Under IAS 2, the standard Gulf companies use for inventory, product cost includes materials, the cost of converting them (labour and production overheads), and other costs of bringing the product to its present location and condition. Fixed overheads are spread over normal production capacity, not over whatever was produced this month.
This guide explains what a bill of materials includes and leaves out, how to build up full product cost, and works through the cost of one product line. It then covers standard versus actual cost, the errors we see most often, and an FAQ.
What is a bill of materials, and what does it miss?
A bill of materials (BOM) lists every raw material, component and packaging item needed to make one unit, or one batch, of a finished product, with the quantity of each. Multi-level BOMs also list sub-assemblies, each with its own BOM.
A BOM for a 1-litre bottle of juice might look like this:
| Component | Quantity per bottle | Unit |
|---|---|---|
| Juice concentrate | 0.18 | kg |
| Treated water | 0.85 | litre |
| Sugar | 0.04 | kg |
| PET bottle, 1 litre | 1 | piece |
| Cap | 1 | piece |
| Label | 1 | piece |
| Carton (12 bottles) | 0.0833 | piece |
Multiply each line by its purchase cost and you have the material cost. That is where many costing exercises stop, and where they go wrong. A BOM on its own misses:
- Waste and yield loss: spillage, trimming, rejects and start-up losses on each run. If 3% of concentrate is lost, the BOM quantity understates real use.
- Direct labour: the operators on the line, by minutes per unit or per batch.
- Machine and production overheads: depreciation, power, maintenance, factory rent, supervisors and quality control.
- Inbound costs: freight, customs duty and clearing on imported materials, which belong in material cost.
The routing, or list of operations and work centres, captures labour and machine time. BOM plus routing, with waste allowances and an overhead rate, gives the full product cost.
What goes into product cost under IAS 2?
Companies reporting under IFRS, which covers most Gulf companies that produce audited accounts, value inventory under IAS 2. The standard sets out what product cost includes and excludes.
| Cost element | Included? | IAS 2 reference | Notes |
|---|---|---|---|
| Materials, at purchase price | Yes | Paragraph 11 | Including import duty, non-recoverable taxes, freight and handling, less trade discounts |
| Normal waste and yield loss | Yes | Paragraphs 11 to 12 | Part of the cost of making good units |
| Direct labour | Yes | Paragraph 12 | Wages and benefits of production staff |
| Variable production overheads | Yes | Paragraphs 12 to 13 | Power, consumables; allocated on actual use |
| Fixed production overheads | Yes, on normal capacity | Paragraph 13 | Depreciation, factory rent, supervision, maintenance |
| Overheads from low production | No, expensed | Paragraph 13 | The share not absorbed because output was below normal |
| Abnormal waste | No, expensed | Paragraph 16 | For example, a spoiled batch from a machine failure |
| Storage of finished goods | No, expensed | Paragraph 16 | Unless storage is part of production, such as ageing |
| Administration and selling costs | No, expensed | Paragraph 16 | Head office, sales team, marketing, distribution |
The rule that catches most companies is normal capacity. IAS 2 says fixed production overheads are allocated based on the production expected on average over several periods, under normal conditions. If a factory normally makes 100,000 units a month but makes only 60,000 in a slow month, each unit still carries the overhead rate based on 100,000. The overhead that is not absorbed is an expense of the month, not extra cost sitting in inventory.
IAS 2 also allows standard costs to be used for valuation if the results approximate actual cost, and if standards are reviewed regularly and revised when conditions change (paragraph 21).
How do you cost one product? A worked example
A juice producer in Sharjah makes 1-litre bottles on one filling line. Normal capacity, allowing for planned maintenance, is 1,500,000 bottles a month. Fixed production overheads (line depreciation, factory rent, maintenance, quality control and supervisors) are AED 750,000 a month.
