Act No. 563/1991 Coll., on Accounting, as amended, Section 25 (5) (c), defines the term internal cost in the valuation of internally developed inventory as direct costs incurred in production, and, where applicable, attributable indirect costs related to production. Regulation No. 500/2002 Coll., Section 49 (5), allows for two methods of determining internal costs, either as actual costs or on the basis of a calculation. This topic is also dealt with in detail in the National Accounting Council’s Interpretation I-35: Valuation of Internally Developed Inventory.

1. Can valuation based on a calculation differ from valuation at actual cost?

The answer is fairly simple: yes, it can, but not markedly. That means that it is necessary to prove that the calculation reflects actually incurred costs. Let’s look at an example. The calculation set at the start of the year anticipated that the cost of material would be CZK 1,000/t and that 1.2 t of material would be consumed for one tonne of product. However, during the year, the price of material decreased to CZK 900/t, and thanks to a new line, the company was able to reduce the volume of waste, and as a result, only 1.15 t of material was used to produce one tonne. If the valuation of products included nothing but material, then the actual cost of 1 t of product would be CZK 1,035, while the cost based on the calculation would be CZK 1,200. In the valuation of inventory, the entity would thus capitalise more than it had really incurred, which is against the provisions of the Accounting Act. The use of calculations is intended to make everyday operations easier and, in particular, help in the capitalisation of attributable indirect costs. It is therefore necessary to make sure that even a less precise method (i.e. calculation) produces results that reflect economic reality.

2. What about attributable indirect costs – what can and cannot be included in them?

Attributable indirect costs do not include administrative costs (e.g. accounting), management salary costs, sales-related costs and warehousing costs or inventory movement costs, unless such movement is a normal part of the production process. Another item that cannot be taken into account in the calculation is inefficiency. This includes, for example, costs related to downtime caused by a breakdown, waste material arising due to error/breakdown or defective products, as well as costs related to unused capacity or wasted labour. Such costs cannot be capitalised in the valuation of inventory because they are not directly related or directly attributable to the production of the product and are therefore expenses of the current period.

3. How often should calculations be changed?

There is no unequivocal answer. As the previous example shows, calculations have to be changed as often as needed to make sure they stay as close to reality as possible. Typically, calculations are changed when there is a significant change in the price of input materials or other inputs (e.g. labour costs, energy costs) or when there is a change in the technological process or when production efficiency is improved. Another reason for a change in the calculation, particularly in the allocation of indirect costs, is a significant change in the volume of actual production compared with planned production. Be careful, however, if the actual production volume is lower because of inefficiencies or underutilisation of normal capacity, the calculation should not be changed. See above. Nevertheless, as part of the balance sheet date inventory taking, the calculations should always be checked to ensure that their input values are not significantly different from reality and, if necessary, they should be adjusted and inventory revalued.

The balance sheet date is when mistakes are often made. Sometimes, a company may incorrectly value inventory at the end of the year using the calculations made for the following year. However, these are usually already based on new (higher/lower) prices for the next period and thus do not reflect the costs actually incurred in production. Another common problem is the consideration of actual values according to inventory turnover. For example, the normal turnover is one month, and the company therefore decides to use the production and cost data for the last month of the reporting period to update the calculation. However, it does not realise that production is significantly lower in December – due to the Christmas holidays – and it allocates indirect costs based on the quantity produced in December. This approach is incorrect because, as stated above, the allocation must be based on the usual production volume. In addition, staff costs for December may be significantly higher on a one-off basis due to possible full-year/Christmas bonuses. It is therefore preferable to base the calculation on an average of, e.g., the last three months.

4. How to check that the calculation is correct?

Verifying the correctness of the calculation is not a simple process. It is necessary to focus on the allocated quantities of consumed material, hours of work, hours of machine time, kWh of electricity, litres of water, etc. and then to value them correctly. It would be incorrect to compare only actual prices with planned ones. There are countless ways of verifying the quantities actually consumed. They range from simple observation of production accompanied by measurement to the use of modern technology that records moments in the production process and the quantity of inputs. It is up to each company to choose the method that is most appropriate for it. However, it must be kept in mind that it is necessary to have sufficient evidence that the calculation has not been fabricated.

5. If I change a calculation, is it a change in policy, a change in estimate, or an error?

Once again, the question does not have an easy answer. If amounts (financial amounts or quantities) are changed based on the current status, then it is a change in estimate. If it turns out that the calculation contained erroneous values, inadmissible costs or a mathematical error, then it is an error. A change in policy will be relatively rare. This would be the case, for example, where an entity had previously disregarded attributable indirect costs in the calculation and now, in order to refine the value of inventory, has started to include them in the calculation. We have written in more detail about the effects of changes in policy, changes in estimates, and errors in Financial statements for 2024: what to keep in mind?.

6. And what does Ruling 31 Af 7/2024-51 imply?

In the case at hand, the company significantly reduced the value of inventory and claimed that the reduction was caused by a change in policy, as the previous calculation included administrative overheads, while under the new methodology, administrative overheads were no longer allocated to inventory valuation. However, the company was unable to prove how the inventory was originally valued, i.e. it did not provide the court with evidence of the original calculation or explain which costs it considered to be administrative overheads included in the value of the inventory. The company’s only support for its claim that the original valuation of the inventory included administrative overheads was the new calculation that reduced the value of the inventory. However, the court pointed out that in individual cases, the new calculation actually increased the valuation of the inventory. The court’s main argument in ruling in favour of the financial administration (which argued that this was not a change in policy but an error) was that the company was unable to credibly demonstrate that the original valuation was correct, i.e. to present the original calculation supported by actual costs. Furthermore, the Regional Court found that the company was unable to quantify the impact of the change in policy because it had not recalculated the value of inventory in stock as of the beginning of the period according to the new methodology, but had only used an estimate based on the calculations used at the end of the period.

Our takeaway from the Ruling can thus be that for the purposes of audits performed by the tax office, it is crucial to have historical calculations available. That can sometimes be problematic, especially in a situation where the calculations are stored only in an IT system and are continuously updated without the possibility of viewing previous values. The court clearly stated that the loss or non-adoption of a calculation formula (e.g. due to personnel changes) cannot be considered as relevant objective reasons justifying the failure to prove the accuracy of the original inventory value.

According to the Regional Court, a calculation change can only be considered a change in policy if both the original and the new method are documented and permissible from the point of view of the accounting regulations and the change is not the result of an error but of a well-thought-out decision of the company that leads to a more accurate/true representation of the transaction/fact in question.