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As noted in IV 1.3.1, inventory is initially measured at cost, which includes the cost of materials, and, for work-in-process and finished goods, the costs incurred directly or indirectly in production, which includes labor and overhead. Full absorption costing refers to the process of allocating (absorbing) overhead into the cost of inventory.
ASC 330-10-30-1 through ASC 330-10-30-8 indicates that variable production overhead costs should be allocated to each unit of production on the basis of the actual use of the production facilities. The allocation of fixed production overhead costs, however, is required to be based on the “normal capacity” of the production facilities, which is defined as the production expected to be achieved over a number of periods under normal circumstances, taking into consideration loss of capacity resulting from planned maintenance. The range of normal capacity will vary based on business and industry factors.
The amount of fixed overhead costs allocated to each unit of production should not be increased as a consequence of abnormally low production or an idle plant. Abnormal amounts of freight, handling costs, and wasted material (spoilage) should be recognized as current period charges and not included in the cost of inventory. Judgment is required to determine what represents an abnormally low production level and an abnormal amount of production costs.

1.4.1 Full absorption costing — tax considerations

In the US, the IRS has specific rules for the costs that must be capitalized (absorbed) into inventory and entities may desire, when appropriate, to conform inventory accounting for financial reporting and tax purposes.
ASC 330-10-55-3 and ASC 330-10-55-4 state that the fact that a cost is capitalized for tax purposes does not, in itself, indicate that it is preferable, or even appropriate, to capitalize that cost for financial reporting purposes. Certain of the additional costs that are required to be capitalized for tax purposes may also be capitalizable for financial reporting purposes, depending on factors such as the nature of an enterprise's operations and industry practice. See Figure IV 1-1 in IV 1.4.4 for examples of inventoriable costs for financial reporting. We believe that usual material, labor, and overhead elements related to production should be included in inventory costs for both financial reporting and tax purposes.

1.4.2 Full absorption costing — cost flow assumptions

The primary objective in selecting an inventory costing method is to most clearly reflect periodic income. In other words, to match the specific costs of an item sold to its related revenues, which may be difficult in practice depending on an entity's circumstances. As a result, the general acceptance of several assumptions with respect to the flow of inventory costs has developed as a practical basis for the measurement of periodic income. The most commonly used inventory costing methods include first-in first-out (FIFO), average cost, and last-in first-out (LIFO). The method selected should be consistent with the primary objective and applied consistently period to period.
Many companies use standard cost to account for their inventories. Standard cost represents the expected per unit cost of direct material, direct labor, and manufacturing overhead for a product typically based on budgets and forecasts. Use of standard cost is acceptable, provided the standards are adjusted at reasonable intervals to reflect current conditions and variances between actual costs and standards are absorbed into inventory so that, at the balance sheet date, the standard cost approximates actual cost under one of the recognized costing methods (e.g., FIFO, average cost, LIFO).
Regardless of how frequently standard cost is updated, actual cost will always differ from the standard, resulting in inventory variances (favorable or unfavorable). At each reporting date, an entity should evaluate whether the inventory balances stated at standard costs need to be adjusted to reflect the variances (i.e., capitalize the variances to adjust inventory to actual cost). When costs are required to be included in inventory that are not captured by an entity’s cost accounting system, but are added during the closing process, consideration should be given to ensure the assessment of lower of cost and NRV (see IV 1.3.2) appropriately considers the adjusted inventory costs.

1.4.3 Full absorption costing — accounting changes

Any change in the composition of the elements of cost included in inventory or a change in the cost flow assumption (e.g., from LIFO to FIFO) is a change in accounting principle under ASC 250. Any such change must be justified as preferable. See FSP 30 for additional information on justifying preferability and reporting a change in accounting principle.
Conversely, the normal process of revising overhead absorption rates or fringe benefit accrual rates is not a change in accounting. Rather, those types of revisions are changes in estimates and are applied prospectively.
In assessing whether a change in the composition of inventory costs is preferable, there is a presumption that omission from inventories of conventional overhead cost elements is not preferable (i.e., a general preference for full absorption costing). In addition, ASC 250-10-55-1 requires that for a change to be preferable, it must constitute an improvement in financial reporting and that preferability among principles cannot be determined on the basis of the income tax effect alone.
See IV 3.5 for additional guidance on accounting changes related to LIFO inventory.

1.4.4 Book capitalization

Figure IV 1-1 illustrates various costs and whether such costs are inventoriable costs for purposes of financial reporting. Note that cost capitalization may be different for tax purposes.
Figure IV 1-1
Analysis of indirect production costs for full absorption
Usually an inventoriable cost
Not usually an inventoriable cost
Cost of indirect materials and supplies
X
Tools and equipment used in production but not capitalized
X
Costs of quality control and inspection
X
Costs attributable to rework labor, scrap, and spoilage
X
Losses from casualty or theft
X
Distribution and warehousing costs (finished goods)
X
Vendor rebates and other credits (1)
(2)
(2)
Depreciation for assets related to or necessary for production or manufacturing
X
Cost depletion (except depletion on intercompany sales)
X
Repairs and maintenance of production equipment
X
Utilities
X
Rent
X
Bidding costs
X
Engineering and design expense (to the extent not research and development)
(3)
(3)
Research and development expenses
X
Factory administrative expenses
X
Insurance related to production
X
Marketing, advertising, and selling expenses
X
Indirect labor and supervisory wages related to production, including basic compensation, overtime pay, vacation and holiday pay, and payroll taxes
X
General and administrative expenses attributable to business activities as a whole (i.e., not directly or indirectly related to manufacturing, retailing, or wholesaling operations) such as costs of recruiting, billing, and accounts receivable
X
Officers' salaries related to business activity as a whole
X
Officers' salaries related to production
(4)
(4)
Pension cost representing current service costs (4)
X
Pension contributions to multi-employer plans (4)
X
Profit-sharing contributions (4)
X
Other employee benefit costs, including worker's compensation expenses, payments under wage continuation plans, amounts includable in income of an employee under nonqualified pension, profit-sharing and stock bonus plans, premiums on life and health insurance, incentive compensation and miscellaneous employee benefits (4) (5)
X
Taxes allowable as a deduction under Section 164, excluding state, local, and foreign income taxes
X
Income taxes attributable to income received on sale of inventory
X
Notes:
(1) Consideration should be given to the impact of applying authoritative guidance, including ASC 705-20, Costs of sales and services – Accounting for consideration received from a vendor.
(2) Individual facts and circumstances should be considered to determine if these costs are capitalizable. For example, capitalization of such costs are not unusual in certain retail businesses.
(3) Individual facts and circumstances should be considered to determine if these costs are capitalizable based on whether the costs are research and development expenses. Officers' salaries related to production are included or excluded depending on the nature of the business and/or how specifically officers' duties can be identified as being directly related to the production effort.
(4) Applies to employees involved in or necessary for production or manufacturing operations. Pursuant to ASC 715-20-45-3A, only the service costs component of net periodic benefit expense is eligible for capitalization as part of the cost of inventories.
(5) Certain elements, such as recreational facilities for employees or expenses in support of recreation and similar costs, are frequently not capitalizable.
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