👋 Welcome to the World of Manufacturing Accounting!
Hello future accountants! In this crucial chapter, we are stepping up from simple retail businesses to the exciting world of manufacturing. Manufacturing businesses are special because they don't just buy and sell goods; they make them!
This means our financial statements need an extra layer of detail to track the costs involved in transforming raw materials (like wood or flour) into finished goods (like furniture or bread). Don't worry if this seems tricky at first; we will break down the process step-by-step!
The Core Difference: Why Manufacturers Need Special Accounts
Think of a standard retailer (like a clothing store). Their main expense is buying clothes (Purchases).
Now, think of a furniture manufacturer. They don't buy furniture; they buy wood, nails, and paint. They must calculate the cost of making one chair. This requires a new account called the Manufacturing Account.
The purpose of the Manufacturing Account is solely to determine the Total Cost of Production for the period. This single figure then moves into the Income Statement.
Quick Review Box:
- Retailer: Calculates Cost of Goods Sold using Purchases.
- Manufacturer: Calculates Cost of Goods Sold using Cost of Production (from the Manufacturing Account).
The Structure of the Manufacturing Account
The Manufacturing Account groups costs into two main categories: Direct Costs and Indirect Costs (Overheads).
1. Calculating Prime Cost (The Direct Costs)
Prime Cost is the total of all costs that are directly traceable to the product being made. If the cost is necessary and physically becomes part of the final product, it’s a direct cost.
A. Direct Materials Consumed
This is not just the cost of materials purchased; it’s the cost of materials actually used up in the factory during the period.
Step-by-Step Calculation:
- Start with Opening Inventory of Raw Materials (materials left over from last year).
- Add: Purchases of Raw Materials (what you bought this year).
- This gives you the Cost of Materials Available for Use.
- Deduct: Closing Inventory of Raw Materials (materials left unused at the end of the year).
- The result is the Cost of Raw Materials Consumed.
Did you know? Raw materials inventory is kept separate from finished goods inventory!
B. Direct Labour (Direct Wages)
These are wages paid to employees who are directly involved in making the product (e.g., assembly line workers, machine operators). If the worker’s time is measured per product, it is direct labour.
C. Direct Expenses
Any other expenses directly related to a specific production run (e.g., royalties paid per unit produced, special hire of machinery for one job).
FORMULA TIP (Memory Aid):
Prime Cost = Cost of Raw Materials Consumed + Direct Labour + Direct Expenses
2. Calculating Factory Overheads (Indirect Costs)
Factory Overheads (also called Manufacturing Overheads or Indirect Costs) are all costs incurred in the factory that cannot be traced directly to a single unit of product. They are necessary to keep the factory running.
Examples of Overheads:
- Indirect Wages: Wages for supervisors, security guards, or maintenance staff (they are essential but don't physically touch the product).
- Factory Rent / Rates: The cost of occupying the factory building.
- Depreciation: Depreciation on factory machinery and equipment.
- Factory Insurance, Electricity, Repairs.
IMPORTANT DISTINCTION: Only costs incurred inside the factory go into the Manufacturing Account. Selling, distribution, and office expenses (like sales staff salaries or office depreciation) go straight into the Income Statement!
3. Determining the Total Cost of Production
After calculating Prime Cost and Factory Overheads, we combine them to find the cost of all resources used in production.
Total Manufacturing Cost = Prime Cost + Factory Overheads
Adjusting for Work In Progress (WIP)
Not everything started during the year is finished. Work In Progress (WIP) refers to goods that are partially completed at the start or end of the financial year.
Analogy: Think of a cake factory. WIP is the dough that is mixed but not yet baked (not a raw material, but not finished either).
We must adjust the total manufacturing cost for WIP:
- Add: Opening WIP (Goods that were half-finished last year and are finished this year).
- Deduct: Closing WIP (Goods that are half-finished this year and will be finished next year).
The final result of the Manufacturing Account is the Cost of Production. This is the figure that gets transferred to the Income Statement.
Key Takeaway for Section 2: The Manufacturing Account calculates the Cost of Production by finding Prime Cost (Direct) and adding Overheads (Indirect), then adjusting for Work In Progress.
The Financial Statements of a Manufacturer
1. The Income Statement (Statement of Profit or Loss)
The Income Statement for a manufacturer looks very similar to a retailer’s, but the calculation of Cost of Goods Sold (CGS) changes significantly because we are now dealing with Finished Goods inventory.
The structure for finding Gross Profit is:
Sales Revenue
Less: Cost of Goods Sold
Calculating Cost of Goods Sold (CGS) for Finished Goods
Instead of adding Purchases, we add the Cost of Production (the transfer figure from the Manufacturing Account).
CGS Calculation:
- Start with Opening Inventory of Finished Goods.
- Add: Cost of Production (The total cost of goods completed this year).
- This gives you the Cost of Goods Available for Sale.
- Deduct: Closing Inventory of Finished Goods.
- The result is the Cost of Goods Sold (CGS).
FORMULA (MathJax):
$$ \text{CGS} = \text{Opening Finished Goods} + \text{Cost of Production} - \text{Closing Finished Goods} $$
Operating Expenses
After finding the Gross Profit, we deduct the remaining expenses, which fall into two main categories:
- Selling and Distribution Expenses: Costs related to sales and getting goods to the customer (e.g., sales commissions, advertising, delivery van depreciation).
- Administrative Expenses: Costs related to running the general office (e.g., office staff wages, office rent, office building depreciation).
Don’t forget that any rent, insurance, or depreciation previously split between the factory and the office must now be charged to the correct place! The factory portion went to the Manufacturing Account; the office/selling portion comes here.
2. The Statement of Financial Position (SFP)
The SFP reports the assets, liabilities, and equity at the end of the period. The main change for manufacturers appears under Current Assets: Inventory.
A manufacturer must report three separate types of inventory:
- Raw Materials: Unused basic inputs (e.g., wood).
- Work In Progress (WIP): Partially finished goods.
- Finished Goods: Completed items ready for sale (e.g., finished chairs).
Accessibility Tip: Always remember to value inventory at the lower of cost or net realisable value, just like any other business!
Commentary and Usefulness of the Manufacturing Account
Preparing the Manufacturing Account is not just an accounting exercise; it provides vital information for management decision-making. We are expected to comment on its value.
Why is the Manufacturing Account useful?
- Cost Control: By clearly separating Prime Costs and Factory Overheads, management can see exactly where costs are being incurred. If the Cost of Production is too high, they can investigate high material waste or excessive overheads.
- Pricing Decisions: Knowing the precise cost to make one unit allows the business to set a selling price that ensures a profit margin. If they didn't know the exact production cost, they might underprice their goods.
- Efficiency Measurement: Managers can compare the current period’s Cost of Production against previous periods or industry benchmarks. A rising cost suggests inefficiency (e.g., machine breakdowns, higher electricity usage).
- Valuing WIP: It provides the necessary structure to accurately value Work In Progress at the end of the period for the SFP.
Common Mistake to Avoid: Confusing the three inventories!
- Raw Materials Inventory is used in the Raw Materials Consumed calculation.
- WIP Inventory is used to find the Total Cost of Production.
- Finished Goods Inventory is used to find the Cost of Goods Sold in the Income Statement.
Keep practising the flow—from materials to production, and then from production to sale—and you will master this chapter! You’ve got this!