In this guide
Inventory valuation under AS 2 means carrying raw material, work in progress and finished goods at the lower of cost and net realisable value at the reporting date. Cost is purchase price net of creditable GST plus conversion cost, and net realisable value (NRV) is the price the stock can fetch in the ordinary course of business less the costs still needed to complete and sell it. The figure you settle on decides two things at once: the closing stock on the balance sheet and, by extension, the cost of goods sold in the profit and loss account. This guide sets out the rule with the working attached, so a manufacturer can see how each rupee of stock value is built and where the standard draws its lines. For a services engagement on your books, our Manufacturing Accounting Services team handles the mechanics; this article stays with the accounting.
What AS 2 requires for inventory valuation
AS 2, Valuation of Inventories, holds that inventories are measured at the lower of cost and NRV. Cost is made up of three layers. First, the cost of purchase: the invoice price plus non-creditable duties, freight inward and directly attributable handling, less trade discounts, rebates and any GST or duty that is recoverable as input credit. Second, the cost of conversion: direct labour plus a systematic allocation of production overheads. Third, other costs incurred to bring the inventory to its present location and condition. Anything outside those three layers stays out of stock.
The conversion layer is where manufacturers most often go wrong, because fixed production overhead has to be allocated on the basis of normal capacity, meaning the output ordinarily expected over a season across a number of periods. The split between direct and indirect factory overheads matters here: direct costs attach to units cleanly, while indirect fixed overheads must be spread using that normal-capacity denominator rather than whatever you actually produced this month.
What is NRV under AS 2?
NRV is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale. It is an entity-specific figure, not a market quote, so two factories holding the same item can arrive at different NRVs if their selling and finishing costs differ. Inventory is written down to NRV when it has been damaged, has become wholly or partly obsolete, when the selling price has fallen, or when completion costs have risen. The write-down is taken item by item, or by group of similar items, never by netting a profitable line against a loss-making one.
Raw materials get special treatment. You do not write raw material below cost if the finished goods it will go into are still expected to sell at or above cost. Only when the finished product itself will sell at a loss do you write the raw material down, and replacement price is then a reasonable measure of its NRV.
How to value inventory in manufacturing, step by step
Working across the three inventory classes in a factory, the sequence is consistent. A bill of materials costing gives you the material backbone, and the conversion cost is layered on top for anything past the raw-material stage.
- Raw material: value at cost of purchase (net of input GST), using FIFO or weighted average. No conversion cost is added.
- Work in progress: value at cost plus the conversion incurred to the stage reached. Reliable work-in-progress valuation depends on measuring the percentage of completion for labour and overhead, not just material issued.
- Finished goods: value at full cost, being material plus total conversion, with fixed overhead absorbed at normal capacity.
- Absorb overhead correctly: spread fixed production overhead over normal capacity units; charge any unabsorbed portion caused by idle or low capacity straight to the profit and loss account.
- Apply the NRV test: compare each item's cost with its NRV and carry the lower figure.
If your factory runs continuous or repetitive production, read our note on process costing versus job costing to pick the cost-flow that fits, then feed those unit costs into the valuation above. The mechanics of turning valued stock into a reported gross margin are covered in how to calculate COGS in a manufacturing business.
Which inventory valuation method is prohibited by AS 2?
LIFO, last in first out, is prohibited under both AS 2 and Ind AS 2, and it is not accepted for income-tax computation under ICDS II either. Permitted cost formulas are specific identification for items that are not ordinarily interchangeable, and FIFO or weighted average for everything else. The choice between FIFO and weighted average cost must be applied consistently to inventories of a similar nature and use. Switching from one to the other is a change in accounting policy, which needs disclosure, a stated reason and, where material, a restatement effect in the notes.
AS 2 vs Ind AS 2: what actually differs
The core measurement rule, lower of cost and NRV, is identical, and LIFO is banned in both. The differences are at the edges: scope, financing and disclosure. Ind AS 2 excludes machinery spares that qualify as property, plant and equipment (those move to Ind AS 16), deals with commodity broker-traders and producers at fair value less costs to sell, and pulls out the financing element when goods are bought on extended credit. If you are deciding which framework applies to your entity, the interactive AS vs Ind AS comparison matrix and the Ind AS applicability checker narrow it down quickly.
| Point | AS 2 | Ind AS 2 |
|---|---|---|
| Measurement base | Lower of cost and NRV | Lower of cost and NRV |
| Cost formulas | Specific identification, FIFO, weighted average | Same; LIFO prohibited |
| Broker-traders | Not specifically addressed | Fair value less costs to sell |
| Deferred settlement (credit) | Not addressed | Excess over cash price treated as interest |
| Machinery spares | May sit in inventory | PPE spares go to Ind AS 16 |
| Disclosure | Policy, classification, carrying amount | Wider: write-downs, reversals, pledged stock, fair value carrying amounts |
On the longtail question of where Ind AS 2 does not apply at all, the standard sets aside financial instruments and biological assets linked to agricultural activity, and it does not govern the measurement of inventory held by producers of agricultural, forest and mineral products, or by commodity broker-traders, all of which follow their own fair-value or NRV routes.
