Accounting (9706) | Preparation of financial statements - Manufacturing businesses

Preparation of Financial Statements: Manufacturing Businesses

Hello future accountants! This chapter takes your financial statement preparation skills (like those for sole traders and partnerships) and adds an exciting industrial twist: the process of making the product itself! We are now looking at businesses that manufacture goods rather than just buying and selling them (trading).

Why is this important? Because a manufacturer needs a special account—the Manufacturing Account—to figure out exactly how much it cost them to produce the items they plan to sell. This cost then flows into the standard Statement of Profit or Loss (SOPL).

Don't worry if this seems like a big step! We will break down the complex idea of production costs, including the tricky concept of 'unrealised profit', into clear, manageable steps.

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1. Understanding Costs in a Manufacturing Business

The first crucial step is classifying costs. Manufacturing costs are split into two main groups: Direct and Indirect costs.

1.1 Direct Costs (The Prime Ingredients)

These are costs that can be directly and fully traced to the specific product being made. If you stop making the product, these costs disappear immediately.

• Direct Materials: The physical components that go into the final product.
  Example: Wood for a table, fabric for a shirt.
• Direct Labour: Wages paid to the workers who are directly involved in converting raw materials into finished goods.
  Example: The machine operator cutting the metal, the assembly line worker.
• Direct Expenses: Any other expenses directly related to the production of a specific unit.
  Example: Royalties paid per unit produced, hire of specific machinery for a single job.

The total of all direct costs is called the Prime Cost.

$$ Prime \ Cost = Direct \ Materials + Direct \ Labour + Direct \ Expenses $$

1.2 Indirect Costs (Overheads)

These costs are necessary for running the factory, but cannot be easily traced to a single unit of product. They are essential but shared by many products.

In manufacturing, indirect costs are split into two groups based on where they occur:

a) Factory Overheads (Manufacturing Overheads)

These are all indirect costs incurred *inside* the factory to keep production running. They are included in the Manufacturing Account.

• Example: Indirect materials (lubricants, cleaning supplies), indirect labour (factory supervisor's salary, security guards), factory rent, factory insurance, depreciation of factory machinery, power and lighting for the factory.

b) Non-Manufacturing Overheads (The "Admin & Selling" Costs)

These are the costs incurred outside the production process. They are treated as period costs and appear directly in the Statement of Profit or Loss (SOPL).

• Example: Office rent, sales commissions, administrative salaries, delivery vehicle expenses, depreciation of office equipment.

Quick Review: The Cost Path

The costs flow like this:
Direct Costs + Factory Overheads \(\rightarrow\) Cost of Production (Manufacturing Account)
Non-Manufacturing Overheads \(\rightarrow\) Expenses (Statement of Profit or Loss)

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2. Preparing the Manufacturing Account

The Manufacturing Account is not one of the main financial statements (like the SOPL or SOFP). It is a supporting schedule used purely to calculate the total cost of finished goods produced during the period.

The final figure from the Manufacturing Account—the Cost of Production—is then transferred to the trading section of the Statement of Profit or Loss.

2.1 Step 1: Calculating Cost of Raw Materials Used

You must calculate how much raw material was *actually consumed* during the year.

• Opening Inventory of Raw Materials
  Add: Purchases of Raw Materials
  Less: Closing Inventory of Raw Materials
  = Cost of Raw Materials Consumed

2.2 Step 2: Calculating Prime Cost

Add the Direct Labour and Direct Expenses to the Cost of Raw Materials Consumed.

2.3 Step 3: Calculating Total Factory Cost

Add all the Factory Overheads (indirect costs) to the Prime Cost.

Common Mistake Alert!
Only include factory-related expenses here. Do not include office salaries or sales expenses—those go straight to the SOPL.

2.4 Step 4: Adjusting for Work-in-Progress (WIP)

At the start and end of the year, a factory often has incomplete goods. These are called Work-in-Progress (WIP).

• Opening WIP: Costs incurred last year on unfinished goods. We must finish them this year, so we add this cost to the current year’s factory costs.
• Closing WIP: Costs incurred this year on goods that are still unfinished. We can’t sell them yet, so we deduct this cost.

$$ Total \ Cost \ of \ Production = Total \ Factory \ Cost + Opening \ WIP - Closing \ WIP $$

The resulting figure is the Cost of Production (the cost of the finished goods that move out of the factory and into the sales department).

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3. Accounting for Manufacturing Profit (Factory Profit)

Sometimes, a business might operate its manufacturing unit as a separate entity from its trading/selling unit. To assess how efficient the factory is on its own, the factory might sell the finished goods to the trading division at a price that includes a profit mark-up.

This is called transferring goods at factory profit (or charging a transfer price).

