IAS 2 inventories explained

Inventory drives gross margin for every retailer, manufacturer and distributor, so the rules on what goes into the cost of inventories matter. This guide explains IAS 2 step by step: purchase and conversion costs, how fixed overheads are absorbed, the cost formulas, and when inventory must be written down to net realisable value.

By Mirza Fahad Baig, Chartered Accountant. Reviewed by Hamza Fida, Chartered Accountant. Checked against official sources on . 3 minute read.

Short answer

IAS 2 Inventories requires inventories to be measured at the lower of cost and net realisable value. Cost includes purchase costs, costs of conversion such as direct labour and a systematic allocation of production overheads, and other costs of bringing the inventories to their present location and condition. Cost is assigned using FIFO or weighted average, or specific identification for unique items; LIFO is not allowed. When inventory is sold, its carrying amount becomes cost of sales.

At a glance

Measure at
Lower of cost and NRV
Cost includes
Purchase, conversion and other costs
Fixed overheads
At normal capacity
Cost formulas
FIFO, weighted average, specific ID
LIFO
Not allowed
Excel
Inventory costing comparison
IAS 2 inventories explainedMeasure at: Lower of cost and NRV; Cost includes: Purchase, conversion and other costs; Fixed overheads: At normal capacity; Cost formulas: FIFO, weighted average, specific ID; LIFO: Not allowed; Excel: Inventory costing comparison.KEY FACTS AT A GLANCEIAS 2 inventories explainedMeasure atLower of cost and NRVCost includesPurchase, conversion andother costsFixed overheadsAt normal capacityCost formulasFIFO, weighted average,specific IDLIFONot allowedExcelInventory costingcomparisonChecked against official sourcesTax BakersIAS 2 inventories explainedMeasure at: Lower of cost and NRV; Cost includes: Purchase, conversion and other costs; Fixed overheads: At normal capacity; Cost formulas: FIFO, weighted average, specific ID; LIFO: Not allowed; Excel: Inventory costing comparison.KEY FACTS AT A GLANCEIAS 2 inventories explainedMeasure atLower of cost and NRVCost includesPurchase, conversion and other costsFixed overheadsAt normal capacityCost formulasFIFO, weighted average, specific IDLIFONot allowedExcelInventory costing comparisonChecked against official sourcesTax Bakers
Key facts at a glance, as set out in this guide.

What goes into the cost of inventories under IAS 2?

Building up the cost of inventoriesBuilding up the cost of inventories1PurchasecostsPrice, duties,transport2ConversioncostsLabour andproduction overheads3Other costsTo bring topresent location4Lower of costand netrealisable value
Cost includes everything needed to bring inventory to its present location and condition.
IncludedExcluded
Purchase price, import duties and non-recoverable taxes, transport and handlingTrade discounts and rebates, which are deducted
Direct labour and materials used in productionAbnormal waste of materials, labour or overheads
Variable production overheads, such as indirect materialsStorage costs, unless needed in production before a further stage
Fixed production overheads, such as factory depreciation, allocated at normal capacityAdministrative overheads and selling costs
Borrowing costs, only for inventories that take a substantial period to get readyForeign exchange differences on purchases

How are fixed production overheads absorbed?

On the basis of the normal capacity of the production facilities, the production expected on average over a number of periods. If production is unusually low, the unabsorbed overhead is expensed, not added to the cost of fewer units. If production is unusually high, the overhead per unit is reduced so inventory is not carried above cost.

Example: a factory's fixed overheads are 500,000 a year and normal capacity is 100,000 units, so 5 per unit is absorbed. If a strike limits output to 70,000 units, only 350,000 is included in inventory and 150,000 is expensed as unabsorbed overhead.

Which cost formulas are allowed?

Specific identification for items that are not ordinarily interchangeable, such as custom-built machines or property developments. For everything else, first-in, first-out (FIFO) or weighted average cost. The same formula must be used for all inventories of a similar nature and use; different formulas are allowed for inventories with a different nature or use. LIFO is prohibited. See FIFO vs weighted average with examples.

When is inventory written down?

When its net realisable value, the estimated selling price less the costs of completion and the costs of making the sale, falls below cost, because of damage, obsolescence, falling prices or rising completion costs. The write-down is expensed and is reversed if NRV later recovers. See net realisable value and write-downs.

Are standard costs and the retail method allowed?

Yes, for convenience, if the results approximate cost. Standard costs must reflect normal levels of materials, labour, efficiency and capacity and be reviewed regularly. The retail method, which reduces sales value by a gross margin percentage, is common for retailers with many fast-moving items of similar margin.

Are there special cases?

Yes. Agricultural produce harvested from a company's biological assets is measured at fair value less costs to sell at the point of harvest under IAS 41, and that amount becomes its cost under IAS 2. Commodity broker-traders that measure their inventories at fair value less costs to sell, with changes in profit or loss, are excluded from the IAS 2 measurement rules, as are producers of agricultural and mineral products measured at net realisable value under well-established industry practice.

When is inventory expensed?

When it is sold, its carrying amount is recognised as an expense in the period the related revenue is recognised. Write-downs and losses are expensed when they occur. Inventory used as a component of self-built property, plant and equipment becomes part of that asset's cost.

How does US GAAP differ?

US GAAP allows LIFO, uses lower of cost or market for LIFO and the retail method, and does not reverse annual write-downs. See IAS 2 vs ASC 330, and model your own figures in the Inventory costing comparison (Excel).

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Questions people ask

What is IAS 2?

The IFRS standard on inventories, requiring measurement at the lower of cost and net realisable value, and setting out what cost includes and which cost formulas are allowed.

What is included in the cost of inventories?

Costs of purchase, costs of conversion including allocated production overheads, and other costs of bringing inventories to their present location and condition.

Are administrative overheads included in inventory cost?

No. Administrative overheads, selling costs, abnormal waste and most storage costs are expensed.

Is LIFO allowed under IAS 2?

No. IAS 2 permits FIFO, weighted average cost and specific identification only.

Sources

Every fee, date and rule on this page was taken from these official and primary sources.

  1. IFRS Foundation: IAS 2 Inventories

Rules and fees change. If you are reading this long after October 4, 2026, confirm the figures with the source before you rely on them.

IAS 2Cost formulas: FIFO and weighted averageIAS 2Net realisable value and inventory write-downsIFRS vs US GAAPIAS 2 vs ASC 330: inventory, LIFO and write-downs

More in IAS 2

TopicAll 3 guides in IAS 2

This guide is general information. It is not tax or legal advice for your situation.