cost or at total cost basis. If variable overheads are taken into consideration and fixed costs are excluded, the consequences are as given above under the heading ‘Arguments for inclusion’.
Similarly, there are certain cases where valuation may be done at total cost basis. There are certain objections which have already been discussed under the heading ‘Arguments against inclusion’.