Costs excluded from inventory value
Four categories are charged to the period's profit and loss account and never capitalised into stock: abnormal wastage of material, labour or overhead; storage costs, unless storage is necessary in the production process before a further stage; administrative overheads that do not help bring inventory to its present location and condition; and selling and distribution costs. Ordinary spoilage within accepted norms stays in cost, but abnormal loss and a routine inventory shrinkage provision for pilferage or damage are period charges. Interest and other borrowing costs are excluded except in the narrow cases AS 16 allows for qualifying assets.
Worked example: costing a finished-goods batch
A unit has a normal capacity of 10,000 units a month but actually produced 8,000 units this month. Fixed production overhead is Rs 5,00,000. Per-unit costs are set out below, and the closing stock is 2,000 unsold units. All figures are illustrative.
| Component | Basis | Per unit (Rs) |
|---|---|---|
| Direct material | Issued at weighted average | 120 |
| Direct labour | Actual | 40 |
| Variable production overhead | Actual per unit | 30 |
| Fixed production overhead | Rs 5,00,000 / 10,000 normal-capacity units | 50 |
| Cost per unit | Sum of the above | 240 |
| NRV per unit | Selling price 260 less selling cost 15 | 245 |
| Carrying value per unit | Lower of cost (240) and NRV (245) | 240 |
Fixed overhead absorbed into the 8,000 units produced is 8,000 x Rs 50, or Rs 4,00,000. The remaining Rs 1,00,000 is unabsorbed idle-capacity cost and goes directly to the profit and loss account, not into stock. Closing stock is 2,000 units at Rs 240, or Rs 4,80,000. Here cost (240) is below NRV (245), so the goods are carried at cost; had the selling price fallen to Rs 245 with the same Rs 15 selling cost, NRV would drop to Rs 230 and each unit would be written down by Rs 10, a Rs 20,000 charge against profit.
Disclosure requirements under Ind AS 2
Ind AS 2 asks for more than a single stock figure. The financial statements should disclose the accounting policy including the cost formula used; the total carrying amount and its classification into raw material, work in progress and finished goods; the amount of inventories carried at fair value less costs to sell; the amount recognised as an expense during the period; the amount of any write-down and of any reversal, with the circumstances that led to it; and the carrying amount of inventories pledged as security for liabilities. AS 2's disclosure is lighter but still requires the policy, the cost formula and the classified carrying amounts. These sit within the inventory accounting and costing workstream and flow into the broader accounting services close.
Key terms
- Work-in-Progress (WIP) Valuation: measuring part-finished goods at cost plus conversion incurred to the stage reached.
- FIFO vs Weighted Average Cost: the two cost formulas AS 2 permits for interchangeable stock.
- Direct vs Indirect Factory Overheads: the split that decides which costs attach per unit and which are spread at normal capacity.
- Cost of Goods Sold: opening stock plus purchases and conversion, less closing stock valued under AS 2.
- Inventory Shrinkage Provision: a period charge for pilferage, damage or unexplained stock loss.
Where inventory valuation touches other manufacturer compliance
Valuation does not sit in isolation. Stock sent out for further processing has to be tracked for GST, which our guide on ITC-04 and job work under GST covers, and the same input purchases feed the MSME payment clock explained in Section 43B(h). If your business is a software or services entity rather than a factory, inventory is rarely the issue, and SaaS accounting services, IT and software company accounting or startup accounting services will be closer to your needs than a manufacturing stock policy.
Key takeaways
- Carry inventory at the lower of cost and NRV, tested item by item at the reporting date.
- Absorb fixed production overhead at normal capacity; charge idle-capacity cost to the profit and loss account.
- Exclude abnormal waste, storage, admin and selling costs from stock value.
- Use FIFO or weighted average, never LIFO, and apply the choice consistently.
- Ind AS 2 mirrors AS 2 on measurement but requires wider disclosure and specific broker-trader and financing rules.
The authoritative texts are worth reading alongside this note: the accounting standards issued by the ICAI, the Ind AS framework notified by the Ministry of Corporate Affairs, and, for the tax treatment of stock and the LIFO position, the ICDS material from the Income Tax Department.
Decision guide
