Wednesday, February 19, 2014

Increasing labour cost and its impact on net realisable value of inventories

In current economy situation, almost all entities have to face the challenges of increasing labour costs. It is not easy to manage the labour costs, as the need may fluctuate from day-to-day, whilst the number of headcount is "sticky" in economic term - i.e. headcount of a company would not change drastically within short period of time. Moreover, the change of regulation may have an impact on the labour costs - for intsance, the increase in social security fund in China.

The increasing labour cost would have an impact on net realisable value of the inventories. Why?

The above is especially true for businesses operating in manufacturing environment. Some of the labour cots represent direct labour to the company, who capitalised direct labour cost as finished goods upon completion of production, and charged to cost of sales upn sales of that particular item.

When a manufacturing accept a sales order for a particular model, they would draft a budget to estimate the raw material, labour and overhead costs. On this basis, they would propose a pricing for the customer. The pricing quote may be valid for a period of 1 year or more. In an environment where labour cost is increasing, the direct labour costs incurred may cause the inventory costs to go higher and higher and resulted in erosion of gross profit margin.

This will be very challenging for business to manage, especially for projets with minimal margin - these projects are sensitive to all the costs incurred to produce these items. The increase in direct labour cost may trigger a net realisable value write-down.

As a result, auditor need to understand how this process is being managed and concentrate on projects with minimal GP margin.

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