| Cost element | Basis | AED per bottle |
|---|---|---|
| Concentrate | 0.18 kg plus 3% yield loss, at AED 9.50 per kg landed | 1.76 |
| Water and sugar | BOM quantities at purchase cost | 0.14 |
| Bottle | 1 piece plus 2% rejects, at AED 0.32 | 0.33 |
| Cap, label and carton share | BOM quantities at purchase cost | 0.26 |
| Materials | 2.49 | |
| Direct labour | 6 operators at AED 22 an hour, 4,000 bottles an hour, plus changeover and cleaning time | 0.05 |
| Variable overheads | Power, cleaning chemicals, consumables | 0.08 |
| Fixed production overheads | AED 750,000 divided by 1,500,000 bottles of normal capacity | 0.50 |
| Full product cost | 3.12 |
The BOM at purchase prices, with no waste, comes to AED 2.43, or 78% of full cost. The difference changes decisions:
| Measure | Based on BOM only | Based on full cost |
|---|---|---|
| Cost per bottle | AED 2.43 | AED 3.12 |
| Margin at AED 3.80 distributor price | AED 1.37 (36.1%) | AED 0.68 (17.9%) |
| Margin at AED 3.10 supermarket promotion | AED 0.67 | AED (0.02) |
The promotion looks healthy on the BOM and loses two fils a bottle on full cost. That does not automatically make it wrong: its price is AED 0.48 above variable cost (materials, labour and variable overheads, AED 2.62), so it still contributes to fixed overheads if the line has spare capacity. But the decision should be made knowing both numbers.
What happens in a slow month? Suppose the line makes only 1,000,000 bottles. Inventory still carries AED 0.50 a bottle of fixed overhead, so AED 500,000 is absorbed and the remaining AED 250,000 goes straight to the month's expenses. Dividing AED 750,000 by 1,000,000 bottles instead would put AED 0.75 into each bottle, overstating inventory and hiding the cost of idle capacity.
Should you use standard cost or actual cost?
Most manufacturers use both. A standard cost is the expected cost per unit, built from the BOM, routing, expected prices and the overhead rate. Actual cost is what each production order really consumed. The difference, the variance, is where the management information sits.
| Variance | Formula | What it usually means |
|---|---|---|
| Material price | (Actual price minus standard price) × actual quantity | Supplier price changes, currency, freight or duty changes |
| Material usage | (Actual quantity minus standard quantity) × standard price | Waste above allowance, wrong BOM, poor machine setting |
| Labour efficiency | (Actual hours minus standard hours) × standard rate | Slower runs, breakdowns, extra changeovers |
| Overhead volume | (Normal capacity minus actual output) × fixed overhead rate | Idle capacity; under IAS 2 this is expensed |
Using the juice example: in a month when the line made 1,200,000 bottles and used 226,000 kg of concentrate, the standard allowance was 1,200,000 × 0.1854 kg, or 222,480 kg. The extra 3,520 kg at AED 9.50 is a usage variance of AED 33,440, worth a conversation with the production manager. The volume variance is 300,000 bottles below normal capacity × AED 0.50, or AED 150,000, which is expensed.
Review standards at least once a year, and whenever a major input price moves. If material price variances run in the same direction for three months, the standard is out of date, and inventory valued at standard no longer approximates actual cost as IAS 2 requires.
What are the most common production costing errors?
| Error | Effect | Fix |
|---|---|---|
| BOM quantities with no waste allowance | Material cost understated; usage variances every month | Add yield or scrap percentages per component, based on measured loss |
| Materials at invoice price only | Freight, duty and clearing missing from cost | Use landed cost for imported materials |
| Fixed overheads spread over actual output | Inventory overstated in slow months; costs swing month to month | Use a rate based on normal capacity, and expense the unabsorbed balance |
| Admin and selling costs in product cost | Inventory overstated; not allowed under IAS 2 | Keep head office, sales and distribution outside product cost |
| One overhead rate for the whole factory | Products using expensive lines look cheap, and simple products look dear | Use rates by line or work centre |
| BOM not updated after a recipe or pack change | Cost and stock usage both wrong | Version BOMs, with an effective date and approval |
Checklist before you trust your product costs
What does HYP see at manufacturers?
At food, packaging, chemicals and building products manufacturers in the Gulf, our implementation team usually finds product cost held in a spreadsheet built years ago by one person. It uses BOM quantities with no waste, materials at an old purchase price and a single overhead percentage. Sales use it to price, finance doesn't fully trust it, and nobody has updated it since the last big price change.
The first useful step is rarely a new costing method. It is getting actual material issues and output recorded against each production order, so the gap between BOM and actual usage becomes visible. In the first few months, the usage variance report typically finds one or two products where real waste is several times the allowance.
In HYP, BOMs and routings drive production orders, materials are issued at landed cost, and overheads are absorbed per work centre, so standard cost, actual cost and variances come from the same records. See how it works on our Production Planning, BOM & Routing page.
Related reading: imported materials should carry freight, duty and clearing. See Landed Cost for Importers: How to Add Freight, Duty and Clearing to Item Cost.