3.1 Why Charge Factory Profit?

The syllabus requires you to know the reasons why a business may account for manufacturing profit:

1. Performance Evaluation: It allows management to measure the efficiency and profitability of the manufacturing department separately from the sales department.
2. Realistic Pricing: It helps set internal prices that reflect market conditions, aiding in decision-making (e.g., make-or-buy decisions).

3.2 The Calculation of Factory Profit

The Manufacturing Account calculates the true cost (Cost of Production). If a profit is added, this is shown as an addition in the Manufacturing Account:

$$ Transfer \ Price = Cost \ of \ Production \ (Actual \ Cost) + Factory \ Profit $$

This Transfer Price (Cost of Production PLUS Factory Profit) is the figure that is carried forward to the Statement of Profit or Loss as the 'Purchases' of the trading section.

3.3 The Problem: Unrealised Profit

The Unrealised Profit is the core conceptual challenge here!

Imagine the factory made 100 shirts at a cost of $10 each, and added a 10% mark-up. The trading division "bought" them for $11 each. If the trading division only sells 80 shirts externally, 20 shirts remain in inventory.

The profit of $1 ($11 - $10) on those 20 unsold shirts (total $20) has only been made internally (factory to sales team). According to the Prudence Concept, we cannot count this profit until the goods are sold to an outside customer.

Therefore, we must eliminate the unrealised profit from the unsold finished goods inventory.

Step-by-Step Elimination of Unrealised Profit

1. Determine the Inventory Subject to Mark-up: Identify the value of the Closing Inventory of Finished Goods (at transfer price).
2. Apply the Mark-up Percentage: Use the mark-up rate set by the factory.
3. Calculate the Unrealised Profit (UP):
   If mark-up is 25% on COST:
   \(UP = \text{Closing Inventory} \times \frac{25}{125}\)
   If mark-up is 20% on TRANSFER PRICE:
   \(UP = \text{Closing Inventory} \times \frac{20}{100}\)
4. Adjust the SOPL: The unrealised profit is treated as an expense in the SOPL (usually shown as an adjustment to the Cost of Sales, or as a deduction from Gross Profit).
5. Adjust the SOFP: The Finished Goods inventory in the SOFP must be valued at original cost (not transfer price). This is achieved by deducting the Unrealised Profit from the inventory figure.

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4. Preparing Final Financial Statements

For a manufacturing business, the Statement of Profit or Loss (SOPL) and Statement of Financial Position (SOFP) follow the standard formats, but with specific adjustments relating to the production process.

4.1 Statement of Profit or Loss (SOPL)

The SOPL for a manufacturing business starts with the standard trading section, but the Cost of Goods Available for Sale needs adjustment:

a) The Trading Section

This section replaces the "Purchases" line with the figure transferred from the Manufacturing Account.

• Revenue (Sales)
  Less: Cost of Sales:
  • Opening Inventory of Finished Goods (at transfer price)
  • Add: Cost of Production (at transfer price)
  • Less: Closing Inventory of Finished Goods (at transfer price)
  • = Cost of Goods Sold
• = Gross Profit (This figure now includes the factory profit)

b) Adjusting the Gross Profit (Eliminating Unrealised Profit)

Immediately after calculating Gross Profit, you must adjust for the profit charged internally but not yet earned externally.

• Gross Profit (as calculated above)
• Add/Less: **Adjustment for Provision for Unrealised Profit**

If the provision increases (Closing UP > Opening UP), you deduct the increase from profit.
If the provision decreases (Closing UP < Opening UP), you add the decrease to profit.

• = Adjusted Gross Profit (This is the true profit earned from external sales)

c) The Expense Section

Subtract the non-manufacturing overheads (Selling & Distribution, Administration expenses) to find the Profit for the Year.

Did you know? The depreciation of the delivery vans (Selling overhead) must be kept separate from the depreciation of the factory machinery (Factory overhead)! Location matters!

4.2 Statement of Financial Position (SOFP)

The SOFP is structured identically to that of a sole trader or partnership, but the inventory section is expanded to show the three types of stock.

All assets and liabilities are shown as usual, but under current assets, inventory must be broken down:

Inventory Section (Current Assets)

The syllabus requires inventory to be correctly valued (lower of cost and NRV).

• Raw Materials: Valued at Cost.
• Work-in-Progress (WIP): Valued at Cost (Total Factory Cost incurred so far).
• Finished Goods: Must be valued at the Lower of Cost (Original Factory Cost) or Net Realisable Value. If the goods were transferred at a profit, the valuation must be reduced by the Unrealised Profit (UP) calculated earlier.

Format in SOFP:
Finished Goods (at Transfer Price) \(\mathbf{\$ X}\)
Less: Provision for Unrealised Profit \(\mathbf{(\$ Y)}\)
Finished Goods (at Cost) \(\mathbf{\$ Z}\)